Why do angel investors negotiate valuation of a startup down to a level that they are happy to invest at? Anybody who has watched an episode of BBC’s show Dragons’ Den will have seen how fiercely the ‘Dragons’ negotiate how much equity they want for their investment. Some pitches are hopeless, some other have problems that need to be resolved before they are investible propositions and some attract the Dragons’ interest. In real life, the ‘Dragons’ on Dragons’ Den are usually known as angel investors. These investors tend to be far more friendly than the ‘Dragons’ and, just like the ‘Dragons’, they can add a great amount of value and bring great contacts to startups.
To show the importance of investing at the right valuation we are going to assume a company called Jolly is looking for £100,000. In scenario A investors invest as part of a crowd and therefore are unable to negotiate the valuation whereas in scenario B the crowd invests at the same valuation that was negotiated by angel investors, just like it happens with SyndicateRoom.
Jolly is asking for £100,000 in exchange of 10% of the company, which means that the value of the company is £1 million after the investment (post-money valuation) or £900,000 before the investment (pre-money valuation). This will be our scenario A and this represents a typical deal in pure crowd funding platforms.
Very often angel investors (or ‘Dragons’) will negotiate the valuation down to a level that they believe they can see a return on their money. For instance, an angel investor may say ‘I will give you the £100,000 but I want 20% of your company’. Let’s assume entrepreneurs and the angel investor agree on an investment of £100,000 for 20% of the company and let’s call it scenario B. In this scenario the angel investor and SR members invest at a pre-money valuation of £400,000 and this represents a typical deal on SyndicateRoom’s website.
So the two scenarios are:
If the company fails, then there is no difference. All investors will lose all their money and the shares will be worthless.
If the company starts doing well it is likely to raise more money to carry on growing and building on its success. This is a very usual process in the life of successful companies and angel investors expect to get diluted in future funding rounds.
Let’s assume now that the company needs £1m to grow internationally and that new investors agree to invest at a £2m pre-money valuation. The two scenarios above become the following:
Assuming the company grew successfully and was sold by £10m, the outcomes of the two different scenarios for investors are the following:
The importance of investing at the right valuation is summarised in the last line of the table above. In the table above is possible to see that the crowd got a very healthy return of 6.7x (i.e. for every £1,000 invested, got £6,700 back). However the angel investors got a return of 13.4x, twice as much as the crowd.
All investors were assumed to invest in the same deals and that only one out of ten investments succeeded:
- The crowd had to invest £1 million before succeeding to get £670,000 from this investment, with a net loss of -£330,000
- Angel investors had to invest the same £1,000,000 before succeeding to get £1.34 million. Unlike the crowd, angel investors get a net gain of +£340,000 (34% total return)
As you can see above, it was assumed that both groups invested in the same ten deals, out of which nine completely fail and one succeeds. The only difference is that angel investors negotiated the valuation at which they invested whereas the crowd didn’t, which is representative of the reality.
As you probably have guessed by now, the top nine reasons why you have to invest at the right valuation to get great returns are all the other nine companies that failed. The winner will always give you great returns, but will it be enough to cover your losses? The tenth and most important reason to invest at the right valuation is to make sure that your wins cover your losses and give you a tidy profit at the end.
This is just one of the reasons why we are strong believers that a sophisticated crowd will always choose to invest side-by-side with those that do this for a living and why we, at SyndicateRoom, allow the crowd to invest together with angel investors that are also investing their own money in the same deals. Sign up for SyndicateRoom and start investing in real angel investments from £500 today.