Category: Angel Investing

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.

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.

Carve Outs for Management in an Acquisition

Carve outs for management is a tool that is often overlooked by boards in angel-backed companies. It is a tool that can be a critical in making an acquisition occur, but is difficult to get right. First of all, both management and the board are often too close and emotionally involved to make a clear decision.

For those that aren’t familiar with the concept of a carve out, it is a payment to management, from the proceeds of a transaction, that is paid out before investors are paid the amount they would otherwise be due from the sale of the company.

Having served on more than my share of boards, and often on the comp committee, I am often asked about the following situation, which is typical of one where a carve out occurs:

  • A company has taken quite a bit of investment, usually from institutions and angels.
  • The deal that was struck has a liquidation preference (if you don’t know what this means, you should educate yourself). Good terms for companies meeting their goals are 1x participating preferred (sometimes capped); bad terms are 2x to 3x and usually granted when a company is in trouble and needs to raise money.
  • Acquisition seems like the best alternative, but the offers are for less than the liquidation preference (or not much more than the preference).

In this case, the common stock and options are essentially worthless. The founders, employees, and others who bet on the upside find themselves in the position of having worked for little-to-no upside (or in the case of board members or consultants who took options – nothing!).

What is the board to do?

Here is my perspective from serving on dozens of boards and many comp committees:

  • It was management’s sweat that got the company to exit. This needs to be rewarded.
  • On the other hand, the board needs to recognize that management did not deliver the value that was promised when the money was taken. (Nor did the board.) It is not fair to give management a great return, while investors lose money.
  • The board should try, as a first priority, to ensure that management gets a good deal from the acquiring company. This is good for the acquirer and allows more of the proceeds to go to investors.
  • One often hears that management is unwilling to allow a deal to proceed if they don’t make enough money. And therefore they would rather the company stay in operation, even if it means a greatly reduced valuation. If the original deal terms don’t either carry enough voting shares, or the rights to force the sale, then the investors might be screwed. This is why alignment with the entrepreneur and deal terms can matter.
  • Finding a fair solution is often difficult. Hiring an experienced person/consultant might be a good idea, if the board and management are willing to follow their dispassionate advice.
  • If a carve out is necessary, I believe that it should be graduated (like a graduated income tax). In that way, as the investors do better, management increasingly does better. This aligns incentives. For example, if the liquidation preference is $10M and the acquisition will be in the range of $5-15M, the carve out might look like this:
    • 5% of proceeds for the first $5M (which is $250k at $5M)
    • Between 5-10M, $250k plus 7.5% of the amount over $5M, which is $375k at 10M
    • $875k plus 10% (plus the value of their stock, which is now in the money) for any amount over $10M
  • This seems to give both aligned incentives and balance the reward for management with the need to get investors their money back.

Of course, all of this looks much better when the company sells for a lot more than was invested!

Alliance of Angels Needs a New Managing Director

One of the good things about the steady success of the Alliance of Angels (www.allianceofangels.com) is the visibility it gives the Managing Director to virtually every deal in the Northwest. However, this also means that the AoA Managing Director is a highly sought-after professional. Our current managing director, Greg Huey, has decided to move on to become the President and COO of Glassybaby (http://www.glassybaby.com/). While we are exceedingly sad to see Greg leave, we are delighted that the Seattle startup community has a new and competent executive. Over the last two plus years, Greg has ably driven the AoA program to new heights, contributing to innumerable companies and making sure the very best were well represented to the AoA. The AoA set new records for annual investment in two successive years with Greg at the helm, a significant achievement while simultaneously navigating the organization through the economic downturn. We look forward to building on the progress AoA has made under his leadership. Greg leaves AoA having firmly established our program as a national model for entrepreneurial investment. While he leaves some big shoes to fill, we are confident that the opportunity to work with one of the most active angel groups in the nation will attract a successor who will continue this great work.

So now it’s time to find Greg’s replacement. The ideal candidate should have several years of business experience, and have substantial knowledge of the investment business (especially early-stage investing) either representing a venture capital or other private equity firm. An MBA would be a plus. The job description can be found here: AoA Managing Director Job Description.

Please feel free to contact me (or send a resume) at dan@drosenassoc.com.

Dan Rosen

The Economic Crisis

A while ago, I blogged on the decline of Microsoft (http://blog.drosenassoc.com/?p=42). Lately, many people have asked me about the current debt crisis, followed by the S&P downgrade of US credit. There are striking similarities.

Until about 20 years ago, for over 200 years, the US has been in a building mode. We have created the economic engine that fueled world growth, established an education system that was the envy of the world, a climate and legal structure that allowed great entrepreneurs to create companies that were the envy of the world. Even when faced with extraordinary challenges, like the great depression or the world wars, we were able to overcome these challenges.

