Last night we were talking about getting angel investment, and valuation, which is one of if not the most important points in the discussion. Valuation is essentially price.

Say you want to bring in $150,000 from an angel investor. The immediate question from the investor will be something like: “at what valuation?” Sometimes that’s called “pre-money valuation,” because the instant the deal happens the valuation will change into post-money valuation, which is always higher — because your company just got some new cash.

Your answer sets your deal equivalent of an asking price. If you say $500,000, then you’re offering the investor 30% of your company for $150,000. If you say $300,000, you’re offering 50%. If you say $1 million, then you’re only offering 15%.

Which leads to the question:

So how do I know? How do I set valuation appropriately? What is that based on? Is it some multiple of sales, or intellectual property, or what?

And that’s a good question, and very hard to answer. Sure, you want some compromise between what you want to give, as a percent of ownership in your company, and what investors would want to buy. Investors will simply say no if it’s not an attractive offer. But that’s still very vague.

• In the case of an existing business, with some history, you do have some formulas you can use. For a great site on that business interpretation of valuation, for existing busineses, I suggest bizequity.com, the zillo of small business.
• When we’re talking about startups, however, you don’t have history and you can’t really apply formulas based on sales, or revenue, or even intellectual property (although that could be more relevant).

So here’s my concrete suggestion:

1. Calculate starting costs. That’s two lists, the expenses you have to incur and the assets you have to have at the starting point — except cash. Leave that blank for a bit.  Add those all-except for cash assets to the starting costs, to get an amount, a number in dollars.  Click here for a lot more on that.  

   So, for example, in the illustration here, that would be about $40,000. Yes, I know it says $38,750, but this is just an estimated guess; always round up. You never guess just right.  

2. Calculate cash flow through the lean period at the beginning, before your sales cover your costs.  Make a good guess at how much money you need to cover the deficit spending to get you to an operational month-by-month break even level of cash. That’s where the cash requirement number in the illustration came from: it seemed like this company would need about $400,000 to survive from startup to break-even.  You can’t see much in the chart below, because it’s small, but it shows a projected 12 months of cash flow (in blue) with a minimum balance, a deficit (in red), of about $400,000.

   

3. That gives you a number. In this case, it’s $400,000. That’s what your cash flow shows you you’ll need to get to cash-flow break-even. In the last two months, the cash flow is positive, so the negative balance starts shrinking. With that estimate as a best guess, you go back into your startup costs calculation, and add in the cash required. It’s $400,000. You can see what that does to the startup costs worksheet in the next illustration here.
4. Having done that, you now know that you need about $500,000 from investors (again, technically it’s $458,750, but you’re using best-guess estimates, so round up.) Set that as the amount of investment you’re seeking. Then — and here it gets hard, to be sure — you need to decide how much of your company you’re going to offer to an investor in exchange for that $500,000.

5. Get some help here if you can. Ask somebody with experience in startups, or dealing with angel investors, or both. Ask an attorney you can trust, who should also be somebody with experience. The thing is, how much of your company you offer to investors is about a compromise between what you’d like — none, free money — and what will entice the investors to write checks.

   At this point a lot depends on your overall business offering, the cards your company brings to the table. Investors want as high return as possible, with as little risk, but in relation to return. How experienced is your team? How defensible is your product? How rich is the market? All these factors determine what kind of a deal will be acceptable to investors.

   • Let’s say, in this case, you’re new at startups, you have very little track record, and you want to attract an active angel investor as a partner. So maybe you set your initial valuation at $750K, meaning you’re offering to give away 2/3 of your ownership to get the money you need. You’re being realistic about what will attract an investor. You better really, really, like that investor, because he or she will essentially own your company. But this is a hypothetical case, and without a lot of experience and defensibility, that may be the best you can do.
   • Or maybe you’ve got better cards to play: you’ve got a team with startup experience, and a defensible new product, with some intellectual property, and it looks like an attractive market. That makes you able to set a stronger valuation, and maybe — we hope — still make it an attractive offer to investors. So maybe you say you’re valuing it at $1.5 million. You’re offering investors one third of your company for $500K.

So there’s a quick and (I hope) simple summary of how you set the initial (pre-money) valuation when you want to attract investment.

Asking for business capital from people you know is very different from putting in a loan application at the bank. The good news is that you already have a personal relationship, so chances are they won’t run a credit check or ask you to put up your home as collateral, and may even give you a good deal with a low interest rate. The bad news is that the whole process – from asking to repaying – can be emotionally charged and an administrative hassle.

