Understanding Angel Investors

Seek first to understand, then to be understood. Good advice overall, but particularly important if you are an entrepreneur seeking funding from an angel investor or VC. There are so many great entrepreneurs that fail in their attempts to acquire funding because they really don’t understand what the investor is looking for. In this article I’ll try to give you a sense for what angel investors are all about, what they are looking for and how to develop your presentation and story-line based on what they want to hear. Note that what an investor wants to hear may very well be different from your normal pitch.

So first, who are angel investors? They come in all shapes, sizes and ages, but generally they are highly successful, financially secure individuals that believe that both their money and their expertise can help an entrepreneur succeed. Angels often have an entrepreneurial and/or senior management background. Angel investors believe that what helped them succeed can be an accelerator in moving entrepreneurs to the next level. Many, but not all of the angel investors are semi-retired; set for life financially, but using the investing and the collaboration with investors and entrepreneurs to stay in the “game”. Other investors and still managing their own companies or working full time and hoping the angel investments will generate future income when they are not drawing a paycheck. Perhaps the biggest takeaway should be that angel investors want to help, want to be of value to the organizations they are investing in and believe that they can personally contribute to the success of the start-ups they invest in.

So what types of investments, what types of companies and what types of entrepreneurs are angel investors looking for? While this will vary from investor to investor, generally these are the types of investments that get angel investors engaged:

  • Early stage, but typically not the very first investment–it is expected that friends, family and owners have invested or bootstrapped the company to this point
  • The company is in a space the angel investor understands
  • A need for $200K to $1.5 million
  • Solid leadership team with passion and determination
  • Product/service is almost ready to launch
  • Preferably some early customers
  • Patents have been filed, IP is protected in some way
  • Clearly differentiated product
  • Market is of sufficient size to support growth projections
  • Expected 5  year Compound Annual Growth Rate (CAGR) of over 50 percent
  • Expected revenue of $50 million plus within 5 years

These above points represent some of the basics that angel investors look for. Please note that these are general metrics that many angel investors are looking for, but often strengths in one area can offset weaknesses in others. For example, a solid patent portfolio in a high growth area can offset some early weaknesses in the leadership team as long as the management appears to coachable. Any serious red flags in these areas will make it harder to get the attention of angel investors. But, of course, the goal isn’t just to get the attention of investors, it is to get the funding you need with terms you can live with. So, assuming there are no major red flags, how do you maximize the potential of getting angel funding? First there is no magic bullet. There are great companies that never get funded and a lot of companies that shouldn’t get funded, but do. That said, I’ll give you my take on what will increase your odds of getting angel funding.

First and foremost be visible to potential investors. Relentless networking is very important. Don’t just attend an event and put a business card in your file…send an email, ask for some comments or input on your plan, meet the investor for coffee, send an email anytime something interesting happens with respect to your business. I can’t emphasize how important this visibility can be. This can be one of the biggest factors in moving your company from one of a thousand funding applications to actually being considered for funding are the relationships you are able to establish. Go to the networking events. Do your research on angel sources locally. Work the contacts you already have and don’t give up.

Here is a quick case study as to how this can work. Tech Coast Angels (the angel investment group I participate in and the largest angel investment network in the US) periodically puts on a meet the angels event. I participated in one last fall with probably 75 entrepreneurs and about 10 Tech Coast Angel (TCA) members. One of the companies participating peaked the interest of one of our members and this member started to walk him through the process. The CEO of this company also followed up with me and several other TCA members. I probably talked with 15 companies that evening, but with his follow-ups I did remember him and the firm. About a month later the TCA advocate that walked him though the process brought him to a screening meeting with about 50 of our members. The connection he established with the lead investor, with me and probably 5 other members set the stage for the eventual funding of over $1 million.

Second, be coachable. This is a tricky area in that investors are looking for a CEO/leadership team that is decisive, confident and very determined. That said, many of the angel investors have already been where the start-up entrepreneurs are trying to go–building, funding and often-times selling their own companies. Many of the investors I work with have had several successful exits and they are excited about helping others succeed. The CEO that presents himself as arrogant and not needed help probably won’t get help or money from the angels.

Third, be flexible on your pre-money valuation. One of the fasted ways to end an angel investment discussion is to play “chicken” with respect to valuation. While the world revolves  around the start-up CEO’s company (from the CEOs perspective), the angel investor commonly sees hundreds of start-ups per year and will ultimately succeed as an investor if they properly manage risk. One of the ways to manage risk is to be very conservative in terms of valuation. Early stage companies, those without large client bases, those entrepreneurs without previous exits, those companies without current product, without patents or protection for their IP will almost certainly get “dinged’ in terms of valuation. I’ve seen several entrepreneurs take this personally and complain that the investors just don’t understand how great this company is. The fact that the entrepreneur is negotiating valuation to me means that the investor does see some potential, but seasoned investors (or entrepreneurs) also understand that there are many risks in start-up companies and the valuation is meant to compensate for some of these risks.

