Ask an Angel: How Can Angels and Entrepreneurs Improve the Valuation Process?

It has fallen upon angels to educate entrepreneurs about the realities of compressed valuations in today’s economy, especially since VCs are supporting very few up-rounds today. John Huston, founder of the Ohio TechAngel Funds in Columbus, talks about a successful and innovative approach to negotiating valuation with entrepreneurs.

ACEF: Compared to your traditional approaches to valuation, Ohio TechAngels is now doing things differently.

JH: We are. Our group didn’t like the feeling that although we were trying to forge relationships that will be in place for three to five years, the most critical party—the entrepreneur—almost always felt taken advantage of.We’ve taken a new approach that we call the Wealth Accumulation Goal (WAG) model. It aligns our interests with the entrepreneur’s much more closely and is working quite well.

ACEF: You began by surveying valuation models. What did you learn?

JH: That there are a lot of them out there and they generally fall into three categories.The first I call heuristics—the thumb rules. For example, there is the “Three/Five Rule.” It takes the entrepreneur’s revenue forecast for the third year of operation but presumes this level won’t be reached until the fifth year. However, this will still consume all the capital they forecast over five years.

The mathematical models fall into a second category of valuation approaches. These are more complex and involve formulas and weightings. Think of the well known Venture Capital model, for example. The third category consists of exit comparables. What have other companies sold for recently?Traditionally, angels have used models from all three categories in trying to convince entrepreneurs that the pre-money valuation should only be a fraction of what the entrepreneurs had hoped.

ACEF: And then negotiations go back forth.

JH: Yes, and it can become contentious and detrimental to relationship building. At the end of the day, the entrepreneur usually has to decide whether to take the angels’ deal at say a $1.5 million pre-money valuation and start to execute the business plan, or to remain unfunded at say a $10 million pre-money valuation.

ACEF: And the entrepreneur who takes the deal feels at best sour, at worst cheated. What is Ohio TechAngels doing to produce a different result?

JH: We decided the process should ideally forge a cohesive partnership aimed at shared goals. In the historic approach angels typically hold the upper hand, having both the money and many more models. Now we replace this by achieving goal congruence with the entrepreneur. We strive to agree on the definition of a realistic and financially successful outcome. Imagine you are an entrepreneur with a great idea for a nano-techno widget. Growing your company to achieve a lucrative exit will probably require your investing three to five years of sixty- to eighty-hour work weeks. If you are really successful you will enjoy a big pay day when the company is bought. We would start by asking you this alignment question. “On the day you sell your company, how large would the wire transfer arriving in your checking account have to be so that you can look back on those incredibly intense three to five years and feel adequately compensated for all your hard work?”

People equivocate and give a wide range of answers to this important question. The right answer, in our opinion and experience, is $3 to $5 million with a maximum of $10 million net addition to your personal wealth (after taxes and transaction costs).

If an entrepreneur were to walk away with $10 million and put it into tax free municipal bonds at 3.6 percent, she would have $360,000 per year or $30,000 per month after tax income for the rest of her life and still have the $10 million to leave to her children or favorite charity. Today’s rates are not that high, but over my life that is about what muni bond rates have averaged.

ACEF: Even half of that—$5 million in the bank and $150,000 in tax free income—seems like a very good outcome.

JH: Especially if the exit can be orchestrated in less than five years. The purpose of our WAG approach is to help the entrepreneur focus on a realistic and achievable definition of personal financial success. To discuss how to accumulate this level of wealth we must agree on how the entrepreneur’s company must look in three to five years to attract multiple eager cash bidders. Is it revenue, EBITDA, protected IP, page views, marquis customers, or other metrics that will make companies (and we are precise in identifying which ones) anxious to be the highest bidder?

Our Capital Access Plan (CAP) template determines how much dilutive capital is needed by stage to achieve those milestones.We use our CAP to size the runway, identify the needed amount of capital, and model the appropriate uptick of valuation at each tranche if milestones are met. Then we calculate the valuation range which will enable the entrepreneur to make $3 million, $5 million, or even $10 million at the exit. The calculation helps entrepreneurs recognize that if their first round valuation is stratospheric then the required size of the M&A transaction may have to set a new Ohio record. When we say to the entrepreneur, “Let’s work together to get you that $3 to $5 million,” we are all pulling the oars in the same direction. This helps an entrepreneur focus on having $3 to $5 million in the pocket rather than thinking he or she left money on the table when the valuation is done. And, it encourages the entrepreneur to be judicious in burning through precious dilutive capital.

ACEF: Do you consider additional data?

JH: Definitely. We always provide industry comparables. We have data on all the venture-backed exits which have occurred in Ohio over the last ten years. We can show the entrepreneur that the median exit price tag has only been $44 million over the past decade of deals. This evidence shows that the odds of entrepreneurs exiting with hundreds of millions of dollars of wealth are exceedingly low, yet they can still walk away with $3 to $5 million at exits well below $44 million.

ACEF: After the round closes, do you revisit the CAP template?

JH: Yes. We view all future capital raising through this lens. As the entrepreneur, how does another round increase the likelihood you are going to put $5M in your pocket? Obviously if you raise $2 million more than initially planned, you will have to increase the size of the M&A transaction because of the greater than planned dilution of your ownership percentage.

ACEF: Was this approach difficult for Ohio TechAngels to implement?

JH: There is nothing about this that is rocket science. It is as simple as educating before negotiating in order to harmonize the interests of the entrepreneurs and angels. Combating blind hope with historic evidence helps to set realistic expectations which we think can provide greater focus on what a reasonable bid might look like.

Our process also rebuts entrepreneurs’ common misperception regarding angels’ primary motivation. Entrepreneurs, at least in Ohio, often think angels merely want to make more money, that we are greedy geezers seeking more green. That is completely wrong for the members of our group. We are much more concerned about making more of a difference for Ohio than just more dollars. None of us foresee an exit which will affect our lifestyle.

The shared attraction of this type of investing is the opportunity to make Ohio’s technology community stronger, more competitive globally, and financially successful. We are pulling for the entrepreneurs to accumulate wealth. We want to help them and their teams build both great companies and a nest egg.

In deals done right, the founders and team put more money in their pockets than the angels do. We prefer focusing on the entrepreneurs’ Wealth Accumulation Goal instead of bludgeoning them with heuristics and mathematical models.

It will be a few years before I can prove the efficacy of this approach, but in the interim, I feel our recent valuation discussions have been much more illuminating to the entrepreneurs leading our portfolio companies.