Startups and angels: Along the way to success

Are Investors Being Unreasonable?

Take a look at this article from the August 20th Milwaukee Journal Sentinel.  It seems to me this may be a sign of the economic times.  Or, of course, it's possible that Jason Weaver (who I know - and I think Sway is a neat company) is a bit frustrated about the "rules" dictated by the current investment environment.

Now, in some ways, I'm in agreement with Jason.  If the comment about "do enough things to us" is a reflection on potential investors who he thinks don't understand his business or can't help him, he should never do business with them.

Who the entrepreneur takes money from (see this post) is always more important than the terms.   So to the extent that he sees that the quality of the investor and his/her connections and abilities is really what the early stage company is buying, the more Jason and I would agree.

If a company is seeking "angel capital" it almost always wants people who can and will be helpful beyond writing a check.  This, in our group, has included providing industry knowledgeable directors, or connections to other groups, or other types of expertise the company wants.

But what about his comment about "ridiculous terms?"  The biggest single failure of terms set by angels is the opposite, historically, of what Jason calls "ridiculous."  The problem has been that too-high valuations and too generous terms have spawned painful down rounds that squash the entrepreneur and his early investors. 

New money, usually VC money, comes in and crams down those early investors and takes substantial shares from the entrepreneur.  This happens more often as the "second round" exceeds the amount early investors can raise, is often a somewhat unexpected round, and usually is associated with missed milestones.  At the same time the company is running low on cash.  This is a confluence of bad events.

Ask any of us who've experienced significant down rounds based on some or all of these things, and one begins to understand the cautionary nature of deal structures.  So in today's environment, caution is the watchword.  No one wants to begin a relationship with a company that is contentious, especially when the investor has no requirement to invest. 

In the case of Sway, it sounds like they are doing ok without investment right now.  And that's an important point.  If the entrepreneur can bootstrap the business, it will always be worth more to the entrepreneur as well as future investors, if any.  It provides more freedom for the entrepreneur.  And more choices.  (People I know are tired of hearing this, but we did bootstrap RTMS, Inc. up to $10MM in revenue.  It gave me a lot more freedom.  Some would argue it also didn't force me to make hard choices that caught up to us later, but that's a story for another time.)  So, I'm a big proponent of bootstrapping and the benefit it provides to entrepreneurs.

So, one of my questions for Jason is really if investors terms are "ridiculous," or even if they're not, shouldn't bootstrapping provide a much superior outcome for the company than equity investment? 

Another thing for the Halos to think about is the inherent difference between VCs and Angels.  VCs have an absolute need to find companies to invest in, and to do it on a schedule.  This is fundamental to their business model.  And it is unarguably what has driven valuation bubbles in the past.   Because they only get to raise a new fund if their latest results are good, they are pretty gun shy on terms right now.  And who can blame someone for trying to keep his job? 

Angels, on the other hand, largely do this for the enjoyment of working with entrepreneurs, socializing with each other, and generally being engaged in the community.  They play for their own money, not the money of investors, so they don't have time pressures or minimum investing requirements.  Many I know will actively seek deals to work on that are run by fun, engaging people who are eager to grow the business and know what they're doing.  The best seem to have a propensity to ask for help.  Here's an example: Flex BioMedical, run by Sal Braico.  Here's a guy (sorry Sal, don't mean to sign you up for more work!) who could give the talk about how to lead an angel negotiation with style and grace.  And a good outcome. 

On valuations, if an angel-backed company can get to the goal line without future rounds of funding, the question of current value is much more manageable. When there is the prospect of future rounds, sometimes evidenced by misses in the past, deal structures become more caution-driven.

So, I don't quite see how Jason's thought about "If they turn enough of us down or do enough things to us, eventually they're going to run out of people to do the work," fits.  If these are funded companies in his group, are they unhappy with the terms they took?  Or is it really the "turn down" part that's the issue?

Just by sheer volume, every would be investor passes on 95% of what comes by.  Our group sees 250+ opportunities a year, many quite good.  We pass on a lot of stuff that we like.  We just don't have the capacity to do more.  We try to provide fast feedback to everyone we talk to, and we try and talk to most everyone who contacts us (at our website). 

So, perhaps a positive use of these group meetings would be to discuss how people did get funded (ask Sal to speak for one!) and what the current requirements seem to be. 

