As many of you know, my two partners, Luis Villalobos and Frank Martinez, and I are busy raising $100M for our Venture Capital Fund called Angel-Led Venture Partners. We will co-invest this money alongside the leading angel groups in the country into early stage ventures. They are both very sophisticated and experienced investors and company builders. I want to share a few of the articles they've written that will hopefully help those of you who are looking to raise money succeed.
Here is the first one:
Exit Ratios and their Implications for
Venture Investment Valuations
By Luis Villalobos
Angel-Led Venture Partners, Managing Director
Tech Coast Angels, Founder & Board of Governors
Angel Capital Association, Founding Board Member
Negotiating the valuation for a venture-where the valuation is based on the percentage of the venture's equity that an investor receives for some amount of capital-may be the most important and the most misunderstood element in seed, startup, and early-stage investing. Important because valuation directly impacts both the percent of the venture that the entrepreneur gives to the investor and the investor's return on the investment, and because the process of negotiating valuation sets the tone for their entire relationship. Misunderstood because entrepreneurs and investors too often don't recognize, and hence don't take into account, the effect of dilution on the exit value of early round shares.
After doing more than fifty deals over the last twenty years as both an angel and an entrepreneur, I have seen repeatedly that when angels and entrepreneurs understand how valuation works and model what is likely to happen to the valuation of the investors' shares compared to the valuation of the venture as it grows, a better informed and more amicable negotiation ensues. Whereas when the two sides have uninformed views of what happens to investors' share valuation over time, the negotiations can become contentious, and even if an investment is made, the parties start off on a shaky foundation with each side believing the other is greedy or unreasonable.
Is this article for angels or entrepreneurs?
When people in my workshops ask me this question, I always answer "both." Effective investors and good entrepreneurs seek to align their interests. Their common goal is to work together to build an enterprise that produces value for the customers, profits for the venture, opportunity for employees, and financial returns for the entrepreneurs and investors. The discussions that precede the actual negotiation of valuation present an opening for angels to educate and coach, presuming that the angels fully understand valuations. However, at times angels take it for granted that they understand valuations and assume that entrepreneurs also understand when neither one does.
This article steps through the mechanics of valuation with a particular emphasis on the exit valuation for the investors compared to the exit valuation for the venture. We will examine the factors that contribute to the dilution of investor shares using Gadzoox Networks, a real life example, to show how exit ratios provide a more intuitive way to explain the effect of dilution on investor shares
Step 1: Understand that the starting ownership percentage of the investor will be diluted over time.
Angels typically invest in seed, start-up, or early-stage ventures with highly uncertain future earnings. A seed stage venture has a proven concept but little more; a start-up has a product or service under development; and an early-stage venture has a product or service in alpha or beta testing or pilot production and is generally pre-revenue, although some early-stage ventures may have revenue from initial customers.
To attract angel investors, a venture at any of these stages must have the potential to scale their revenue rapidly to $30 to $100 million in three to five years. It takes this sort of hockey stick growth to produce the 5X to 10X return that angels seek for the risk they take.
Angels tend to think of their return in terms of absolute dollars: If they invest $1M in a Series A round they want to see the potential of a $5 to $10 million payback within sixty months or they will invest their money in a different place. Entrepreneurs, on the other hand, tend to think in percentages; they think in terms of raising $1 million in return for some percentage (usually low and sometimes as low as 10 percent) of their company.
Most entrepreneurs accept the reasonableness of an angel having a shot at a 5X to 10X return, but most entrepreneurs also believe that the exit valuation of the enterprise will be the same as the investor's exit valuation. This is the point where negotiations can begin to break down. To keep their discussions on track, the angel needs to help the entrepreneur recognize that if the Series A shares start with 10 percent ownership at the time of investment, they will be worth considerably less than 10 percent of the exit valuation.
Step 2: Forecast the terminal value and the dilution the investors' shares will experience.
The valuation of the venture, immediately after the investment is made, has three components: (1) investor capital; (2) the existing or current value; and (3) the imputed future value of the enterprise, which is usually the dominant component. Component 1 is called the "money," components 2 and 3 together are known as the "pre-money," and the three combined are known as the "post-money."
The current value of the venture takes into account those things that are worth something at the moment and excludes any value the venture may create in the future. Current value consists of items like cash on hand, patents, raw materials, WIP inventory, computers or engineering equipment, and receivables. These items shape and influence the valuation of the venture, but the quality of the management team and the imputed future value of the enterprise, which are expected to have much greater value than the current value of the venture, drive the valuation.
