There is an inherent tension in a negotiation between a founder and an investor. An experienced investor knows this. Even an inexperienced investor knows this. Anybody who has ever been asked to provide money in exchange for an intangible – or tangible asset – knows this. An experienced founder knows this, if only by once being an inexperienced founder.
An inexperienced Founder may or not know this. If you have never been in such a negotiation before you are by definition inexperienced. But, stay with me here, you too are about know this.
The investor, a good, serially, successful venture capitalist that has weathered the harvest of his first round of harvests and is busily valuing the seconds of a subsequent season, preferably one that has weathered at least one business cycle, has an equation in his head. It’s a simple one. It’s 10X.
That is, he invests in companies that each have a potential return of 10 times his investment.
When you’re shopping your business plan, you’ll meet a lot of people that will offer to help you find money. You’ll meet more people that will offer help than will offer money. I’d say for every 100 people you pitch, 80 won’t be interested at all. 20 may give you a hearing. Only one of those will offer to help. You’ll meet 20 of those helpers before you get your first real pitch. (Your mileage will vary and improve to the extent that you take a more targeted, 80/20 approach, and be prepared. Reserve your pitch for the right people: customers before investors before helpers, though you’ll need all three.)
But here’s the tension. You as the Founder think the idea is worth Y. How you arrived at Y is an important issue. We’ll come back to that. For now, Y is a given. And, you’re prepared to give up some portion of your company to help get it to Y.
After some thousand pitches, emails, phone calls, meet-n-greets, and assorted growth hacking events – you finally meet, possibly, the right investor. She likes your idea.
The tension begins. One of two things can happen. X = Y, X > Y or X < Y. If X equals Y, she still needs 10X to be happy. She’ll want all of your company or as close to it as possible. She’ll begin to work on you, explaining all the – very real – hurdles you have that can only be solved with her and her money. She looks at you as though she were a mentor-in-waiting and suggests that you take her offer. The hurdles are real. That you need the money is probably real. That you need her specifically, is debatable. Still, you have tension. It is subject to negotiation. That’s the point. The better armed you are, the better. The better information you have the better. The more it looks like you know what you’re doing, the better. (This is where helpers can actually be a big help!). And this is where an excellent financial model can be of decisive help.
If X < Y, then you have lots of tension. Probably insurmountable tension. Her insistence on 10X means extraordinary costly dilution (particularly in terms of operational control). An interesting thing happens when X > Y. The thing is you won’t know this unless she tells you. If X > Y, she may be more likely to sign up for an investment closer to what you wanted in terms of percentage of shares without really calling your attention to it.
Which do you think more likely? That she tells you that she values the company higher than you or that she appears to be conciliatory and asks for minor concessions, like board control?
Here’s a rule of thumb. If you prefer, it’s a hypothesis to test. If the investor agrees to invest X, she may think that she can get at least 10X – from her share. She may be wrong but if, say, X represents 50% of the shares, then she thinks the company is or could be worth not 10X but 10X / .5 (10X*2) – 20X. Test that for yourself.
The point is that these valuations are part educated guess and part negotiation. If you go into valuation negotiations thinking that these are merely valuation discussions, you’ll lose the negotiation.
Be prepared. Have a financial model. Show your assumptions. Test your assumptions.