Real angels, as I've mentioned, don't have to invest in anything, and all of us see lots of opportunities from people we know and trust.  Most won't struggle much with difficult situations pre-investment.

I hope perhaps a dialog might get started around these topics that will help everyone - entrepreneurs and angels - come together for their mutual benefit - and satisfaction.

The Other Guy's Point of View

"It depends on your point of view," is a universal principle.  I have been reading some technical valuation papers lately and one author points out that the first time entrepreneur frequently "decides they need $2M and will 'give up' 25%, so the  'valuation' is $8M" without considering the investor's interests or point of view. 

Here's a "guest essay" from John Huston, manager of the Ohio Tech Angels that adds a point of view (tongue in cheek) from the angel's vantage point on "How to Avoid A Successful Exit."

SEVEN STEPS FOR PRECLUDING PROFITABLE EXITS (aka “WORST PRACTICES”)

1)  Acquiesce to the entrepreneur’s requested stratospheric valuation in the first round (because you can’t build a friendship if you start by being disagreeable).

2)  Don’t bother to estimate how much additional dilutive capital might be required to orchestrate an exit (because crafting a Capital Access Plan involves too much imprecision to have value.)

3)  Base your potential return calculations on an IPO exit versus a company sale (because the enterprise is less likely to re-locate post-IPO).

4)  Disregard data about historic M & A exit proceeds for VC-backed enterprises in the same industry (because today’s market is obviously in flux, as evidenced by one recent transaction).

5)  Base your investment decision solely on who has already committed to invest (because this avoids wasting time on boring due diligence which they probably have already performed).

6)  After making your initial investment move to the “mute money mode” (because by spurning opportunities to assist the entrepreneur you can retain your objectivity).

7)  Only participate in the first round (because by being a “Willie One Check” you not only will have invested all your money at the lowest valuation, but will also avoid haggling over term sheet provisions regarding Pay to Play or Pre-emptive Rights).

Note:  The efficacy of these steps can be vastly enhanced if angels will just make the following assumptions when reviewing a business plan:

    a)  The founder/inventor deserves to remain CEO until the exit (besides, this horse is such a winner any jockey can ride it to the finish line).

    b)  It is unlikely the enterprise will encounter any challenges not covered in the  business plan (since it is so thorough).

    c)  When new investors are needed they will grasp the value I have provided the   company to date (so they will surely respect my existing terms).

    d)  The level of detail in financial forecasts is highly correlated with accuracy (so the more complex the financial forecasting model, the higher the likelihood its        predictions will be achieved).

    e)  There are some transformational ideas which truly do “sell themselves” once they are made available to the marketplace (and fortunately this is one of them because “great science can trump any sales strategy”).

    f)  If cash flow break-even can be achieved with just a tiny market capture percentage, then sales will not be a daunting task (especially if the forecasts haven’t even considered penetrating possibly gargantuan international markets).

    g)  For medical devices:  If a device obviously improves patient outcomes the  medical community will embrace it (because physicians are solely concerned about enhancing patient experience).

© 2008 OhioTechAngels; John O. Huston ([email protected])

Thanks, John.

Nothing is a Proxy for What You Don't Know

I've once again been asked about what I've come to think of as the proxy issue.  The potential angel investor is interested in the business.  It's clear that the idea is novel, at least to the investor (whose market knowledge may not be fully informed). 

The entrepreneur - i high integrity scientist - offers the following kinds of proof of the market.

1.  I've gotten a grant from some referred source for this business/idea;
2.  Angel group ABC says they are interested and will co-invest;
3.  Our management/staff/advisors are working for reduced salaries;
4.  Our key suppliers, such as lawyers and accountants, are deferring billing;
5.  The product idea meets or exceeds the gold standard for other products in this space.  Other commercially available products are (we acknowledge) clearly less adequate for important reasons.
6.  I have a patent application in process and my attorney says it is very strong.

These are all nice to knows and cannot help but pique the investor's interest.  They are important for the investor to know and for the scientist to report.  But they are not a substitute for firsthand market knowledge and scientific validation.  These questions only get answered by a process of drilling down, first with the company and the entrepreneur (Where are the risks? What do you worry about?  What will the next big breakthrough be? etc.) and then with the market and the proposed customer.

