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
One of Angelsoft’s angel networks in Europe, the BiD Network, has launched an new opportunity for angels across the globe. Taking a cue from the success of micro-finance and the problem with finding any type of early stage funding for SMEs in emerging markets, the Business in Development Network has created a way for angels to start investing in newly emerging markets. Investments with comparably high risks, but often in untapped markets with unlimited opportunities.
In our rapidly globalizing world, it is vital to keep up with the latest investment opportunities. Read on for a short interview with a business angel without borders.
Why are you committed to the BiD Network and her entrepreneurs? "I think I can meaningfully support SMEs in emerging markets, by sharing my expertise and by providing access to finance to promising entrepreneurs. I consider this an important personal objective. The BiD Network offers a professional platform to get in touch with the entrepreneurs I am looking for."
In which BiD Network entrepreneurs did you invest? 'In 2006 I invested in Stewart Craine and his business called Barefoot Power (click here). Last year I decided to continue with another two entrepreneurs: Peter Meijer and Victor Mfinanga.
Peter is starting up a workshop in Malawi. He is going to manufacture bicycle carts as a mean for transportation, as mobile shop or even as an ambulance. Peter knows Malawi very well, saw a clear opportunity and is highly dedicated to make this business a success. I will provide Peter a loan of about 23,000 US dollar.
One of my friends went on business travel to Tanzania. He did me a favor to also visit Victor Mfinanga whom I already met at a BiD Network event in the Netherlands. My friend reported positively on Victor, proving my gut feeling to be right. I am currently negotiating with Victor on a 20,000 US dollar equity investment in his milk business. I believe that Victor is the right man to make it happen.'
What do you expect from the investments? 'I do not have calculated expectations. But obviously the repayments and financial returns will influence my possibilities to make new investments as well as the confidence I have in the entrepreneurs I invested in.’
To learn more about the entrepreneurs and matchmaking services of BiD Network, please visit www.bidnetwork.org/matchmaking or send an e-mail to matchmaking@bidnetwork.org. To learn about more examples of business opportunities, please click here. If you would like BiD Network to tell you when relevant deals come in, please indicate your investment preferences in the “Expression of Interest”. Access to deals relevant to you will be provided via Angelsoft.
The BiD Network is a member of the European Business Angel Network and is headquartered in the Netherlands.
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.
Since Bill Hewlett joined with Dave Packard in 1939 to create what is today the world's largest personal computer company, there has arisen an evergreen debate as to who is more important in starting a tech company: the techie or the business guy? Steve Jobs or Steve Wozniak? Bill Gates or Steve Ballmer? Jim Clark or Marc Andreessen?
I propose that it is time to reject the notion of the “business guy” (or “business gal”) entirely. The underlying problem is that there are really three different components here, and like the classic three-legged school, they are all essential for success, albeit with differing relative economic values. What gets things confused is that the components can all reside in one person, or multiple people. And what gets people upset is that there are different quantities of those components available in the economic marketplace, and the law of supply and demand is pretty good about consequently assigning a value to them.
Perhaps surprisingly, the components are NOT the traditional coding/business pieces; nor are they even coding/UI/business/sales, or whatever. Rather, here is the way I see it, from the perspective of a serial entrepreneur turned serial investor, listed in order of decreasing availability:
1) THE CONCEPT
A given business starts with an idea, and while the idea may (and likely will) change over time, it has to be good on some basic level for it to be able to succeed in the long run. How excited am I likely to be when I see a plan for a 2008-model buggy whip? another me-too social network? The 87th investor-entrepreneur matching site with no investors? The base concept has to make some kind of sense given the technical, market and competitive environment, otherwise nothing else matters. BUT good ideas are NOT hard to find. Not at all. There are millions of them out there. The key to making one of them into a home-run success brings us to:
2) EXECUTION SKILLS
It is into this one bucket that ALL of the ‘traditional’ pieces fall. This is where you find the superb Ajax coder, AND the world-class information architect, AND the consummate sales guy, AND the persuasive biz dev gal, AND the brilliant CFO. Each of the functions is crucial, and is required to bring the Good Idea to fruition. In our fluid, capitalistic, free-market society, the marketplace is generally very efficient about assigning relative economic value to each of these functional roles, based upon both the direct result of their contribution to the enterprise and their scarcity (or lack thereof) in the job market.
