Investments – Page 2

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.

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.
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.
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.
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

Aprimo what a wonderful year-end surprise

I was the founding managing partner for Frazier Technology Ventures (http://www.fraziertechnology.com/), which unfortunately was founded in May 2000, possibly the worst time for starting a new venture fund. Up until last week, the fund’s performance was in the middle of the pack (and therefore did not come close to returning capital). This was a financial, professional, and personal disappointment for me.

After more than 10 years, the fund had only one surviving company that was still private and alive, Aprimo (http://www.aprimo.com/), an integrated marketing software company. The founder and CEO, Bill Godfrey, started with a vision that marketing professionals needed a strong and consistent platform that supported their needs and aspired to fill that need. He was supported by good investors, who shared that vision and stood by the company in the lean times as well as the flush ones. The FTV board member, my partner, Gary Gigot, had consistently forecasted that Aprimo was creating a new category, would dominate that category, and therefore would be a very valuable company.

And then on December 22^nd, Teradata announced that it would acquire Aprimo for “approximately $525 million” (http://www.aprimo.com/TD/). The transaction is expected to close sometime in 1Q2011. Well done Bill and the Aprimo team! This is a spectacular outcome for Aprimo, Bill, and the investors, as well as for Teradata.

And this acquisition wraps up Frazier Technology Ventures I on a high note, placing FTV I in the top quartile of its peers in that vintage. For all of my friends that invested in my fund, I am thrilled that your faith in me turned out OK.

Quebec City Conference on Public Policy on Venture Capital

Last week, I was invited to attend and speak at the Quebec City Conference Public Policy Forum on Venture Capital and Innovation (http://www.quebeccityconference.com/eng/about/about-ppf.php ). It was a presage to the main conference on Innovation. The participants and speakers were all excellent, with the majority non-US, which gave the event a perspective not usually seen in similar events. While I could write at length about each topic (e.g. getting innovation out of universities, supporting industries during times of transitions, and international models), I will focus on some of the insights about the VC model itself.

Starting with a well-tread topic VC returns, which are negative in the last 10 years, Thomas Hellman of UBC, did some cool analysis of the Thomson/Reuters data which analyzed the returns from US VC funds from inception through 9/3/08, and plotted the ROIs against the percentile of those ROIs. Stunningly it showed that the top 1% of funds had 41% of the total returns, the top 5% had 70%, the top 10% had 84%, and the top 25% had 104%. Several key thoughts follow from this:

75% of the funds lost money.
If you aren’t in the top 10%, you probably won’t do too well.
LPs are deserting the asset class, if they aren’t already in a top decile fund.

So what does this mean? Clearly the VC industry will continue to contract as the funds that haven’t performed well can’t find LPs. This has been discussed at length elsewhere. At the conference, in the networking sessions, and afterward, I learned more. But, with LPs abandoning any but the most established VC funds, should governments sustain them? Or is the VC model broken? (Those that follow my blog, know that I suggested this a long time ago, http://blog.drosenassoc.com/?p=7).

And.. if you assume that the VC industry will collapse back to the top decile+ of funds, what does that mean to funding early-stage startups? That was one of the major topics of the conference. It was also the reason that angel investing got so much attention! (And, of course, why I was there.)

As I’ve blogged before, it is evident to both governments and policy makers that “high-growth startups,” primarily in tech, healthcare, and cleantech, can propel the economy. Many of the government speakers and participants acknowledged this and are struggling with how to make this happen in their geography.

Many of the policy makers that were present (and many of the VCs from outside the US) seem to believe that angels and angel groups must play a key role, both in financing and helping startups. But what does that mean? The conference participants adopted my term “professional angels” to distinguish between those that make occasional angel investments and those “professional angels” that (a) primarily do angel investing, (b) develop and maintain a portfolio, (c) invest with an experienced discipline, primarily in groups, and (d) help their companies and often serve on boards. A great deal of discussion was how to encourage Professional Angels to invest more and pick up some of the load from the VCs who will disappear.

A number of government incentives were discussed, including tax credits, capital gains holidays, etc. It seems that Canada is well ahead of the US in considering these. Hellman presented the results from some of the BC programs that have worked. When his study is published, I’ll include a reference.

