Paul Graham, the entrepreneur-turned-investor behind the ground-breaking YCombinator, has written what may be the most useful, unvarnished, searingly-honest essay on raising money for startups. It should be mandatory reading for every early stage company, and indeed is so good, and so true, that we're considering making reading it a click-through pre-requisite for submitting a plan through Angelsoft.
His major points are that fundraising is hard, hard work that goes against just about everything that is inherent in being an entrepreneur. It takes longer, costs more, and is more fraught with difficulty than you could possibly imagine. Investors are indecisive, subject to peer pressure, and difficult to nail down.
The odds of getting funded are much, much more difficult than any entrepreneur realizes: Paul quotes David Hornik of VC August Capital as noting that the odds of his funding you are between 0.125% and 0.4%, which in our experience is absolutely typical for venture capital firms as a whole. The angel investing side is somewhat better, particularly for early stage deals, and our statistics here at Angelsoft (derived from tens of thousands of pitches delivered to over ten thousand investors) show that over the past several years organized angel groups have funded 1.32% of the deals that submit to them. But that still means the odds of your getting funded, even by an angel, are worse than a staggering 70:1 against.
Nevertheless, Paul's essay provides excellent advice for both the mindset and actions that will give you the best chance of succeeding with your startup. In particular, pay close attention to the concept of ramen profitability. Get to there, and the world will seem an entirely different, and more hospitable, place.
To follow up on Jason's post about unfundable deals, I wanted to lay out some guidelines for what makes a fundable deal:
Entrepreneur/Team
Angels invest time and money in seed/startup and early stage deals. They seek investments in ventures lead by inspired, experienced entrepreneurs who genuinely seek counsel of experienced investor/advisors. While the management team need not be complete, the entrepreneur should have a good understanding of the team necessary to do the job and probably has a team member or two waiting in the wings.
Scalability
Funding startup entrepreneurs is very high risk investing. Only 10 to 15% of startup ventures provide all the return on investment for angels. Consequently, angels only look at companies that can scale revenues quickly to at least $30 million in revenues in five years or less. Angels personally invest $25,000 to $50,000 in seed/startup rounds ranging in size from $250,000 to $1 million. (Less than 5% are larger than $1 million.)
Business plan/Strategy
Angels seek entrepreneurs who have a complete business plan, not just a product or technology description. Company should have a well-articulated strategy to capture and defend a significant market share, including the ability to construct significant barriers to entry. Complete proforma financials for three to five years are a must.
Location
Most, but not all, angels seek investments within an hour’s drive of the angel’s residence, so they can conveniently visit the entrepreneur, as needed. Helping local companies can also be part of the angel’s give-back strategy for his or her community.
Bill Payne is an angel investor on the west coast, and has a website here at BillPayne.com
As an entrepreneur, when you login to Angelsoft you are brought to the My Applications tab where you can manage all of your applications to groups. Recently we added the ability for entrepreneurs to see updates on investor activity relating to your deal.
On the right hand side of the My Applications tab you will find the News Feed
Here is a guide to better understand what each news item means:
– Application rated:
An investor has rated your deal and chose to anonymously share it with you. Investors use a star system, moderating the best opportunities to the top. They rate your deal using a 1-4 star scale on four categories: Management, Market, Product, and Deal Terms. Some groups use the rating system as designed, others use it as a proxy for interest in which case the actual values don't mean anything. Investors can also leave comments which often includes advice for the entrepreneur.
– Application was privately rated:
If the investor does not share their rating, your News Feed will tell you that the application was privately rated. We are actively encouraging investors to share their ratings with entrepreneurs. However, in some cases it would be inappropriate to do so.
- An Investor has reviewed your application:
An investor has clicked on your application and read it over
- New Investment: $100,000 from John Doe, East Coast Angels
An investor has committed funds to your deal
- New Investor: John Doe, East Coast Angels
An investor has expressed interest in funding your deal, but has not entered an investment amount.
- Invitation: Name Of Event:
An investment group has invited you to an event. Clicking on the event name will link you to the details
- Referred from Group1 to Group2:
Angelsoft is a network and groups will often share deals between them. This is called a referral. When your deal is referred, it is sent to the second group as if you had applied to that group directly. A new application will show up on your My Applications tab.