That is why it is not uncommon to see big enterprise sales people making high six figure, or even seven figure, salaries or commissions, while a neophyte coder might be in the low five figure range. Similarly, a crackerjack CTO might be in the mid six figures, but a kid doing inside sales may start at the opposite end of the spectrum. Coding, design, production, sales, finance, operations, marketing, and the like are all execution skills, and without great execution, success will be very hard to come by.
BUT, as noted, each of these skills is available at a price, and given enough money it is clearly possible to assemble an All Star team in each of the above areas to execute any Good Idea. That, however, will not be enough. Why? Because it is missing the last, vital leg of the stool, and the one that ultimately–when success does come–will reap the lion’s share of the benefits:
3) THE ENTREPRENEUR
Entrepreneurship is at the core of starting a company, whether tech-based or otherwise. It is NOT any one of the functional skills above, but rather the combination of vision, passion, leadership, commitment, communication skills, hypomania, fundability, and, above all, willingness to take risks, that brings together all of the forgoing pieces and creates from them an enterprise that fills a value-producing role in our economy. And because it is THIS function which is the scarcest of all, it is THIS function that (adjusting for the cost of capital) ends up with the lion’s share of the money from a successful venture.
It is thus crucial to note that the entrepreneurial function can be combined into the same package as a techie (Bill Gates), a sales guy (Mark Cuban), a UI maven (arguably Steve Jobs), or a financial guy (Mike Bloomberg). And that it is the critical piece that ultimately (if things work out) gets the big bucks.
Who do you think got the biggest relative return from the development of Trump Tower? Architect Der Scutt (the IA)? Engineer Irwin Cantor (the coder)? Broker Louise Sunshine (the sales gal)? EVP George Ross (the biz dev guy)? Or whomever happened to be The Entrepreneur in that deal?
The moral of the story is that for a successful company, we need to bring together all of the above pieces, realize that whatever functional skill set the entrepreneur starts out with can be augmented with the others, and understand that the lion’s share of the rewards will (after adjusting for the cost of capital), go to the entrepreneurial role, as has happened for hundreds of years.
netwroTExt is a Bellingham based company providing a service that allows users to send free texts to a group via their phones and their computers.
The amount of funding was undicslosed, but I got a chance to speak to their CEO and Founder, Derek Johnson. In regards to the round, he said
"we raised it to re-launch the website under it's new name, Tatango. This website is much cleaner, easier to use and will incorporate many features that were missing with the original website. This website will go into private beta on July 15th. Last weekend alone we received over 1,000 beta invite requests. "
networkText grew to over 15 million text messages since their launch in late 2007 and now have over 400,000 users. They are now currently looking to raise another angel round or go straight to VC's.
Perhaps the single biggest area of confusion in the world of early stage investing is the answer to the question "what should an 'appropriate' return be for a VC or angel investor in a startup company?" This is crucial, because the answer directly affects the valuations that investors are prepared to give early stage companies, and the assumptions that underlie the answer are the context for the long term relationship between the investor and the entrepreneur.
Before the question can be answered, however, there are several different numbers and theories involved, and it's important to understand each of them in context:
IRR (Internal Rate of Return) is the return on an investment OVER TIME, usually expressed as an annual percentage rate (that is, if you invest $10 on January 1 and get back $11 on December 31, that would be a 10% IRR.)
ROI (Return on Investment) is the return on an investment REGARDLESS of time, and is usually expressed as how many times the original investment is returned (that is, if you invest $10 and get back $30 at some point in the future, that would be a 3x ROI.)
PORTFOLIO TARGET RETURN is the IRR that an investor hopes to receive in total, taking into account ALL of the investments, profits and losses made in a given time frame.
ASSET CLASS TARGET RETURN is the IRR that an investor hopes to receive from all investments of a certain type (such as CDs, stocks, bonds, venture capital, angel investments, etc.)
TARGET ROI is the ROI that an investor hopes to receive on any one particular deal, taking into account the typical holding period for an investment of that type.
