This time around I'm going to set a valuation, though, and put a stake in the ground. The reason for this is initial valuation is relatively arbitrary; what matters is the percentage of ownership at the exit. 20% of a company at entrance is meaningless at exit if there are liquidation preferences, and the sale is for less than any cap on the preferences.
I'll explain. (The numbers I'm putting forward are not for my startup--they just make the math easier.).
Say I'm raising $400k, at a post-money valuation of $2 million, ($1.6 pre-money value plus $400k), with typical downside protection; the first money out of any deal goes to investors. This is called a 1x "liquidation preference"--you get your money back in the case of a sale greater than the amount invested.
We will add to this "participation", which means investors will first get their money back, then receive their full percentage of the remainder as well.
In the event of an exit of, say, $500,000, with $400k invested, investors get their $400k back, plus 20% of the remainder, or $20,000. Not a great return, but not a loss, either. Better than the 2008 Dow, anyway!
In the case of a $200k exit, they get $200k and call it a day--a loss of 50%.
In the case of a sale at $2.4 million, investors get their original $400k, leaving 2.0 million, and then 20% of the remainder, or $400,000, for a total of $800,000 , or 30%. So 20% becomes 30% on the exit--not a bad deal for investors. Common (founders, employees), split $1,600,000. Not great, especially if it's after 4 years of work. But it beats working for the man.
Say the participation cap is at $4 million, so any sale over that removes the preference. At $4 million, this means straight percentage return--20%, or $800,000, a 100% gain.
What' s interesting is that it's in the investors interest for the lower sale of $2.4 million, which provides a 3x return, than on the higher sale of $4 million, which provides a 2x return. While there are ways to smooth this out, it's not really worth the complexity at that level of exit.
The ideal situation would be to sell the company for a much larger amount--say $8 million. Everyone makes their pro rata amount because the preference is capped and goes away at $4 million, so it would be a straight 20% to investors: $1.6 million, or 4x their investment. (I'm leaving out accrued interest; most deals carry 8% annual interest until exit, which mitigates risk for the investors but can really nail Common if the startup gets long in the tooth. It's another incentive to do well quickly).
The challenge is to create real value over time so that the exit is good for investors and good for employees and founders. The tradeoff with taking investment of this type isn't terrible: you get the chance to build your startup, and if you do a great job, it will pay off for everyone in the end. If you don't get it to a decent value, then at least you've taken the shot and haven't gone bankrupt doing it.
Remember to take a salary; I went without one for 5 years with Mission Research (I could afford to at the time), and while I received some additional stock for it, it wasn't close to the amount of time I put in or my market value as a startup CEO. But that was a trade-off I accepted at the time, and I have no regrets about it--it's a solid company and I'm proud to have started it. But the message is this: don't forget to take care of yourself--at least the basics.