Raising Angel Funding #2: Money

Through the law suits I've been involved in over the last couple years, I have become privy to documents that I otherwise would not likely see.  In them I've seen what people--many of them investors--have written about me when they didn't think I would see it.  In some cases it is humbling, in others sobering.

At the end of the day, I am reminded that investing in a startup company is a financial transaction.  Yes, they must believe in you.  Yes, they must think that your technology hung the moon.  Yes, the team, and the market, and the product all have to be perfect.  But in addition, the numbers have to line up.  Here are some very practical tips that, if there were not so much hanging on them, would otherwise be quite boring.

Market

The market has to be big and growing.  At the end of the funnel, after everything is eliminated that isn't immediately accessible, it should still be at least a billion dollars within five years.  Fast growth would be near 20% annually, and really you shouldn't consider anything that is growing less than 10-12% annually, unless it is really big and there is a huge differentiation.

Margin

Worst case near term margins for a startup product need to be 50%.  Large volume, distant-case gross margins should be in the 60-80% range.  Higher than that, and the price should be lowered to gain market share (assuming some elasticity). Lower than that, and high value niches willing to pay a premium need to be found (and the market size reduced accordingly).  (Business professors and textbook authors who have never had to make payroll may not advise this pricing, and I encourage you to listen to them if you also have the luxury of not having to make payroll.)

Valuation

There are a thousand ways to value your business, very few of which have any meaning.  Here are a couple:

• Discounted cash flows of future revenues:  These work fine for established businesses with modest incremental changes every year.  If revenues are going to grow 4% next year, use this method.  If they are "going" to grow 40%, or 400%, then this method is meaningless.  Anything can happen and trying to account for the risk with huge discount rates is a nice mathematical exercise, but nothing more.
• Net present value of a future buy-out:  Again, if business is growing 4% for the next five years, these can be relied upon.  For fast growing businesses, the connection between the model and what is actually going to happen is not solid enough, and again applying high discount rates increases the uncertainty of the model to the point where the uncertainty is higher than the value. 

(Remember, you are reading the blog of an experimental physicist, not a business professor.  When the uncertainty is larger than the value measured, the value itself becomes meaningless.  If you are trying to estimate the value of a buy-out in ten years and don't know whether to apply a 15%, 25% or 50% discount rate, I can assure you the uncertainty is more than the value.)

You can pay $25-50,000 for someone to do a fancy valuation of your business based on one of these meaningless bits of calculus.  You could also spend $50 on EZNumbers (www.eznumbers.com) and do it yourself.  Doing it yourself, you will find how easily an assumption can be changed by a smidge, and the "value" of your company increased by $50 million.

A calculator that has a firm foot in reality is this one, if used with sober assessments:  http://www.caycon.com/valuation.php  Using this for Dreamweaver, I get a valuation of $7-8 million, and $10-13 million for a slightly more aggressive assumptions.

One that gives meaningless high valuations based with no care to the dynamics of the marketplace is this one:  https://www.equitynet.com/crowdfunding-tools/startup-valuation-calculator.aspx  With it, Dreamweaver has a classroom-defensible valuation of over $35 million.  (For those of you who do not know, Dreamweaver is at the cusp of revenues with a developed, producable, patented product portfolio, but otherwise still a startup.)

Some rules of thumb for an advanced materials startup:

• Keep it in single digits for pre-revenue companies.  If the value gets above $10 million before significant revenues are achieved, the likelihood of a down-round becomes extraordinarily high.  If the valuation stays low, there is always room to inch it up in the next round. One down-round can be far more devastating than several very marginal up-rounds.
• Keep it below $5 million until there is a fully validated, fully producable product.  For the same reasons, until customers are far advanced in their evaluations and the product has been made at a scale that could be commercial (even if you have aspirations for larger scale), keep the valuation below or at $5 million.
• Keep it below $3 million for a technology that works in the lab, but has not yet been proven with customers in their applications. This again gives room for advancing the valuation based on milestones.

You'll find that these fit with the Cayman Consulting valuations, but CC takes into account several other factors.

Company Structure

Use an LLC until all of the money put in by active partners/investors has been used up.  This gives them large immediate tax breaks that can offset this investment.  After that, switch to a Delaware C-Corp, and use Delaware or New York state laws for as many of your contracts as you can.

Investment Structure

For the first round of Angel investment into the C-corp, use the documents at www.seriesseed.com.  They are preferred shares with rights that go down the middle of the fairway, and allow you to set up the company and an investment round for under $5,000.

After that, it gets more complicated.  Any group that is going to put in more than $1-2 million will want a more robust set of investment docs like those from the National Venture Capital Association.  These might cost you $25,000 to put into place, or half that if there is not too much dickering.  Under no circumstances take money from one of the many criminals who "demand" participating preferred shares.  This is robbery in a pinstripe suit.

Only use a bridge round if you are near to closing with a large investor.  I bat about 50% once we are "near to closing," and I'm told this is not out of the ordinary, so there is still a lot of risk.  For these rounds, use convertible debt with a 20% discount to the valuation of the round, 10% interest, and otherwise all of the rights and privileges that will come with the new shares. Make the debt uncollectible for 2 years, with an automatic conversion after any significant investment, even if it is much smaller than the one that you are "near to closing."

Investment Size

Never take more money than you expect to spend in the next two years.  It will help you develop bad habits that otherwise will be hard to get rid of.  Also, never seek less than what you need for the next six months.  If you do, you are ensuring that you will spend all of your time raising money, and have no chance to hit the milestones that are critically important to raising the value before the next round.

Investors

Above all else, seek investors with high integrity who understand both you and your business.  I have taken investment from people who fit that description, and also from those who did not.  It is difficult to remember in the frenzy of a closing, but the wrong investors can trash a perfectly good company that otherwise would succeed, and the right investors can help make valuable a company that otherwise might not get more than a few feet off the ground.

Here are some rules of thumb:

• Never, ever take more than 2-3% of someone's net worth.  You must confirm this in person with everyone, and watch their eyes to make sure they are not bluffing.  No one who would invest more than that into a single startup is smart enough to be your business partner.
• For people investing more than $250,000, meet their spouse or business partner.  You want to know them and know their context.  No matter their net worth, this is a serious investment, and you should be prepared to have a serious relationship with this investor.  Also have your spouse or business partner meet them as well.
• Seek business people:  Yes, there are people with generational money who have no real idea where it came from or how to replace it when it is gone.  They will not understand your business, and they are far more likely to give bad advice and insist that you take it. People who understand business may be more difficult to close, but worth the effort in the long run.

In Closing

These guidelines apply primarily to advanced materials startups seeking money from individuals.  Over the course of the last nine years, I have had the privilege of meeting a great number of individuals who considered investing in one of the companies I was running, and I frankly love the dynamic, the relationships I am able to build, the advice and coaching that I get, and the genuine care and concern that (most of) these people have had for me as an individual as well as for the company they invested in.  Coming through for them is a huge motivator for me--much more so than any personal wealth could be.