Category Archives: Strategy

Note to the SEC on Accredited Investor Definition

8 June 2014

 

The Honorable Mary Jo White, Chairman

US Securities and Exchange Commission

100 F St. NE

Washington, DC  20549

 

RE:  Accredited Investor Definition

 

Dear Chairman White:

 

As a board member of the Angel Capital Association (ACA) and the Chair of the Seattle Alliance of Angels, I urge the Commission to protect angel funding to ensure the health of the startup economy we support, by retaining the existing financial thresholds in the current accredited investor definition.  These thresholds — $1 million in net worth or $200,000 in income — have worked well for decades, creating a vital accredited angel investor sector that is the primary source of funds for early-stage companies that drive the innovation economy and job-creation nationwide, and with very little fraud.

I have been an active angel investor for over 25 years, founded and chair the Alliance of Angels (the largest angel network in the Pacific Northwest that has invested over $80M in almost 200 companies during the last 18 years), and have helped start many companies, leading several to IPOs.  During this period, I have come to know many entrepreneurs and even more angel investors.  I have yet to encounter even one investor who said that they would benefit from changing the accredited investor threshold.

Angel investors are sophisticated.  Unlike bankers or VCs, we invest our own money – not someone else’s.  We are not in just the financial centers of New York, Boston, and San Francisco, but are in every major city and town in the country.  We invest not just our own money, but also our time, energy, expertise, and reputation in helping startups get off the ground, thrive, and become major forces in the economy.  We do this because many of us have been entrepreneurs and benefited from the innovation ecosystem.  And we do this knowing that a large percentage of the investments we make will not succeed.  But some will and what successes they can become!

 

If financial limits were sharply increased, angel investment in early-stage companies would suffer.  An increase in the net worth threshold to $2.5 million, advocated by some, could cut upwards of 60 percent of current accredited investors out of the market.  The startup ecosystem would be devastated by such a dramatic shrinkage of this vital investor pool, especially in regions where venture capital is not prevalent. A contraction in angel investing could stall local economic development, university technology initiatives, and stem innovation and job growth. At the same time, millions of Americans would instantly lose the opportunity to participate in the innovation economy that is largely the purview of companies raising funds privately from accredited investors.

 

It is important to consider investor protection, the public interest and our current economy.  However, the SEC should note that, as more accredited individuals have engaged in angel investing, direct investment in startups has remained largely free of fraud.  This is a result of concerted due diligence, negotiated terms, and ongoing entrepreneur support and mentoring that are the hallmark of angel investing.

 

Given the importance of the innovation economy to the nation, the need for capital formation in the early-stage sector, and the need to balance access to investment opportunity with investor protection, I urge the Commission to adopt the following approach to the accredited investor definition:

 

  • Maintain the current financial thresholds of $200,000 income per individual; $300,000 for joint filers, or $1 million net worth not including primary residence for individuals to qualify as accredited investors.
  • Incorporate the concept of “sophistication” for individuals who do not meet the above thresholds to prudently expand the accredited investor pool, using a detailed questionnaire to identify qualitative information about knowledge and experience with this type of investment.

 

Such an approach will continue to provide investor protection while also recognizing the growing role and importance of accredited investor investment in innovation and growth that are essential to serve the public interest and sustain our nation’s economy.

 

I believe that raising the limits will have a chilling effect on the angel investment ecosystem, with adverse effects on the entire economy for a generation.  At a time when risk capital is exceedingly hard for entrepreneurs with great ideas to obtain, any action to place further limitations on angel investors is likely to cause a further retraction of the highest growth segment of our economy.  While I understand that is not your intent, it will be an unintended consequence.  In the strongest possible terms, I urge you not to take such an unwarranted action that will have deep repercussions for years to come with no real upside benefit.

 

Thank you for your consideration.

 

Sincerely,

Daniel Rosen

Chair, Alliance of Angels (Seattle)

Member of the Board, Angel Capital Association

 

At the Clinton Global Initiative – CGI America

I recently participated in the Clinton Global Initiative that was held in Chicago on June 7th and 8th. It really was a fascinating event in many respects. The agenda can be found at: http://www.cgiamerica.org/2012/agenda/. The basic thread was what specifically can be done to put America back to work. There were a slew of great speakers and breakouts. I was invited to help guide the Entrepreneurship sessions.

