

Should I invest $100K in a startup for 3% equity? – pre money valuation is $20M - bobbysax

I&#x27;m stuck in a situation. I started consulting for a start up for a fixed dollar amount per month. This startup is owned by 2 partners - one of them is the CEO. Since 2012 when they started it, they both have invested around $350K total. Up until now, they have not asked for funding. They have a monthly revenue of around $20-25K (mostly consulting revenue) with a $30K monthly burn rate. For the 1st time, they went cash flow positive last month. They don&#x27;t have any full time employees, but have around 10-12 guys working on and off on temp basis - on 1099. Now, they are looking to get funded. There is an investor willing to invest $2M as seed and asking for 10% of equity and a board seat. They are very interested in that offer and considering it. Their cap table looks something like founder shares - 80% and common stock - 20%.<p>I have been consulting for them for 4 months now. After 2 months, I realized they don&#x27;t have the cash to pay me for my consulting fees. However, since I believe so strongly on their product &#x2F; services &#x2F; business model, I decided to stick. In return, they offered me to do a cash investment around $100K for a 3% equity (undiluted founder shares). With this cash influx, they plan to start paying back my consulting fees arrears.
Also, with the $2M funding, they are offering me to become a full time employee with executive role.<p>I&#x27;m looking at this from a long term perspective. What attracts me is the 3% equity in the company and with my 100K investment, they will start paying my consulting fees monthly.
I&#x27;m not able to decide if this a good deal for me? Also, what happens if the $2M funding does not come through? Ultimately, how can I protect my investment? With my investment, should I also ask to become a board observer?
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trcollinson
First off, you should retain an attorney and ask that attorney all of these
same questions. This is non-negotiable. You will want this moving forward.

If the contract for this transaction is sound (refer to the "Get An Attorney"
section) then you are buying 3% of the company at $3.34mm valuation and, if
the seed money comes through at the amount and percentage you state, you have
6x'ed your investment. That's not a bad deal. However, there are some caveats.
It all smells fishy.

First, this company has been in business for 3 years or so and they have not
seen a profit until last month? Their valuation is effectively $0, especially
if they are in the consulting space and not the product space. They have no
assets. They make no money. They have essentially no history of being
successful. I am not suggesting that they have no hope of becoming successful,
just that they currently should not be valued at $3.34MM. That would be 13
times annual gross? No way.

Second, we can extrapolate that they are not worth $20MM. You mention that
they were cash positive last month for the first time. Let's say that means
they made $35k on a $30k burn. Let's also say they can keep at that level,
month over month. At a $20MM valuation they are being valued at 47 times
annual gross? No way. The investment firm will learn this quickly as they do
their due diligence.

Third, let's look at debt. They aren't paying you. How many other 1099
contractors, vendors, and others are they behind payments on? Do they account
that debt and those payments into their $30k monthly burn? I will not
speculate, but if you are planning to invest $100k into them, you should know
for sure.

If you were going to invest $100k into a company like this, I would suggest a
much lower valuation. I would also suggest that you get a board spot. I would
not be shy about asking for a stepped up equity position under various
circumstances (The other investor doesn't come through? More equity for you.
You spend more time working for the company? More equity for you. etc). Say
10% equity for $100k. another 10% if the seed money doesn't come through. X%
annually as you help them grow the business over the next 4 years.

Now, if it were me, I would never invest in this deal. $100k is enough to
invest in my own successful business without the baggage. I would leave,
invest in my own company, and sue them for my unpaid work. But, that's just
me.

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kkowalczyk
Obviously you have way more information about this, but judging from what
you've disclosed, it's a terrible investment.

Stock in a company is worthless (literally, as in "worth $0") until 2 things
happen: * the company gets sold * the company does an IPO

Those are hard for all kinds of companies but next to impossible for a
consulting company.

Consulting companies don't scale they way product companies do.

Revenue of $20k/month is nothing (this is what Google spends on a good
engineer per month). They don't make enough to pay you a market rate.