TIME VALUE OF MONEY is a fundamental economic concept that means $1 in your hand today is worth more than $1 a year from now (because you can put that dollar to work during the year, and make more money with it.) As such, ROI calculations are meaningless without an associated time frame. A 10x return that an investor would be ecstatic about if it came back in six months, would be a major disappointment if it took twenty years to come back.
RISK/RETURN TRADEOFF is the principle that the more risk there is in an investment, the higher return there needs to be to compensate for it. As such, an investor willing to take a 2.3% annual return on a US Treasury bill (essentially risk-free), might require a 12% annual return to be enticed to invest in a higher-risk corporate 'junk bond'. (See tinyurl.com/6fby2v)
PORTFOLIO BALANCING means that most investors aim to diversify their risk/return profile by investing in several different types of asset classes, because in any given year one class will do better than another...but it's difficult to predict which. It is therefore not unusual for the same investor to hold both US T-bills AND junk bonds, as well as several other asset classes. (See a fascinating historical chart of the relative returns from different asset classes over the past 20 years: tinyurl.com/5jygn2)
VENTURE/ANGEL INVESTMENTS in early stage companies are considered (for good reason) among the riskiest possible investments one can make. A majority of startups, no matter how promising, fail completely within a couple of years, losing 100% of the money that was invested in them. On the other hand, there is no way that an investment in T-bills (or General Motors) could ever have the potential return of an investment in a company like Google or Facebook.
Sooo...all of the above leads us into the following scenario: Mr. Typical Investor would like to get a somewhat higher total return from his investments than he would get by investing only in T-bills, and is therefore prepared to take some risk to get it. He decides to create a diversified portfolio with an overall annual target return of, say 5%. Since this is more than double the return of the average money market fund over the past five years, Mr. Investor's safe (but low return) investments have to be balanced by some higher risk investments, such as small cap growth stocks, or international funds. But for investors who have an appetite for real risk, and the consequent ability to lose some of their investment if things go wrong, they can go even further up the risk/reward scale to...venture capital.
VC funds in general target a 20% or so annual return to their investors, which can certainly bring up the overall average return on Mr. Investor's diversified portfolio. That sounds great, but with that high return comes equally high risk. Last year, a majority of US venture funds actually lost money and had negative returns, let alone not making their 20% IRR target!
Indeed, venture capital is only one part (the riskiest part) of an asset class called "alternative investments" that include things like private equity buyout funds, commodities, hedge funds, etc. And most institutional investors (the university endowments, pension funds and insurance companies who provide the majority of money to VC funds) nevertheless put only 2-3% of their capital into alternative investments as a whole...because they're so risky.
Let's look, therefore, at what it takes a VC fund to get that elusive 20% IRR. Well, it turns out (in case we didn't already know) that investing in entrepreneurs is indeed a Risky Business. VC's fund fewer than one in 400 deals they look at, but even with that discriminating judgment they are resigned to the fact that between 30% and 50% of their prized investments will crash and burn. Completely. And another 30% or so will end up being "walking dead", that is, making just enough money to keep themselves alive, but not enough to provide any return on the investment. Indeed, statistics over many years have shown than virtually ALL of a VC fund's returns will come from fewer than 10% of their investments. It's the one home run with Google that makes up for all the WebVans, Pets.com and eToys.
Thus, continuing with our math lesson, and taking into account the facts that: one in ten companies in a VC portfolio need to come up with all the return for the portfolio; the average holding time for a VC investment is 5-7 years; and the return for the whole VC portfolio needs to be 20% or so, we can calculate at the end of the equation that ONE company needs to deliver an ROI after six years of something north of 20X! And therefore, since the VC doesn't know WHICH of his investments is going to be The One (otherwise, of course, he wouldn't invest in the other nine!), EVERY one of his investments must have the potential to hit a 20X return.
It's because of all the forgoing realties, concepts and math that there is typically an enormous disconnect between entrepreneurs and investors. The former figure that 'risk adjusted return' means that an investor should be delighted if his/her/its investment brings back a 20 PERCENT profit (which is five to ten times the return from less risky asset clases), while the latter realize that if they don't aim on each deal for a 20 TIMES profit (which is required on a deal basis to deliver the 20% return on a portfolio basis), they will be out of business.
The result? A two-order of magnitude misunderstanding.