Here are the Top 10 Tips on how to navigate these potentially rough waters to access the capital you need:

1. Look for entrepreneurs. Seek an older, wealthy individual who has been or still is an entrepreneur. Studies show that these folks are most likely to make informal loans and investments in the businesses of people they know.
2. Pay close attention to the personal relationship. Don’t ask for money from people who can’t afford to lose it — such as those on a limited, fixed income — especially if you know they’ll have a hard time saying no to you. Also, be sure you’ll both feel OK about it when you owe this person money. Trust your gut and don’t take money from someone who will be a thorn in your side.
3. Be prepared. Have a business plan ready. Grandma Rose deserves a good description of how you plan to use the money, as well as when and how you will repay her. Decide in advance of the request how much you need, what interest rate you’ll pay, and what kind of repayment plan and security you can offer.
4. Use email to introduce your business idea. Email is a great way to cast a wide net, gently and informally. Describe your concept and invite anyone interested to contact you for your business plan. Follow up with those folks, discuss your need for capital, and ask if they have any suggestions on how to raise it.
5. Ask for advice. If it’s too hard or awkward to ask for money directly, ask for advice. Explain what you’re trying to do, describe what you need and ask for suggestions on how to accomplish your goals. You’ll be surprised at how many of these conversations actually end with an offer of financial support.
6. Suggest a range, instead of a fixed amount. When you finally start talking about money, let your supporter decide the amount by providing the range needed. If you don’t feel comfortable using a range, suggest up to three options.
7. Offer a competitive return. Offer an interest rate that is better than what the person could earn in a similar-term financial investment. For example, if the return on a 5-yr CD is 4.5%, offer 7% to really grab their attention. Chances are, you would have to pay 8 or 9% to borrow from a financial institution, or more on your credit card, so it’s still a good deal for you.
8. Make the request informal. If you make the request in person, be yourself, describe your business and your passion for it, describe your fundraising effort and gauge their interest. Indicate why you thought of them in particular. But don’t confuse informal with unprepared. Show the person that you’re prepared with a business plan, and have ready the financing options you hope they’ll consider.
9. Make the agreement formal. The secret to successful private lending is to treat the agreement you reach the way you would if it were with a stranger. If it’s a gift, you only need a letter from the giver. If it’s a loan, you need a promissory note signed by the borrower and a plan for repayment. If it’s an equity investment, you need a stock purchase agreement. When you formalize the agreement, both parties feel more confident because expectations are clear and both parties’ interests protected.
10. Offer to have the loan managed by a professional. Companies like CircleLending can formalize and manage your private loan, all the way down to sending you an email to remind you that monthly electronic funds transfer from your bank account to your lender’s is about to occur. Having a third party creates a neutral buffer to handle the business of the loan, allowing you to keep it arm’s length from the personal relationship.

You’ve developed a plan and submitted it to investors. You’re comfortable with the plan and the submissions process. Several investors have declined. Now what?

The investment process works as a filter, sorting business plans, pushing some to the top and others out of the way. This filtering process is a good thing for many entrepreneurs who have the sense to listen to it. If the investment community doesn’t invest in a plan, there may well be some very good reasons why not. Sure, there are exceptions, people who made their own way despite rejections and hit it big. However, there are a lot more cases of people who didn’t listen to investors and pushed their plan anyhow, borrowing too much money, investing funds of friends and family, and ending up in failure. Think it over:

1. Try to identify the reasons for rejection. One rejection means nothing, but a collection of rejections is significant:

• You may not be getting good feedback. Investors have no legal obligation to tell you the truth.
• Is your team as good as you say? Do the investors agree?
• Are your assumptions believable? Are investors not believing the huge growth rate and return you have in your plan?
• Are you taking too much, or asking too much?

2. Think about this business idea. The investor community reviewed your plan and doesn’t want to invest. Maybe this isn’t such a great business plan, or even such a great business.

3. Maybe they’re doing you a favor. Take the investment community as a group of well-trained professionals, and then reflect on your rejections. If all of these people chose not to invest in your plan, maybe it isn’t such a great idea after all. Maybe you should completely revise your plan. Or, stick to your day job.

4. Don’t insist on failing. You have a series of experts sending you a warning. Listen to that warning. They aren’t all that stupid.

If I could make a point with budding entrepreneurs, it would be that you should know what money you need and understand that it is at risk. Don’t bet money you can’t afford to lose. I’ll always remember a talk I had with a man who had spent 15 years trying to make his sailboat manufacturing business work, achieving not much more than aging and more debt. “If I can tell you only one thing,” he said, “it is that you should never take money from friends and family. If you do, then you can never get out. Businesses sometimes fail, and you need to be able to close it down and walk away. I wasn’t able to do that.”

The story points out why the U.S. government securities laws discourage getting business investments from people who aren’t wealthy, sophisticated investors. They don’t fully understand how much risk there is. Although you don’t want to rule out starting your company with investments from friends and family, don’t ignore some of the disadvantages. If your parents, siblings, good friends, cousins, and in-laws will invest in your business, they have paid you an enormous compliment. In that case, make sure that you understand how easily this money can be lost, and that you make them understand as well. Go into this relationship with your eyes wide open.