What was also striking was how much the government officials in Canada and elsewhere are looking at the Angel group model in Seattle and wondering how they can duplicate what we have done. As we in Seattle realize that the model needs to be local (we couldn’t just copy the model from the Bay Area), it won’t be simple to extend it to other geographies.

Angel Investing is Vibrant and Getting More So

Not much surprises me these days, particularly during this mud-slinging political campaign season.

However, Marcelo Calbucci’s Tech Flash post (http://www.techflash.com/seattle/2010/10/have_we_killed_the_angel_investor.html) did. How my posts could be so misunderstood by someone I respect baffles me, especially when that misunderstanding is posted to a widely read blog.

My previous post on Angels forming LLCs for their investments IS entrepreneur friendly, and based on national best practices. Any entrepreneur who has a successful venture with 50 angel investors knows the pain (including excessive legal fees) for getting signatures on every shareholder issue. If a large number of these angel investors are in an LLC, you only need one signature much more efficient and much less costly. This is the practice in many places, including some of the largest angel groups in the Bay Area and East Coast. It is not widely done in Seattle. And it is not a way to get better terms in seed and A round investments; there really is no relationship between the two.

It is a way for Angels to preserve their rights in the face of a VC round that follows. VC’s typically don’t like to have to get 50 signatures, so they reserve certain rights to “major investors” in their term sheets. This typically either washes away or severely limits the investor rights of Angels, once VCs have entered the deal. It is definitely in the interest of the entrepreneurs, Angels, and the company to make sure that a broader base of investors has a say in the future of the company; the trust from shareholders (the owners of the company) that they will be treated in an open and democratic way is the basis of our entire equity system.

Angels who work together to learn best practices make for a much stronger ecosystem. That is why I spend so much of my personal time trying to learn from other angel groups, both locally and nationally, about what works and doesn’t work. My colleague Angels do likewise. We run a bunch of educational events locally to share our knowledge and insights and encourage other Angels to strike deals that are balanced between return and being entrepreneur friendly. It is why I spent so much time crafting a “Series A Angel Term Sheet,” (http://drosenassoc.com/Draft%20Term%20Sheet%20for%20Alliance%20of%20Angels.pdf) that is now being widely used, not just in Seattle, but around the world. It simplifies the process of bringing in early money for startups, while lowering the costs. All of these activities lower the barrier for entrepreneurs raising money, not as you assert, making it more difficult.

Angel groups are a fabulous way for an entrepreneur to raise money. It is much more efficient to present once to 60 active angels than to set up 60 individual meetings. I don’t know one entrepreneur who would argue with that proposition. And, through the Angel Capital Association (a Kauffman Foundation spinout), we are now sharing best practices, participating in educational events, making sure that public policy encourages early-stage investment (e.g. http://blog.drosenassoc.com/?p=41), making sure that as many Angels as possible enter the ecosystem, and encouraging each other in bleak economic times.

As part of this socialization, it is evident that Seattle IS progressive. We have funded as many or more early stage deals at a slightly higher price than our peers in the Bay Area and Boston. Your assertion that entrepreneurs in the Bay Area are getting their deals funded without a financial projection or a solid plan is an urban myth that is not supported by fact; it encourages behavior that neither helps entrepreneurs or investors. We do help the “the next great idea from two guys who are just finishing their computer science degree at The University of Washington” in part by helping them understand what it means to create a great business. In my 25 years of experience, I have not seen a success where throwing money at people without a great business concept created a great business. It is the marriage of great technology, great people, and a great plan that makes the breakout companies. Yes, this takes some discipline and hard work. Saying that the best model is angels willing to throw money at entrepreneurs who are not committed to a disciplined approach is not only wrong, it does a great disservice to the entrepreneurs willing to quit a high-paying job to risk everything to build a great company.

And during the last year, I’ve spoken at events throughout North America without reimbursement. Like you, Marcello, for me this is a passion, not a business. But most Angels need a return on their investment, if they are going to continue to invest. We need more maturity in the process, not less.

We all want to see more intelligent, high-net-worth individuals in Seattle become Angel investors. They way to do this is NOT by telling them that they should “invest and pray”. It is by showing them how to be successful angel investors, how to lead deals without as much pain as in the current process, and by making it easy to pull the trigger on their first few investments. One way that other communities (e.g. Bellingham) have used is the deal-specific LLC that started this conversation.

