Approaching investors for that crucial first round of funding can confound even the most intrepid entrepreneur. How can you sell them on your idea? How do you close the deal? A big part of getting the right answers to those questions lies in knowing what the angels on the other side of the table are thinking and the potential promise — and pitfalls — of the deal to come.
The looming question that plagues early-stage investors is how to value a business that’s not yet a business. Putting up the initial funding for a venture is always a risky proposition. The normal indicators of value — revenues, customers, cash flow, and (some day?) net profits — lie far in the future. So angels look to other indicia when a promising startup is raising seed money. The more areas in which you can assuage an angel’s fears, the closer you will be to getting the funding you need.
Investors always focus on management. A good track record with other startups will help your cause. So will strong experience from other business endeavors, but the people with the money are also looking for softer assets that are difficult to quantify. Leadership, energy, salesmanship, and charisma are all under scrutiny — the more you can bring to your pitch, the better.
When it comes to evaluating actual business plans, investors take various routes. Some try to create a complex cash flow analysis, plugging in your projections, factoring in the inherent risk, and coming up with a number. Others check out how the market is valuing startups, surveying to see what other angels are giving to seed-round ventures.
While both of those techniques seem precise, neither works particularly well. The discounted cash flow analysis hasn’t proven reliable, and the survey approach is severely limited by the resources of the investors and entrepreneurs. Reliable statistics on what the market is doing are few and far between. Professional investors with a number of deals in front of them can gauge the market fairly well, but in the angel round of funding the pros often hold back, waiting to see how the company gets along with money from smaller investors.
Given the risk, many sophisticated advisors tell angels and entrepreneurs to postpone the valuation decision until the first professional (Series A) round is closed. A typical structure entails a bridge loan which is convertible into stock at a later date, and at a value to be determined by the Series A round (usually discounted off the hypothetical Series A round price by 20% -30%). If the entrepreneur fails to close Series A funding by a certain date, then the angels get stock at a very favorable price.
This kind of deal will punish an entrepreneur who doesn’t deliver the next round of funding, but the pain does have its limits. Investors aren’t generally allowed to call the loan and demand payment.
Remember, from an angel’s eye-view, that seed-round investing is essentially a throw of the dice — and a bridge loan offers some small harbor against potential storms. Still, a such a deal pushes a lot of the risk back on the entrepreneur, something to consider long before you ascend to the angel round.
Find out more about Joseph Bartlett and venture capital at VC Experts.