- Group1 invited Group2 to collaborate:
To finish out a round of financing, Angel Groups often need to collaborate on a deal, or co-invest. When this happens, Group2 is invited into Group1s deal room. In this case, you will not see a new application on you’re My Applications tab
- A member of East Coast Angels has referred your application to his group:
An investor has referred your deal from OPENdeals to his investment group for further review.
- Investment Terms updated by John Doe:
An investor has made changes to the investment terms, which can be viewed on the My Investors Tab
- Application posted to Open Deals by John Doe: OPENdeals is an investment community inside Angelsoft. Investors post deals there when they are looking for outside investors to finish out a round. Applications posted by investors are labeled differently than those posted by entrepreneurs.
Market size is an important factor when an investor is considering your application. An ideal market for an investor is at least a billion dollars. If you don’t think your market is that large, then you may not be right for investment.
Chances are you think your market is much larger than that, which is one of the biggest pitfalls that entrepreneurs fall into. You will not impress an investor with inflated market numbers; it signals a lack of understand about the business you are trying to start. The goal is to hone this number down to a true reflection of the number of people that could be interested in your product or service.
Here’s an example using fake numbers for simplicity:
If you’re selling guitar strings, you could say that your market is the billion-dollar music industry, but that includes plenty of people that don’t play instruments.
You could claim that it’s the million-dollar musical instrument industry, but there are plenty of people that play instruments but not guitar.
You could say you plan to capture the $500,000 guitar owner market, but your strings are for electric guitars.
The electric guitar market is $250,00, however your strings are made of carbon-fiber. They are a huge step forward in the guitar string industry, but can only work with 50% of electric guitar models. Now your market is down to $125,000
This is the type of exercise that is necessary to determine the true size of your target market. When you get down to it, you may find that your market is too small. This is invaluable information to know BEFORE you invest yourself into a business that isn’t sustainable. You don’t want to a pitch an investor and look like this:
"As has been discussed for several years, Birmingham is in dire need of additional startup capital for our many worthy high growth and high tech businesses and BAN will be a great resource for many of those companies."
Watkins is Managing Member of the Watkins Law Firm, one of the few firms in the area that works with early stage companies on all manners of financial transactions, and adds he is looking forward to "seeing the group grow and become a powerful driving force in the Birmingham and Alabama economy."
I found this report that Jason Nazar, founder of docstoc.com, wrote on raising capital. It provides a great overview of the entire funding process that is essential for entrepreneurs to understand.
I particularly like pages 3-4 which explain the funding lifecycle. I receive a lot of questions from entrepreneurs who are confused about what stage an Angel Investor is looking to invest at. Highly recommended reading:
If you want to set off an entrepreneur, tell them that their business isn't an Angel deal. We receive more complaints from entrepreneurs when an investor says that, than anything else.
There are a lot of reasons that a deal may not be right for investment, and over the next few weeks we will be covering a number of them. The important thing to remember is that just because a business isn't right for early stage investors, doesn't make it a bad business. However, it does mean that if you want to go ahead, you will need to find another way to finance your startup.
Lifestyle Business
A lifestyle business could generate enough money for the entrepreneur to live comfortably, but lacks the potential for scalability that would make it attractive for acquisition. It may also mean that even if the company could scale, it appears that the entrepreneur has no real ambition to do so past providing a comfortable income.
Example 1: The entrepreneur has a plan for a high-end concierge service for wealthy New Yorkers. The entrepreneur projects $2 Million in revenues every year.
It would be very difficult to scale this company. There are few places in the world where this service would be needed, and the potential market is relatively static. It may provide a nice salary for the entrepreneur, but there is little potential to grow this company to the point of acquisition.
Example 2: A famous designer decides he wants to break off and start his own company. He wants to work at home so he can spend more time with his children.
This is not the hallmark of someone who is interested in building a company. While he may be able to trade on his name to turn the new company into an international brand, it doesn’t appear that he has the ambition to do so. He is looking to create a lifestyle that is comfortable for him.
