Negotiating Early Stage Investments - 07/17/2008

We have been looking at the primary stages of early stage angel investing, as categorized in the book in Winning Angels: The 7 Fundamentals of Early Stage Investing, by David Amis and Howard Stevenson.

The 7 Fundamentals of Early Stage Investing

In prior posts, we have sourced and evaluated suitable investments, valued them, selected and structured a deal the way we want it, and set some initial terms. So now the question comes up, how hard should we negotiate before cutting the check? This is a question to which there seems no easy answer.

According to the authors, many angels do not negotiate. They take the terms as presented, or don’t invest. Others will set their required terms and tell the entrepreneur it is a “take it or leave it” situation, with a time limit to decide. Others negotiate directly, especially on valuation, and feel this is the most important single factor in maximizing their chances of a high payout later if the company is successful. Some use the negotiating process as a “test” for the entrepreneur, to see how well they can work together on a difficult issue. Finally, many others will negotiate, but never directly, always through an attorney or other 3rd party so that bad blood is not created between the investor and entrepreneur.

It seems negotiating may be a personal style issue more than anything else. With that said the risk of creating an adversarial relationship through a tough negotiation seems like a real one, and care must be taken to keep negotiations based as much as possible on facts. Unfortunately, good facts, especially with regards to early stage valuation, are hard to come by – valuation is almost always subjective.

Recently, with on-line software such as Angelsoft (www.angelsoft.net), there is a growing library of comparables that can be referenced. Our angel group and many others across the country (and increasingly internationally) use this tool to manage the process of deal-flow, and as a result, good libraries of deals build up after a period of time. When I use the software, I can look at the history of deals we have seen in our group, which typically include pre-money valuation expectations, and even reference open deals that are available to any investor within the Angelsoft system. Best of all, the system is free to use. Angelsoft states on their site (http://www.angelsoft.net/free.html) that their business model is based on consolidating anonymous data from the angel investment market and later selling that data.

In addition to seeking appropriate reference data points for negotiating, external circumstances will also play a big part in determining whether a negotiation is appropriate. For a well-known investor with a history of successes, and a regular stream of deals on a week-to-week basis, I am sure “take or leave it” would work just fine. For a fairly new investor looking at fewer deals, allowing for some negotiation to get a deal done on terms acceptable to everyone would seem like a worthwhile investment of time. Sometimes you like a deal, but feel it is priced wrong and need to assess how willing the founders are to move on that point. From my perspective, I see no harm in expecting to negotiate on terms and even on valuation. If the investor expects to be actively involved in the enterprise, a 3rd party may help everyone keep things non-personal.

The experience of the entrepreneur or their counsel may also be a factor. If the company CEO has done four successful startups in the past 10 years, chances are they know the valuation they are seeking and have good reasons to justify it. Negotiate at your own risk: the CEO has good reason to demand a premium if there is a good chance they can do it again. Alternatively, experienced counsel may already know the appropriate valuation range for the company. Whatever the number is, it is more than appropriate for the CEO to be asked to support the requested valuation as part of the process.

Valuation and negotiation are also likely to be a factor in follow-on investments; something not covered in the book. When a company runs into trouble, they will often come back to the existing investors to seek further support. Obviously, if a company is not meeting its goals and returns to the investors for more money, there is likely to be some significant negotiation involved. From the investment perspective, the most important decision will first be whether or not to provide further funding at all. When you have some time, and are not too sleepy already, it is worth reading an interesting study on venture capital and how prior investments cause a significant bias when considering whether to invest further (http://www.huizenga.nova.edu/jame/escalation.htm). The basic point is that you should ignore your prior investment when making the new decision, because it is irreversible. But in practice, individuals will tend to “put good money after bad” in an attempt to avoid admitting failure or accepting total loss of the prior investment.

In my experience, I try to set parameters up-front regarding what I think reasonable terms are for an investment and if I cannot achieve them I am prepared to walk away. I believe most software deals brought to angels by a new executive/founder team with a limited track record, a basic product in place (or at least an advanced prototype), and ideally at least some revenue or customers would be in the 1-2M range. If valuation is way off that, I will usually not engage.

In closing the discussion on negotiation, here is some important advice for the company founders: it will take a lot of time to raise money from angels, so start as early as you can. The process of negotiating and reaching a decision can take many months. It may be better to approach investors prior to hitting a key milestone, such as a product release or key customer win, so that a valuation and decision point can be placed on hitting that milestone (e.g. invest 200k at a valuation of 1M when we get our first software license order). Remember that a small company running out of money is never in a very strong position to negotiate.

7 Responses to “Negotiating Early Stage Investments”

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