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THE SYNERGY BETWEEN ANGEL NETWORKS AND CORPORATE VENTURING
TOUGH TIMES FOR STARTUPS
The growth of a seed or start-up company is heavily dependent on the availability of risk capital. In early-stage companies, traditional sources of financing come from personal savings, family and friends, and severance packages. This form of financing, sometimes called “love money,” is usually sufficient to finance market research and to explore a product concept, but is rarely enough to reach prototype development. At this stage, entrepreneurs must begin looking for new sources of financing. In most cases, venture financing is not appropriate, as venture capitalists are reluctant to examine opportunities where the total financing is less than $1 million. As a result, angel investors, who are typically successful entrepreneurs with seed capital and acumen, help to bridge this financing gap.
When love money has been expended, many start-ups will pursue grants and government funding. In Canada, examples of these funding sources include the Scientific Research and Experimental Development Program (SR&ED) and the National Research Council’s Industrial Research Assistance Program (IRAP). Some may choose debt financing in the form of low-interest loans or credit card advances, while others pursue supplier or angel capital. Despite these multiple sources, raising early-stage capital to fill the gap between love money (e.g., $150,000) and professional venture capital financing (e.g., $1 million) is still difficult.
ANGELS FILL THE FUNDING “GAP”
Angel financing is one of the few early-stage “smart money” sources that can fill the early-stage financing gap. As Carleton University professor Allan Riding remarked at the University of Toronto’s “Financing Innovative Continue reading ANGEL NETWORKS AND CORPORATE VENTURING
Angel investors address the gap between love money and venture capital or more sophisticated sources of downstream capital. Generally considered the weakest segment of the financing services spectrum, angel investors must address higher risk, uncertain liquidity, long investment horizons, management gaps and a wide range of other industry-specific issues. Historically, angel investing has been carried out primarily by individual private investors; disciplined investment managers rarely invest at the angel level.
Relatively little has been known about angel practices and how they might be improved. Indeed, relatively little has been known generally about the angel investing “sector.” It is unclear, for example, how many angels there actually are in Canada. Oddly, many angels do not even recognize themselves as angel investors; they might not even be familiar with the term. Yet, the reality is that angels invest more than five times in early stage businesses as the entire venture capital industry combined.
“Down-rounds” have become a critical challenge for angel investors. These are the declining valuations that often accompany the entry of new investors into subsequent financing rounds. In some cases, down-rounds are substantial enough to severely diminish or eliminate entirely the equity stake held by angels and other early investors.
Angel investors are often quick to criticize venture capital investors (VCs) for down-rounds. However, angels who are careful about keeping their eye on the ball are much less likely to suffer heavily in down-rounds. VCs and angels may exhibit differences in approach and may be driven by different prerequisites. Nonetheless, the two have much in common. With better attention to detail and a better understanding of the VC process, angels can make early-stage investing a more congenial and rewarding experience.
How does the prudent angel avoid getting burned in down-rounds? The primary rule of an angel investment – as with any investment — is to plan for one’s eventual exit. Angel investors need to consider their exit strategy from the outset, and continue to do so through the entire investment process to payout. Only the naïve will expect later-stage investors to look after their interests
THE INVESTMENT CLIMATE
By the end of 2002 and into 2003, the environment for early-stage financing had become as discouraging as it has been for the past 25 years. Little money was being invested and fear tended to dominate investment decisions, making negotiations difficult and seriously reducing risktolerance.
This tough environment intensified the inherent conflicts between angels and VCs. While many angels pointed to VCs as the source of their problems, the truth is that both angels and VCs found the investment climate trying, albeit for somewhat different reasons. However, with a little perspective, angels can understand the venture capital process better and thereby improve their own positions.
The prudent angel investor knows and understands his competitors and his allies.
VCs AND ANGELS ARE BOTH EARLY-STAGE INVESTORS
The earliest investors frequently include the company’s founders, the management team, friends and family, and angel investors. Some venture capitalists may enter at this early stage, though this is unusual. It is often a mixed crowd that supports an early-stage venture, but what these investors share is a powerful interest in growing the company. These people are investing in the future, based on what they know about the talents of the management team and its ideas and products.