The whole process of impartial scientific validation is also critical.   Not only do we want to know whether the science will perform as described, but also whether it has known or perceived flaws that will not allow it to perform in the market as planned.  We also want to know how we learn of general or specific trends that will eclipse this concept.

Finally, is there any scientific discovery still required in the  remainder of the task to get to market, or is it all engineering?  Engineering is a known process; scientific discovery has high risks.

This is a long way of saying that nothing offered by way of a proxy for the process of actual validation will reduce investor risks adequately.

There Must be a Way Across The Inventor Chasm

For not the first time, I've met with an inventor who has what I consider to be a pretty good idea, and a prototype.  His opening statement was something like "All investors want 60% of the company for whatever they invest, so I've developed a plan to maintain complete control while providing them their 60%."  Kind of went downhill from there.

I tried to assure him that my own interest was in seeing entrepreneurs succeed and that investment metrics (in my mind) were only there to measure probabilities of returns.  We couldn't even agree about that, and within 30 minutes, we were done.  I'm disheartened.

My fellow angel network managers say that they usually won't talk to inventors because the company anticipated is usually not ready for angel investment.  But then where do these people go?  Some wind up in the hands of individual investors who have experience and capability and can forge good working relationships.

Some wind up in the hands of individual investors who do not have experience and no real expectation of loss - little tolerance for risk, in other words.  When the inevitable happens, it becomes an unhappy event. 

I would love to find a way to give people the opportunities they deserve by their innovation and creativity.  There has to be a way to do it.  But it is not yet another program or center or something.  I don't know what it is, but building a trusting relationship going both ways is right in the middle of it.  Maybe it's just the process of talking to a lot of people with a helpful focus.   And resisting the urge to be cynical.  If you are hopeful and optimistic, someone said recently, you can be mistaken for being naive.  But if you're cynical, everyone knows it.  Let's be hopeful and optimistic anyway.

Who Gets To Break The News That Your Puppy is Ugly?

I'm at the National Association of Seed and Venture Funds meeting in Rochester NY today. 

One of the speakers this afternoon, talking about helping entrepreneurs get ready to present to investors, said something like this:

"Instead of letting people who I don't think are investable spend a lot of time on presentations to investors, I just tell them they either aren't investable or shouldn't be in business."

Now, let's assume that there are potential entrepreneurs that "shouldn't be in business," and that a smart advisor can accurately identify them.

The question is, though, who gets to tell them?

There isn't anything in it for the investor to tell them, especially if the entrepreneur(s) are in sales mode.  The investor does not want to be critical, is concerned he may be incorrect, and worries about protecting his reputation-based deal flow.  So he says things like "we aren't investing in these type of businesses right now," or "our investors don't seem to be sufficiently interested to warrant you spending any more of your time."

Occasionally the investor gets a frustrated blowback from the potential entrepreneur, perhaps underlining that "uninvestable" belief. 

If you're getting these kinds of vibes, and before you shop a deal so thoroughly that the guy bagging groceries at the local store knows about all of its flaws, figure out your personal best way of getting critical feedback.  Try using a diligence checklist (you can find them anywhere) to walk through a series of questions with the (now-ex) investor.  Listen.  Don't argue.  Seek to learn.  Or devise some other way to disarm the investor enough to get helpful information. 

Look yourself in the mirror and ask what you are hearing.  Do there seem to be areas of importance that you don't know about?  (As an example, are you getting signals that your claims/beliefs are hard to validate?  Does that suggest you ought to seek validation prior to pursuing more investment?)  How can you cover these?

Have you benchmarked yourself against others to see what you may not have?  Or may need?  Have you tried asking the investor about these things?

Are you looking for the wrong kind of investor?  What kind of investor is your business best suited for?  And so forth.

I'm a bit surprised at how many potential entrepreneurs really don't want feedback and waste a lot of time - years - finding out they're not investable.  And then finding something to blame (environment, poorly educated investors, low risk taking attitude here in ---fill in the blank --) rather than learning.

Four weeks of experience is repeated twenty times.  (No mistakes in life, just lessons repeated until learned!)

Doing Lunch Rather Than Being Lunch

I got an email the other day that I've excerpted a bit of as follows---

Good Morning.

