Chapter 5

Learnings From An Angel (Part 1)
Note: This article was originally written and published for DailyDAC as the fifth installment in a series of articles.

Having gotten active in angel investing over 15 years ago, I felt compelled to provide to share in some of my own personal learnings as well as those that I have learned through my fellow colleagues. As the saying goes, it you want to make a small fortune in a new venture, start with a large fortune! Early stage investing is a high-risk activity, and investors need to be prepared for the potential that an investment can be a total loss. In addition, the likelihood of any particular company being a homerun has a low probability. But that being said, angel investing is not always about making money. It is certainly a large component, but one of the reasons that many of us continue to be involved in such early ventures is not so much the ultimate pay-off, but it is that many of us are intoxicated with the smell and adventure of the creation of something new. The rollercoaster of a start-up is exciting for many, and the very notion of being able to be involved in such effort, and having opportunity to either work alongside, or even pass on experience or knowledge is incredibly rewarding. For those in their later part of their lives, angel investing can become a rich man’s fountain of youth, especially as they will be interacting with 20-something entrepreneurs from multiple companies.

While angel investing can be sexy, and the tenure of people’s activity may be short, I am hoping to quickly provide a few high level concepts to qualified investors in making their investment experience, hopefully more rewarding and successful, and as such, I hope this allows each of you investors t be active in this activity for a long time. Some of these concepts may not be applicable to you, may not be appropriate for certain investee companies, or only a few might work well together, but I believe they provide a good framework for a decision and can drive a healthy combative discussions on the merits and cons for each.

Key Angel Investing Concepts to Remember:
Contact Sport
Do Research
Know Your Leaders
Interact with Investors
Play the Numbers
Extra Firepower
Take Your Time
Surround with Smarts
Valuation
Open & Frequent Communication
Close to Home is Best
Be Supportive & Giving

Contact Sport: Although much of angel investing is done as a passive activity, your active involvement with a company will typically increase the odds of a success. Getting your hands dirty is helpful. Many times this will be done within an angel investor’s area of expertise, but it doesn’t need to be. The key is that when there are more investors who are willing to go the extra mile to help the companies think through strategic issues, and to leverage their networks, this can help lead to strong potential outcomes. See whether you have a passion for the vision or mission of the funding company.

Do Research: You owe it to yourself and your family to have spent some time researching the company and its market before investing. This does not guarantee that you will make the right decision, but it helps. By even the most simple review, your questions to management, and their responses to those questions will give you a good insight into their knowledge as well as more importantly their reasoning capability. Also, as the investor base for a company is more knowledgeable (and supportive, and smart, and reasonable, etc.), their will hopefully be value-add to the company without an obscene amount of administrative burden in managing those relationships.

Know Your Leaders: Spend time with the founders and key management team, both in business and within social environments, including potentially with their significant other. It is amazing how different people act in different environments, and the information that will be revealed in this situations in mind blowing. Validation of past successes, better understanding of failures, as well as greater insights to external pressures are illuminating to help decide on whether you have confidence in the team within the complicated lives that we all weave for ourselves.

Interact with Investors: In a similar fashion to learning about the leaders, it is helpful to know about the expectations, goals, and ambitions of the other investors with respect to the investee company. In essence, you want to know with whom you’ll be getting in bed, as the decisions of these people will affect you through multiple year life of your investment. Although the prominence of many smaller investors may not make this as critical given your relative inability to effect change, however you will be in a much better position if the investors have similar time horizons as well as liquidity expectations. As shareholder votes on critical matters arise, and as investors utilize their ability to provide support to the company with introductions, this “synchronicity of vision” can become very important.

Play the Numbers: In short, it is better to have a diversified portfolio. Spread your bets across multiple companies, and try to manage the concentration of investments in particular companies. Too often I see times where people have made extremely large investments in a particular company because they thought it had a high likelihood of being hugely successful. These investors either cite their own personal experience in the sector, how hot the sector is, or the promises of near term and large returns by the company. Unfortunately, investors are not able to always pick the winners, and often the ones that we invest the most $ into are not likely to even be those winners.