In contrast, later investors generally have a better sense of the business’ prospects, and are investing on the basis of visible results rather than personal knowledge, instinct or experience. These later investors, who are almost exclusively venture capitalists, are interested in making deals that will bring a good return within a specific time frame. While some VCs look at the bigger picture and are comfortable with long-term investments, many prefer to earn a healthy return with a quick turnaround. Liquidity is a key consideration, as venture capital funds must generate a steady return for their investors.
This need for relatively quick returns on investment often push VCs to sell an equity position sooner rather than later. In so doing, they may leave early investors and managers with nothing but bitter experience. Naturally, this is a key source of tension between angels and VCs. However, since this is a well-known element of
early-stage investing, it is sensible to plan for the eventual entry of secondary investors. The prudent angel will learn as much as possible about the role and motivations of VCs, and will also attend closely to the start-up’s stage of growth and need for new capital injections.
BEGIN WITH A REALISTIC APPRAISAL OF THE INVESTMENT
Entrepreneurs are enthusiasts by nature and will occasionally woo investors with grandiose predictions of how much revenue they can generate over a short period of time. It has not been unheard of for start-ups to boast expected revenues of $5 million or $10 million or more. And yet, a simple review of available statistics quickly reveals how inflated such projections can be. A recent survey ranking the top 100 independent software companies in Canada in 2001 (Branham 100, www.branham.com) noted the following:
Only 63 of the 100 had revenues of over $10 million a year.
The companies had, on average, been in business for 15 years.
The 100th ranked company on the list had revenues of only $2.8 million.
These figures illustrate how risky it is to place one’s trust in an entrepreneur’s earliest projections. As early-stage investors, angels often get swept up in management’s enthusiasm. Instead, they need to put their financing on a more cautious footing and ask themselves: “If these sunny projections don’t materialize, how am I going to protect myself when the company goes back to the market for more money?”
MONITOR THE INVESTMENT FROM THE OUTSET
The prudent angel investor will ask for best and worst-case projections at the outset and assiduously track results against them. Angels need to know when the company’s course deviates from expectations, and when it does, be prepared to take the necessary steps. These may include a further personal investment, joining the Board, helping with marketing, finding a purchaser for the investment, writing-off the investment, finding additional angel investors or providing stronger incentives for management to deliver.
THE ENTRY OF THE VENTURE CAPITAL INVESTOR
Let’s assume the angel investor has retained his investment. A few years have passed and the early, enthusiastic, hockeystick revenue projections are a distant memory. The company has built a solid foundation and is now attracting interest from venture capitalists. This is great for the company and may help it to realize its goals. However, angel investors must be aware that their situation changes with the entry of the VCs.
Once in, the VCs need to make a quick exit in order to provide a constant flow of income to their investors. They also need to leave some value in the company for managers to ensure the necessary incentives are in place to continue growing the business. However, as noted above, early-stage investors can easily get squeezed out.
Having provided the initial capital for growth, the prudent angel is alert to the ongoing need to protect and build his investment. Fortunately, there are several mechanisms available to help him. These include averaging down, the use of formal debt instruments of various sorts, guaranteed pay-outs, management fees, finders’ fees, shotgun clauses triggered by share dilution and representation in the form of directorships, among others.
In truth, new businesses rarely begin generating revenue momentum — or VC interest — until the third or fourth year of operation. This may be too long for many angel investors to wait, as the risk is simply too high. Consequently, there is often a gap between the time when angel investors should or must get out and venture capitalists are ready to come in. The result can be a stalemate in which all parties withdraw from the game — VCs because they can’t get the requisite returns within the requisite time frame, companies because they don’t like the terms of investment and angels because they don’t want to risk more money.
Ideally, the prudent angel identifies the need for more money early on, and works with the investee to pinpoint and attract a venture player whose terms are mutually agreeable. Unfortunately, the reality in today’s environment is often rather different and angel investors must be prepared for it.