The entrepreneur should also focus on the what the angel investors are looking for…high return exit potential, a management team that the investor would enjoy working with and the ability to actually help the entrepreneur get to the next level.  Following the above advice will greatly increase your odds of getting funding. Good luck.


Revenue Capital: An Alternative to Traditional Funding

Many, if not most, entrepreneurs have been frustrated by the time, effort and, often, lack of results as they try to gain funding to get their company to the next level. One of the biggest stumbling blocks is often valuation. The entrepreneur has put his/her heart and soul into building a company from scratch and any funding will require a giving up substantial equity. This is further complicated by huge gap between the entrepreneurs’ pre-money valuation expectation and the number the VC or Angel investor suggests. But it gets even worse…since the investor is betting on the future value of a company, every assumption the entrepreneur makes will be scrutinized with a fine toothed comb. Furthermore, even if a start-up has a solid business with stable growth, but can’t show a clear and believable path towards a 10X or greater increase in valuation, the Angel or VC may not be interested.  Another tricky part of this process is determining how much money the firm really needs as well as how much equity to part with. Often companies won’t fit into a range that makes sense for a VC (generally $5+ million) or an Angel investor (varies, but often in the $500K – $1 million range). Smaller amounts are often garnered by “friends and family”, but in this economy, that isn’t always an option.

The scenario I described has prompted a few firms to offer an alternative to traditional equity capital and debt financing called revenue capital or royalty-based financing (RBF). The concept is pretty simple; instead of the entrepreneur giving up equity or taking on debt in exchange for funding, the investors fund the business and generate returns based on a percentage of company revenue. This means the entrepreneur gives up no equity, requires no physical collateral and doesn’t have to incur personal liability for repayment. The expected payments will range from 1.5 to 4 times the initial investment and are generally expected to be paid back in 5-7 years. The investor may ask for warrants to give them some upside (although this is not always the case) and most will require full payback if there is a change in control.

While the concept of revenue capital isn’t new in industries such as oil/gas, it is beginning to emerge in the technology space. This model can be particularly attractive if the entrepreneur is concerned about dilution. The model is particularly attractive to the investor if you already have substantial revenue, have stable growth and the likely prospect of growing revenue over the next several years.

The revenue capital concept was recently presented to Tech Coast Angels, the angel investing group I participate in, and the largest angel investment group in the US. The presenter, Dr. Rob Wiltbank is from Revenue Capital Management  http://revcapfunds.com and also a professor at Willamette University in Portland. Revenue Capital Management invests in companies with established revenue streams in exchange for a percentage of monthly gross revenue. They typically invest 5%-15% of annual revenues for from 3%-10% of the  company’s revenue stream, paid on a monthly basis. They also typically cap the total payment at 2x the initial investment if paid back within 5 years. They are looking for companies with the following profiles:

  • Established revenue of $2 million – $20 million (but they will consider lower amounts of revenue for smaller investments)
  • Profitable or near break-even with a strong gross profit margins
  • Companies seeking growth capital, including project financing
  • Ownership transfers including company buybacks, generational transfers and ESOPs are considered

Another RBF source is lighter capital http://www.lightercapital.com/ They have a cool website worth checking out even if you aren’t looking for an investment today. Their basic model is similar to Revenue Capital Management’s approach, but they will look for warrants to get some additional upside. Their loans are typically between $50K and $500K. Typical payback is 1% to 5% of revenue, which can ratchet down if certain milestones are hit, with a loan term of up to 5 years. They will generally EITHER cap the payment (1.5x -3.5x investment) or cap the term with 1% to 5% of revenues, ratcheting down if milestones are hit.  They are looking for companies with the following profiles:

  • Early stage / start-up companies, but must be operating and have at least 12 months of revenue history (no pure start-ups)
  • Minimum trailing 12 month revenue of $200K, or growing fast with minimum monthly run-rate of $16K
  • Annual revenues of up to $5 million
  • Gross margins greater than 50%
Revenue capital funding isn’t for everyone. The pure start-up without revenue won’t qualify. Larger companies (over $20 million in revenue) are better suited to traditional debt or equity financing. An early-stage company with some revenue history, solid gross margins and a sustainable revenue stream with funding requirements of $50K to $500K is a strong candidate for royalty-based financing. If you fit the RBF profile, you want to determine whether you are better off giving up equity and pursuing angel/VC funding, or if revenue capital is a better model. This decision may be made for you if you are (for whatever reason) not attractive to angels/VCs. If you are an entrepreneur that believes your future valuation will be astronomical, leveraging revenue capital gives you the ability to fund growth without any dilution of equity.