Success will come by finding more ways for entrepreneurs and Angels to communicate and understand common goals and then achieve extraordinary results. And success will build more success.

Investor Relations for Private Companies

One of the questions I am asked by first-time startup CEOs: what is an appropriate level of communication with my investors?

This is both a difficult and profound question. It is simple to say that more is better than less. It is also simple to say that any good investor would rather have you spend your time executing your plan than spend your time chatting with investors.

So.. my simple rule of thumb is that you should treat your investors (and the money that they have invested in your company) with respect. And you should recognize that their support, encouragement, and trust that came with that money are incredibly valuable commodities that will continue to pay dividends over time. Let me give rules of thumb for great investor relations by private companies and some issues that need to be considered.

Ten Simple rules for great IR for private companies:

Get the bad news out fast and first. Even if the news in embarrassing (like we are running out of cash sooner than we anticipated, or our customers found a flaw in our product), share it first and fast. Be very candid about the failings as well as the successes.
Don’t bury bad news at the end of a report.
Don’t wait to issue the report until you have good news to share.
Don’t forget to share your passion for your business that’s generally what made your investors invest!
But don’t allow your passion to obscure the operational facts, like the numbers are not what we anticipated.
Communicate frequently, but not too frequently. These communications should never be less than once a quarter. But remember that your investors are not your employees, so you don’t need to send daily/weekly updates with operational trivia. This just defeats the purpose of making sure that your investors know the state of the business by burying them in the minutia.
Communications can written or in person or a combination. Face-to-face quarterly meetings are a great idea for a company that is growing and needs support and help from its investors. They are especially good for a company that needs to show its product. But they take some time to prepare.
Communications can be short, but never skipped. For example, a simple note to all of your investors that “we have had to revamp our product plans and details will follow within 30 days” is an OK message. As is, “we have received an acquisition offer, but the terms require us to keep the details confidential, so we will let you know as soon as the deal is consummated.” Don’t surprise them!
Your investors are smart, so treat them accordingly. Be very realistic and forthright about the impact of any misses/changes. Early stage investors know the risks. Tell them if the board insisted you take a salary cut or that you have had to lay off key people. These things happen. Sometimes the impact will be that their investment will never realize the potential you had hoped for, but that you will work for the best possible outcome.
And, lastly, NEVER have the communication of the change of your company status come via a package of documents from your lawyers! Even in the case of good news (which is rare), you owe it to your investors to be the one who communicates FIRST. Even if it’s an email (or cover letter in the legal package) that says, “we have had to do X, because of Y, and the result is that your shares have to be changed in the following way. You will be receiving a package by FedEx to implement that change. I will be holding an emergency investor meeting tomorrow at 9am to explain these changes. Those who can’t be there can phone in.”

Even with these simple rules in hand, there are a number of issues that you need to consider.

Can I share proprietary information with my investors? This is a tough question. Seek counsel from your lawyer. In general, most startups do share proprietary information, but make sure your investors know it is proprietary. Make sure that they know they can’t redistribute or share it further. Only give info in writing that is less sensitive.
Know your investors. Ask them if they have investments in competitive companies. If they do, it doesn’t disqualify them from investing in your company, but make sure that they know they can’t share the info you give them.

Simply put.. if you treat your investors well, they will be there to support you when you need them. Not just in this company but in future ones.

Merger of Angel-backed Companies

Most startups first create a feature. If they are smart, it will be a unique feature that fits a demonstrable customer need in the market and they can have many customers adopt their technology. If the company is really good, they will transform this feature into a product. If that works, they might get to create a series of related product and make a product line. Rarely will the startup create a full-fledged company.

It is when a startup grows its business to the Company stage that it can get exceptional value (<$100M). In general this takes experience and skills that aren’t usually found either in a startup or on their board.

Most angel-backed startups have trouble making it beyond the feature or product stage. In the past, many startups counted on VC funding to grow to the product line and company stage. This is now exceedingly rare, given both the number of angel-backed startups and the limited activity of VCs (see some of my previous posts).

So what does that mean? One outcome is that we move our angel-backed startups to profitability and they grow organically. This can lead to an acquisition, but more often than not, exits are rarer than we would like. (I will be doing a post on this soon.)

I predict that we will begin to see a wave of mergers between successful angel-backed companies. This makes perfect sense.

When two companies are in alignment and have products/features that can satisfy a broader set of customer needs, builds revenue and a customer base that exceeds critical mass, and gives the combination the chance to get to the company stage creating a lot more value than the two companies separately.

Rescue of Angel Financing Imminent

by Dan Rosen, Joe Wallin and William Carleton

As we have previously blogged, Senator Dodd’s financial reform bill has posed a grave threat to angel investment and startup communities nationwide by virtue of two provisions in the bill that would have upended Regulation D. These “reforms” were ostensibly to address the problem of unscrupulous brokers, dealers, and promoters who have abused Reg D to defraud investors. The problem was, the provisions in Sen. Dodd’s bill were unnecessarily broad. Fraud is uncommon in angel investment transactions, and there were other ways to reform Reg D without gutting the rule that is working well to make startup and angel financing safe and efficient.

Here’s a quick refresher on the two problematic provisions in Sen. Dodd’s bill, problematic for startups and angels. The first provision would have adjusted the threshold at which angels qualify as “accredited investors,” sending two-thirds of active angel investors in the United States to the sidelines, ineligible to participate in getting startups off the ground. The second provision would have required companies to wait 120 days for the SEC to determine if they qualify for a securities law exemption that is self-executing (meaning, no waiting) today.

Well, whatever the outcome for the overall financial regulatory reform legislation now being debated in the US Senate, it appears that the startup and angel investing community can breathe a huge sigh of relief this week.

That’s because it now appears that Reg D will survive largely intact.

In fact, Reg D may be amended in a way that will improve it.

The below table compares what had been proposed with amendments now making their way to the Senate floor. We believe the amendments to save angel investing and startup financing will be sponsored by Sen. Dodd himself. The sound policy represented by these amendments was achieved largely through the efforts of the Angel Capital Association, under the leadership of its Executive Director, Marianne Hudson, supported by the ACA members’ contacts with Senators and their staffs.

Original Proposal

New Proposal

Adjust Accredited Investor Thresholds

As originally proposed, would have adjusted the accredited investor financial thresholds for inflation since the thresholds were first set. This would have eliminated approximately 2/3rds of angel investors currently active. In addition, the first proposal would have required an adjustment every 5 years.

Adjust Accredited Investor Thresholds

As now proposed, the net worth standard for an accredited investor will stay at $1,000,000, which is where it is now, with one important change: net worth will exclude the value of a person’s primary residence.

In addition, the bill would require the SEC to review the accredited investor definition to determine if it should be adjusted. The first review would be within 6 months, and thereafter reviews would be not less than frequently than every 4 years. Significantly, the new language also requires the SEC to consider the economic impact of any change, arguably leaving the door open for a future decrease in the accredited investor thresholds.

SEC Review of Filings

As proposed in the bill approved by committee, would have required the SEC to review all accredited investor offerings within 120 days of the filing with the SEC. If the SEC did not undertake that review in time, states would have been free to impose their own rules.

Disqualifications for “Bad Actors”

Directs the SEC to issue rules for the disqualification of offerings and sales of securities involving individuals who are “bad actors.” “Bad actors” are persons with a prior record of violations of certain federal or state laws.

To date, the legislative process has worked better than we imagined it could. The language of the amendments saves angel investing, keeps costs for startups where they are now (still not low enough!), and gives state regulators the green light they need to pursue the fraudulent broker dealers and scam artists who have abused Reg D. (No responsible member of the start-up ecosystem would want fraud to take cover under Reg D; that favors no one and, as members of the startup and angel investing community, we hate bad behavior as much as any group of citizens.) The angel investing community was able to focus the attention of the Senate Banking Committee on preserving what works well now, while meeting the direct problem that concerned state securities regulators. All of this was supported, in the background, by Senators and their staffs who “got it.” We also believe that Congressional staffers who tweet could see the groundswell of rising consciousness on the issue among entrepreneurs. Architects of this effective social media effort included Matt LeVeck and Irene Tamaru.

The new reforms are not law yet, so we must remain vigilant. The sections could be further amended on the floor of the Senate, putting harmful provisions back in the bill or changing the provisions once again. If the bill is passed by the Senate, it would yet need to go through a reconciliation process with the House; and other action by the House could effect changes. So we’re not letting our guard down yet. But we are saying, it’s time to tell your representatives that you thank them for listening, and that you’re keeping watch on how this finishes.

Dan Rosen