How to Avoid the Venture Funding Slaughter

Costly mistakes entrepreneurs make when negotiating with angel and venture fund investors

Q.  What percentage ownership of a high tech startup company do investors take in exchange for their investment dollars?

A.  It's quite common for startup entrepreneurs to use the word "take" when asking angels and venture funds to give them money. This revealing word choice represents every entrepreneur's fear that a slick investor will take advantage, take control or take over the company altogether. That's why you and other entrepreneurs repeatedly ask "What will they take?", "How do I know if they are setting me up for failure?" or "What will come back to haunt me?"

Recently, I wrote a column on steps entrepreneurs can take to keep their executive role after receiving funding. I noted that if the entrepreneur is meeting key development milestones and not suddenly steering the company in an unexpected direction, then the entrepreneur's position is generally safe from the nasty "board bounce."

Another factor that may affect a founding CEO's longevity with a company is the pricing or "pre-money valuation" of the company's first few rounds of venture funding.

Seattle-based technology funding expert Dan Rosen provides the following experienced perspective, "Sometimes CEO's can be too short-sighted in seeking top dollar valuations for their startup or early stage companies. When investors pay more, they expect more in terms of management performance."

Rosen warns that when CEO's miss key goals, their leadership is vulnerable to challenge by let down investors. And if the company is desperately in need of more capital, the company will likely face an excruciating "down round" " in which the rescue investment round is priced well below the first round. While every early investor loses in a down round, founding management loses far more in terms of share dilution and credibility. It's a Herculean task to recover this lost ground.

There is an old Wall Street expression that seems to fit today's frothy venture market. And it is, "Hogs get slaughtered." If you are at all uncertain of the timing of key operating milestones or anticipate that you will need several rounds of capital to achieve your goals, it may be safer and less costly to pursue a fair valuation rather than a premium valuation. This way you have a little more leeway to steadily improve your company's operating position on an investment round to round basis.

So, how do you determine a fair number for your business? Frustrating, but true, there is no consistent or quantifiable way to value startup technology businesses. As such, investors look to qualitative evidence of potential fast revenue growth and competitive technical advantage to estimate a young company's value.

In VC-speak, these points are called "investment fundamentals." Obviously, the more fundamentals you can present to investors, the greater your negotiating position. Heightened interest in your target industry "space" among Silicon-Forest, (San Francisco to Portland to Seattle), Austin, Research Triangle Park, North Carolina, New York City and Boston-based angels and VC funds also tends to lift young company valuations.

Before making first investor presentations, it's worthwhile to consult local or regional law firms that specialize in venture transactions. These firms can provide information on the valuation climate and points of negotiating flexibility. Also seek out technology entrepreneurs who have recently received startup funding, active angel investors and angel forum groups for added tips on valuation pricing.

It's important to remember that the best investors offer so much more to startup entrepreneurs than just cash. As a balance to today's discussion of what investors take in venture transactions, come back next week for some thoughts on what angels and VCs can give to entrepreneurs too.

Take Command Action Step

Don't settle too quickly on any specific company valuation. First feel out the market by asking lawyers, executives within your industry, and potential investors for their opinion. Remember, you don't want to look foolish by asking for the equivalent of a Ferrari price when your company's startup value is closer to a Chevy. You can do it!

Do you need time-saving tips to help fund and grow your business? Ask Susan How! Write to small business funding expert Susan Schreter at susan@takecommand.org

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