Angel investors are always looking for good entrepreneurs to invest in, and when they finally do identify a startup which they feel meets their sweet spot, they’re quite happy to fund it so they can get on with helping the founder to grow the business.
However, even after offering a term sheet, there are times when the deal doesn’t get consummated and entrepreneurs push back. They refuse to accept the money because they’re not comfortable with the terms which are being offered.
One of the stickiest issues is that of valuation. Typically, entrepreneurs always feel that they’re being undervalued, and their biggest worry is that the investor, who has much more experience in doing these deals, will take undue advantage of their naivete. They believe they are being offered a pittance, compared to the potential value which they’re bringing to the table, and they fear they will end up getting much less than what they’re really worth.
This is why founders use lots of different metrics in order to come up with a valuation for how much they think their startup is worth. The truth is that valuing a startup is extremely difficult to do because it’s all about valuing future potential – and as well all know, the future is uncertain.
Entrepreneurs are always excessively optimistic that they will be the one startup which succeeds against all odds, while investors know that the fact that 80% of all startups fail is the base rate which should never be ignored. This is why there’s often a gap between how much the investor is willing to offer and the entrepreneur is willing to accept.
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However, there really is no sound reason for the number which the entrepreneur comes up with – or which the investor offers either, for that matter, in all fairness! The founder obviously wants as much as possible, and he may fall prey to an anchoring bias. Thus, he may insist he is worth at least a million dollars ( for some reason, Indian founders still love discussing valuations in dollars), and insist that he get at least this much. Their logic is “Our pre-money valuation should be at least $1 million because in Silicon Valley it would have been at least $3 million.”
One of the reasons he gets biased is because he only uses the successful startups – the ones who actually get funding as reported in the media – as his basis for comparison. However, the reality is that lots of other startups which were in exactly in the same space folded, even after raising funding – and some did not even manage to do that.
The biggest fear of every investor is that he may end up losing all his capital, which is why they need to be very conservative about how they deploy their funds. After all, they need an ROI so they can continue investing in other startups! They know that no matter how good the team may be, how good the product; and how passionate and resourceful the founders are, the base rate for startup failure is 80%, and there’s no reason to expect that this particular startup is going to be different from the rest!
This is why we prefer talking to entrepreneurs who are mature enough to understand the importance of negotiation – they should want to create a win-win situation. If they don’t, they make it very difficult to continue the conversation on an intelligent basis.
As an investor, you know that the only negotiation power you have is before you sign the cheque, and therefore you want an entrepreneur who will try to help you to win, rather than selfishly looking after his own interests.
If he’s very rigid at this time, before the cheque is signed, it’s unlikely that he will treat you as a valued partner after he gets the funds. If he doesn’t think that the investor brings a lot more value to the table than just money, this means he will do not respect the investor’s contribution, and there’s really no reason why a good investor would want to continue having a conversation.
Effectively, this means that these entrepreneurs then usually end up getting stuck with an investor who only looks at them as a source of money – someone who will want an ROI by exiting, rather than trying to help them grow the company.
[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]