How is this company going to ever get to multi-million dollar a year _profit_
(a condition necessary but far from sufficient for a sale or IPO) ?

You seem to be so pre-occupied with details of the deal that you seem to be
missing the obvious thing: investing in this company looks like a terrible
idea because there's no way this company is going to be so successful to
warrant a sale or IPO.

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bobbysax
Thanks a lot everyone for an amazingly prompt response. I did leave some
important details.

The CEO is a serial entrepreneur - he has sold 2 companies to Autodesk and 1
to IBM in the past. He has enabled investors to realize exit profits in the
US$180 million range with his founding team member involvement. He is also a
highly rated and a well renowned speaker - this is how he gets business. Also,
yes - they have been consulting so far but along the way, they have several
prototypes developed (to be evolved to full products dependent on funding). I
guess thats where the valuation comes in.

Someone1234: I like your idea of not putting all eggs in one basket. I think
he did PMV at worthworm.com. Also, the fact that someone is willing to invest
$2M - 10 multiple of the seed amount is $20M. Is this how you typically
validate the PMV? And yes, one of my incentives to invest is to get myself
paid. Is that a good approach?

kkowalczyk : I agree consulting companies cannot scale that much. But, this is
positioned to become a product company (dependent on $2M funding) - in that
case, what are your thoughts?

Jeffmould: The CEO has confirmed I will be at the top of the stack. Future
funding will not dilute my equity. I like your idea of convertible debt to
safeguard my investment. In fact, the CEO did mention this to me - he will
take this investment as a loan to be returned to me - maybe he meant
convertible debt? Is there anything more I should watchout for?

auganov: Thanks for your honest answer. I don't blame you as I left out the
relevant details earlier. But how can I ask for 15% for only $100K when Mr.
$2M is asking only for 10%?

lxfontes: Yes, if the $2M seed comes through, they have offered me a full time
employment with some common stock but without the founder shares. Founder
shares will only be given with cash investment.

~~~
jeffmould
Thinking about this even more, the company is only cash flow positive because
they are not paying you. And if they are not paying you, the question begs who
else are they not paying.

Just because the CEO has sold multiple companies and realized profits for
previous investors, does not automatically make this a golden egg as well.

Finally, just because the CEO says you are at the top of the stack and future
funding will not dilute you, does not mean it will not happen. In fact it is
fairly certain to happen if additional, bigger investors come on board. If you
want to get an idea of the dilution, Google an Excel cap table example
(there's actually a pretty good one on
[http://cooleygo.com](http://cooleygo.com)) and play with the numbers a bit.

I would honestly skip the whole deal, push for either them to pay you what you
are owed to date or go with a convertible note. I would also talk to an
attorney before I made any decision. It just seems to me that the CEO is
trying to make it sound like a great deal with no risk, when in essence the
risk is enormous.

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js4
What kind of product is it?

A consulting business isn't really worth what you are proposing -$300k a year
with a valuation of > $1m.

If I am understanding you right, if you invest $100k into the company, they
would use that money to just pay back your consulting fees right? Why not have
them compensate you outright stock and forgo cash compensation? It seems like
a waste of time to put cash into the company and then pull the cash back out.

Also if you are concerned with them not raising the funding you could just
make your investment contingent on the raise. Basically say to them "assuming
that we can get this round done, I'm in for $100k". As an entrepreneur I hate
this (makes me think you are betting against the company) but I could be
persuaded if you picked up the axe and charged into battle with me. So make
sure that if you do this you are busing ass trying to make the round happen.

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jeffmould
IANAL, or an accountant for that matter, but something does not add up or you
are leaving a lot of detail out. If you invest $100K for 3%, then the investor
comes on at $2M for 10% you are going to take a hefty dilution from that.
Without knowing all the details of the company or who/what they do, I am
skeptical that a company only generating $20-25K monthly from consulting
revenues is getting a $20M valuation. That seems a bit high for a consulting
company that has been in business for 3 years doing less than $500,000 annual
sales.

From the sounds of it, they are only asking you to invest so they can turn
around and pay you from your investment.

With that in mind, you may want to consider doing a convertible debt and
if/when investors come on you have an option to convert to equity or collect
what is owed to you. And if the investor does not come through, the company
still has a debt to you.

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semmem1
If he has had multiple exits worth any considerable cash, why doesn't he just
put in the money himself instead of getting investors, especially an investor
like you. Seems like he himself is not confident in his idea and doesn't want
to risk his own money in the venture.