My business partner  and I are in the process of setting up a company and looking for money. We have been offered 2 million dollars from (X)  but he is looking for a very, very substantial return and I think we can do better.

We have a patented process to manufacture (Y) products different than they are currently being manufactured. Our process has many advantages and we believe will take off once introduced to the market. We are in the process of having a machine manufactured so we can make samples to show potential investors.  We believe that our business plan is attainable and the numbers are on the conservative side.  We also have several potential customers waiting for the samples.

Here's what's interesting about this.  I called the person who sent this to me.  The product is pretty credible and will address the home construction market.  But the deal that they were considering was not very good.

They were going to sign up to performance penalties that potentially would cost them the company if they missed their projections by six months or so.

This is a product that ought to produce nice growth, but inevitably growth takes longer to achieve than plans call for, especially out three years, and especially when beginning with only an idea (albeit a pretty good one). 

So why would an investor offer a couple of million dollars?  An industry insider would know the value of the product in the market and the distribution required to make it go.  Perhaps the long term prospects are excellent.  (Perhaps the "offer" was only meant to be so egregious as to suggest that any sane entrepreneur should walk away.)  In any event, the entrepreneur was going to put herself in a corner from which there is little escape.  If things don't go perfectly in this case, the investor owns everything. 

The nightmare scenario is one in which the product performs, but not as well as projected, and the investor takes over and forces the entrepreneur out.  A year later, the thing is a growth story.

What's a better idea?  A partnership with someone on the distribution side might be a better answer, as well as a prototype developed on friends and family money - or on a good deal with that partner.  Yes, a deal like that will have a buy-sell, but constructed properly, everyone can win.

This probably isn't an angel deal because the returns will be good but not in the range of returns angels look for.  Also, I told him, this may be a very nice company for a long time, and forcing a sale may not be in the best interests of the company.

How do you avoid these situations?

1.  Know what is being proposed.  This seems obvious.  It's not.  Understand what the mechanics are for warrants, common vs. participating preferred stock, convertible debt, and all of the terms investors are talking about to you.  Of course, consult experts - but make sure you understand what is being proposed - not what their interpretation is. 

2.  Have a low burn rate.  Easier if you are younger, I suppose.  But the ability to require very little cash as you develop your venture pays huge dividends in flexibility and opening up choices.

3.  Don't think that all equity investors want the same "harvest" event.  People who invest other people's money invariably want it back on a schedule, and therefore invest in deals with a sale of the company as a goal.  But, there are investors who may be happy with a piece of the action for a long time (as long as there is a way to trigger a buy-sell in the future) especially if they may have another strategic interest in the deal, such as a distribution partner.

4.  Beware of individual investors who do not have to worry about their public reputation as investors, as VCs or angel networks do.  They can make this kind of predatory offer with little regard for who may know about it. 

5.  Ask yourself what value the investor can add - beyond the money. 

Who's Who of Angels

This is an interesting article from today's VC Experts website (vcexperts.com) that they forwarded to me.  It's a discussion of return calculations for angels as well as a description of "types" of angel investors.

Download of_angel_investors_npv_and_irr.pdf

Podcast: Having A Candid Conversation with Angel Investors

Here is my first attempt at a podcast.  It's a talk for Entrepreneurs (this recording is from the State Entrepreneur's Conference in June 2006) about how to select angel investors and also meet their expectations. 

This file is large (20+MB) in a format that is Real Player, iTunes and Quick Time compatible.  I'll try and figure out how to compress the next one.

I'd be very interested in your comments about this talk and about whether you would lke to see more podcasts here.

Thanks!

Download candid_conversations_with_angels_copy.m4a

How to assure yourself that no professional investor will ever want to invest in your venture:

I normally shy away from writing “don’t do this or that” because, while it’s compelling to learn from the negative side, it’s also a bit wearing in large doses.  Additionally, I intend this blog to be for entrepreneurs as a way of helping them to succeed, in some small way, and negative stuff is the wrong orientation.

Please pardon me today for breaking that rule.  I don’t think there’s a better way to present these ideas.

So, here are some thoughts on assuring yourself that professional investors will not be interested in your venture:

1.    Be unwilling to discuss any risks in detail.  Insist that the only risk is “finding true believers” to invest.  Proclaim to everyone you talk to that “once the cash is in the bank, there’s no risk at all.”

