Startup Funding - Startup Valuation at the Friends and Family Round
For most startups, the Friends and Family financing is essential to get the company started. Unfortunately, most people who invest in Friends and Family financings probably shouldn't. Most just don't have the expertise to know if the structure, terms or valuation are reasonable.
One of the most common ways Friends and Family financings are not fair to the investors is over-valuation.
Why the Entrepreneurs Make This Mistake
The biggest reason entrepreneurs wind up treating their friends and family unfairly is that they just don't realize they are doing it. And they are entrepreneurs, so being wildly optimistic is an essential ingredient for success.
It also feels good. The psychology goes something like: "I have 2,000,000 shares and somebody just paid $0.50 per share, so I am already a millionaire."
A headache for Angel Investors
Over-valuation is one of the most common structural problems angel investors encounter. Angels often have to spend tens, or even hundreds, of hours to rectify the problem before they can invest. Many angels who have done this once swear they will never do it again, so they just walk away.
The only way to correct an over-valuation is to reallocate the equity in the company so everyone ends up with a number of shares they should have owned if the Friends and Family investors had invested at a fair valuation. In other words, the entrepreneurs and startup employees effectively 'give' some of their shares to the Friends and Family round investors. This sounds easy, but it's not - there are enormous legal, tax and psychological hurdles that have to be overcome to rectify an over-valuation.
Why over-valuation is difficult to fix later
Securities regulations are designed to protect shareholders - especially minority shareholders. The process of re-balancing the equity allocation after an investment has closed is exactly the type of thing the regulations were intended to prevent.
Psychology is often a significant factor because founders and startup employees are often not very sophisticated about securities laws and early stage financing challenges. Even worse, the people they get their advice from, like their uncle the accountant who does tax work for a resource company or their friend who is a lawyer practicing family law, may think something nefarious is going on and recommend trying to block or otherwise resist the process.
The tax ramifications of repairing an over-valuation error are also a huge nightmare.
So What Is a Fair Valuation?
There really isn't any objective way to do a fair startup valuation. These days, angels most often invest at pre-money valuations between $1 and 3 million dollars. The angels are often investing after the company has deployed the Friends and Family investment to achieve some significant milestones. This puts a pre-money valuation ceiling on the Friends and Family valuation in the range of $250k to $1 million.
That is still a pretty broad range. If it was any other round than a Friends and Family round, the best way to determine the final value would be to let the 'market decide' by seeing what investors would actually pay. But that won't work here because friends and family investors don't have the experience to know what's fair. The best way to get to a final number is to ask an experienced, active angel investor. If you can find a few angels you can ask, even better.
Of course, there are always special cases. The most likely is when a valuable asset has been vended into the startup. The most common example would be a patent portfolio or web property with established traffic.
A good valuation test
If someone actually offered you a $500,000 cash to buy all of your startup, would you take it? How about a quarter million? How about $100,000? Yes, it's exactly the same valuation as when someone invests. That test often helps an entrepreneur put a realistic valuation on their startup.
Being Fair and Equitable
There are many reasons why it's essential to be fair and equitable at every round of financing. And these, after all, are our friends and family.