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.

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.

Crowdfunding

Crowdfunding is about to be approved by Congress and signed into law by the President. For those unfamiliar with the concept, you can read Wikipedia (http://en.wikipedia.org/wiki/Crowdfunding) or simply put it is raising money for startups, typically via the Internet, in small chunks from people who may never meet with or diligence the company. Crowdfunding has been used in some non-profits for years and has been successful in Europe for the last two or so years as well.

Most existing investors in this early-stage asset class hear of crowd funding and have the immediate reaction: “Won’t this lead to massive fraud?” Today, investments in unregistered securities require that all investors be “accredited” so that they are assumed to understand the risks in these investments and ensure that sophisticated investors carefully vet deals to ensure that there isn’t fraud.

But, times change. Some VCs and Angels have become fabulously wealthy and famous by investing in early-stage companies, and the media has made a big deal about this. Think Google, Facebook, and even Microsoft. And, in our current economic malaise, creating high-growth, innovative startups is seen as a way out of the mess. But many innovative startups fail in trying to raise money. Angels do their part (see many of my previous posts). But many believe that the need is greater than sophisticated (“accredited”) Angels can finance.

So.. the idea of Crowdfunding has gained great momentum. The current vehicle, H.R. 2930, the Entrepreneur Access to Capital Act, as amended and approved by the House Financial Services Committee on October 26, 2011, (see http://financialservices.house.gov/UploadedFiles/hr2930ai.pdf for the original). The amendments are important, since they lower the size of the amount raised. While the situation is still fluid (the House reportedly just passed its bill and the Senate is in draft), it appears that there will be a $1M annual cap on raising money through Crowdfunding. Crowdfunding is exempt from current broker-dealer rules. Other issues, like how companies handle scores or hundreds of investors or allowable fees that Crowdfunding platforms can charge, remain up in the air.

I have heard rumors about this being done in Europe for the last several years, but cannot substantiate that startup companies have been funded this way. Wikipedia reports that “One of the pioneers of crowd funding in the music industry have been the British rock group Marillion. In 1997 American fans underwrote an entire U.S. tour
to the tune of $60,000, with donations following an internet campaign…” And movies have been known to use Crowdfunding. Any readers with more data?

This is a brave new path for the US. While many (myself included) think that our current SEC regulations that limit investments in startups to “accredited investors” are too narrow and should allow other knowledgeable investors to participate, there is established law and precedent for the investment market. I worry that we might be opening Pandora’s box. Many startups fail and investors that are not willing or able to do due diligence should not be investing in them. It is one thing for sophisticated, accredited investors, like me, to invest in a company and loose their investment. We understand the risk going in. We did our due diligence on the management team, the market, and the technology and reached a positive conclusion. It is quite another thing for someone to “advertise” a deal to the Crowd and have people send them money based solely on the company’s information without any substantiation.

I believe that broadening the participation in the early-stage asset class is a good idea and Crowdfunding is one way to achieve this. I just don’t want some bad actors who use the Crowdfunding mechanism for fraudulent transactions to poison the entire asset class. I think it would behoove both the entrepreneurs that raise money with Crowdfunding and the investment community to find a way to have a trusted platform that verifies that the company is who they say they are and that some investment professional has done due diligence appropriate to the investment.

I also worry that Crowdfunding could lead to some very high priced deals. Investment professionals (including “Professional Angels) have a great deal of experience setting the price for early stage deals. This experience comes from many years of investing, forecasting companies’ success and capital needs, and understanding how exits are likely to occur. Without this discipline, prices might not reflect true value. For example, if an entrepreneur is told by the investment professionals in their community that an appropriate valuation for their company is $2M, but they go to the Crowd with a $10M valuation and raise $500k, what happens when they need to do their next round? After they have spent the $500k, they might approach either Angels or VCs who will then set the price well below $10M. The Crowd will then find that their investment is worth very little. If the Crowd understands that risk, I have no problem with Crowdfunding, but if this isn’t transparent or well-disclosed, I think we could have many disgruntled investors.

I really want Crowdfunding to work. I don’t want a bunch of “mom and pop” unsophisticated investors ripped off.