Hi, I’m David G. Cohen.

Through TechStars, my other investments or just at random, I’m often approached by entrepreneurs who want advice on what to do when a potential acquirer first brings up the idea of buying their company. Often, the company being targeted for acquisition is “up and coming” and is very early stage. For that reason, the entrepreneurs are often rightfully concerned that the “acquirer” is really just digging for information. That’s a valid concern for many early stage companies. Here’s the advice I usually give concerning this situation.

Step 1. Assess the acquirer. First and foremost, you should assess the potential acquirer. Can you really see yourselves working with them? Do you like them? Are you willing to be an employee of that company? Do you trust that their interest is genuine? If the answer is no, recognize that it’s either a non-starter or that it’s going to take one heck of an offer to pique your interest.

Step 2. Notify the board. Notify your board and/or key investors. If you have a board of directors, you should promptly notify them (email is fine). You might also notify key trusted advisors and mentors. Make sure to mention that the interest is very early, and that you’re exploring it. As always, getting mentorship can be key.

Step 3. Set your number. Next, if you haven’t already done it, you should have an honest discussion with your co-founders and key management about the minimum number it would take for you to sell the company. When doing this exercise, it’s useful to think about the following issues:

• Talk about the stock/cash mix that would be required.
• Talk about how long you’d be willing to work for the acquirer at market salary. Assume at least two years.
• Assume that you’ll have no ongoing control of your company or product, and that it just won’t be your baby in any way, shape, or form any more.

Recognize that it’s very easy to trick yourself at this stage. It’s really important to define the minimum number without padding. In other words, you’re effectively deciding that if the offer clears this hurdle, then as a team you want to work towards taking it.

Step 4. Engage the acquirer. When you first enter into discussions with the potential acquirer, you should expect them to ask you all sorts of questions before they make any sort of offer. You can expect questions about revenues, expenses, headcount, conversion rates, attrition rates, and all sorts of detailed stuff.

At this point, it will be your natural reaction to ask for an NDA with the acquirer. While this is a good instinct, delay doing it up front. Don’t worry – you will use it as leverage shortly. Without mentioning an NDA, provide a few high level answers that you’re comfortable with them knowing and when the questions get into the “zone of discomfort” ask them to provide a detailed list of their questions via email so that you can work on them.

Step 5. Ask for the ballpark offer. Now that you’ve answered just a few high level questions and have a more detailed list of what they’re after, it’s important to go for the “ballpark” offer before proceeding. Explain that you’ve received their email, you’re obviously flattered with their interest, and that you’re happy to answer all of their questions under two conditions. The first condition is that you’d like all of the information that they requested to be covered by an NDA. The second condition is that before proceeding, you would like for them to provide the likely “ballpark” paramaters of the acquisition via a simple email, including the likely cash/stock split.

Most acquirers will happily accept the first condition (not doing so is a serious red flag) but will avoid the second condition. It’s important to stand firm on both conditions before proceeding. The acquirer will likely claim that they don’t have enough information to make an offer, and that they need their questions answered. Assuming that you’ve given them basic revenue and expense figures, this is bullshit. Hold firm. Explain that you’re very busy working with customers and improving your product, and that you can’t afford to distract the company without having at least a ballpark understanding of the offer. Explain that it’s obviously non-binding and that you won’t hold them to it, but that you’re just trying to get a sense of it. Sometimes there is a little dance at this stage, where they will look for a couple more tidbits of information in order to give this ballpark offer. That’s fine – use your best judgement. Just avoid dropping your pants completely until you get the ballpark offer. Note that this does not mean sign the NDA and give them all the answers that they’re seeking! This is your leverage to get the ballpark offer, so don’t give it away. Recognize that the NDA won’t protect you from giving the “fake acquirer” exactly what they wanted.

If the acquirer resists the NDA or the ballpark offer, they’re probably just fishing. You’re not being difficult. You’re asking a perfectly reasonable question about ballpark deal terms before wasting your time.

People who are not high up enough in the acquiring company to actually be making this offer will be scared off at this point. That’s a good thing. Perhaps they never had permission to be pursuing an acquisition in the first place. This technique weeds those people out since they have to provide the non-binding ballpark offer in writing via email.

Don’t proceed without the ballpark offer.

Step 6. Identify mentors. Now that you have a ballpark offer, you have what I would consider serious interest. Now make sure that you’re working with someone who has been involved in multiple acquisitions, ideally on both sides of the table. Perhaps one of your existing investors or advisors can fill this role. It’s critical to have someone on your team that can help you negotiate terms, and to help you understand their impacts. I can tell you from experience that when I had my first exit from a company I founded, I left millions of dollars on the table before I learned this lesson. Do not underestimate the ability of experienced mentors to greatly increase your ultimate outcome. If you don’t have an advisor, contact someone that you trust that has done this before and ask them to help. It’s fine to pay for this help if you don’t have other options, but you should only pay in a success case and you should recognize the dynamic that this creates: 1) This person loses nothing if there is no exit other than time and 2) they’re motivated to help you maximize the exit at the expense of everything else.

Step 7. Assess the ballpark offer. Take the floor value of any “range” that they gave you for both the total comp and the cash percentage of the stock/cash split. This is all you should “hear” – ignore the rest of the range. The actual offer is very likely to end up being very close to the low end of the range unless there are multiple competing offers. You should now compare this to what you discussed in Step 3. If the offer isn’t high enough to be interesting, then your best bet is to simply tell them that and politely decline to provide any other information.