THE RETURN OF REASONABLE VALUATION
Returns in almost every market, from equities to venture capital, have fallen during the past two years. In hindsight, the real question is not why the fall occurred, but why it did not happen sooner. Valuations between 1998 and 2000 were outrageously high and added to investors’ uncertainty about how to assess risk. Amid all the energy and excitement that surrounded the late 1990s, people began using bizarrely high multiples, overly optimistic forecasts, market share projections and other novel methods to estimate potential success. None of these novel methods lasted beyond the bubble.
Thankfully, the past two years have seen a return to the fundamentals. Investors of all kinds are looking at conventional valuations (based on actual earnings, revenue, cash flow, and other tangible indicators) and conservative valuation strategies using lower multiples and more realistic forecasts. Indeed, the pendulum has swung back with a vengeance.
Everybody has been affected. Early-stage companies, financed by angels at the height of the madness, are now being funded at reduced valuations. Of course, this puts a further financial squeeze on angel investors. The prudent angel is just as likely to have been swept up in the madness as everyone else – and just as likely to be looking at lower portfolio valuations.
The solution lies in formulating strong funding and defensive strategies. Angels must ensure that an investee company has a solid business plan outlining how and when it will deliver promised results. They should also be prepared to supplement this by providing hands-on management and marketing assistance, as required. In portfolio terms, the prudent angel will focus careful attention on the fundamentals, including value propositions, sales channels, competitive advantage, market size and product and service differentiation.
Moreover, angel investors must remain keenly aware of developments affecting their investments. If restructuring is required, then the investor should try and lead it – by contacting management and other stakeholders to arrange for financing. By being the initiator, the angel investor will retain a measure of control and reduce the risk of being squeezed.
PARTICIPATING IN LATER ROUNDS
At some point, there will be a later round of financing. For angels, this can be an opportunity – after all, a down-round is a good time to invest as businesses have reduced their valuations, the inflated sales figures are flapping like torn flags, and management is increasingly eager to negotiate. However, the decisive factor for further investment must be sustainable profitability. Clearly, bubble-type valuations have had a lasting negative impact and investors and managers have become more concerned with building profitability. The prudent angel will have also adopted profitability as the fundamental element in investment valuation.
PREPARE FOR THE FUTURE AND BE READY TO STAY IN THE GAME
Angels who have prepared for the next round of financing will have already determined their course of action. If not, they still have a choice. They can enter the next round, where a better deal is being offered (in essence, averaging down, but retaining some control over the dilution); they can hold tight and watch their investment be diluted (the classic squeeze); they can scramble for leverage and payback (management fees, fees for services, directorships, shot-guns); or they can pull out.
Clearly, early preparation works better than last-minute scrambling, and enables the angel to plan how best to participate in later rounds. For example, if an angel reduces his initial payout, this can leave funds in reserve to enable reinvestment at the next stage. This allows the investor to get in on the ground floor and help build the company, while participating in the terms and benefits that go along with later-round financing. It also gives the angel leverage in new rounds and keeps the door open between the angel and the VCs, which is key to cooperative investing and, in effect, bridges the gap between the first and later rounds.
To reiterate, the prudent angel must be prepared for the next round of financing and has already planned the route that is most workable.
CO-OPERATION CAN PROVIDE MUTUAL BENEFITS
There is great value to be had in today’s market. After a couple of years of blight, even big brokerages are beginning to take an interest in small, well-run companies. In one recent deal, management, a national brokerage, VCs and angel investors were all involved at the same time. The company had positive cash flow and money in the bank. The arrangement seems to be working even though the compound annual growth rate isn’t quite at 30 per cent, which is something of a concern for the VCs. But the pricing was simply too good for the players to resist.
In this case, all management needed for continued growth was funding. The investors are working together to make sure management has what it needs. None of the participants wanted this company to fall into the angel / VC gap, and took steps to ensure this didn’t happen.
The lesson from this example is that the prudent angel welcomes partners who can help the investee.
