Seven Steps to Heaven
It pays to think like an angel -- investor, that is. Angel and author David Amis explains what you need to know about getting financing in these tough times.
The Nasdaq's falling.
Dot-coms are still dying.
And long forgotten are the days when going public seemed as easy as ordering a cup of coffee.
So you can't blame some investors and entrepreneurs for thinking that now is the worst of all possible times to get start-up financing. They say owners of new companies can no longer go to venture-capital firms for a quick financial fix. Nor, the pessimists add, can entrepreneurs rely on angel investors, wealthy individuals who seek businesses to invest in and mentor.
While some of the pessimism is warranted, much is due to confusion over the relative roles that VCs and angels play in financing companies. Contrary to common wisdom, the two groups are not interchangeable. Angels, who are often cashed-out entrepreneurs, invest money of their own, typically the $250,000 to $500,000 that companies need to get off the ground. VCs, by contrast, invest mostly institutional funds, and they typically come on board later in a company's life, supplying the $1 million or more needed to keep both early-stage and midstage companies going.
Although VCs have sharply reduced their investment activity in the past year, angels by and large have not. That said, tough times have caused some angels to retire from the scene. Perhaps 10% to 15% of angels have recently hung up their wings, estimates Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire. But most of those angel dropouts weren't experienced entrepreneurs; instead, they were professionals who'd made a killing on Wall Street. "They could make the investment," says Sohl, "but they couldn't bring the important knowledge to help the start-up."
Those angels who remain are investing at levels similar to last year's, encouraged in part by lower company valuations, which let angels do more deals with the same money, explains Sohl. In fact, angels will invest an impressive $30 billion or so this year, he estimates. While that figure doesn't match the roughly $40 billion angels invested during the height of the dot-com boom, it's still a hefty bundle. In fact, says Hans Severiens, a veteran angel and founder of Silicon Valley's Band of Angels investment club, current investment levels should not be compared with what was essentially an aberration. Instead, he advises, "think of this as it was four or five years ago."
So what does all that mean for entrepreneurs? For starters, the ball is back in the angels' court. Angel investors are once again reviewing potential deals carefully. They're studying business plans, requiring mature management teams, and really doing their due diligence. They're asking entrepreneurs tough, even embarrassing, questions. "What right do you have to run this business?" asks Severiens as an example. "How the hell do you know what you're doing?"
As a result, it now takes entrepreneurs longer to find money. Figure on at least six months, as opposed to the quick three months or less entrepreneurs recently enjoyed, says Severiens. Investment horizons are back to normal, too: angels now expect the companies they invest in either to go public or to be acquired in a reasonable five to seven years, not an artificially contracted one or two years. For entrepreneurs that means shifting the emphasis from cashing out -- what angels call a "liquidity event" -- to the business itself. "You're not building exit strategies now," says Sohl. "You're building companies."
So how do you go about getting financing from the newly sobered group of angel investors? You need to think like an angel yourself. Approach angels with a full understanding of what they like and don't like, what they need and don't need, and how they make and sometimes lose money.
If it's true that it takes one to know one, David Amis is your man. An angel himself, Amis has invested in 15 start-up companies. With Howard Stevenson, a Harvard Business School professor and angel investor, Amis wrote Winning Angels: The 7 Fundamentals of Early Stage Investing (Financial Times Prentice Hall, 2001).
While the book is a practical guide for angel investors, it also can be read as a playbook for winning over angels. You'll have a much easier time getting financing if you know what the people with the money require before they write you a check. Take Amis, for example. Within seconds of shaking your hand for the first time, he has already put you in one of three file folders he mentally carries at all times. No matter what your company does, no matter how charming and smart you may be, you are, according to Amis's personal classification system, one of the following:
A LIFESTYLE ENTREPRENEUR. You enjoy owning your company, working for yourself, and living your self-directed lifestyle. Making sure your pleasant existence continues is more important to you than creating the next billion-dollar company.
AN EMPIRE BUILDER. You love your company's growth rate. Truth be told, you also love being the ruler of your domain, small though it may be -- and it won't be small for long! You wouldn't sell the company if your life depended on it. They'll carry you out with your boots on.
A SERIAL ENTREPRENEUR. You'll expand your company to the best of your ability, sell out or go public, then start another com- pany. Then you'll do it again. And again.