~~~
smileysteve
> especially an investor like you

This is a good point, at 100k for a round you're very friends and family
sized, and the responsible question is, are you a qualified (legally and
financially planning wise) to lose this much money.

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Someone1234
They're certainly making you a better offer than the $2m/10% individual. That
person is effectively paying $200K/1%, as opposed to your $100K/3% deal.

I would say consider this two separate deals, don't conflate them(!):

1) The investment: You're out $100K and have a fairly risky investment in this
company that could be worth $0 one day (and no set payback date). $20m
valuation is meaningless, it just helps you vaguely judge risk, but not much
(also who did the valuation? How confident are you in them? Who is the 2m
investor? Do they even exist?).

2) The full time employment: A full time employment offer, when or if, that
happens should be considered on its own merit (although that alone sounds
almost like a further investment as I imagine they're going to "under" pay you
since you're now a stakeholder, or worse expect free work)

The ultimately question you should be asking is: Can you afford to lose 100K
outright? Because that is on the table. Could you put that 100k on black on
the roulette wheel, and risk a 50/50 shot of losing it? Or worse on a 1/16 or
1/32 shot. Because that is the reality.

To be honest I'd consider taking a 3%/100K if I could afford to lose
(completely) 100K (and the company had good prospects). But I wouldn't work
for them below market rates, because then the risk has risen too much, and it
sounds like you do pretty well anyway on your consulting.

So if I did the investment I would then go and make money elsewhere, so that
even if this company burns to the ground, my maximum liability at that stage
is "only" 100K, not a penny more.

Working for them for 50% of normal or worse not getting paid reliably (as now)
is just more and more investment and before you know it you might be throwing
another 100k or 200K after your initial investment just from lost wages alone.
Essentially trapping you into more and more risk.

So look at risking it on the company but curtail the level of risk. You
shouldn't be in as deeply as a founder, your potential compensation isn't high
enough.

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ranty
No.

The $2M is complete bollocks and they need the 100k to keep going until they
can find some actual investment. Otherwise they'd be paying your bills.

So tell them you'll consider it once they pay you - and get some kinda signed
statement that they do, in fact, owe you for two months consulting.

Frankly, it smells bad and for me that's enough.

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lxfontes
short answer: I wouldn't do it.

1\. I would ask for my unpaid consulting fees

2\. Ask if they want me to join without the 100k down and take less % on
shares

The rationale here is:

\- Low monthly revenue for a long time

\- Not paying contractors is bad

\- How many other people have this 'offer' on the table?

If I were to put 100k of my money somewhere, it would be on a 1-year
sabbatical and start my own thing.

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brudgers
I would not give $100k to anyone who didn't pay me and didn't tell me until
after I had done the work.

You could cut out the middle man and just pay yourself. Anyway 3% isn't a
controlling interest and you are entirely dependent on their goodwill in any
liquidity event.

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fsk
Investing on the hope that they will use the money to repay what they owe you
is pants-on-head retarded.

Option #1 - convert the debt to equity at the proposed valuation.

Option #2 - get paid, don't invest

Option #3 - expect to never get paid - walk away or continue for fun

Don't give those fools money. Working for 2 months without getting paid is
enough of a gift.

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auganov
OMG NO.

3% would be a bad deal even for a regular employee considering they don't have
money to pay you. If you really want to do it you should ask for 15%+. But
please, don't.

Do you even trust these people? Unless we're missing some important
information they sound either ignorant or shady.