Start-up Survival–Cash is King

So you have a great idea. You can’t wait to leave the boring day job, collaborate with a few of you friends and start a company. You will be living the dream. You create a 5 year plan showing $80 million in revenue in year five, calculate valuations based on current comps and plan your retirement. Life couldn’t be better until you wake-up from your dream and face the reality of  how hard it will be to survive the  first 18 months. The first instinct is to get a war chest of other people’s money, but without a product, a seasoned team, a prototype, customers or any revenue it is either unlikely you will get funding, or, if you do, it will eat up much of your equity. Generally a combination of personal savings, friends and family funding and possibly angel investing will keep the lights on. This can be coupled with some innovative early revenue generation opportunities and very tight cost controls to give you the best chance of survival until either significant revenue or funding occurs. The following are ideas and guidelines to help you get through the early days of your exciting start-up.

  1. Be Prepared: Do as much as you can before leaving the security of the day job. This includes building up personal savings and liquid assets to support your needs and the company needs for the first 12 months. To determine the cash needs you need a detailed plan itemizing all anticipated expenses. You also want to have back-up plans to cover unanticipated expenses. These buffers may include a line of credit, credit cards, a rich uncle, partners with personal savings and other means of getting through hard periods. A good rule of thumb is to estimate every expense you will incur prior to offsetting revenue/funding and then double those expenses.
  2. Develop Your Funding Strategy: Develop your strategy for acquiring funding very early. For most organizations I like a funding in phases with specific milestones and use of funds within each phase. For example, an early seed round or friends and family round may get you a prototype and your first full-time employee. When this is accomplished you will be in a better position to get some more significant angel funding at a better valuation.
  3. Network, Network and then Network: Over the first 18 months you are going to need so much help in so many areas. Establish your networks, both formal and informal. Communicate via Linked-in, Twitter, Facebook and other social networks about your ideas, needs, updates on the company and so on. Then start focusing on the key relationships that will help you the most. For example, the top engineer you want to hire once funding comes in, your friend’s Dad who is an Angel investor, A CEO you know that could be a potential advisor and others that can be helpful now or in the future. Also look to industry groups, trade associations and non-profits that can be helpful and gain you additional credibility in the space you are focused on.
  4. Develop a Detailed Financial Plan: Cash is safety. Treat cash like your most prized possession. This starts with a detailed understanding of every possible expense in the foreseeable future. Develop a model that estimates expenses and then update these assumptions with actuals on a daily or weekly basis (depending on the urgency and your cash outflows). Tie this into a regularly updated cash flow model that also projects your cash position for at least the next 6 months. This modeling will make or break many start-up companies. You always need to know how long you can last if you expect to properly mitigate risk.
  5. Innovative Revenue Generation: One of the ways to last longer and give you a better chance for success is to figure out how to generate revenue even before your core product is ready for prime time. For example if you and your partners have in-demand skills you can help support your company with consulting revenue. This has the added advantage of developing trust relationships with prospects for your full product. Another revenue generator can be a trimmed down version of your full product perhaps targeted at a specific market segment. In addition to revenue generation, this could give you real customer input for your full product. The trick here is to generate enough revenue to lower your risk while spending sufficient time on your core product/strategy.
  6. Execute on Your Funding Strategy: If possible, you should be working on your funding strategy 6 months before the funding is needed. I’m not saying that you should be pitching VC’s before you are ready (see my top 10 list of what not to do when seeking funding), but you should be taking the steps to be ready including networking, working on the investor pitch, getting the prototype completed, signing up the first customer or whatever is important to achieve your next round of funding well in advance of the date you actually need funding.

If you follow the steps I’ve outlined, you will be better prepared to avoid the dilemma I’ve seen many entrepreneurs face…being forced to acquire funding to keep the lights on. This is like being backed into a corner and having to take any funding you can possibly get including suboptimal terms and a low valuation, or, not getting funding and abruptly ending your dream. While I have learned that there are no absolutes in business, I do believe that thinking about the steps I’ve outlined will improve your odds of success. Please feel free to comment adding your ideas,  input, experience or suggestions.

