Best Practice Guidance for Angel Groups: Deal Structure and Negotiation

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Structuring the deal is a key aspect of completing an angel round of financing. It is critical to ensuring that management, employees, past investors, current investors and future investors are all satisfied with the company under its new capital structure. As a result, negotiating and structuring the deal can be the most complex aspects of angel investing.

“Often times the best negotiated deal is the deal in which each party feels like they could have done a bit better – or simply put, nobody got everything they wanted.”

-James Geshwilerof CommonAngels

Valuation

Angel investing groups generally aim to take 20 to 50 percent ownership stake of early-stage companies. Therefore, structuring the deal and negotiating the terms begin with the valuation of the company. The valuation of a company represents its price tag, wherein the pre-money valuation is the value of the business before it receives investor funds and the post-money valuation incorporates the amount of investor funds raised. For instance, a company has a premoney valuation of $2.5 million, then it receives an angel round investment of $0.75 million to result in a post-money valuation of $3.25 million.

Typically angel investor groups look for less than $5 million pre-money valuation and as low as$500,000; however the investment range varies by groups. Many times the different investment opportunities available to the investors at a given time are taken into consideration. That is, all other factors equal, $500,000 invested on a pre-money of $1.5 million is a more attractive percentage ownership for an investor than $500,000 invested on a pre-money of $3.5 million.

“We have to be careful of valuations that are too high because if there’s too much dilution, then we won’t make money. We also look at the type of capital requirements of a company. The semiconductor and pharmaceutical sectors are almost impossible to do low cost development. They require huge amounts of capital unless the company gets lucky and gets bought out at an early stage. So it almost never makes sense to invest at the angel level. Clean technology is also capital intensive so also hard to invest in. Software and services are less capital intensive.”

- John May of New Vantage Group2

The angel investors will often feel that the valuation of a company is less than what the entrepreneur has proposed. However, investors will work with the entrepreneurs’ financial projections and use various valuation methods to arrive at a valuation. Such valuation methods include transactional value, market value, and return as a multiple of investment. The valuation methodology most frequently used is backing into it from the exit value. For example, if the company is expected to be worth $50 million in five years, the company needs to raise a single$1 million round to reach that valuation, and the investors will require a 10X cash-on-cash return upon exit, the investors’ share must be worth $10 million in five years. Thus, the investors would need to own 20 percent of the company, which implies a $4 million pre-money valuation and $5 million post-money valuation. (Note: this presumes no further dilutive capital is needed.)