Words of warning
Don’t take private placement, angels, friends and family as good sources of investment capital just because they are described here or taken seriously in some other source of information. Some investors are a good source of capital, and some aren’t. These less established sources of investment should be handled with extreme caution.

Never, NEVER spend somebody else’s money without first doing the legal work properly. Have the papers done by professionals, and make sure they’re signed.

Never, NEVER spend money that has been promised but not delivered. Often companies get investment commitments and contract for expenses, and then the investment falls through. Avoid turning to friends and family for investment, especially in desperation or in moments of crisis. The worst possible time to not have the support of friends and family is when your business is in trouble. You risk losing friends, family, and your business at the same time.

Angel investors are a wide range of different investors, not as formally established as venture capitalist firms, and not as homogenous a group either. An angel investor might be a successful business person, a wealthy individual, a group of professionals such as doctors or dentists, or a local investment club, or somebody else completely different. Your angel might be a rich uncle.

Here’s the basics of finding angel investors:

1. Finish your business plan. You need a plan for at least two obvious reasons:
   • to help you estimate how much money you need; and
   • to communicate with your investors
2. Create your summaries. You need a compelling business plan summary to communicate with investors. Prepare a brief but exciting email, one page at most, outlining the growth prospects, type of business, and potential investor payoff. Prepare an investor summary memo (unless you have a Business Plan Pro plan that does the summary automatically).
3. Look for potential angels. We have ample resources for you on this website and in our site network. Search our Ask the Experts database for the term “angels.” Consider Harold Lacy’s “six degrees of separation” method. Your angel might be somebody you know, recommended by somebody you know, or a local investment club, business person, perhaps even a local development agency. Search the Web, search your contacts. Lacy recommends that you ask everybody you know, not whether they want to invest, but whether they know anybody who might.
4. Research your possibilities thoroughly. This is no time for mailmerge or email processor software. As a potential investor emerges, find out whether he or she prefers a phone call first, a meeting, a complete business plan, a summary memo, email, fax, or whatever. If you have Business Plan Pro, then you can eventually invite a potential investor to read and comment on your plan on Secureplan.com; first, however, you need to establish some interest.
5. Make sure you have a good relationship with an experienced attorney. You definitely need the right legal help to make a real deal. Make sure your attorney has been through similar deals; if not, then they should recommend a specialist instead. Investment deals are serious business.
6. If you don’t find anything, what’s next?
   • Think it over. Maybe the investment filter process is a good thing.
   • You might try other means instead of angel investors.

Information

• Yahoo! search for angel investors
• Radio talk show discussions of related topics at the Small Business Advocate website.
• The book Other People’s Money, by Harold Lacy, at amazon.com.

You probably know all of this already, but here are some refresher tips on how to secure funding for your business:

1. Polish your business plan. Re-read the executive summary, management team, competitive edge, and financials. If you’re operating in Internet space in the present market, make sure you are generating traffic and focusing on marketing much more than profits.
2. Develop your summaries. Summaries are critical to the Venture Capital process. You don’t send business plans to VCs until they’ve asked for them. Instead, you send summaries to establish interest. Many VCs prefer emails (just a few paragraphs) to faxed or written summaries, so you need to prepare both: a compelling business plan summary to communicate with investors, and a brief but exciting email, one page at most, outlining the growth prospects, type of business, and potential investor payoff. Prepare an investor summary memo, 5-10 pages at most.
3. Select VCs carefully. Don’t shop your plan. Instead, research your VCs carefully, looking for deal size, industry, and geographic preferences that match your plan.
4. Approach selected VCs correctly. For the VCs whose criteria match your plan, find out how they want you to submit your plan to them. Know whether they prefer email summaries, summary documents, phone calls, or whatever. This is a matter of millions of dollars, so do it right. If you have Business Plan Pro, then you can eventually invite a potential investor to read and comment on your plan on Secureplan.com.
5. Make sure you have a good relationship with an experienced attorney. You definitely need the right legal help to make a real deal. Make sure your attorney has been through similar deals; if not, then they should recommend a specialist instead. Investment deals are serious business.
6. If you don’t find anything, what’s next?
   • Think it over. Maybe the investment filter process is a good thing.
   • You might try angel investors instead of venture capital.

General Resources

• The U.S. National Venture Capital Association has an easy-to-use listing of hundreds of VC firms, including web links.
• U.S. Western Association of Venture Capitalists. More than 100 of the better-known mainstream VCs.
• America’s business funding directory. Fill in your profile, and if your plan is interesting, lenders and investors will contact you. Free to the entrepreneurs.
• British Venture Capitalist Association.
• Canadian Venture Capitalist Association.
• Google listing of venture capital firms.