Just as with businesses, in times of plenty, it is incumbent upon a business (or society) to put aside for the lean times. (I won’t cite Biblical references here, but they are obvious.) Since WWII, we have had numerous times of plenty. In the late 40s and early 50s, as a county we hugely increased our infrastructure (think the Interstate highways), invested heavily in universities (which have been the envy of the world and fueled much of our entrepreneurial growth), and through the concomitant consumer spending, created a surge in our standard of living. Many of these improvements allowed us to weather some of the storms that followed. With confidence, we strode into space – landing on the moon, created the Internet and countless other platforms that fuel global innovation.

But, our generation seems to have lost sight of what is really important. We have spent with reckless abandon. We have made poor strategic decisions. We, as a society and management team (the political leaders we elected) made bad strategic decisions. If we were a company, our stock would be trading at record lows and our investors would be clamoring for a change of leadership. But we have lacked the will and foresight, not to mention the systemic governance issues that prevent truly innovative leadership from coming to power. We need to make changes in the way we are run.

We are negligent for not having done this in the US. And, despite politicians’ desire for reelection demanding that they give us a silver bullet, there is no silver bullet! It took 20 years to make this problem – 20 years of lack of political will to curb spending and live within our means. But, just as I suggested with Microsoft, there are reasonable long-term solutions.

From my point of view, the solution is to unleash the entrepreneurial spirit that is embodied in the startups. This is where the economic growth, job creation, and invigoration of our society can come from. In a very specific sense, legislation before congress, like Senate Bill S256 “American Opportunity Act of 2011” (http://www.opencongress.org/bill/112-s256/text), sponsored by Senators Mark Pryor and Scott Brown that gives a 25% tax credit to angel investors; when similar legislation was enacted in other places, dramatic increases in angel investing and increased tax revenues have resulted. Another example are the proposed changes to IRS Section 1202, exemption for gains on qualified small business gains, which will give 100% exclusion of capital gains for angel investment.

These actions will spur angel investing in those high-growth startups that will ultimately move the economy. While modest in cost, they could be large in impact.

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

Success! What happens now?

I am often asked: “my company has achieved its initial goal of getting to $1M in revenue and being cash flow positive. What now?”

In order to grow to be a $10M revenue company, we need to scale up sales and marketing, add new product lines, etc. We therefore need to raise $5M in the business and will need to raise if from institutional investors. When I project forward my cap table, I realize that I would be much better selling on the promise of where we are, if we can sell for a reasonable amount. The alternative: spending the next six months talking to investors instead of growing my business.

So what is a “reasonable amount?” Most businesses in this state (if they have been reasonably capital efficient) will have raised about $1M or so and have a post-money valuation of less than $5M. Therefore, even at a sale price of $5M, the investors could make 2x, if there is a 1x liquidation preference, and the entrepreneur will make $3M. The investors would get a 3x return if the company sold for $10M (if there is a 1x liquidation preference). At a sale of $20M, the return is spectacular.

But how does this happen?

One major problem is that is it exceedingly difficult to sell small companies to large acquirers. When I was at Microsoft and Bill still approved all acquisitions, regardless of size, he once chastised me for doing a $3M acquisition of a UW spinout tech company. “It’s just as much work as a larger one and your time is too valuable. Do bigger deals.” That was true then and even more true now with increased government regulations and widespread use of open-source software in the products that small companies sell (which causes enhanced scrutiny of the code base for any infractions).

But even more importantly, small companies that are angel-backed and therefore “capital efficient” (meaning run very cheaply!), don’t tend to build the same infrastructure that a company with more capital would build. This is what makes them such attractive angel deals. But it is also one of the root causes of what makes them difficult to acquire.

The typical first-time successful startup CEO will build a great product, get their initial customers on board, and build marketing and sales to sell that product. This is very different than marketing and selling a company.

Selling a company to a large acquirer necessitates several other factors:

  • A vision about the company’s importance to the acquirer that clearly shows where the initial product leads;
  • A coherent and believable business plan that clearly shows the impact of the acquisition on the acquirer, as well as the costs;
  • Clean legal and financial docs, prepared by experienced and believable people, so that the acquirer won’t have to spend six months in due diligence;
  • Well-documented IP and code, that allows for rapid due diligence;
  • A well-honed understanding for the acquisition process, its key touch points, timing, and sensitivities.

Generally, these things can be provided by the company management team, board, or paid advisors. But in small, thinly capitalized companies, they are missing more often than they are present.

Therefore, selling a small, but valuable, angel-backed company seems akin to selling a beautiful home by placing a “for sale by owner” sign in the yard and hoping people will decided to call and make an attractive offer.

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