The Do-It-Yourself Angel Round
HOW TO FINANCE [almost] ANYTHING
Looking for capital? Here's how one company bootstrapped its own funding
Back in 1993, when he began StockMaster.com Inc. as a graduate student at MIT, Mark Torrance had no idea it would blossom into a viable business. All he wanted, at first, was a way to chart his own portfolio without breaking out the graph paper. By the summer of 1996, however, things had changed dramatically. Torrance now ran the company out of his condo in Quincy, Mass. He'd moved StockMaster to an Internet service provider's servers, since it had been using too much bandwidth over at MIT. His wife, Leslie, had $30,000 in company-induced debt on her credit card. And Torrance had become what seemed like an anomaly in the 1990s business world: a tech-savvy Internet founder without wads of start-up funding.
By the end of 1997, StockMaster had broken another Web stereotype: it had turned a profit on $1 million in revenues, which came from its advertisers and from designing and producing content for investor-relations Web pages. By that time Torrance had moved the company to Silicon Valley. But by the end of 1998, StockMaster still had gotten no seed money -- even though it was again profitable, on sales of $1.8 million. Torrance's patience was melting. "We had 12 employees, and I was stretched completely thin," he says.
Torrance knew he needed capital, but like so many other small-business owners, he was in a bind about how to get it. He couldn't afford to hire an investment bank; he also didn't want to take himself away from the day-to-day issues. His solution: he turned to someone he'd recently hired, chief financial officer Jim Drury. Over the next two months Drury developed a capital-raising game plan, by both studying how other companies had done it and networking with alacrity. His strategy ended up paying huge dividends for StockMaster and can serve as a useful primer on capital-raising fundamentals for any company.
Of course, when Drury set out to raise money, StockMaster, with its five-year, highly bootstrapped run, looked a lot more like a conventional brick-and-mortar small business than it did a cash-infused Internet start-up. And like many of his not-com cohorts, Torrance wasn't overjoyed about his financing possibilities, despite all he'd heard about an abundance of capital out in the Valley. Yes, he'd had some attention from venture capitalists. But "I thought their offers would be more like buyouts. VCs might say, 'Give up two-thirds. We'll grow it for you," he says.
The venture folk, naturally, have their reasons for wanting control. "I've heard of venture funds asking for as much as 90%," says Bill McCready, president of Venture Planning Associates Inc., a financial consulting firm with a venture arm. "That's because a lot of these entrepreneurs have no business experience."
But Torrance, now 30, had come too far to relinquish so much. So that's where CFO Drury came in. His first decision was that StockMaster should target angel investors rather than the venture community. The decision aligned with Torrance's company goals. Both for the sake of control and to maximize cash-outs through an initial public offering, Torrance's main capital-raising agenda was to not surrender big chunks of equity. "It's my first company, and I value highly how much wealth I'm building," he says.
Despite his 18 years of accounting and finance experience, Drury didn't have much of a track record in angel wooing. So he began his search for would-be investors with two trustworthy sources: his fellow employees and the company's attorneys at Pillsbury Madison & Sutro, a firm known for its work with emerging businesses. He asked that they refer him only to angels who'd made seed investments before. One particularly helpful employee was president and chief operating officer Troy Anderson, whose father was acquainted with angel John Stephens. In addition, Drury found four investors by schmoozing with Barry Turkus, the president of BT Commercial, StockMaster's real estate brokerage firm.
Mark Torrance had come too far to relinquish so much. His capital-raising agenda was to not surrender big chunks of equity.
Drury also turned to the company's law firm to help get himself up to speed quickly. Officially, his agenda with Pillsbury Madison & Sutro was making sure that company records and employee-stock-option agreements fulfilled legal requirements for a first round of financing. But Drury also hoped to learn from his lawyers how successful IPO-bound companies had behaved during their early-stage offerings. "I'd show them documents I'd found and ask them why one company did something different from another," he says.
