Choosing the right source to finance a start-up firm II (Evaluation and debt converted to equity)

Giving an equity to angels in the early stage could not be a good idea. Giving an equity requires the an evaluation of the company. An evaluation of non-IPO* high tech firm can be calculated by 10 times the revenue. However, a start-up firm does not have or have a little revenue. An evaluation is very difficult.

If the value of evaluation is higher than reality, then an angel loses money. If the value of the evaluation is lower than reality, then an entrepreneur loses money.

For example, let’s that a firm will actually be worth 100,ooo USD in 5 years.

If the value of evaluation at the start-up is 100,000. If an angel puts his money for 25,000 USD at the start-up, then the angel could get at least 25% of equity. As a result, an angel and an entrepreneur could have 25,000 USD and 75,000 USD worth of equity at the end of year five respectively. Fair.

If the value of evaluation at the start-up is 50,000 (lower than reality). If an angel puts his money for 25,000 USD at the start-up, then the angel would get 50% of equity. As a result, an angel and an entrepreneur will have each 50,000 USD worth of equity at the end of year five. When an evaluation is lower than reality, then an entrepreneur loses an opportunity to make some money. Not fair for an entrepreneur.

If the value of evaluation at the start-up is 200,000 (higher than reality). If an angel puts his money for 25,000 USD at the start-up, then the angel would get 12.5% of equity. As a result, an angel and an entrepreneur will have each 12,500 and 87,500 USD worth of equity at the end of year five respectively. When an evaluation is higher than reality, then an angel loses an opportunity to make some money. Not fair for an angel.

So how do angels deal with this problem?

In the beginning, an angel finances a start-up firm in a form of debt. Then evaluation is done later on when a firm makes some solid revenue. After the evaluation, a debt could be turned into an equity.

IPO – Initial Public Offerring – when a firm is publicly traded on a stock market.

Angel – an investor who invests smaller amount of money compared with VCs (Venture Capitalists)

I am just a student, so I do not have any real experience. Knowledge is from the talks (Edinburgh Entrepreneurship club), guest speaker from the course Informatics Entrepreneurship I & II and the book (Technology Venture: Idea to Enterprise).