The core step in the valuation process-forecasting the exit value and discounting by the target internal rate of return-is well documented and understood¹. The critical question is what percentage of the imputed future value of the enterprise will the angel's investment actually command at liquidity, and what is the expected absolute dollar value of that portion?
Step 3: Calculate and compare enterprise and investor exit ratios at various valuations to demonstrate dilution effect.
After the angel invests (in Series A in our example), the venture continues to issue additional shares (for subsequent financing, to attract additional senior executives, to expand the employee stock option pool, to compensate directors, consultants, leasing companies, etc). By the time a venture reaches an exit event, these ongoing share issuances have significantly diluted the angel's fractional ownership of the venture.
If the angel started with 30 percent ownership, at exit it may be down to five to ten percent. Exit ratios offer a useful way to understand and explain this effect. Although this example considers a Series A round, the same calculations may be made for any subsequent round.
NOTE: The Relative Exit Ratio is the same as the dilution factor that those investors experience.
The table below demonstrates this dilution effect using actual data from Gadzoox Networks.
Table 1: Investment Rounds in Gadzoox Networks
Round | Angel | VC | SP # 1 | SP # 2 | IPO |
Date | Jan-96 | Sep-96 | May-97 | Sep-98 | Jul-99 |
$/share | 0.74 | 1.80 | 4.78 | 7.65 | 74.81 |
Pre-money ($X million) | 4.6 | 17.0 | 69.4 | 135.1 | 1,766.0 |
Money ($X million) | 2.0 | 8.0 | 10.1 | 21.0 | 73.5 |
Post-money ($X million) | 6.6 | 25.0 | 79.5 | 156.1 | 1,839.5 |
Angel Equity % | 30% | 19% | 16% | 13% | 11% |
Angel Exit Ratio | 101 | | | |
|
Venture Exit Ratio | 279 | | | |
|
Exit Ratio Venture to Angel | 2.8 | | | |
|
The columns represent the data from five funding rounds. In the first round angels invested $2 million and received shares at $.74 per share for 30 percent of the equity. Note how the angel percentage of ownership continues to shrink with subsequent rounds from 30 percent to 11 percent. At the close of the IPO the price per share was $74.81 making the exit ratio for the angels 101 ($74.81 ÷ $.74). At the close of the angel round the venture's valuation was $6.6 million; however, at the close of the IPO the venture's valuation was $1,839,500,000. Therefore, the exit ratio for the venture (keyed to the angel round) was 279 ($1.839 billion ÷ $6.6 million).The Relative Exit Ratio of 2.8 (279 ÷ 101) corresponds directly to a dilution factor of 2.8X, and the angels' ownership percent drops from 30 to 11 percent (30 ÷ 2.8).
The performance of Gadzoox Networks was exceptional both in the valuation of the venture, which grew nearly three-hundred fold, and in the valuation of the shares, which grew slightly more than a hundred fold. Yet even with this spectacular performance of the share price, the relative exit ratio (or dilution) for the angel round, was almost three to one. Even before the IPO, the angel percentage had dropped from 30 percent to 13 percent with a dilution factor already of 2.3 (30 ÷ 13).
While I cannot point to any robust study of dilution factors, experience shows that the range of relative exit ratios (or dilution) is around 3X to 6X from the angel round to the exit for an early stage investment. The relative exit ratio (or dilution) would be even higher for seed or start-up investments.
The key point is that when entrepreneurs calculate what investors will get at liquidity, they focus on the exit valuation of the venture. In the "10% of the company for $1 million" scenario, entrepreneurs are projecting that investors will receive 10% of the exit valuation of the venture when this is almost never the case. Instead, as in our 10% example, the investor can expect to receive 2% to 3% (10% ÷ by 3 to 6).
Step 4: Use the exit ratios to arrive at the entry valuation.
As experience and the Gadzoox Networks example illustrate, venture investors who are seeking a 5X to 10X return can reasonably expect their early stage investment to be diluted by a factor of 3X to 6X as the number of shares in the venture increases. Those that understand the dilution effect can educate the entrepreneurs and negotiate a valuation that is mutually agreeable. Investors who don't understand the dilution effect, but know from experience that they cannot realistically expect a 5X to 10X return if they use the venture's exit valuation, instinctively bargain for a higher return multiple (20X) or aggressively curtail the entrepreneur's projections (and hence reduce the projected venture's exit valuation). In either case, the relationship gets off on the wrong foot-if any investment is made at all--because the entrepreneur may view a 20X target return as excessive or may feel that the investor is unreasonably cutting down the revenue projections.
