Category Archives: Investments

General Solicitation

Once again, through inadvertent action, the federal government is about to threaten Angel Investing. This all started as a way to increase investment in startups, when congress passed, and the Obama signed the JOBS Act (see: http://blog.drosenassoc.com/?p=97). Title II of the JOBS Act allows “General Solicitation and Advertising” of private placements (like Angel deals). One would think this is good for two principal reasons: (1) it roughly brings current practice into compliance, since many angel groups post their deals on a web site (like Gust, which is used by many angel groups) or run events where companies present to their members and others; and (2) more and more angel deals are funded by many angel groups (usually called syndication), so there is an implicit solicitation. We liked this idea. It allows our companies to reach a broader audience of only accredited investors. All good, right?

Well, not so much. The legislation also asks that the SEC use “reasonable steps to verify” that they are accredited. Even with that, it seems pretty straightforward. The reasonable steps to verify have been around a long time (under Rule 506B). Every time angels (or other accredited investors) make an investment, the deal documents come with a short form that you fill out how you qualify as an accredited investor. The SEC has given “safe harbor” using this mechanism.

But the SEC is considering that this long-accepted method will not be acceptable if an issuer (a startup company raising money using Regulation D) uses the new General Solicitation rule (Rule 506C). Instead, the SEC originally proposed that investors would have to give the issuer copies of their tax returns. The Angel Capital Association (ACA) wrote a very strident response that this would severely diminish angel investing, since few angels would turn over their tax returns to a startup. And, of course, the startup would have to find a way to preserve these records and keep them confidential – a real mess, given that most startups don’t even have permanent offices.

The ACA Public Policy Committee fought hard to ensure that existing “quiet offerings” (Rule 506B). Therefore, if you don’t take advantage of the General Solicitation (“noisy offerings”), you still can take advantage of the existing rules.

If you do use a noisy offering, then you will need to follow new rules, which have not yet been written. But the preliminary rules (and discussions with SEC) show that the SEC is unlikely to allow “self certification” for these offerings. Therefore, one of two outcomes now looks likely: (1) issuers (or their attorneys) will have to collect a lot of information about their investors and investors will have to share a lot of personal information; or (2) new third-party certifiers will emerge to do this.

Is this really so bad? YES – this is bad. First and foremost, we all rely on the “safe harbor” on the Reg D investments. At this point, the rules don’t give this safe harbor for any particular mode of validating accreditation. This means that deals can be challenged and unwound. Very bad. Secondly, even using third party validation, will cause the costs of these deals to increase. Instead of money going to hire engineers and sales people, it will be used on deal overhead. Very bad. And lastly, most angels HATE extra paperwork. If the validation requires that you hunt through and list all of your deals for the last 5 years (it would take me hours to do this!) And, I would be generally unwilling to provide my tax returns to anyone. In the end, it would just mean a lot of extra paperwork and time. I would probably avoid any deal that used a noisy offering.

I think that the SEC (and the legislators who supported the JOBS Act) really needs to recognize that the angel investing arena has self-regulated very well and the current system has worked well. Extending the current process for noisy offerings makes a ton of sense. It is the right way forward.

After all, “if it ain’t broke, don’t fix it!”

SkyCast – the cooler path to in-flight entertainment

Occasionally, you see a deal where you immediately understand both how cool it is and the impact that it will have on an industry. Couple that with one that will also have an impact on you personally and a great team, and you have SkyCast Solutions.

Founded by the inventor of the digEplayer (if you fly Alaska as much as I do, it needs no introduction), Bill Boyer, who is joined by my friend, Peter Parsons, and Greg Latimer (former VP Marketing at Alaska Air), this is a team that understands the industry. It is no secret that airlines have troubles with profitability. As fuel prices soar and the sluggish economy depress business travel, the problem gets worse. Airlines have learned that ancillary sources for revenue (like baggage fees) are an attractive way to make up any gaps. The problem with fees: customers hate paying for something that brings them no enjoyment that they think should be free.