Open Deals provides you with a place to view and rate & review deals. Whether feedback is positive or negative and whether the deal is local or all the way across the country, your feedback is valuable! As more and more member provide negative feedback, other investors won't waste their time looking at the less interesting deals, and the good deals will rise to the top.
Also, as you build a reputation as a great deal reviewer, other Angel groups will begin to know who you are and what types of deals you like. Open Deals becomes your private community to establish your expertise , reputation, and trust as an investor.
1) Start with the Deal Dashboard:
If you do not know how to find the Deal Dashboard for a deal in Open Deals, please view the Basic Guide to Open Deals tutorial.
2) Scroll to bottom to find Ratings & Review section:
3) Click "Rate & Review this deal":
4) Enter in your ratings for each category:
5) Type up a review with all your opnions on this deal:
Here is where you can establish your credentials. The more valuable your feedback, the more other investment groups will appreciate your work. The more thoughtful your reviews, the more you will establish your area of expertise in the eyes of the early stage investment community.
Open Deals is a new feature on the Angelsoft platformt that many of you have been starting to use since its release about a month ago. It comes from the fact that we had many investors asking us for new sources of dealflow, and many entrepreneurs asking for ways to get in front of more investors. Open Deals solves these problems and much more. It gives investors a private place to collaboratively discuss deals, find co-investors, and build a reputation within the investment community.
To learn more, please follow the tour:
1) Finding Open Deals:
Open Deals is located in the upper right hand corner of your screen when you are logged into Angelsoft and viewing your groups deal list. Click on it to view the Open Deals space.
2) Understanding the Open Deals Home Page:
In the Open Deals Home page there are 3 main sections, and a number indicating how many of each type of deal there is.
1) "Recent Deals" - this will take you to a list of all the most recent deals that have come into Open Deals.
2) "Deals from other groups" - clicking this will take you to a list of all the deals that have come into Open Deals through an existing Angelsoft user.
3) "Deals within 500 miles" - clicking on this will take you to a list of all the deals within a certain geographic range of your group or personal profile location.
Now, click on any one of these to be taken to the appropriate view in the Deal Directory.
3) Deal Directory:
The deal directory is a list of deals filtered by the options on the left hand side. If you want to see deals by proximity to your location, you can cick on "closest to me", if you want to see deals that the most investors have viewed, you can click "Most viewed".
4) Deal Summaries:
When looking at the Deal Summaries in more detail you will see there are two types of deals. First, there is a Group Deal. This a deal referred into Open Deals by an Angelsoft User. Deals that do not have the "Group Deal" designation are deals that have been directly submitted by an entrepreneur into the Open Deals space.
5) The Deal Dashboard:
Once you click on a specific deal, you will be taken to a deal dashboard that is very similar to what you are used to seeing in your own Angelsoft account. The main difference is that, if you want to show this deal to your group, then you just have to select your group from the "refer this deal to my group" button.
6) Ratings and Reviews:
Scroll to the bottom of the Deal Dashboard, and you will see the Ratings & Reviews section. This is where you can make comments and rate the deal in question. Your feedback positive or negative contributes to the communities ability to filter out the good deals, while it helps establish you and your groups reputation on the system.
Open deals can be used as a source of extra deal flow for your investment group. As you navigate from deal to deal putting in Ratings & Reviews, if you find a deal that might interest your investment group, you can simply refer it back to your group. With the click of a button, you can send a copy of this deal to the new submissions folder of your group on Angelsoft, where it is then ready to go through your group's investment process.
1) Find the Deal Dashboard:
If you do not know how to find the Deal Dashboard for a deal in Open Deals, please view the Basic Guide to Open Deals tutorial.
Women2.0 held their annual event this past weekend at Stanford and over 300 attendees came to watch 5 tech companies with over 50% female ownership pitch. Here are some pictures from the event.
Congratulations to the Koolage, who won the main prize, and to Gaiagy, who won the People's Choice award for the event. Koolage took home a prize of over $15,000 in business services and a private meeting with Esther Dyson, CEO of EDventure and serial angel investor (member of the NY Angels). Included in the package was a free submission to Open Deals!
To follow up on Jason's post about unfundable deals, I wanted to lay out some guidelines for what makes a fundable deal:
