If a startup has an unreasonably high valuation in its F&F round, would Angels and VCs be concerned?
Yes, absolutely. In my experience, that may well be the #1 killer of deals that should otherwise happen.
Consider the math: if the F&F round is $60K for 1%, that means the ‘post investment’ valuation of the company is $6 million. If the company now approaches a professional investor such as a VC, angel group or serious angel, let’s say that this new investor is prepared to put in $400,000. But based on their experience and knowledge of the market, they are only willing to do so at a ‘pre-money’ valuation of $1.2m (that is, they expect to get 25% of the company for their investment.)
This sets up a very uncomfortable situation for the entrepreneur, with only three possible outcomes, none of which are good:
1) Take the money from the new investors, and don’t do anything to the F&F investors. Result: your uncle has just lost 80% of the value of his investment because he had the faith to make a bet on you when you were starting out…and now he feels you cheated him by overstating the value of your venture. How comfortable do you think the next family dinner is going to be?
2) Take the money from the new investors, but retroactively adjust the valuation of the company used for the F&F investors, so that the value of their holdings remains intact (this is technically called “full ratchet anti-dilution protection”.) Result: if the two ends are being held constant, the only place from which to take the ‘make-up value’ is from the pocket of the founder, which means that you personally take 4% of the equity from your share and give it to your uncle (which, added to the 1% he already had, brings him to 5%, which is what his $60K investment *should* have gotten him in the first place.)
3) If the first is too painful and the second too expensive, then you do neither…which means that the new investor walks away, and the company has locked itself into a position from which it will be unable to raise additional financing.
For precisely these reasons it is *highly* advisable to do F&F rounds as Convertible Notes with a 10—20% discount. This leaves valuation to the professional investors, gives the F&F an immediate uptick in the value of their investment, and is efficient and cost-effective from a legal documentation standpoint.
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*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *
Written by David S. Rose
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