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I have an opportunity to invest and work in a food manufacturing startup. I feel like the group has a lot of integrity and not a lot of experience. The CEO has placed what I feel is a overly high current value on the company using a valuation of 3X the projected revenue (I like to use net income) at month 18 from their pro forma. They are currently doing about 10% of the projected sales for month 18 (We're currently in month 1). This future valuation is 2.5M and they are offering 1% ownership positions for 25K. I like the industry, I like the people and I like the position they've offerred me as COO. Based on the valuation my $200K and sweat equity would buy about 20% with an option to buy an additional 15% at a slightly lower price of 20K for each 1%. The CEO has personally put in $25K and raised about $100k more by selling 1% ownership positions. My intuition tells me to be very skeptical of 10x growth even though they are only a month or two old. Assuming I want to invest is there a standardized way to inject my capital and receive ownership based on performance? I don't want to put in my $200K and time and have sales not grow and have a low percentage of ownership. I was thinking of proposing to give them X dollars and time and that would get vested at a pre-set time in the future against a pre-set valuation (let's say 5x on net income). Example. I give them $100K and a year's work ($60K). At one-year the company has a valuation (let's say $600K) and my $160K vests as 26%. Is there a way to structure this and is it normally done? Note: I have additional capital to offer the group if we are on track. Thanks in advance for any help you are able to give to me, Sean

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up vote 1 down vote

First be aware that most of the people here including myself are much more familiar with the hi-tech world than food manufacturing.

There are a couple of ways to break up this thing. Let's analyze the numbers a bit. In rough numbers, the CEO expects around $800k annual revenus in 18 months, or $65k a month. Right now, these guys are doing $6500 a month. Considering the $125k investment, that could be a very good return, but it's hard to tell without knowing more about the headcount, current expenses and the market.

Now you're going to come in and invest almost double the current investment and invest sweat equity into the business. This makes things complicated, and I propose you separate the two.

Let's start with the investment. The CEO wants to use 3X of the sales in 18 months. Why 3X and why 18 months? Can he show you where 3X is the standard valuation for your kind of business? For that matter, you really need to spend some time and understand how this kind of business is valued, both to figure out your investment value, but also to understand exit options. Check out something along the lines of https://encrypted.google.com/search?num=100&hl=en&safe=off&q=food+manufacturing+business+for+sale

I do like the idea of a convertible note. The triggering event does not need to be a VC investment. It can be the 18 months deadline. At that point, you value the company at 2X or 3X of sales (whatever you agree on), and you get your share based on that.

You also need to understand who's got more leverage in this scenario you or the CEO. If he's got a bunch of people wanting to invest in the company, he's got more leverage. If you're the only prospective investor at this point, you have much more leverage. Usually, the easiest way to find out, is to wait a bit. You need to take some time and get familiar with the industry and the opportunity anyway. If he becomes more desperate and/or more pushy about the deal, it's a sign that you have the leverage, and push for a better deal. Now, I'm not advocating that you squeeze him to the max. I think it's best practice, and he's going to be your boss, and you guys need to work together. But the description of the current deal sounds like you're not getting a quite fair deal.

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and welcome! :-)

My first question to you is: Can you stand losing those $200k flat out; or will it be a burden on you? Seed investment is notoriously high risk, and you shouldn't play that game if you can't shrug off such a loss.

using a valuation of 3X the projected revenue (I like to use net income)

Both valuation based on revenue and net income are highly questionable at this stage. The entire sales forecast is typically just a wishful dream. It is possible to forecast the expenses of a startup with some precision, but not the income/sales.

inject my capital and receive ownership based on performance?

I'm not sure what you mean here -- get ownership based on your performance as COO? Your investment as investor/business angel is not subject to performance evaluation.

My main suggestion to you is to look for 'business angel groups' in your area. By this I mean organizations like Band of Angels, or AngeList. If there is something like this near you, perhaps you could join, and gain access to their expertise?

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Lose the $200K? I'd survive it but I'd be unhappy as it represents a significant portion of my free capital. I like your point about valuation...it certainly is consistent with this situation. I think my question is a little confusing so let me see if I can't clarify it. I would like to put in an investment amount of X. Because we don't know much about how the company will perform I want to wait to value X in terms of ownership when we understand the model a little more, like after a year or so of revenue/net. Has anyone done this or something like it? Probably cake and eat it too. Thanks – Sean Aug 27 '10 at 18:52
@Sean: I have tightened my language a little in the response above. I really think you should hook up with some other Angels. As one example: "wait to value X in terms of ownership when we understand the model a little more" -- ehh, no. Lack of understanding of the business model comes out of the entrepreneurs cut, not the Angel's. Cash is King -- if the model isn't fully developed, you invest at a lower valuation today, and expect the Entrepreneur to develop the model fully (on your cash) before the next investment round. And in the next round you will both get diluted. – Jesper Mortensen♦ Aug 27 '10 at 19:33
up vote 0 down vote

How about a convertible note?

Venture Hacks has some good discussions on this topic. Plenty of good links on that site in general.

NOTE - that link provided may not be the best for describing it. You should look around.

Whatever happens, please keep us updated/inform us what you chose to do for our education.

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Tim- Thanks a ton for responding. I looked at the convertible note and the subsequent exchangeable note. They seem to be vehicles designed to reward Angel investments relative to VC's, compensating them for their heavy level of risk consistent with being the first in the water. Then if subsequent VC investors are able to buy at a discount you're able to exchange your shares for shares at the same price or with the same rules. I think I'm looking for a more direct way to get there in case there isn't a second round anytime soon. – Sean Aug 27 '10 at 18:43
Well, there is nothing that says you can't force a valuation or other means of converting in the agreement for the conversion. You can set up a schedule of valuation based on revenue or performance, or whatever you like - but I like the convertible note because it retains the higher of the values between money/debt OR equity. (With the understanding that the company may become insolvent), but at least you are a creditor and first in line for assets) – TimJ♦ Aug 27 '10 at 19:27

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