Enter SkyCast Solutions. They make a VERY cool in-flight entertainment solution, called TrayVu™ (http://www.skycastsolutions.com/NEW/products.html). It is an android tablet that goes into the tray table, can be viewed through the table, and automatically flips up when you put the tray down. This offers many advantages, including being light weight (a short IRR for the airlines on fuel savings alone), ability to show ads or other things below 10,000 feet, having use of your tray table with the screen in a perfect viewing position, a credit card reader to buy food or pay per views, and (maybe most importantly to anyone who has had the person behind them play angry birds in a seat back system) when you play a touch game you don’t disturb the person in the seat in front. It is an exceeding economical system for the airlines to install and use, brought to you by an industry veteran who knows how to make these things work.

OK.. in-flight entertainment won’t change the world. But it will make long flights much more fun. This is why I (and other Alliance of Angels members) chose to invest in SkyCast Solutions.

AppAttach – Serving the long tail

I recently invested in AppAttach (http://www.appattach.com/about), an online marketplace for device manufacturers (OEMs) to find and sign up software vendors (ISVs) and receive a bounty the way the very largest hardware OEMs do.

It’s widely known that software preinstallation has become key to profitability for consumer electronic device manufacturers, but whether it’s major OEM bundling an antivirus application with a PC or a small Chinese handset manufacturer pre-installing Internet Search on a new mobile device, there’s no efficient way for buyers and sellers to quickly see what placement opportunities are available and easily conduct business. Most software vendors can only do such deals with the very largest PC manufacturers, because there is no efficient process for consummating, implementing and tracking such deals. Today’s market is crowded with new tablet entrants, who (other than the iPad) have limited market share. Likewise, the PC marketplace has a lot of custom-built PCs (like the one on which I’m authoring this blog).

AppAttach has created a marketplace and set of value-added tools and services that greatly reduce the cost of finding, negotiating, and monetizing pre-installed software and online service transactions. Simpler and less expensive transactions allow small/mid-size OEMs and ISVs to strike pre-installed distribution deals, while at the same time allowing large manufacturers to strike smaller, more targeted deals that maximize per device revenue and enhance the end user’s out-of-box-experience.

The appAttach Marketplace facilitates transactions in all major categories of software and online services, including security, productivity, browser, search, multimedia, entertainment and gaming, on devices ranging from desktop computers to mobile phones. The appAttach Marketplace is a neutral, secure interactive trading exchange where members can bid via auction-based or fixed-price listings for pre-installed software and online service placements, allowing its customers with the ability to negotiate and agree on pricing, quantity, delivery, quality and other terms online.

James DePoy, the appAttach founder, worked at the OEM group at Microsoft prior to founding appAttach, so he understands the industry dynamics and the needs of both hardware OEMs and software ISVs. His vision and drive should allow him to build an great company.

I like smaller companies that can customize a computer (or tablet) to your needs. I believe that appAttach is a missing piece of the business infrastructure that will enable smaller companies the freedom and flexibility to grow their revenues.

Virticus Acquired by LSI

One of my AoA portfolio companies was acquired today by LSI Industries. http://www.nasdaq.com/article/lsi-industries-inc-announces-acquisition-of-virticus-corporation-20120319-00192

Virticus is an integrated set of products and services that reduce energy and maintenance costs by 30-50% through a communication and control system that allows the management of lights individually and collectively. It is a cost-effective solution that scales from 10 lights in a church parking lot to 10,000,000 lights managed by a city. Virticus is a great example of how modern network and software technologies can be a green way to lower energy consumption, while maintaining (or improving) functionality. Its customers were delighted with what it could do.

The decision to sell a company early in its life cycle is always a difficult one. While Virticus had enormous promise, it also participated in an industry with many mega-players. Customers, like municipal governments, are generally not very quick to adopt new technologies, even when they have the potential to safe budget dollars. Selling to large governmental customers (or large industrial ones, too) is particularly difficult for a small startup.

Virticus was completely financed by angels.

Congratulations to the Virticus team and board for building a great product, company and team. And then having the wisdom to sell at the right time.

Crowdfunding and Angel Investing

My friend, Bill Carleton, posted a very thoughtful blog on Crowdfunding and angel investing: http://www.geekwire.com/2012/angels-crowds

Bill has teed up some excellent questions. See my response.

While you should definitely read the entire post, here is brief excerpt:

Crowding out angels from startup financings?

March 3, 2012 at 1:52 pm by William Carleton

As early as next week, we may know whether Congress will change US securities laws to permit startups to sell stock to the general public over the internet.

You know how, today, companies raise money on Kickstarter by offering products, t-shirts, and other bennies? Imagine those same companies selling stock to investors over a Kickstarter-like platform. If the law changes – and this is something that one chamber of Congress has already passed and that President Obama supports – entrepreneurs seeking capital will have one more alternative to angel investors and venture capital firms.

Sound too good to be true? There is a catch. The proposed law (known as a “crowdfunding exemption”) would apply only to offerings that place strict limits on how much money can be raised and how much an individual investor may invest. For example, the new crowdfunding exemption might say that the startup may raise no more than $1,000,000 in a given year. And that each investor may invest no more than $1,000 per deal. (Actual limits are still being debated in Congress.)

My reply to his blog:

Bill – as always, great and thoughtful post. The original intent of the Crowdfunding bill (as drafted by Scott Brown) was to help replace Friends & Family money that has dried up with real estate prices. (Gone are the days when an entrepreneur could take out a mortgage on their home!)

As every professional angel knows, angel investing is not for the faint of heart. Many deals (even ones that seem like a sure thing) go to zero. Some are successful, but take a very long time. Almost every deal will take multiple rounds. (There is a reason for the “accredited investor” rule!) I don’t think anyone believes that a company can be funded from inception to exit by Crowdfunding.

And, angels provide much more than capital – they provide knowledge and assistance.

One historical perspective: in the early days of angel investing, VCs often would not invest in angel deals. Less experienced angels (particularly those not in groups) would screw up the valuation and terms, so VCs wouldn’t want to take the time to fix them up. As you highlight, Crowdfunded deals might follow the same path – the terms might just not be right to incent angels to invest. And cleaning up the deal for angels to follow might be a great deal of work, especially at a time like this where there are a lot of deals vying for our attention.

This next year will tell a lot about how this will play out. It’s going to be interesting!

Angels Anonymous

Dan: “Hi. I’m Dan and I’m and addict.”

AA Group: “Hi Dan”

Dan: “It’s been one month since I did my last Angel investment.”

AA Group: “Way to go Dan.”

Dan: “But I’m weak. I know that I’ve failed forty times in the last 6 years. I really need to make another Angel investment soon.”

AA Group: “Be strong, Dan”

So goes the internal dialog of an active Angel Investor. I admit it – I’m an Angel investing addict. And I’m proud of my addiction.

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.

Severance – Oh No!

Many entrepreneurs, when they take outside money into their company, want to protect themselves. This is a perfectly reasonable thing to do.

The investors putting the first money into the deal also want some protection, especially when the founders own a vast majority of the overall stock and probably have a majority of the board seats.

One of the items that entrepreneurs sometime request is a severance package. In Washington State – DO NOT DO THIS. I don’t know about other states, but in Washington, the law apparently makes individual board members liable for any salary owed employees and not paid. For historical reasons, severance was considered salary in Washington. That would mean that board members might become liable for the severance of a fellow board member and company executive.

Clearly, this is a bad idea and the law needs to be changed.

But in the meantime, do not agree to a deal where there is a severance agreement.

I have modified my model term sheet to reflect this (http://drosenassoc.com/Model%20Term%20Sheet%20for%20Alliance%20of%20Angels%20revised%20May%202011.pdf).

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.

Seattle Alliance of Angels has a terrific 2010

The Seattle Alliance of Angels had a wonderful 2010. To quote the headline: Alliance of Angels Invests Record-high $10.3 Million in 2010; Group hits new milestone with investment in 33 Northwest-based startups; surpasses previous investment record by more than $1 million.

I was quoted:

“Once again, our angels have set a new standard for investing in innovative, young companies,” said Dan Rosen, chair of the Alliance of Angels. “For the second year in a row, AoA has cemented our position as the most active angel organization not just in Washington, but in the whole of the Pacific Northwest.”

“What is especially gratifying,” he continued, “is that 95 percent of our members have made at least one investment in the past two years. Even as the economy struggles to rebound from the recession, our members continue to support the AoA portfolio with initial and follow-on investments.”

“That is a testament to the quality of our deal flow, the value of our screening and coaching, and the eagerness of our investors to support entrepreneurs with promising ideas.”

Seems that angel investors are once again full of hope for the future.

See full release: http://drosenassoc.com/AoA%20results%202-23-11.pdf