In either case, there is no exit for the company, and therefore no way for an investor to see a return. If the investor can’t get a return, there is no reason to invest.
So how do you start a lifestyle business without investors? If you’re going to start one, make sure you can bootstrap your way to revenue. Use income from another job, raise money from friends and family, or take out a business loan. If you can’t, then you may want to reconsider your business.
The question of whether angel investments in early stage companies should be in the form of a loan that converts (usually at a discount) into the equity, and at the valuation, of the following (usually VC) investment round, or instead in the form of Convertible Preferred stock (typical of a venture capital investment round) is one which generates a lot of heat in entrepreneurial circles. It also frequently leads to disagreements and hard feelings between entrepreneurs seeking funding and the angels who may be in the best position to fund them. But in reality, the answer is very simple:
"Smart Money" does NOT invest in convertible debt. Period.
This is not a negotiation, or a matter of what is right, or a matter of choice, or anything else. It is simply a definitive, rational, factual statement.
But it does have one corollary, and one exception.
The multiple reasons that smart money (which includes venture capitalists, modern organized angel investment groups, and the leading independent angel investors) simply won't (and shouldn't) do convertible notes are amply and clearly spelled out by Bill Payne, formerly Entrepreneur in Residence at the Kauffman Foundation and generally regarded as the world's leading trainer of angel investors. The primary reason, of course, is economic: the angel is investing at an earlier, riskier stage and therefore should expect a higher return than the VC, who is coming in when some of the risk has been removed, and after the entrepreneur has made the company more valuable using the angel's money. For the angel to wait until the next round to value the company results in exactly the opposite: he or she takes the early stage risk and ends up with later stage valuation: a lose/lose proposition!
Another perspective on why convertible debt sucks comes from Furqan Nazeeri, a serial entrepreneur with EIR experience who is an extremely perceptive observer of the startup financing scene. He points out that from the side of the entrepreneur, doing a convertible debt round correctly is complicated, creates a perverse incentive for the angel investor to work against the company, and ultimately doesn't make a big difference for the entrepreneur.
The practice of convertible debt had its heyday about a decade ago, when inexperienced angels found themselves getting hammered by VCs in follow-on rounds, and decided that it would be better to join them instead. Since then, serial angels have gotten a lot smarter, best practices in angel investing have been standardized, and a funny thing happened to all the serial angels who started out doing convertible notes: they found themselves losing money because of the poor risk/reward relationship, and therefore either (a) stopped angel investing, or (b) got smart and stopped doing convertible notes.
But wait, you say. I mentioned earlier that there was a corollary and an exception. OK, here they are:
Corollary: "Not-Smart Money" SHOULD invest in convertible debt.
Huh? Why? Because the primary trick to raising early stage money in a 'priced' round of Convertible Preferred stock is to price it to value it correctly! And this is the essential difference between 'smart' and 'not-smart' money.
Perhaps the single biggest problem we see with companies applying for funding to New York Angels is that they have done an earlier Friends & Family round that valued the company at a significantly higher valuation than we (the so called "smart money") believe it is worth. In this situation, there are only three possible outcomes, none of which are good: (1) the entrepreneur won't do a 'down round', so we simply walk away and don't fund; (2) the entrepreneur does a down round, and poor Aunt Edna, who invested $50,000 of her retirement money, sees her investment lose half it's value; or (3) the entrepreneur falls on his/her sword and protects Aunt Edna by taking the full valuation hit personally. Ugh.
In cases like this, the BEST thing the entrepreneur can do is take the unsophisticated money in a convertible note, because that way it will end up getting priced correctly when the smart money comes in. But one thing to beware: the next round investors, whether professional angels or venture capitalists, will be the ones to ultimately decide what discount the convertible note will get...regardless of whatever was written into the original note. In practice, few sophisticated investors will have a problem with a 10% discount, which will usually stand. And if there has been a fair amount of time between the note and the venture round (say, six months to a year, or more) a 20% discount has a decent chance of holding. But don't bet the farm on the new investors accepting anything much more than that. If the note has, say, a 50% discount, it will almost certainly be eliminated, or, in a best case, factored into the lower pre-money valuation the VC offers.