KEEP YOUR EYE ON TOMORROW
There are two key questions for every early-stage company: “How do we attract money today to build the business now?” and “How do we make this business grow into the future?” Angels need to focus on the same questions on behalf of their investees and keep in mind that the past is history. The world has changed, valuations have changed and priorities have changed. An angel cannot change what has already happened. If VCs have already bitten into the investment, the challenge is to find a way to make the most of the flesh that remains.
The prudent angel investor stays focused on today and tomorrow and leaves yesterday behind.
TAKE ADVANTAGE OF TODAY’S PRICING
Angel investors are better off than they were two years ago, though they may not realize it. The reason is that investees are generally better managed today and more focused on revenues and profitability than ever before. Many of them are showing they can survive with a delayed or even evaporated second round. Also, as noted above, there is a small resurgence of investor interest in early-stage companies. While not definitive enough to constitute a trend, dollars are slightly more accessible, which will help to close the angel / VC gap, at least for some lucky companies.
The involvement of venture capitalists could hurt if there is a big down-round. However, valuations today are such that many angels will want to stay involved with their companies and participate with later-round investors. They can, in fact, help to reduce VCs’ anxiety about valuation by maintaining or building both their presence and their investment in the target company.
The prudent angel investor talks with VCs about valuations and how to realize intrinsic worth in their investees.
BUILD RELATIONSHIPS BASED ON TRUST
VCs are looking for quality deal flows. For this they need good relationships with those in the business community – including angel investors. Angels can provide access to a world of deals that VCs wouldn’t otherwise know about. This change in philosophy has been noticeable in the term sheets turning up recently.
There is no question that some VCs – driven by fear and the need for quick returns – squeezed some early investors unconscionably. There were more than a few very ugly deals. But the good faith required for successful business dealings cannot grow when one side is taking untoward advantage of the other. The ridiculously lopsided terms that were common in the recent past have begun to give way.
The prudent angel investor will look for mutually rewarding relationships and will not judge all VCs by the actions of a few.
BE PREPARED TO COMPROMISE
The key to a new relationship between angels and VCs is compromise. Relationships take time and both sides have to learn to trust one another and to support one another’s objectives. Even when the goals of the parties no longer align, if the relationship is strong, it is possible to get through with grace and dignity.
The benefits of compromise also apply to investment targets. Given the current environment, investors should aim for smaller profits on more deals and greater diversity in their portfolio to spread risk and enhance income. This goes for angels and VCs both.
BUT ARE VCs WILLING TO TAKE LESS INTERNAL RATE OF RETURN?
VCs are beginning to look at things in the longer term. The late 1990s saw an unbalanced market and a very demanding and somewhat unrealistic set of investors. Today, many VCs have learned that, as an early-stage investor, a short-term approach to making money just doesn’t work. Many are beginning to realize that the tough provisions inserted in term sheets when valuations were unrealistically high need to be altered now that valuations are more reasonable.
Slowly, the market is changing. At a recent venture fair, several major VCs made it clear that they were not interested in seeing companies project revenues of $100 million within five or seven years of start-up. They even suggested that their earlier demands had resulted in a whole generation of managers making unrealistic projections just to get on the radar screen. Another venture fair conversation featured a VC who had left the industry because he felt that the VC model resulted in too much money coming out of early-stage companies too soon.
The prudent angel investor encourages companies to provide realistic valuations and projections.
PICK YOUR PARTNERS, BUT….
There are good and bad VCs, and most angels would rather deal with VCs who never participated in the scurrilous squeezes. However, in this changing market, angels must be willing to look past VCs’ recent behaviour, because, realistically, there isn’t much choice. In tough times, any VC who is willing to get involved in a project and who has money is a good candidate for later round financing.
That being said, however, angels need to look to themselves. Based on their years of experience, relative freedom, and closeness to the investees, it is their responsibility to behave like the professional investors they are. That means building on their knowledge and experience to establish workable term sheets that provide reasonable protection. It means structuring various types of investment arrangements, creating measurable and monitored goals for investments and holding themselves accountable for the performance of their money.
