From vcexperts.com: “Wash-Out Round: A financing round whereby previous investors, the founders, and management suffer significant dilution. Usually as a result of a washout round, the new investor gains majority ownership and control of the company. Also known as burn-out or cram-down rounds.”
At the CDVCA conference in DC in March, a VC made the ear-catching comment that “Angels get crammed down because they overpay.” After watching several Bay Area Angels grit their teeth as they referenced dot-com era cramdowns in the Kauffman seminar I took last year, this was definitely the other side of the coin. I definitely believe there are abuses on both sides of the investor-entrepreneur relationship, so it was interesting to be thinking about the Angel/VC relationship.
Do Angels overpay? A mentor suggested to me early on that the first round is the worst round, it’s the last round that gets the best deal. That runs counter to expectations, but makes sense if the company lives out a story like: 1) entrepreneurs, out of optimism or desperation to attract investor attention, set ambitious projections. 2) when you don’t meet your projections, you can find yourself in difficult financial straits, thus giving leverage to your next negotiating partner. 3) if you’re not making your projections, you’re not worth the valuation that took them into account. Thus, a down round.
However initial valuation is derived, it becomes a key point when negotiating the next round. According to a 2005 survey done by Tony Stanco and Uto Akah at The George Washington University [about 5 miles from my childhood home –sm] “The number one reason for making angel portfolio companies unattractive to VCs is the fact that angels tend to give start-ups overly high, unrealistic valuations.” (p 11.) according to this survey, VCs think angels need more work on valuation skills. This seems to be the case in the social enterprise markets as well. Cathy Clark and Selen Ucak write in their report on the market experience of Social Entrepreneurs that some feel like the funding markets are not rational. “Potential investors do not know how to evaluate our market or viability.”
So why not? I think its in part because Angels are at a serious resource disadvantage. As single investors without back offices we don’t have access to deal databases and can only read so many PE newsletters. In my observation, particularly since most exits these days seem to be via acquisition, estimating a value means knowing the current M&A market. The only way an Angel can be that informed is to hug close to a single industry, ideally the industry they made their money in and theoretically have an information advantage from their experience. Another key factor in valuation is simply negotiating leverage. If you’re a VC and can offer to fund ¾ of their current raise, you have much more leverage than a group of angels suggesting they’ll band together to cover 1/4, which is much more of the world I see outside the core VC money centers. A single VC is also much better positioned to apply that leverage as a focused negotiating party, as opposed to angel groups worried about fiduciary responsibility and being very hands-off in helping angel investors organize. To be thorough, we could also accuse Angels of not thinking too hard about future funding rounds. In order to do multiple rounds of funding with any kind of markup and end up at a valuation that’s realistic on the last round, that first round has got to be pretty low. We can put that blame on the entrepreneur as well.
However, surf any number of VC blogs and deal-pricing is inevitably referred to as an art. Let’s face it, we’re trying to predict the future value of something in the face of a great deal of risk – this is all about risk capital, right? In my mind, its all about negotiation, and if Angels are getting regularly crammed down to support VC profits that says as much to me about relative leverage as relative smarts. That said, I’m way more wary about high valuation. This is also changing in the world of SOX – the feds are getting more stringent about how assets are marked to market value and this may drive more standards in valuation and use of professional appraisers– but primarily in the professionalized VC leagues. The amateur angel leagues are still likely to wing it, which leaves us vulnerable to cram-down between our lower negotiating leverage and our less well priced first round, which I will contend is part of the higher risk of the early stage.
What to do? The National Association of Seed and Venture Funds (NASVF ) recommends doing convertible debt rounds for early rounds. That helps postpone the valuation negotiation until a later round when there will a) be more information and b) you’ll be side-by-side with those bigger, more experienced institutional players and get their same valuation. The next question with this route is how those seed round investors get compensated for their early risk. One common strategy is to convert into the next round at some discount to the round: IE if it’s $1/share you buy in at 85 cents. Or you accrue interest at some rate that allows the discount for the next round to adjust based on how long it takes. Or you get warrants of common stock for investing in the debt round. Does that help? Some. I’m seeing many deals go through more than one round of all-angel, so we build up a bigger pile of low-leverage, poorly organized investors before we get to the big guns.
Net, I do think companies frequently come to Angels with excessively high valuations, and Angels in the capital hinterlands are less well-equipped to negotiate those down. We need to develop more experience with valuation and perhaps appraisers, and figure out how to better negotiate as groups, and after the dot-com boom and bust hopefully we’re in an evolutionary stage where VCs and Angels are learning to play better together.