Raising funds? How Much Equity Should You Dilute?
This is exactly what the angels wanted to hear. “Flexible Valuations.” So for the same amount invested, the angels would get a larger slice of equity in the company.
Winged Angels Network, one of the leading Angel Investor networks in the country, was holding its monthly meeting in Delhi. Making a pitch to them was Ramji Ghanshyamji Babubhai Alfred S. Patel, a bright young entrepreneur with past experience in the hospitality industry.
Ramji (if the reader is OK, we will use his first name, rather than upset the editor of this journal by filling up the entire page) had created an interesting app for the restaurant industry. The app allowed users to search for restaurants in their vicinity, based on the kind of cuisine they wanted to try out. Inputs would also be provided from customers who had tried out these restaurants in the past, along the lines of Zomato.com. And finally, it would let the customer book a table, and keep him or her informed about the waiting time. Essentially, the customer could locate a restaurant, book a table, and then arrive at the restaurant just in time. Obviously the app needed to interface with the restaurant’s own IT based system, and this had already been done with some twenty restaurants in the city.
Even in the crowded space of food and restaurants, the idea was good. Keeping track of waiting times was seen by the angels as the real USP. It had already been piloted in twenty restaurants, and was now ready for take-off.
“So how much do you need, and at what valuation ?” was the inevitable next question.
“Well, we need to build traction fast, and cover the entire city. That’s the only way we will build up any kind of entry barrier. This means a lot of Sales and Marketing spend, for which we need 4 crores over the next one year.”
At this the Chartered Accountants in the room asked several questions, but were satisfied in the end. And then Ramji continued, “And we are flexible with regard to valuations.”
This is exactly what the angels wanted to hear. “Flexible Valuations.” So for the same amount invested, the angels would get a larger slice of equity in the company. “Right now you are largely in pilot phase. The business is not really proven, and there is no traction. We will not be able to give you any significant valuation. Over time, once you have expanded the business, you will obviously get higher valuations,” said one, and the other angels around the table nodded wisely.
And so, over the next month, the deal lead (the representative from Winged Angels) spent time with Ramji, and they finally arrived at an acceptable valuation – A pre-money valuation of 2 crores, and therefore a post-money valuation of 6 crores. Which essentially meant that after raising 4 crores from the angels (and any other sources), the total equity in the company would go up to 6 crores, with 2 crores or 33 % being owned by the promoters. The angels were of course, delighted with the deal, and celebrated – over beer of course !
So the money was raised, and the business grew. Not as fast as anticipated, but Ramji did achieve traction. Till finally he started running out of funds, and therefore started approaching Venture Capitalists for the next round of funding. Starting with Mauri Partners, one of the best known VCs around. Mauri Partners took one look at the equity structure of the company, and almost exploded, “You guys only have 33 % equity ? Why ?”
“Well, we needed funds, and valuations were hard to come by,” said Ramji, but he sounded uncertain.
“We’ll think about it,” said Mauri Partners, and the meeting ended abruptly.
The next meeting, with Sing Sing Ventures, was no different. “Only 33 % ? Not interested.”
Several negative responses later, Ramji and his angel investors were sitting down over a quiet bottle of beer. In their rush to build traction, the amount raised in the angel round was large. And in their keenness to grab lots of equity, the angels had pushed down the valuations. So much so, that the promoters’ stake in the company had come down to a very low 33 %. And every VC worth their salt figured that this was not enough to keep the promoter interested. What if he had another great idea and lost interest in this one ? After all, for the promoter to remain interested, he needed to have sufficient stake in the business.
Too late, Ramji realized that valuations were a double edged sword. And so did the angels. Too late, they realized the blunder they had made – that of raising too much money at a valuation that was too low. Ideally they should have raised less at the valuation agreed to, so that the founder would have enough “Skin in the Game.” And gone in for a subsequent round of funding at a higher valuation. Things could have been so different…….
The angels morosely examined their mugs of beer, which tasted so terribly flat this time round. And thought about what they had learnt about valuations - the hard way. And so they drained their mugs, said goodbye to each other a little sheepishly, and walked out into the cold Delhi winter night.
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