Exception: Smart Money should consider a convertible note as a bridge to a legitimate term sheet, and should always have a backup price.
Bill Payne walks through these economics in detail, but in a nutshell, if a VC has already signed (or is thisclose to signing) a term sheet, it will be at a fixed valuation, so the angel bridge will be at a known discount to a known 'correct' price. In this case (a) the 10-20% discount is a fair benefit for the risk being taken (which is that the term sheet might fall through), and (b) if the term sheet DOES fall through, the angel now has debt, which is a better thing than equity to have when things go bad, which they will if the VC walks. Nevertheless, even in this case the convertible note should have a fallback feature of a set price, so that if the term sheet doesn't happen the angel will STILL end up with an investment at a known, appropriate, valuation.
Note to angel investors: As Ben Franklin said, "experience is a hard school, but some will learn through no other." Let me add one more piece of advice: no matter HOW iron clad a term sheet you think you are bridging to, NEVER make the bridge loan subordinate to other debt, and ALWAYS ensure that you are first in line (ideally, make the loan secured.) Don't ask me how I know this.
So, there you have the definitive answer on convertible debt vs. preferred stock. It's not hard. It's not emotional. It's just business.
Charlie O’Donnell over at ThisIsGoingToBeBig.com wrote a great post on the value that the right investors can bring to a company. He uses the case study of Summize vs Tweetscan to highlight how the right investors led Summize to get ahead in the Twitter search race.
This is the definition of what it means to have Smart Money in your deal. Smart Money refers to investors that have insight into your business or industry that can help you grow as a company. Dumb Money refers to investors that can write a check and not much more.
When you’re handed a term sheet where the investor is taking a sizable chunk of your company, make sure you’re taking into account the value of that investor. The right investor can help you grow making the additional percentage your giving up negligible.
While it may feel like investors are evaluating you, you should be equally critical of them. This may seem hard to stomach when your in desperate need of capital, but getting the right person in can prevent you from having your back up against the wall in the future.
1. Enter your location in the left hand column of the Group Finder to sort groups by distance from you.
2. Click the View Site link to learn more about the group and the Start Application button to begin the application.
3. You can have up to three active submissions. If you apply to more than three, your deal will go into the group's Bulk Submission folder.
4. If you want to apply to an additional group click the Delete button next to an active submission. This will free up a spot and allow you to submit without being placed in the Bulk Submission folder.
Full Explanation:
Finding the right group to apply to can save you considerable time and money. Groups often have specific criteria they are looking for in a business such as industry and investment range. Applying to the correct group greatly increases your chance of additional funding talks. While it may seem like a good idea to send your plan to as many groups as possible, this can actually hurt you. Angelsoft is an ecosystem, and investors quickly ignore companies that abuse the system. To further prevent misuse, if you have more than 3 active submissions, your application will go into a group's Bulk Submission folder. You may delete an application to free up a spot. If you are looking for broad exposure we suggest applying to OPENdeals, which is accessible to the 8000 investors and 450 groups that use Angelsoft.To find the right group for you, start by entering your location in the left hand column of the Group Finder. This will display the groups that are closest to you. A local deal is more attractive to an Angel, so these are the best groups to apply to first.
Click the View Site link next to a group's name and familiarize yourself with their funding criteria. If you think your company is a fit, click Start Application. If you do not have an Angelsoft account you will be asked to register.
You can save an application as you work on it, so there is no need to finish it at once. All of your applications can be managed from the My Application tab. You can start as many applications as you want; you will only be placed in the Bulk Submission folder if you SUBMIT to more than three groups.
If you have already submitted to three groups, and would like to submit to an additional group, you can click the Delete button next to an active submission. Usually you would do this after the group has declined your deal. This will allow you to submit to an additional group without being placed in the Bulk Submission Folder.
– Application rated:
- An Investor has reviewed your application: 
- New Investment: $100,000 from John Doe, East Coast Angels
- Invitation: 
- Referred from Group1 to Group2:
- Investment Terms updated by John Doe:
