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.

Clarisonic – what a fabulous exit for AoA

Clarisonic, a signature Alliance of Angels portfolio company, was acquired by L’Oreal at the end of 2011 (http://clarisonic.com/about_us/press_releases/press/claire_release_12_15_11.php). David Giuliani, the CEO of Clarisonic, was an AoA member at the time and brought the deal to the group. Naturally, many AoA members immediately invested; I was among them. Those fortunate enough to be in that first round received a return over 20x at the time of the acquisition.

And when Clarisonic raised its second round, most reinvested and even more AoA members invested too. That round returned over10x.

This is a great success story for the community. David and the Clarisonic team kept the production in Western WA, creating over 500 jobs.

Partially as a result of this exit, we have also seen many of the angels begin to reinvest the proceeds in new deals. This is what angels do!

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!

Angel Investing on NPR

NPR ran a great story on Angels and entrepreneurs in Milwaukee. Worth hearing. http://www.npr.org/2012/02/10/146697508/angel-investors-and-startups-mingle-in-milwaukee

This is another example of government beginning to understand the impact of the benefits of high-growth startups backed by angels. It is good public policy to encourage angels to help create companies through extension of the zero percent capital gains (Extension of 100% gains exemption on Qualified Small Business Stock (Sec 1202) – Current Senate bill 2050, Small Business Tax Extenders Act of 2012) and a 25% tax credit for investing in these businesses (Current Senate bill 256, American Opportunities Act, which would provide a 25 percent tax credit for investments in innovative startups).

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.

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.