2.    Insist on raising all the money you are sure you will ever need, all at once.  This is especially good for true startups where there is very high execution risk and steep downside risk.  Try to raise $10MM all at once so that you “can get on with building the business.”  Dismiss staged investments and rising valuations based on results as “sissy stuff.”

3. Develop a plan to amass large fixed assets in plant and equipment prior to making any sales.  This assures that the $10MM will be sunk quickly. 

4.    Proclaim that “80% is committed” already so “take it or leave it.”  Do this early in the meeting so the weary investor can politely say, “I’ll leave it,” and leave. 

5.    Tell investors that “since we are all in this together,” you will issue all common stock with no preferences or debt restrictions.  Set the valuation very high so that if there is so much as a missed monthly milestone, any new money will be certain to cram-down all of the investors.  Absolutely don’t even consider any investment vehicle used by professional investors, like converitble debt or prefered stock.

6.    Try to get an NDA during the initial presentation.

7.    Use structures and investment vehicles appropriate for three friends opening a bar to raise money for a high tech venture.  This means no exit capability on the part of investors, reliance on a pre-appointed board of directors and management team with long-term fixed contracts, prioritization of insider debt in front of investors, and, overall, makes sure that every other sentence in your presentation starts with “Trust me…” For good measure, promise to share cash income “as soon as it makes sense to the founder.”  Of course, never consider vesting founder’s shares, or holding the CEO responsible for performance.  You are all buddies and want to make sure everyone knows “you’re doing all of this on trust.”

8.     Don’t do any work on alternatives to reduce risk.  When these questions are raised, sell the original idea more loudly.  Don’t consider early testing rather than building plants; make sure you don’t understand the industry.  Tell investors “there is no outsourcing in the industry,” right before they do a google search to find out that there is a $28Billion outsourcing capability.

9.    Use analogies about buying cars, opening restaurants, and doing deals with your brother in law to persuade the prickly investor that her fears are unfounded.

Pick Your Investor With Care

The great day has arrived.  Tomorrow, you're going to close your first professional investment with "Fred," a wealthy individual you met at a networking event.   Just this morning,  he called to tell you how enthused he was.

"Just a couple of tweaks from those lawyers," he laughs with a wink in his voice.  "They're making me put in some technical stuff.  Nothing to worry about."

When the list arrives, you decipher the changes and seem to find that his investment is now a loan and requires preapproval from him to borrow more, along with a new set of warrants based on performance.  It looks like if you miss your quarterly goals, Fred will own more and more of your company.   He's also requiring that you source your software development through his consulting company at a price "to be negotiated."  Finally, if you fail to agree on a price for the development within 6 months, he gets his money back with 18% interest. 

This wasn't the deal you thought you were getting, and in the meantime, you've turned away several other investors.   It's true, you did talk to Fred about his development capability but you hadn't really expected this. 

And, while you haven't really spent the money, you have certainly got plans.  If you accept this deal, you really can't prudently spend anything for six months while you negotiate a price.

"Well," you think, "we can work this out.  I like this guy."

But ---

1.  Did you get references from people he's done deals with?  From references that you got from the references he introduced you to?  Have you checked him out on the jungle grapevine?

2.  Have you asked him - directly, if politely - what the meaning of these changes are?  If you start using lawyers to talk to each other, each will do what he is paid to do - represent your position and work back and forth, hopefully towards agreement - and as a byproduct, a big bill. 

Does this happen?  Is the sky blue? 

I've seen:

• A business fall into the hands of a minority investor who controlled the offshore manufacturing. 
• Deals that were put together so poorly that the entrepreneur had little room to work. 
• Structures that disproportionately favored one side over the other.

Good deals do none of these things.  Good investors never let their advisors make substantive document changes without discussing them with you.   Good deals are easy to understand and don't motivate one party or the other to work against their mutual best interests.

In all of these cases, the investors were individuals working with the entrepreneur directly.  This is great if you know the person investing or you know their reputation.

But, if neither of these facts apply, be very cautious.  Groups of investors usually cannot afford to try this kind of stuff; their deal flow dries up. 

After all, the investor is thinking of you, the entrepreneur, from a cautious perspective.  Do the same. 

Or, "Err in Haste; Repent at Leisure."