Dan Rosen & President Bill Clinton

It is impressive to see what former President Clinton can get companies and individuals to do – there were specific commitments to create programs, hire returning veterans, and great discussions and commentary about what has gone wrong and what can be done.

Several highlight comments:

  • Bill Clinton talked about the need for “creative cooperation” instead of the partisanship that is choking our political process.
  • He also talked about transforming our society to one that is sustainable, citing Costa Rica which has 26% national parks, is 51% forested, and has 92% of its energy (going to 100%) from renewables. He saw this model as a challenge model for the US.
  • Fareed Zakaria had a memorable quote, when saying he didn’t have a PowerPoint: “People who use PowerPoint rarely have power and never have a point.”
  • He then discussed the impact of two concurrent revolutions – globalization and technology – and how they are a “pincer movement” on American employment, where the American worker is stuck in a bad place, because we have had a divergence of capital and labor.
  • He cited that most countries have a cabinet level position to enhance tourism (“every tourist is a walking stimulus program”), where the US has a cabinet level position to prohibit tourism.
  • Rahm Emanuel, the new mayor of Chicago, cited the need for cities like Chicago to stop looking to Washington, DC or Springfield (the Illinois state capital) for help or answers; “the reinforcements aren’t coming.” He talked about programs he has done locally to help the city and employment in public-private partnerships and how he has gotten the cooperation of the unions.
  • He also made some interesting global comments about the economy. Apple, one of our most successful companies by any measure has over $100B in revenue, but only employs 40k people in the US. But, Foxcon, which make many of its products, employs over 1M people, primarily in China, to build Apple’s products.
  • Clinton: “I was just in Silicon Valley meeting with business leaders. I was told that, if we had the workers with the right skills, we would hire 3M people.” This was a segway to discussion about education.
  • I was really impressed by Ai-jen Poo, Director, National Domestic Workers Alliance. He spoke eloquently about the need to change both models and training in financial education. Paraphrased: “today the role models in disadvantaged communities are drug dealers and rap stars. They are successful and rich. We need new role models that bring financial dignity and literacy. Today, in these communities, you have liquor stores, pawn brokers, payday loans, and drug dealers. If you could raise the average credit score from 500 to 650, then you would transform them to convenience stores, credit unions and banks, and thriving businesses. This requires making “smart” sexy. And teaching and giving financial literacy and financial dignity.” Truly inspiring.
  • Clinton (in his second keynote) talked about Lincoln. In the teeth of the Civil War, he did the following:
    • Created the transcontinental railroad;
    • Created the National Science Foundation;
    • Chartered the land-grant universities
    • Others…
    • And wrote the Emancipation Proclamation.

    He was clearly in the “Future Business.” This is what we need now!

  • Kasim Reed, Mayor, City of Atlanta, said: “Being a mayor is where hope meets the street. It is a question of will – doing the right thing even when the cost is high.”
  • Another passionate and brilliant speaker was Neil deGrasse Tyson, Astrophysicist and Director, Hayden Planetarium, American Museum of Natural History. He said (paraphrase): “Getting students to study the hard STEM topics is more a question of inspiration than knowledge. We need to inspire our youth.”

The only downside for me was the seeming confusion between lending and equity. There was much discussion about helping small business and a lot of confusion about loans as investment. We angels have our work cut out for us.

Early Stage Company Valuation

To outside observers, it sometime seems that investors are very lucky when they get an exit and make a spectacular return. Those of us who invest regularly in startups, and then take an active role, know that there is a great deal more than luck involved. It’s really hard to have a startup survive to get to exit. There is no formula, nor is there an algorithm to follow that makes this so. Would that it were so! If you drive your car by looking intently in the rear-view mirror, you will know with great precision where you have been, but are unlikely to avoid the truck that is driving straight at you.

But.. there is one thing that is generally predicative of success – valuation. If the valuation is set too high, you risk crashing on a down round when the inevitable happens and things that can go wrong, will go wrong. If you set the valuation too low, then the entrepreneur owns too little of the company to be incented; and follow on rounds with new investors is difficult because ownership is too concentrated in the hands of the early investors.