Soon he was acting in a similarly inquisitive manner with his accountants at PricewaterhouseCoopers. In doing so, Drury discovered several capital-raising principles, many of which were de rigueur to them but foreign to him. He learned, for example, to issue equity in preferred stock rather than in common stock in order to avoid what's known as the "cheap stock" issue. That problem can arise if the Securities and Exchange Commission sees a large discrepancy between an IPO stock price and the price at which pre-IPO common stock options were issued. The SEC may then require that companies record an expense on par with the disparity. "In the Internet world, where there are some extremely high IPO prices, you can end up with some significant charges," says Jim Burton, a partner at Grant Thornton's San Jose office. "We've seen it in the millions."
Another key lesson was making sure StockMaster's stock-purchase agreements -- the part of a private-placement memorandum that spells out (among other things) how company control changes with the issuance of equity -- were written in terms most favorable for StockMaster executives. Being stringent about stock-purchase-agreement specifics is something start-ups often neglect, especially when they're desperate for investors.
Once Drury understood what terms to pitch to angels, the next step was actually pitching them. Having asked his lawyers and accountants "tons" of questions about the best methods, Drury devised a wooing method that combined individualized investor attention with planned professionalism.
First came the phone calls and E-mail messages to potential angels, with the referring parties making the initial contact. The likeliest prospects were passed on to Drury, who stressed his 24-hour availability for investor queries -- something he was able to do since Torrance had relieved him of some of his other duties. He left his cell-phone number with all his messages and returned all calls within hours. "People called at all hours of the night, and they always got a live person," he says.
Drury's simple aim was getting face time with all the names on his list, since he'd learned that when one angel likes a deal, he or she is likely to rope in others. And so it went for StockMaster. Turkus, for example, told some investors about the company, and they in turn got word to their networks. Venture Planning's McCready, who often connects clients with angels, agrees that viral strategies work. "You can get 50 to 100 leads from a list of 5 or 10 of the right people," he says.
To fully capitalize on his leads, Drury scheduled group presentations for investors, at which he and Torrance made their case. To illustrate potential return-on-investment scenarios, Drury used industry figures, basing his numbers on the SEC registration statements of financial-information Internet companies that had revenues, sales growth, and page views similar to StockMaster's. Because the registration statements contained histories of companies' equity distributions, Drury could provide reasonable ROI calculations by comparing private-round stock prices with IPO prices. "It's not a bad approach, though you've got to recognize other variables when comparing yourself with industry leaders," says Chris Rodskog, a senior vice-president at Point West Ventures, a venture firm in San Francisco. "But nothing is perfect. You've got to use whatever numbers you've got."
Which is exactly what Drury did, never forgetting to emphasize the speculative nature of comparing StockMaster's illiquid stock with the stock of public companies. "He presented a fair evaluation of what they were doing and didn't hype the story at all," says John Dunning, a member of the Angels' Forum, who subsequently invested in StockMaster (though he declines to disclose how much he put in). Including Dunning, StockMaster amassed 55 investors for its first round, which was completed last April at $2.50 a share for $3.2 million -- approximately 8% of the company.
Of the 92% of StockMaster equity not issued in the first round, Torrance still held 70%. He hopes to take StockMaster public later this year and expects to keep more than a 40% share -- which is a lot more than he imagines he would have had if he'd gone the VC route a few years ago.
Retaining equity has given StockMaster an edge not only in recruiting but also in making acquisitions. Last year the company acquired one business in exchange for stock and another for a mix of stock and cash. Still, Torrance and Drury have several regrets about how they conducted their first round of financing. "We picked a fixed end date for the round because we thought we had to," admits Drury, who has since learned to cap an investment round at a dollar amount rather than a date. In StockMaster's second round, for which shares are valued at $3.60, the company is shooting for $10 million. Drury also learned how to arrange StockMaster's offering so that if the company is acquired before its IPO, investors will receive an additional payout. But he learned too late of a better way to protect investors. If he could have changed the provisions for StockMaster's second round, he would have included a preferred-stock provision giving all the second-round investors the option of choosing the acquisition price or the share price plus 50%.
Although he's pleased with the networking it took to lure the 55 investors, all of whom put in between $50,000 and $300,000, Drury wishes StockMaster had channeled more effort into recruiting outside board members. (At press time, John Stephens was the only investor who had joined the board.) Then there are the managerial headaches of handling 55 investors. Drury has morphed from CFO into investor-relations manager. "Investor relations has turned into a half or a third of Drury's job," laments Torrance.