If you fall into one of the first two categories, Amis will be happy to make small talk with you. But only if you fall into category three -- that is, you're a serial company builder -- will he consider investing in you and your company. Amis wants to invest only in people who plan to first get big, then sell out. In fact, all things being equal, the time frame is less important to Amis than is the entrepreneur's commitment to cashing out.
But don't take Amis's word for it -- he's only one guy. Instead, take the word of 50 experienced angels. They're the folks Amis and Stevenson interviewed for their book. Among them are well-known investors such as Esther Dyson of EDventure Holdings Inc., Mitch Kapor of Accel Partners, and "virtual CEO" Randy Komisar. But their ranks also include lesser-known though experienced angels, including Lucius Cary, who has invested in more than 50 companies; John Hime, who's invested in 29; and Bert Twaalfhoven, who's invested in 24. Among the companies funded in part by Amis's Fabulous 50 are Apple Computer, Amazon.com, House of Blues, Idealab, and Sun Microsystems.
You can use Amis's research to create an entrepreneur's checklist. Follow these steps to catch an angel.
STEP 1: Sourcing, or Who Are You, Anyway?
The best angels are always looking for good new deals. They call it "sourcing." Before you go courting them, do some sourcing of your own. Look for angels who can do you the most good. Here are five traits all good angels share:
CONTACTS. You want angels who can help you locate suppliers, customers, and employees. Ideally, your angels will know important players in your industry.
INDUSTRY EXPERIENCE. Related to the first point, you want someone who understands your business and has worked in your industry. Such an angel can help you anticipate some problems and deal with others as they arise.
ENTREPRENEURIAL EXPERIENCE. Angels who have previously raised money for their own companies tend to be easy, quick, and direct to work with. They also can detect the likely trouble spots in your company. That way, they won't be too surprised when, for example, that 12-month project stretches out to three years.
ANGEL EXPERIENCE. It's four times easier to deal with someone who's been an angel before than it is to work with an investment first-timer. Says Amis: "Everything moves so much quicker."
DEEP -- BUT NOT TOO DEEP -- POCKETS. The ideal angel has a personal net worth of $2 million to $50 million. If an angel has more than that, the $50,000 your company needs may fall beneath his or her radar. But if your angel has less, you'll be out of luck if you need to go back for follow-on financing.
OK, so you've narrowed your choices. Now you need to get noticed. Even the best angels can't invest in your company if they don't know you exist.
The most effective way to find them, as in nearly every other aspect of commerce, is word of mouth. "You want to come recommended," says Amis. In a perfect world you'll have a track record and will be known by someone who knows an angel. That someone introduces you, and you're off and running.
But what if you don't know a friend of an angel? Here's where the definition of recommendation can be stretched a bit. "If you talk to someone you don't know and they say, 'Why don't you call so-and-so?' you've got a referral," says Amis.
Another option: get an invitation to present to a local angel group. Most won't take cold calls, so you'll need to wrangle a referral. (See above.) But once you're in, angel groups offer a unique opportunity to present your company to anywhere from 10 to 110 angels in one throw.
Resourcefulness never hurts, either. Explore your network of friends, acquaintances, and friends of friends. Talk to professional-service providers you know -- for instance, accountants, investment bankers, brokers, consultants, and lawyers -- who are likely to know angels. It may sound hokey or obvious, but it works, says Amis. He recounts the story of an entrepreneur in the medical-products sector. The entrepreneur knew of an angel who he felt certain would be the perfect investor but who wouldn't return his calls. The upshot? Says Amis: "He finally found out who the angel's accountant was, worked on him, and had the accountant make the introduction." Go forth and do likewise.
STEP 2: Evaluating, or Let Me Get This Straight ...
During evaluation, angels size up your company's fundamentals in four main areas, says Amis:
PEOPLE. You, the entrepreneur, and your management team, of course, but also your other investors, advisers, and significant stakeholders -- anyone who has a stake in your company's success.
BUSINESS OPPORTUNITY. Your business model, market size, potential and actual customers, and the timing of the opportunity.
CONTEXT. External factors that could affect your business, including available technology, customer needs, the overall economy, regulation, and competitors.
DEAL. The price of the deal you propose and its structure. Price starts with your company's valuation. Structure refers to the terms of the investment and other factors -- board seats, salary limits, and so on -- that can affect the likelihood and the size of the angels' return on their investment.
