When we raised our first round of capital for Equidam, about a decade ago, we didn’t know much of what we now know about fundraising. We were lucky to have some incredible mentors, but the resources available to young entrepreneurs, especially in the Netherlands (or anywhere outside the US, really), were minimal. Plenty has changed since then.

Perhaps the most constant has been the Friends and Family round, where the deal structure is light and capitalization is minimal. Typically this round is a small injection of cash used to get a proof of concept off the ground, or set up the core business and beyond that point. They’re quicker and easier to complete than an angel round, as the personal relationship displaces much of the due diligence and complexity.

Given that these rounds are built on trust, through the relationship between founder and investor, Friends and Family funding rounds have a particular emphasis on being FAIR. Neither side of the deal will be experienced with valuation or investment, so the formula really only makes sense if you are both shouldering risk in equal proportions.

And you might still want to go for dinner with these people, right?

What makes a valuation fair?

Valuation is the calculation of risk vs reward. Buying equity is placing a bet on the future of the company, and that must be carefully priced to offer an equal potential for upside to all parties.

An equity deal, particularly at early stages, must allow founders to retain enough of their company to be motivated to put in the hard work required to grow a new business. Whatever the amount of mentorship and advice an investor can offer, it pales in comparison to the ‘marathon of sprints’ that is entrepreneurship. The more that founder can see the value of their ownership grow, the more inclined they will be to drive growth further for themselves and their investors.

At the earliest stage in that journey, when they are raising their first round, it’s important to consider what the future may hold in terms of further fundraising. How quickly will they be looking at a pre-seed or seed round? How much of their ambition is going to be dependent on external capital? This should all factor into that first round, how much equity is offered to early investors, and what that leaves in terms of capacity for dilution in future.

What makes a valuation unfair?

It’s relatively uncommon for either side of an equity deal to deliberately propose unfair terms to the other party. It should be a long-lasting relationship, with both parties contributing to the success of the venture, so poisoning that well on day one is foolish to say the least.

Most of the time, unfair deal terms, or an unfair valuation, are the product of inexperience, lack of confidence, or unfamiliarity with the particular market and investment trends.

Undervaluation

Lots of people are familiar with investment in some form or other. The most common might be the mark-up they achieved when selling a house (especially in recent years) where a return of 20-50% is enough to feel pretty happy with yourself. A more financially savvy person might be familiar with index funds or commodities.

It can be a little harder for those people to compute the relatively extreme growth potential of a startup with a global market and digital acquisition channels. Revenue projections which compare well to peers may look completely erroneous to someone more experienced with ‘brick and mortar’ business, or watching their pension fund go up. They may have a far more modest view on the future of your business, which will reflect in an (unfairly) lower valuation.

The situation is bad for both sides, and it’s not an easy decision to reverse. Both the founders and those early investors will have to take on more dilution to raise capital later on.

If the founder isn’t yet in a position to justify a higher valuation, then the obvious route is just to raise the absolute minimum from friends and family to get to that next milestone. Once the proof of concept is launched, and the first customers are on board, it will be much easier to raise capital at a higher valuation.

Overvaluation

The other side of that ‘inexperience’ coin is, of course, overvaluation. If you are a charismatic founder, with an infectious passion for what you are building – and some wealthy relatives – it can result in them buying into your dream with too much enthusiasm. Believing that you might be creating the next Facebook, there’s a good chance they’ll accept whatever valuation you suggest at face value.

The obvious (and fairly devastating) threat here is that you will be grossly underperforming expectations on that valuation when you need to approach professional investors. They’ll force you (and your innocent F&F investors) to take a severe haircut on valuation, which makes you look bad and is a real blow to the morale of all involved. It undermines your initial promises, the vision that you asked others to have faith in, and your own judgment.

A steady and consistent increase in value, reflecting the growth of your business (increased potential, reduced risk) is the gold standard you should be aiming for. That’s much harder to achieve if you are starting out on an already-inflated valuation.

How to set a fair valuation

There are a few key ways to ensure you are setting a fair valuation. In no particular order:

Seek qualitative and quantitative feedback

  • Check your operational assumptions with other entrepreneurs.
  • Check your numbers with experienced angels in your network.
  • Check the valuations on crowdfunding websites which also attract early-stage entrepreneurs. If you consider crowdfunding as an alternative; we’d be happy to make an introduction to one of our partners.
  • If the startup is particularly early, check accelerators, would you take their deal? If so, calculate your valuation from there, if they are offering $20k for 8%, that is an implied post-money valuation of $20k/8% = $250k, and so a pre-money of $230k.

Educate your potential investors about your company, and startups in general

  • Try to make the business more tangible, draw parallels to industries or investments they are familiar with and take time to explain the core concepts.
  • Make the risk associated with startups VERY clear, e.g. the fact that >90% of startups fail. They should not be using their kids college fund for an investment as risky as a startup, however confident you are.
  • Don’t sell potential investors with promises of returns which are obviously uncertain. The good ones aren’t motivated by that, and only the bad ones are gullible enough to believe those promises.
  • You may not face the same level of scrutiny and due diligence as you would with an angel investor, but you should still be as transparent as possible with potential investors about your business.

Perform a valuation on Equidam (situations like this are why we created it!)

  • Making a fairly basic set of financial projections is a great way to focus your business model and think about eventual profitability. They don’t have to be accurate or precise, but they should broadly represent your ambition and where that money will be used.
  • Present your valuation to potential investors with as much context and information as possible. While not everyone is interested in understanding complex financial jargon, it can help to see the basis for numbers and the key assumptions they are built on. Equidam’s valuation report is designed for this purpose.

Be open to all possibilities, including walking away

  • Your relationship is worth more than any investment. It might be as simple as one side or the other just not feeling confident enough about their own knowledge to sign off on the deal. Amongst the worst possible outcomes of a F&F round is having a reluctant investor on your cap table.
  • Valuation is always fairly uncertain and tricky to determine, and includes some big assumptions at the earlier stages. If the two parties have assumptions or ambitions that are too far apart, it might not be worth trying to force a compromise. Their investment would be a partnership, and a partnership should only ever begin with comfortably aligned expectations and interests.

(A note on feasibility studies: they don’t add value. No successful startup ended up doing what they set out to do at the beginning, and no consultant could have predicted their success with any degree of certainty. Don’t waste money on feasibility studies.)