From both the entrepreneur’s and Angel’s point of view, it is better to grow the valuation steadily (and most usually slowly) than to have a high valuation at the start and then not increase the valuation later. Raising money is difficult at best; it becomes ever more difficult when valuation expectations are not aligned.

So, I make the following three recommendations:

  1. Balance, balance, balance. It is critical to understand the amount of capital that must be raised in the first round, what milestones that money will attain, and if that is sufficient to achieve the following round. Some businesses are just not financeable by Angel investors. If, for example, if your company really needs to raise $2M to ship your product that only addresses a potential $10M opportunity, you are unlikely to raise that money. And.. raising only $250k with the hope that, before you hit a meaningful milestone, you will later raise more is not fair to you or your investor.
  2. Try to project capital needs for future rounds (yes.. I know that most plans say this will be the ONLY money that the company will ever need. But I can’t think of an example where that was actually the case). Understand that each new investor in these future rounds will expect that their investment will lead to a good return – in short a good deal. The existing investors will like their investment to grow; they took a risk on the entrepreneur and the company and would like to see value commensurate with the risk they took, especially if you need them to continue to invest. And lastly, the entrepreneur team wants to maintain a reasonable stake that can lead to a good value on exit. While this is hard in the initial round with only one set of investors and the entrepreneur team, it is much more difficult when there are also new investors joining the process.
  3. Know the market. Angel Groups, like the Alliance of Angels, see a lot of deals and know what Angels consider a fair valuation for the risk and reward that those companies present. There is a market for Angel financing of startups. And, like any market, supply and demand matters. Seek advice on valuation from trusted sources, but weigh the advice heavily towards those that write checks to startups. We often ask entrepreneurs how they came up with their valuation. The most common answers are: (a) my lawyer told me that was fair; (b) I looked on the Internet to see what bloggers were suggesting; and/or (c) I build an excel spreadsheet that shows the valuation after we are successful and did a backward projection. While all of these methods have merit, they rarely lead to a true market-based valuation that leads to a quick and successful financing. While it is no fun to explain to an entrepreneur that the current value of their company is significantly less than they believe it should be, this is why “professional Angels” have become a trusted source for setting fair valuations.

In summary, the best way for an entrepreneur and Angel to agree on valuation is to see the deal from each other point of view.

More startups fail because of poorly set initial valuation (both too high and too low) than almost any other cause. This is an easy problem to solve, but it must be solved up front. We are lucky to have professional Angel groups that are willing to work with entrepreneurs to help startups succeed.

Why Cloud Computing Is Happening Now

Sometimes things just happen. But rarely do they happen without many antecedents. And rarely do we see the antecedents until after they happen.

I believe that Cloud Computing has followed this pattern. The obvious antecedents are Moore’s Law (http://en.wikipedia.org/wiki/Moore%27s_law), the rapid drop in disk prices, the proliferation of virtualization, and the emergence of large, efficient datacenters. Much has been made of all of these factors.

One that isn’t mentioned is the network capacity required to move vast quantities of bandwidth required to move the huge amounts of data from customers to datacenters and between datacenters. The networks have a long lead time to install. And require vast sums of money. Think about digging very long trenches and laying fiber optic cables between cities. And then each of the cities need to be hooked up with fiber. This is outrageously expensive, especially when you consider that rights of way and approvals need to be acquired, etc.

Given that the lead time for installing these networks was decades and we didn’t know that cloud computing was going to be a key application, how did these networks get installed to be there when we needed them?

I think the best answer is bad business decisions. Wait … did I just say that? Cloud computing is a key technology for the future, so how can it be a bad business decision? At the time vast quantities of network infrastructure we being put in, the Internet was in its infancy and doubling in size every 90 days. Companies (like WorldCom, Global Crossing, and MCI) decided to install capacity at a fever pace. And then the bubble burst in 2001 and the companies had a ton of stranded capacity and many went out of business. But the capacity remained, and at lower cost basis when acquired out of bankruptcy. Sometimes decisions made for one reason in one era have massively positive consequences in another.

Should Entrepreneurs Pay Angels?

Should entrepreneurs be asked to pay angels and angel groups for the opportunity to present their business?

As the seed stage/angel asset class becomes more prominent and popular, this becomes an ever more frequent question. There was a blow up about a year ago when Jason Calacanis took on the Keiretsu Forum and the amount they charged early stage companies. Not much has changed, but the number of people trying to part the entrepreneurs from their money has done nothing but increase.

Let me start with my emotional answer. It is hard for me to understand why an entrepreneur who has quit their job, mortgaged their home, and gone “all in” on their startup should pay a bunch of rich people for the privilege of pitching their deal. It just seems wrong. And, from my point of view, not something I would do.

But, if I take an entrepreneur’s point of view, I need to raise money. It’s such a daunting task and many entrepreneurs really neither have the time nor resources to pull it off. So, unless I see an alternative, if someone offers me a path to raise money, I take it. If I have to pay $10-25k to raise my needed $500k, I probably take it. I don’t ask questions like:

  • “Are the investors coming in aligned with our strategy?”
  • “How many investors are in my deal?”
  • “What impact do they have on my structure?”
  • “Do the deal terms mesh with raising more money later?”
  • And perhaps most importantly, “If I take this money, does it eliminate other sources, especially if I pay a fee to a broker?”

Experienced, professional angels have been through this lots. Groups like the Alliance of Angels don’t charge a fee for raising money for entrepreneurs. We help get deal terms that are fair to both entrepreneurs and investors, and allow for the necessary future financings (even when the plan says there won’t be any other financings).

It is hard to clean up the mess from a poorly constructed and overpriced financing. Most investors won’t do the clean up and instead will just pass on the deal.

University Spin-Outs

I am a big fan of high-tech companies. People that know me (and my co-investors) know that I like companies that are “changing the world” or “creating new industries” through technology innovation. And they know that I believe that research universities spawn great technologies and deserve public support. Universities do a terrific and efficient job of educating students, organizing research projects, getting and managing grants, and investigating science in a way that can make meaningful contributions to society.

I do not believe, however, that universities can do a good job of creating companies from the technologies that they create. This is a fundamentally different skill set than most (if not all) universities have as a core competence. It has been well demonstrated (e.g. Josh Lerner’s book, The Boulevard of Broken Dreams) that most governmental organizations don’t do well in creating or nurturing entrepreneurial businesses.

I do, however, believe that it is a fundamentally good idea to help start companies from university technologies. While the universities play a key role in making this happen, I am disturbed by a trend that seems to be emerging of universities establishing internal angel funds to spin out companies. It is a good idea to give very limited amounts of money and a great deal of support to key university faculty or grad students to help them understand if their technology makes sense to commercialize. Many universities already have small funds that give grants toward this end – something like $25-50,000 to help bridge the gap between pure research and a product or to pair business school students with engineers. But setting up multi-million dollar funds to compete with existing angels and VCs is a really bad idea.

It is really hard to take a new technology, build a company around it, and bring products based on that technology to market. This is something that VCs and, increasingly, angel investors have done successfully for many years.

History is littered with examples. How many states in the US and countries worldwide have decided to create “clusters” for specific technologies so that they could participate in the explosive growth of a new industry? Very few have been successful. Incubators have come and gone, wasting a lot of public money.

I believe that, instead of spending precious resources on trying to take companies from the “research stage” to the “company stage” it is a much wiser course for research universities to work with established financing sources for early-stage companies, like active angel groups. And for governments to help sponsor that collaboration by setting a public policy that incents angels who are willing to put their own money on the line to help create a company.

Many states have now established tax incentives along these lines. The Angel Capital Association has a summary of these activities. (http://www.angelcapitalassociation.org/public-policy/state-policy-kit/ ) This makes much more sense to me than asking universities to replace or augment Angels or VCs.

AoA Results – why are they so good?

In my previous post, I noted that the AoA had a great year in 2010. (http://blog.drosenassoc.com/?p=61 or the full release http://drosenassoc.com/AoA%20results%202-23-11.pdf)

Typically, most angel groups or VCs see about 25-40% of their deals die in the first 4 years. (This is called the J curve, since the portfolio value goes negative for the first 3-5 years and gets positive when you begin to get exits in year 5 – this valuation curve looks like a J.) The AoA has what appears to be unprecedented results – almost all of our investments in the last 5 years are still alive! Many people have asked my why we did so well in a crappy market. I’ve certainly spent a great deal of time thinking about this. I believe that there are four principal reasons that caused the great year.