Extra Firepower: Be ready for future follow-on investments. A company often needs more money than it claims, and as such, as a good investor, you should be prepared to potentially invest in the future, either to provide a bridge during difficult times, or for future offerings. You should do the research, and decide whether a future investment is a proper decision, but you should have the capability if it was needed. As I and many others saw during this past Great Recession, many of our portfolio companies needed to raise capital, and in many situations, the valuations of these companies were dramatically reduced (50% in one case). In the right situations, the ability to make these investments can dramatically increase your IRR. Extra Firepower is closely correlated to Play the Numbers and should encourage you to reduce the first investment in a company, and to then potentially increase your stake over time.

Next installment: Learnings From An Angel (Part 2)

Chapter 4

What is Angel Investing?

Note:  This article was originally written and published for DailyDAC as the fourth installment in a series of articles.

Outside of the founders, and friends & family, angels are the most typical next step in the private equity continuum as shown below in Illustration 1. Whereas 79% of a first round capital came from the entrepreneur’s personal savings or family and friends, this made up only 11% of the second round, whereas angels provided 34% of the capital in the second round#.  Angels provide the critical capital needed by an entrepreneur to grow the business and with venture capital funds to provide the next stage in capital.   Angels are individual investors, sometimes organized within informal clubs or formalized angel groups, who invest their personal money into a company.   Angels are distinct from venture capital or private equity funds, who have created investment partnerships that manage a pool of capital, typically with a significant portion from larger institutions such as insurance companies, pensions, and endowments.

Illustration 1

Source: VentureLab

Angels come in all shapes, sizes, as well as quality.  Their experience, their financial ability to fund, and their ability to add value to a company is quite varied.  One of the key aspects of an angel is whether such an individual is qualified as an accredited investor.   In short, as defined by various securities laws, there are criteria by which individuals are measured against to see about the appropriateness for them to be investing in high risk opportunities, with small private companies being a key sector.   When a company is raising capital from outside individuals, it will require the investor to complete an Investor Questionnaire that will qualify them as an accredited investor.   Being an accredited investor does not necessarily make that person a better investor, but it is important for complying to securities regulations, for managing the communication with investors, and in working with future investors, notably venture capital investors.

From a company point of view, restricting investors to accredited investors or limiting non-accredited investors allows the company to comply with securities regulations and helps to reduce the additional burdens that would be required with respect to disclosure and the amount and frequency of information that would need to be shared.  In addition, each additional investor brings with it administrative and other ongoing support, and by limiting the number of investors, especially ones where the loss of their investment may be particularly impactful on their life (typically non-accredited investors) or those that are just plain needy, the time commitment and difficulty servicing the investors will hopefully be reduced.  Lastly, venture capital investors prefer “clean” cap tables (the schedule of ownership in company), and as such, entrepreneurs are encouraged to limit the number of angels, especially as this helps to reduce the complexity and difficulty in reaching and get investors to respond to any required shareholder approvals.

Investments from angel investors are significant, and have historically been at relatively comparable levels invested by venture capital firms.  According to Angel Capital Association, there are approximately 330 angel groups in the United States and Canada.  According to both the UNH Center for Venture Research and PWC Money Tree, angels invested $26 billion into 57,000 companies in 2007, most of which were early-stage.  By comparison, institutional venture capital firms invested $30 Billion in 3,918 deals, most of which were at a later-stage.  It is estimated that there were 258,000 active angel investors in the U.S. in 2007.  The Angel Capital Association is a convenient way to search for angel groups, by both geography as well as sector areas of interest.

The typical angel according to a 2007 survey from the University of Washington is male (86%), middle-aged (57 years old), college educated (99% with degree), with an advanced degrees, and has a significant amount of entrepreneurial experience (14.5 years), with the founding of several companies (2.7 companies founded).  As always, as an activity gets more mature, the standard changes, and as such, there is a much greater influx of female angels, and given the great success of recent companies with select examples of Google, Paypal, and EBay, there are a great number of younger angels to balance their more experienced and more gray brethren.