The Entrepreneurial Spirit

I always wanted to be an entrepreneur. When I was 8 years old, we moved into a new house in New Jersey. We owned one of the first houses built in a new development that would ultimately have hundreds of homes. So there were a lot of homes in the process of being built and it was a hot NJ summer. This was in the mid-1960s and there were no mobile canteen trucks serving the many construction workers that were  toiling under the hot sun. So I came up with the idea to buy soda from the local store, ice it up and take in my wagon from site to site. I bought the sodas for $.07 a can and resold them for $.15 a can. My mom would drive me to the store to to pick up the soda (free transportation and storage helped my margin).  I really enjoyed it and learned so many business lessons. For example, after doing this for about a month, a new neighbor (competitor) saw what I was doing and went out before me in the late morning and mid-afternoon to sell sodas to the construction workers. My neighbor stopped after a few days because most of my customers said no thanks, Gary is coming in 15 minutes. My first taste of competition, but also the value of being reliable and treating your customers right…building loyalty. Another business lesson started one day when I shocked to find that the generic brand soda was out at the local store. So I could buy the name brands at $.25 a can, increase my price, take a loss or just not sell soda that day. I decided to be upfront with the customers, bought the sodas for $.25 and resold them for the same price. I learned to be honest with customers, if you have a good relationship they will understand.  That said, a few wouldn’t buy and though I was ripping them off, but most paid and appreciated my candor and my making the rounds. At the end of the summer I actually bought a bike, bought a TV (don’t think the IRS can go back this far) and learned some great lessons. And while the money was nice, creating something from nothing was priceless. As it would turn out, the following summer canteen trucks were all over the neighborhood, with soda, burgers, ice-cream and so on. It was like Wal-Mart moving in next to the small retailer. It was a nice ride, but it was over. Another lesson learned, always look out for your competition and know when to take your ball and go home.

I love entrepreneurs. I love working with them, advising them and being an entrepreneur. So how do you know one when you see one? They come in all shape, all sizes, all ethnicities, and all social and income classes. They do have one thing in common–what I refer to as the entrepreneurial spirit. They want to build something from nothing…take an idea and turn it into a product, solve a problem, create a market. They are always thinking of ways to solve problems and better ways to do what is already being done. But the idea isn’t enough. You have to have the intestinal fortitude to put it all on the line and actually do it.  And the passion to really want to do it. It  isn’t just the high profile names like Facebook or Google, its anyone defying the odds and doing it on his/her own.

The entrepreneurial spirit is what I look for in advising a company or investing in a company. I want to see the passion, the fire, the fortitude to turn a concept into reality. These are the people I respect and want to work with. While it is hard to specifically define it,  you know it when you see it. For me it is like looking in the mirror at the 8 year old boy.


Entrepreneur’s Top 10 List of what NOT to do when seeking funding

While building and then selling two companies, providing guidance to many start-ups and working as an angel investor, I’ve observed several show-stoppers, areas to avoid when addressing VCs or angels. I have had the pleasure to review funding pitches and/or support probably 200 entrepreneurs over the past few years. It very troubling how many start-up CEOs shoot themselves in the foot with totally avoidable mistakes. This topic reminds me of an old George Carlin skit in which he reflects on why he can’t get a job…the first question he asks the prospective employer is their policy on Monday and Friday absenteeism. He then makes disparaging remarks about the family picture on the interviewers desk. Not sure why he didn’t get the job. So here is my list.

  1. Don’t say we are another Facebook. There will not be another Facebook for a long time. If you mention Facebook, talk about how you will be different, or how you will provide significant value-add to massive base of Facebook users.
  2. Don’t describe your product/concept as having NO competition. This is a fast way to lose credibility. Instead focus on your competitive advantage and differentiation, but recognize the competition. It is also great to put a competitive matrix together that shows your product and several key competitors on one axis and desired features on the other.
  3. Don’t forget to CLEARLY describe what it is you are doing and why it is better than the competitive offerings. You need to show a sustainable competitive advantage, but, also you need to make sure the investor understands your basic product/service concept. I’ve sat through many painful presentations trying to figure out what the company actually does.
  4. Don’t propose to use most of the funding for salaries for the founding members of the company. An investor wants to see the entrepreneur rapidly scaling the company with marketing, sales expansion, distribution channels…not simply funding the pockets of the owners.
  5. Don’t be inflexible about valuation, especially in the seed round. Investors are taking a significant risk and you will probably end a discussion if you appear too inflexible early on. I’m not saying you shouldn’t stand your ground for a reasonable valuation, but you want to buy some time to fully engage the investor.
  6. Do not engage any investor before you are ready. This seems obvious, but a lot of start-ups make a VC tour as part of their learning process. The problem is that you only have one chance to make a first impression and it may be hard to get another visit when you actually are ready.
  7. Don’t ignore adding advisors and a experienced board of directors. A strong outside team can help offset weaknesses the founders may have.
  8. Don’t gloss over your exit plan. This is how an investor ultimately gets paid and you should be as specific as possible…list specific companies likely to acquire you and the value you would provide these organizations.
  9. Don’t confuse overall market size with your total addressable market. While the overall market may be billions of dollars, investors want to see the size and opportunity associated with the specific segment you are addressing
  10. Don’t forget to build a credible case to support your revenue numbers. While investors will almost always discount your hockey stick revenue growth curve, it is a show-stopper if you don’t have a cogent go-to-market strategy.
I’ll have future posts that will discuss specifics of developing business plans, funding pitches and how to “wow” the potential investors, but if you avoid some of these common mistakes, you will be making a step in the right direction.