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.

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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.