One of the largest trends in angel investing has been the growth in angel groups.  There were approximately 100 in 1999 and with this number reaching 300 by 2009.#  Groups typically invest $100K-$500K in a deal, and with recent surveys showcasing that the average investment is in the mid-$200K, and that there are multiple groups syndicating investment.  Groups for the most part invest locally, but with some groups have chapters either across a state or even across the country, the ability to invest nationally or internationally has become more comfortable.  There is a membership fee typically associated with participating in an angel group.  A brief summary of benefits to angels of belonging to a group include:

• Strong deal flow
• Established procedures for screening and due diligence
• Experienced set of individuals involved in early stage investments
• Diverse set of experiences and domain knowledge
• Ability to have multiple people conduct due diligence
• Greater financial capability allows for better investment terms

Next Installment: Learnings from an Angel

Chapter 3

External Financing Options for Early Stage Companies

Note:  This article was originally written and published for DailyDAC as the third installment in a series of articles.

The majority of early stage companies fund their initial capital needs personally, but the capability to do this is limited, and without external funding, a business will be starved of the nutrient required to allow it to grow to its full potential.  The amount of funding needs typically increase with each stage of the business, and the sources of capital will change according to the stage.

As an entrepreneur of an early stage company exhausts his/her personal capability or willingness to fund the business, he/she needs to look for “less friendly” sources of capital.   External financing sources have a financial return as a much higher priority, and the entrepreneur must showcase the viability of the business.

As explained, in a prior installment, funding the business through internal means can include use of personal savings; taking out and using home equity loans or other personal debt obligations, proceeds from selling investment portfolio, withdrawals from retirement accounts, and even maxing out credit cards.  In addition, the entrepreneur will leverage the family and friends network (F&F).

Early stage companies have no operating history, and as such, the risk of failure is high.  And, as the adage goes, with risk, must come reward.  Once family and friends are exhausted, funding from outsiders depends on being able to demonstrate a reasonable probability of a financial return commensurate with the risk of the opportunity.

As noted above, the amount of funding needs typically increase with each stage of the business, and the sources of capital will change according to the stage.  As shown in Illustration 1, start-ups generally follow a similar path in terms of what funding source they seek out as they grow and as their business models are proven to higher degrees of certainty.  And, as a company grows and seeks out greater amounts of capital, the deal with each successive provider of capital tends to be more complex than the last.

Illustration 1

Source: VentureLab (www.theventurelab.com)

Through future installments, we will further discuss the activity of angels, angel groups, venture funds, and private equity with respect to investing in companies.  The size of investments from each of these groups, and their level of activity is constantly changing with the market.

The investments referred to above are typically made as equity (both common and preferred), although convertible preferred notes are relatively common in early stage funding.  These are promissory notes, typically with an annual interest rate attached, and have conditions upon which they convert into equity, usually at a future round when the valuation is established.  The various investment structures will be discussed in future articles as well.

One other set of funding sources must be mentioned.  You can think of them as non-dilutive sources, since they may provide dollars for the building a business without requiring equity in return.  These include:

• Business Plan Competitions
• Incubators
• City & State Economic Development organizations (i.e. Chamber of Commerce)
• Government grant programs (SBIR, STTR, NSF)

Business plan competitions typically offer prizes that are worth between $10K-$100K in cash and in-kind services.  These competitions are also a means for a company to refine the pitch.   Further, they also provide access to potential investors.  With respect to government grant programs, there are no less than 11 federal agencies that collectively award billions of dollars annually to small business to support innovation-based R&D.

Raising capital from external sources is a full-time job and takes the management team away from product creation or revenue generation activities.  The efficiency of the capital raise is, therefore, important. A company should map out its capital needs and have a strategic plan to fulfill them.

A proper strategy will break down the tranches of capital to be raised and the likely sources of such capital for each tranche.  A goal should be to hit enough critical milestones so that the uptick in valuation resulting from each milestone is significant enough to counterweigh the dilutive effects of additional equity investments.

The value of the capital that each external funding source brings to the company varies, and this value may be a crucial factor in a deal being finalized with any source.  Although the value rating that the investor and entrepreneur ascribe to each of these criteria may vastly differ, these are some key checkboxes than an entrepreneur will be looking for from an investor:

• Can investor provide necessary capital and/or help finding the additional capital

• Timing and effort required to complete funding

• Value-add of funding party to company business (experience, rolodex, etc.)

• Ability provide follow-on capital

• Shared business vision

• Corporate governance

Next installment:  What is Angel & VC Investing?