  1. World-class, innovative deal screening process. The AoA sees great deal flow, largely because we have a reputation of being savvy investors, who bring lots of value, and do “write checks.” One of the true core competencies we have developed over the last 15 years is our ability to take all the deals that are submitted and invest in the very best. This takes a lot of work, starting with our selection of our staff (both full-time managing director and 2 part time program managers) who have the right skills and knowledge to help startups be ready to enter our process, continues with preliminary screening by the staff, through the selection by our screening committee (the 10-15 most experienced angels in our group), and finally the presentation to our members who invest in good deals. This process is both efficient and respectful for both angels and entrepreneurs. And, it is complemented by a rather extensive knowledge base of market terms, deals and conditions. All of this leads to great companies, presenting well to our members, and being prepared for due diligence and investment.
  2. Get the deal terms right. We work with entrepreneurs to set terms and valuation that are deal and market appropriate, which allows companies to endure. In the past, too often investors didn’t understand the impact of setting a price too high, raising too much or too little money, and/or having either investor or entrepreneur-unfriendly terms. While they can often be seductive at the outset, bad terms lead to long-term problems at companies. The AoA has taken a lead role in the Pacific Northwest in bringing forward deals that make sense for both investors and entrepreneurs. By setting terms correctly, companies can survive and thrive even after market or strategic problems push the company off track.
  3. Active, engaged investors. The AoA members not only write checks, but often get actively involved in the companies in which they invest and often take board seats. As a group, we bring a ton of knowledge and experience – the kind of experience that many startups couldn’t afford or acquire any other way. This knowledge often helps our portfolio companies avoid mistakes, see them earlier, or find more innovative solutions to fix them. We are also a source for follow on rounds, especially at this time when VC financing is either not forthcoming or inappropriate. This pool of active, engaged investors helps companies survive and thrive.
  4. The right strategy, done early enough to make a difference. About 4 years ago, we realized that our investment results then were mostly dependent on a few of our most active members investing in a lot of companies, but this wasn’t sustainable. We realized that we needed to increase the “capital capacity” of the group, if we were going to remain relevant. We were fortunate to ride the trend of the “professionalization of angel capital,” where individual angels realized that working together led to better results. Over the last four years, we have succeeded in (a) reformulating our strategy, vision, and mission, with a rebranding of the AoA; (b) recruiting a continuing stream of new members; (b) putting in place education programs that help our new and existing members know how to do good deal; (c) putting in place an angel term sheet (http://drosenassoc.com/Draft%20Term%20Sheet%20for%20Alliance%20of%20Angels.pdf) that helps angels get deals done quickly and at low cost; (d) train our angels to be good deal leads, board members, and investors; and (e) be an advocate for better communication from startups to their investors.

While the ultimate measure of success is a positive return through lucrative exits, we also know that for these early-stage startups have a long period to exit – typically 7-10 years. Since our data prior to 5 years ago isn’t very good, our surrogate measure is the “J Curve.” The fact that the AoA has succeeded in dramatically changing the J Curve implies that the strategy is working.

Comments welcome.

Apple Overtakes Microsoft as the Most Valuable Tech Company

John Cook from Tech Flash asked me to comment on the following question:What should Microsoft do to reposition itself as the most dominant and valuable tech company on the planet?

This is not a problem that has appeared over night; it has been decades in the making and can’t be cured with a single act.  The industry has matured, and Microsoft is still run like the company it was 20 years ago.  It lacks the visionary who can anticipate what its customers will desire and the ability to delight and surprise (in a positive way) those customers with a clean and crisp innovation.

Microsoft has become the IBM of the last generation – it is a de facto enterprise solution and “no one will get fired for selecting Microsoft.”  Microsoft had the ability to lead the way in the Internet, but it instead focused on the competition inside and didn’t dream the big dream.  Worse – it became boring!