Prudent angel investors cannot sit back and blame management, the VCs, the investment climate, commodity pricing or the telecom upheaval. Instead, they must realize that they have at their fingertips the resources to make good and profitable investments.
What resources? At the very least, they have each other in Canada’s increasingly active and organized angel network. And they have the experience of working with their fellow investors – the VCs and the brokerages. They need term sheets. They need regular meetings with management. They need to be kept in the loop and to keep themselves informed. They need metrics. They need to track investments against stated and communicated goals. They need to know how to say “no”. They need an understanding of business models, business management techniques and valuation criteria. Because, let’s face it — if they had invested as professionals in the first place, it would have been much harder to squeeze them.
The prudent angel investor treats his or her investments as a business.
As they develop national expertise, angels need to focus on ensuring a better and more business-like working relationship with both investees and other investors. This will go a long way to helping bridge the gap between angel investors and venture capitalists.
In response to current market conditions, angel investors are looking for ways to minimize risk while contributing to the development of new ventures. Clustering or investing in groups has been identified as one means for angel investors to reduce transaction costs while increasing opportunities and returns.
By pooling assets, angel investors can share the risks and leverage the expertise of partners. They can also participate in offerings with high-quality private growth companies, which may not be available to the individual angel investor. This approach also gives investors more negotiating power with respect to the terms of the financing and the direction of the business. And by pooling their money, angel investors can present an attractive value proposition to growth companies that readily competes with formal venture capital dollars.
While there is no “ideal” angel structure, this paper will address two specific types of structures that facilitate group investing: limited partnerships and the Capital Pool CompanyTM (CPCTM)program of TSX Venture ExchangeTM. It also outlines two other structures, which are currently unavailable, but are worth considering for the future.
Angels have used limited partnerships for many years as a way to bring together capital and expertise for specific investments. Syndication allows for greater leverage of funds than individual investors can achieve on their own.
There are five key elements that angels should consider before investing in a particular enterprise. These are the legal, financial, technology, marketing and human resources aspects of the company. Each of these areas presents the investor with several fundamental issues, which should be examined and addressed before embarking on an investment. The experience of many investors is that a failure in just a few items can easily result in failure overall. Thus a major challenge for investors is to distinguish between those items that are deficiencies, and can be remedied, and those items which are fundamental flaws.
There are several factors to consider with technology. For instance, is there a demonstrated demand for the product? Creating a superior rat-trap – or even a wholly new product or technology for which there is little consumer need – will rarely result in a well-trod path to the company’s door. A product’s success is directly related to its utility.
Secondly, will the technology function reliably under the real-world conditions proposed? To what extent has it been effectively tested?
Does the technology offer benefits that are not available from competing products – such as added functions or features or lower costs – or does it simply duplicate offerings currently available?
Is the technology protected? Are patents in place? To the extent that there is no proprietary technology, what evidence is there of an ability to create a competitive business?
Efforts should also be made to check the employment history of management and to determine whether or not the technology or any part of it was engendered in the course of prior employment. Former employers Continue reading Angel Investing Due Diligence
Managing Members, Guiding Presentations and Finding the Right Angel Investor Deals
Angel investing has long been an important source of financial support and mentoring for new and growing businesses, bridging a gap between individual and institutional venture capital rounds of financing or being the only source of external financing. Over the past several years, the number and types of organized business angel groups has grown, and the business models for the groups continue to evolve. These organizations are generally better financed than ad hoc groups of individual investors, but they also face their own organizational and structural challenges. This paper outlines some of the lessons shared among business angel investment groups around North America during an “Angel Organization Summit” held in October 2002.
Best practices shared by the 25 groups participating in the summit include: managing membership participation, coordinating company presentations, finding the right fit for potential investments and working with other investors, particularly venture capitalists and other angel groups.
MANAGING PARTICIPATION OF MEMBERS
Since angel groups are disaggregated organizations of individual investors, one key goal for angel group leaders – whether they are members themselves or hired managers – is to maintain appropriate levels of member involvement and application of members’ expertise. Strong member involvement ensures that the group provides more value-added contributions Continue reading Angel Investing Group Best Practices
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