Once you've identified potential investors, you must next prepare to cover those four areas in your first meeting with them. "You want to make your argument so compelling that they have to learn more," Amis says. "It's just like going on a sales call. You plan what you're going to say, warm up the prospect, then close -- that is, you ask for them to make an investment."
Be sure to tailor your pitch to the angel. "Almost everyone immediately launches into a 30-minute explanation of the deal, and that is wrong," Amis says. "You want to talk only about the things that interest the potential investors."
First, focus on your team. Angels want you to have a team of at least five senior executives in place. Your name may be on the door, but there's no way you can do everything yourself and still build a company big enough to attract angels. You don't have to bring the entire team with you to your first angel meeting, but you should offer to make them available later. "If the company is built around a good idea, I will never understand it as well as the principals," Amis explains. "That's why I want to know who is running the company."
Remember, what potential investors are really evaluating at this point is the people behind the company, not the validity of the company itself. Potential investors can do the market analysis on their own or hire someone else -- a market researcher or consultant -- to do it for them.
Second, show that you either have sales or can get them. The longer it will take you to get your product into the marketplace, the longer it will be until the angels get their money back. All things being equal, angels would rather cash out sooner than later.
Third, be sure the deal you're proposing makes sense. In other words, propose the deal from the investors' point of view. Tell angels what's in it for them. Think through what the investors need to get out of the deal in terms of ownership and potential returns. Don't aim to simply squeeze every last nickel out of them.
Fourth, head for the exit. When do you expect to sell your company or go public? Angel investors will want to know when they're going to get their money back.
Fifth, have the necessary documents at hand. The Boy Scouts have it right: be prepared. Bring everything potential investors might want in the way of backup: your business plan, financials, corporate bios, and more.
Finally, respect the angels' time. Be punctual. Ask how much time the angels have for the meeting. Keep your answers short and to the point. If you don't know the answer to a question, don't fake it. Say you will find out within in a certain time period.
STEP 3: Valuation, or How Much Is It Worth?
Valuation is all about putting a monetary value on your com- pany and on any investment an angel might make in it. How much is your company worth? How much money are you trying to raise? And what amount of ownership -- in stock or other securities -- are you willing to give up?
Angels price your company based on its potential capital return in the future. The share of the potential gain they ought to get in return for their investment depends not only on the amount of money they contribute but also on their time, reputation, contacts, and opportunity costs (that is, money they might be making doing something else). By the same token, your company's future returns to the angels are not just financial. Your angels could also enjoy such intangibles as the excitement of launching a start-up, a sense of contributing, and an opportunity to give something back to the entrepreneurial world.
Most commonly, angels value a company at a lower price than the entrepreneur would. For example, let's say you have a young company that's presently little more than an idea and a team. From the angel investors' point of view, ideas are cheap. It's the execution that adds value. And potential investors haven't a clue, at this stage of your company's life, whether you and your team will be able to execute.
While every deal is different, here is a valuation model that was created by Dave Berkus, a full-time angel and founder of Berkus Technology Ventures LLC, in Los Angeles. (See box, below.) Just remember that "quality" can be defined differently in different deals.
| What's your fledgling company worth? |
|IF YOU HAVE THIS|| ADD THIS TO YOUR |
|Sound idea||$1 million|
|Quality management team||$1 million to $2 million|
|Quality board||$1 million|
|Product rollout or sales||$1 million|
|Total potential value: $1 million to $6 million|
So now you know how angels are likely to value the deal. Price your company accordingly. Of course, you can always ask for more. The risk? You won't be taken seriously.
STEP 4: Structuring, or Keep It (Sort of) Simple
When angels ask, "How are you structuring the deal?" they're in effect asking two separate questions:
One, on what terms will the angels invest? In other words, what type of financing will the angels provide: equity or debt? What kind of equity? Will the investors get their cash back before the entrepreneur does? Will the angels have the right to invest in future rounds?
Two, what role will angels play in your company going for- ward? Will they be silent investors, active ones, or something in between?
You'll also need to think about the three fundamental ways angels are likely to share in your company: common stock, preferred convertible with various terms, and convertible note with various terms. Each has its pros and cons, and each has its angel fans and foes. Common stock is the simplest but provides few safeguards to the investor. Preferred convertible is more complicated but can benefit the investor to a greater degree. Convertible note allows no negotiation on price but offers angels the most protection.
Your angels' involvement in your business can be tricky. Once angels invest, their role in your company may be anything from passive shareholder to board member. It's all negotiable, and the time to negotiate is before the term sheet gets signed. Unless everyone knows how the relationship is going to work up front, the potential for problems is limitless.
STEP 5: Negotiating, or Put Your Best Deal Forward
How much of your company are you going to give up and at what terms? And how much haggling will there be along the way? If you haggle, remember that you're negotiating with people who are going to be your investors. The trick here is to align everyone's interests. The position you want to end up with, says Amis, is "It's you and me against the world" as opposed to "It's you against me."
During negotiations, angels tend to focus on the numbers, specifically their initial ownership stake. They believe that will have the greatest impact on the future value of their investment, so many will bargain hard over it. Angels also have the advantage of time: While you may need their investment quickly, they most likely don't face the same time pressure. On the contrary, many angels prefer to take their time during negotiations, not least of all in the hope that you'll eventually come around to their terms. You've been warned.
Some angels will enlist a lawyer, an angel investor who is not involved in the deal, or another professional to do the negotiating for them. Yet others maintain a strict policy of not nego- tiating at all. When those angels see a deal they dislike, they simply reject it and move on.
There's no reason why you, the entrepreneur, can't take the same no-negotiate position. Put forward your best deal and say -- politely -- that it's a take-it-or-leave-it proposition. If you're asked why, simply say you don't want to start your relationship on adversarial footing.
STEP 6: Support, or They Want to Hold Your Hand
An angel's investment should be just the beginning of the interaction. Unfortunately, many entrepreneurs, and the people who invest in them, see it as an end point. As a result "entrepreneurs only get 5% to 10% of what they could out of the relationship," Amis says.
That's dumb. By this point in the process, the angels' interests and yours are in alignment. The angels have invested in you and your company and most likely are entrepreneurs, too. So feel free to solicit their help in any way you can. Angels can and should help you find potential customers, follow-on investors, key staff, suppliers, and more.
Angel investors can also help your company move toward what investors call "value events." Those are anything that can improve the real or perceived monetary worth of your company, as well as its chances for success. Examples include signing deals with strategic partners, lining up venture financing, and landing a well-known account.
But keep in mind, support should be a two-way street. The best entrepreneurs provide regular updates, maybe two pages' worth sent once a month, to all their investors. Not only does that let the investors know what's going on, but it also makes them feel they're an important part of your company.
Also, adding a note to your update along the lines of "We are currently trying to contact XYZ Industries to see if we can make it a customer," might jog an investor's memory. Maybe an investor just happened to have been seated next to someone from XYZ at a charity dinner last week. Stranger things have happened.
STEP 7: Harvesting, or They're in the Money
Harvesting is what investors call the process of getting back their investment -- and then some. You'll impress your potential angels by agreeing to do everything in your power to help them achieve a positive harvest -- one in which they make a profit. That is the way they measure the success of their investment. Positive harvests come in five basic forms:
WALKING HARVEST. Your company distributes cash directly to its investors on a regular basis.
PARTIAL SALE. Your investors sell their stakes to your com- pany's management, another shareholder, or an outsider.
STRATEGIC SALE. A competitor acquires your company for strategic reasons; your investors receive their negotiated share of the acquisition price.
FINANCIAL SALE. A buyer outside your industry acquires your company for its cash flow; your investors receive their negotiated share of the acquisition price.
INITIAL PUBLIC OFFERING (IPO). Your company sells stock in the public markets, creating a market for your investors' shares.
Investors use the phrase negative harvest to describe what the rest of the world calls bankruptcy. Whether it's a Chapter 11 or Chapter 7 filing, bankruptcy is not a pretty sight. If your company files for Chapter 11 bankruptcy, your investors will have a shot at regaining at least some of their original investment. But if you go into Chapter 7, your investors will typically get little or nothing.
Bottom line? From day one, start talking to your angels about how they'll cash out. For example, during the negotiation process you might say, "Two to three years from now, it might make sense to sell to X."
Your commitment to cashing out your investors must continue after you have gotten their checks. For example, you might say that your salary will remain fixed until the company is sold. In your updates to shareholders, periodically mention potential buyers of your company -- and what you're doing to increase their interest.
May the angels be with you.
Paul B. Brown is the author or coauthor of 12 books and editor-in-chief of DirectAdvice.com. Additional reporting was provided by associate editor Thea Singer.
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Related link on Inc.com: Directory of Angel Investor Networks