Look at Windows Vista and Office 2007.  Neither were improvements on previous versions, nor were they more stable or easier to use.  And, of course, Microsoft had the clear shot at the Smartphone operating system.  Instead, it tried to bring us Windows on our phones.

Customers wanted new thinking, sleek products, and ones that were much easier to use.  The iPhone was really a breakthrough – a browser-based phone that was truly useful and enabled 1000’s of cheap, easy, and imaginative apps.  Apple unleashed the imagination and creativity of an entire generation.  And then they extended it to the iPad.  They took leadership of the entire industry.  They earned the mantle.

The fact that a large company loses its ability to innovate is not a surprise.  I call this the  “$0B Business Problem.”    As an illustration, I was the first GM of the Microsoft Search team.  We had a great plan to lead the search business that would grow to a new $250M business in 3 years. (Any VC would have funded this business; it returned over 50x ROI.)  But we competed for resources with Excel, which needed the same 25 headcount, and had an net present value of $4B.  In that context, my $250M rounded to $0B, and we didn’t get the people.

Microsoft needs to find a way to unleash it’s innovation.  It needs to behave more like  a startup.  When I was there, I suggested Microsoft form a group called “The Idea Factory,” where innovative and entrepreneurial employees could “spin in” (rather than spin out) a new idea, and create a startup around that idea.  The notion was that an internal VC group would vet and fund a portfolio of ideas, in exchange for ownership in the new company(newco)  and a right to acquire the entire company at a later date at a market price.  The employees who transferred to newco would exchange their options/restricted shares for newco stock.   And the newco would hire a great startup CEO to build the company.  These newcos shouldn’t be constrained to “work within the existing system,” or you will get another Windows Mobile instead of an iPhone.

Changing leadership at Microsoft, but keeping the system, won’t change the company’s trajectory.  Acquiring a large and already successful company won’t solve the problem.  Nor will decreeing that it is going to “kill Google,” or “kill iPhone.”  Microsoft still has the most formidable research and intellectual ability in the industry.  Microsoft needs a better vision, one that is tied to delighting customers.  Technology that is easier to use and just works.  And technology that surprises it customers.  If Microsoft can’t make this transition, it risks becoming irrelevant in the industry. That would be sad.

Setting a Strategic Course for a Startup

Setting a strategic course and vision for a startup is one of the most potent weapons to get your company on the right path, become capital efficient (because you will spend your resources wisely to reach your goal), and then get to a premium exit valuation. Yet, many startups don’t spend sufficient time early on setting their strategic course. This post offers some simple tips in doing this.

Since I am a professional angel investor, many people now see me through that lens – a finance guy. People who have known me for some time would think that laughable. “Dan is a techie or a strategist,” would be a much more common refrain. Good angels must help their startups with more than just money – startups need the benefit of the experience their professional angels can bring to bear.

The first step in setting a vision for you company is simple – sit back in a quiet room and think about what you define as success. Write down all of the statements that come to mind. If there are several co-founders involved, do this as a team activity (or maybe do it individually and then come together and merge your visions). While anything is acceptable, specific statements are most helpful. Examples might be:

  • Newco achieves $100M in revenue.
  • Newco is recognized as the market leader in the emerging XXX category.
  • Newco is acquired by XXX for $300M.
  • Newco revolutionizes solar energy production with its latest generation of solar cells.
  • Newco’s proprietary algae system creates the first commercially viable alternative to petroleum for gasoline.
  • Newco buys Microsoft.
  • Etc.

Several statements are probably better than one.

With these in hand, think about the date at which you hope to achieve those goals. Then comes the fun part.

Write the front page Wall St. Journal article that appears about your company on that day. Remember several things.

  1. The headline is important; it must reflect the story.
  2. Newspaper stories are written as an inverted pyramid structure. The most important information goes at the top of the story and the details follow.
  3. The total article must set out why the achievement is important in both a business and strategic sense. Why it is a milestone?

This will be fun, but it is often more challenging than it appears to be at the surface. Try it and post your feedback.

For extra credit, put together the time line of headlines/articles that get you there.

If done well, it will point out with a degree of precision where you are heading, what it will take to get there and if there are differences among the founders, or other key stakeholders.