Earlier in the week, one of the entrepreneur members of the Amplifier Network reached out to me for some advice.  He had an “angel” investor who was ready to invest some money in his company.  He wondered how to structure the deal so that it would be appealing to a professional investor, or at least wouldn’t discourage an investment by an institutional investor.  As I spoke with him I realized (much to my surprise – well, not really) that I had some strong opinions on how he should structure his deal.  So, as we ended our call, and he went off to do his deal, my parting comment was that I was going to do a blog entry on our conversation.  Names won’t be used, to protect the innocent: we’ll call him “George” here.

Anyway, George started the conversation by saying that he and his investor had agreed to an equity investment, and that they needed some guidance on valuation.  That was a reasonable enough request, but it was really not as simple as he was hoping.  Merely providing guidance on valuation wouldn’t solve George’s problem, it would, in fact create more issues.

Here’s the basic issue: if you sell equity in a company, you must value the business.  This has two major implications. 

Firstly, if you attempt to value a business without professional input (i.e., from a professional investor) you run a serious risk of not getting the valuation “right” when you later approach professional investors.  As I have mentioned in an earlier blogs, venture valuation is a process that is arcane, and usually VCs value a business below where an entrepreneur will.  This matters because if you sell equity to an angel and then a subsequent professional investor determines to invest at a lower valuation you have a real problem on your hands.  It’s just not a good thing when an angel investor finds out that the stock he paid $1 per share for is only worth $.25 to the professional investor. 

You might say, well, that’s just a market. But, the reality is that no professional investor happily goes into a situation where earlier investors are going to be unhappy.  It often ends badly.  Perhaps your reaction to this is to say, “sure, but couldn’t the entrepreneur get the valuation wrong on the downside?”  That’s possible, but it’s just not the way human nature seems to work with start ups.

Secondly, if you value your equity by selling some to an investor, it then becomes practically impossible for you to provide equity to others at a lower price (i.e., your option grant price, or the value of stock you give to other founders or employees, has to approximate the value of the stock paid by your investor).   One of the most valuable things an entrepreneur can provide to early stake holders is “cheap” equity – indeed often that is the best currency he has.  So, doing anything to make a start up’s equity more expensive, should be undertaken very carefully.

So, after I told him all this in answer to his seemingly simple question, George asked, perhaps more patiently than I might have, “so if I can’t sell stock, what should I do?”  Here’s what I told him:

If you are going to raise money from non professional investors, your default position should be to structure deals that postpone valuation as long as possible.  How do you do that?  By issuing debt instead of equity.  Borrow the money.  Well, that was easy….. so obvious.  Of course, it’s a little more complicated than that.

People invest in start ups, particularly in the early stages because they want a high return possibility – 50 to 75% per year (that’s the equivalent of an interest rate of 50 to 75%). Well, who wants to pay that much interest? And, more to the point, what start up can afford it? So, if an investor wants a start up rate of return for his investment (which, by the way, he is generally entitled to for the risk he is taking by financing an early stage business where the risk of business failure is large), the only way an entrepreneur can provide it is to sell equity, because in equity substantially all the return is generated by the difference between the purchase price and the ultimate sale price.  Remember – “buy low, sell high.”

So, an angel investor should want equity, and indeed that is what he should get.  What the entrepreneur should do, however, is postpone the valuation of his company until it can be done by a professional investor as part of a professional financing.  However, George needed money now so what to do?

Do a convertible debt deal that has the following terms:

• A market interest rate.
• A maturity date some reasonable period of time in the future, say a year.
• An obligation on the part of the investor to convert the note into the first equity investment priced by a professional investor (usually referred to as the “first institutional financing”).
• Provide that the investor gets an economic advantage for basically pre purchasing the equity offered in the first institutional financing.  There are many ways to do this – the most customary being to provide the angel with a “discounted” purchase price for the equity obtained in the conversion.

The point of this structure is that it provides the earlier angel investor with two economic advantages: (i) the ability to participate in a professionally structured investment downstream, an investment opportunity that might otherwise not be available to the angel investor and (ii) a better purchase price in the round than the professional investors.