Step 8. Get to know them and answer their questions. At this point, the offer is “interesting.” Your goal now should shift to getting some face time with the acquirer and getting to know them on a personal level. It’s fine to do this by phone, but find ways to spend time with them physically. This will help you figure out if they are “for real” or not. Ideally, if practical you’ll start to this before fully “dropping your pants” and answering all of their questions. It’s a fine line between being coy and stalling. You can’t stall too long, but you can offer to meet with them personally to go through their questions. Basically, the more time you spend with the potential acquirer, the more you can develop trust and build from there. Provide the requested information under NDA to continue the process. Be sure to mark all information provided as confidential under the NDA. Keep a copy of everything that you provide.

Step 9. Push for a term sheet. Even at this stage, many acquirers will go silent for a long period of time. Sometimes this is normal – these things just take time. Internal fires that have nothing to do with you come up. People go on vacation. Things always move slowly. Do not assume this is going to happen. Keep building your business in the meantime. Continually push for a term sheet fully describing the acquisition. At every meeting, ask what information you can provide to work towards getting a definitive term sheet describing the acquisition.

Step 10. Decide. If at any point in the discussion you decide that something is not right, just stop. Ask for the return of confidential information, and politely bow out. If the deal happens – congratulations! Assume it won’t until it actually has.

Good luck! I’d love to hear your thoughts and experiences in the comments.

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I received this question today via email:

… I am a young entrepreneur… I am currently involved in a… start up… We are currently in the process of raising a friends and family round of funding, and right now we are struggling with the valuation. I am looking at the TechStars framework (a $300,000 post-money, if my math is right) because it appears outwardly that we are at a similar stage of business development compared to the TechStars companies. However, I would like to confirm with you what stage a typical company is when they apply for TechStars? We currently have a BETA test version of our website up with 1700 members, and we pull about 2000 uniques per month. I am wondering if we are on par with a 300K post-money?

I’ll come at this answer two different ways. First, I’ll address the flawed thinking inherent in simply comparing your company to another known data point based solely upon valuation. Second, I’ll address the question of how to think about and possibly determine a fair valuation, especially in the peculiar context of a friends and family round.

TechStars is providing much more than just money. It’s providing access to extensive mentorship, a very large network, a community of startups, office space, legal work and other free services, a platform for credibility, and access and opportunity with literally hundreds of investors. It’s unlikely that friends and family will bring the same resources to bear. It’s more likely that they’re simply bringing money. Clearly, it’s not going to be an apples to apples comparison. So in order to compare a TechStars valuation to a friends and family valuation, you first need to somehow determine the value of all of the things that TechStars brings to the table. Unfortunately, this is not easy to do. The value is in the eye of the beholder. But clearly, a simple comparison is flawed thinking.

More broadly, the lesson here is that you can’t simply compare valuations in any context. Valuations tell only a small part of the story. “When” matters: Consider the average startup valuation a year ago vs. today. “Who” matters: Consider Bill Gates doing his next startup that is exactly like yours, vs you doing it. Or consider who the investors are. Investors who bring more to the table might well deserve a lower valuation. Even “Where” matters: The same startup in Silicon Valley is probably going to draw a higher valuation than if it were located in rural Iowa.

Now that I’ve cleared that up (I hope) and all the readers from Iowa are gone, let’s address the part of the question pertaining to coming up with a valuation for friends and family. This is really tricky, because in my experience it’s very easy to drive an extremely high valuation in these scenarios. Usually, friends and family are investing in you, and will not pay so much attention to the valuation. They’ll often trust your judgment above theirs (which is part of what makes them “non-professional investors”). Depending on all of the factors I’ve described above, typical web company startup valuations run somewhere in the $1M-$3M range, pre-money. From what little context I have from the email, I’m guessing the startup in question would be valued on the low end of that range, assuming investors wanted to do the deal in the first place. With professional investors (angels and venture capitalists) this simply turns into a negotiation. There is no magic formula – it’s simply a number that both parties can agree to. But with friends and family, given the dynamic, I generally recommend a completely different approach.

With friends and family investors, the right approach for companies that think they may want to raise more money in the future is almost always going to be to use convertible debt. Instead of issuing equity, you can simply document it as a loan to be repaid with interest potentially with a right to have their money “converted” at the next value event (funding or acquisition) based on the valuation that is assigned at that point. Often, a small discount (10-25%) will be offered so that early investor gets additional equity at that point as compared to those bringing in the new money. The benefit here is that the valuation at this next value event will typically be assigned (and negotiated) by an acquirer or by professional investors. It avoids the whole messy discussion of valuation with friends and family, and feels “fair.” The other benefit is that it’s likely that venture investors are going to want to buy out any friends and family investors when they do a large financing. Using a debt instrument makes this an easy step, while still rewarding your early friends and family investors.

Now, you may be wondering if this advice is in conflict with other advice you might have heard about “misalignment of interests”. After all, if you raise a debt round, isn’t it going to be in your investors best interests to keep your next valuation as low as possible, so that they get the maximum effect from conversion? The answer is yes, which is why I generally recommend and use preferred equity in most of the deals that I participate in. However, I’d submit to you that in the case of friends and family, they’re unlikely to take that point of view for the same reasons that they’re unlikely to push valuation as an issue in the first place. Finally, another benefit is that it’s less expensive to create legal documentation for a debt financing than for an equity financing.

In summary, I generally recommend using a debt instrument for a friends and family round. I also think that it’s critically important to look at much more than the valuation in order to truly understand any equity financing.

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