Step 5: Dilution is the currency and natural consequence of rapid and successful growth.
Frequently the entrepreneur, whose viewpoint is often colored by inexperience, insists that once the venture receives first round funding the expanding business will generate all the cash they need to grow. Angel investors know that most ventures lose money for the first couple of years, and even if a venture is immediately profitable, it is virtually impossible to grow revenues to $30 million to $100 million in three to five years without substantial infusions of cash.
To create a framework for this discussion, lay out a capital plan for the venture. Model the entrepreneur's vision, and then add what is likely to happen in real life. Use balance sheets and expense projections to model cash flow projections, and don't forget to include development costs, capital equipment and other items that are capitalized-capitalized expenses can result in a company that shows profits but consumes cash. Calculate the increase in distribution and marketing costs as sales and revenue climb. A venture that has almost zero cost of sales, no receivables, and no inventory will still need cash balances and reserves.
Even if the entrepreneur can make a convincing case that accelerated revenue and rapid turns on their accounts receivable will offset the need for cash, you still must account for how much equity will be issued to attract and reward key employees, to compensate directors, advisors, consultants, to pay for equipment from leasing companies, or to obtain credit lines from banks. Non-investment dilution will occur as it is in neither angels' nor entrepreneurs' best interest to short change on options and hire inferior executive or employees just to save on equity.
Table 2 separates the dilution that resulted from additional financing from non-funding dilution for Gadzoox Networks. The total funding dilution was almost twice the non-funding dilution.
Table 2: Funding and Non-funding Dilution for Gadzoox Networks.
Round | Angel | VC | SP # 1 | SP # 2 | IPO | TOTAL |
Date | Jan-96 | Sep-96 | May-97 | Sep-98 | Jul-99 | |
$/share | 0.74 | 1.80 | 4.78 | 7.65 | 74.81 | |
Non-money shares | | 0.5 | 0.6 | 1.0 | 3.2 | 5.4 |
Shares pre | 6.2 | 9.4 | 14.5 | 17.7 | 23.6 | |
Money shares | 2.7 | 4.4 | 2.1 | 2.7 | 1.0 | 10.3 |
Shares post | 8.9 | 13.9 | 16.6 | 20.4 | 24.6 | |
Conclusion: A common understanding of valuation and exit ratios produces smoother negotiations and can be instrumental in building a constructive relationship between investors and entrepreneurs.
Investing isn't like heads-up hold-em poker where each player withholds information from the other and each tries to convince the other that they have a better hand than they actually do. Quite the opposite, in investing the objective is for both sides to share information as completely as possible, and then work together toward their shared goal of building a very successful company.
Strong angels know the finance and investment process and have extensive operating experience. As they create the environment for joint discussion, entrepreneurs have the opportunity to reciprocate by educating investors on their technology and markets. Both sides are able to go beyond the jargon and understand the business at a deeper level and become better able to recognize the value each brings. When a relationship starts this way, good things happen even when things hit a rough patch.
Not too long ago, one of TechCoast Angels' ventures was forced to do a down-round. The CEO and founder was so appreciative of the value he had received from TCA, that instead of a ‘washout' round, he set it up so that a 20 percent investment in the down-round protected the entire position from earlier rounds. Our shares weren't washed out; the company turned around and was sold. Those of us who invested in both rounds made a good return.
When the relationship between angel and entrepreneur is rooted in common understanding and mutual trust, the angel can offer useful advice, which the entrepreneur is tuned to accept. The angels and entrepreneurs are in alignment, and once the deal is funded they can work together to build a great venture and share in the rewards.
NOTES
¹A Method of Valuing High Risk, Long-Term Investments, The "Venture Capital Method"; Harvard Business School, HBS 9-288-006.
Luis Villalobos conducts workshops on valuation and related subjects. This material is protected by copyright and is extracted from a book that he will be publishing this fall and may not be copied or distributed without his express prior written permission. ACA and the Kauffman Foundation have invluded this article in the ACA newsletter with the author's permission. You can reach the author at www.angel-led.com.
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leadership
February 2007 
Kelly
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