In an effort to attract board members -- and reduce its investor maintenance -- StockMaster is considering VC firms for its second round of financing, even though that might mean less equity and control for the management team. "There's always a trade-off," says Jim Nolen, a finance professor at the University of Texas at Austin. "With 55 small investors, no one has enough of a chunk to force an issue. The question is, What else do the VCs bring? It's worth a lot to have someone like Kleiner Perkins opening doors for you. I'd rather own 20% of a big pie than 50% of a smaller one."
Torrance is still debating what the company will do, but he can be certain about at least one thing: StockMaster is at long last shaped like a classic Internet company. In the past year it's swelled to 60 employees, a number that grows by the week. Each day, Drury gets "a steady stream of calls" from across the nation as news spreads about StockMaster's path on the IPO fast track. With the increased spending on infrastructure and advertising, StockMaster now has one other thing in common with standard Web companies: it's no longer profitable.
That's OK with Torrance, who still remembers his glee when StockMaster received its first check, four years ago. "We got $27,000 that month selling ads," he says. Back then, of course, his wife's credit card funded StockMaster's debt. Because of Drury's legwork and his own staying power, Torrance believes that StockMaster faces a much brighter future. He also believes he'll personally pocket more cash this way than he would have under different financing circumstances. And that, ultimately, is this grad-student-turned-entrepreneur's bottom line. "In the end, the thing that matters most is creating value," he says, "for me and my wife."
Ilan Mochari is a reporter at Inc.
HOW YOUR CFO SHOULD RAISE MONEY: WHAT THE EXPERTS SAY
Jim Drury considers himself one of a new breed of chief financial officers: those who actively network to raise money in addition to handling the paperwork. Some members of Drury's capital-raising network gave their thoughts on his approach:
Dana Frankfort is the president of Frankfort Simmons Capital Management Corp., in Los Angeles. He is a StockMaster angel who's since referred other prospective investors to the company. "Obviously, they're not the first in their space, which is one reason I wanted to meet them personally," Frankfort says. "I felt if I could sit down with management and learn how they'd build the company differently, it would either swing me or it wouldn't. So Drury's strategy of bringing it directly to us appealed to me. It was a little unorthodox that they did it that way, cutting out the middleman. Usually, to get information you have to go through the VCs or some other intermediary."
Suzanne Gueydan is a manager at PricewaterhouseCoopers in San Jose. She advised StockMaster on accounting issues related to selling stock. Drury is "constantly evaluating what the impact of what he does will be on future IPO-related disclosures," Gueydan says. "He's very proactive about it, whereas a lot of people are more reactionary. Most of the time, clients just want to be told the answer and want us to do it. ... He asks questions before finalizing things, whereas a lot of my start-up clients get themselves in trouble, and then I have to work my way out of it. He knows enough to know what he doesn't know. A lot of people in the Valley think they know exactly what they're doing all the time and don't want to admit when they don't."
Naoki Shimazaki is a partner at Morrison & Foerster in Palo Alto. He used to work at the law firm Pillsbury Madison & Sutro, where he helped draft StockMaster's stock-purchase agreements. Says Shimazaki: "Drury was more sophisticated in financial terms than most guys we deal with who have tech or marketing backgrounds. He has a finance background. ... It's hard to generalize, but you get a lot of guys who just want the lawyer to get stuff done and don't care for explanations. ... In the Valley, lawyers have become very busy the last few years, and I think that, in being so busy, it sometimes can become like doctors' appointments, where you can't ask questions because of time pressure. Often it's a choice of using the time for explaining or getting something done."
John Dunning is a principal at CrossFire Ventures, in San Jose. He is also part of an investors group called the Angels' Forum, through which he was an early investor in StockMaster. Dunning says: "Drury is easy to get ahold of, which is important in this market, since angels don't have a lot of time to study people. Many people give out phone numbers, but he gave out three numbers and an E-mail address and always responds. He always answers every question and never hesitates. That he always had good answers was also impressive; he was ready to do this with facts, data, and presentations. ... Most start-ups don't have a CFO, but because StockMaster has been around and they've been profitable, they had one. CFOs have to be ethical, honest, and clear, and he's got that. He had all the documents you need, which most people at the angel stage don't. And he can really share a story."
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