dan – Page 8 – Dan Rosen

Opposition to Sections of Senator Dodds Financial Reform Bill that will Hurt Angel Groups and Financings

This open letter was sent to Senators Murray and Cantwell, Secretary Locke, and Representative Inslee. Please feel free to forward this to any other Senators or Representatives.

I chair the Alliance of Angels in Seattle. We are a not-for-profit group of over 60 individual and small institutions that invest in early stage startups in the Pacific Northwest and are one of the most active angel groups in country. In the last 3 years (2007-2009), we have invested $7.3M, $16M, and 17.5M in 44, 36, and 29 companies respectively. In almost all cases, we were the primary source of financing for these 109 new companies. The Alliance of Angels has been widely recognized for the benefits it provides to the community, to startups, and for potential economic development these startups bring with their new and innovative products and services.

I believe that Sections Sec 412 and 413 (pages 380-381) and Sec 926 (pages 816-819) of Senator Dodd’s Financial Reform Bill will have a significant negative impact on Angel investing, and might even cause groups like ours to no longer be able to function. While I applaud many of the goals of Senator Dodd’s bill that lead to better visibility and accountability, the three sections cited will have many unintended and disastrous consequences. This cannot be allowed to proceed.

Section 926, entitled “Authority of State Regulators Over Regulation D Offerings” (pages 816-819) is the most problematic. Today, startup companies can raise money from “accredited investors” like the Alliance of Angels simply and easily. As a result, we have funded over 100 new, innovative, and high-growth companies. Senator Dodd’s bill will force these startups to have to make a filing with the SEC and the SEC will have 120 days to review the filing. And then, if the review doesn’t happen, the individual states could then apply regulation. Section 926 will replace an accepted and working system with one riddled with uncertainty and delay. For a startup, a 120+ day delay in financing is often a death sentence. From an investor point of view, many Angel investors, recognizing the increased risk of failure from this added costly and burdensome regulation, might make the difference between continuing support of the entire early-stage investment asset class.

Furthermore, an added layer of state regulation over angel financing that currently works well will put a chill on angles syndicating deals across state lines. At this time such regulation is as unwise as it is unneeded. At the Alliance of Angels, we consider deals from across the Northwest (Washington, Oregon, Idaho, and Montana). If there is additional cost or restriction or time required, co-investment by angels in other state will be chilled. We need more angel investment, not less.

Lastly, Section 412 of the bill will change the definition of an “accredited investor,” adjusting this for inflation. Currently, and accredited investor must have net worth over $1 million or income over $200,000 ($300,000 for a couple) in the current year. People with this net worth or income are sophisticated financial investors. Do they need additional regulation to protect themselves from investing in startup companies?

According to Scott Shane, if you use a database on wealth from the IRS and calculate inflation based on information from the Bureau of Labor Statistics, the new thresholds for accredited investors would be $2.2 million in net worth, $450K in individual income ($775K in salaries for married couples). I believe that this will cripple groups like the Alliance of Angels and would cause a significant drop off in angel financing for startups.

In summary, “it’s not broke, so don’t fix it!” Angel investing in the United States has sufficient safeguards and does not need these provisions in Senator Dodd’s bill to make it safer. Instead, it will put a chill on the entire angel investing process, injecting uncertainty, excess costs and more risk. Please take whatever actions you can to make sure these provisions are eliminated from the bill.

Setting a Strategic Course for a Startup

Setting a strategic course and vision for a startup is one of the most potent weapons to get your company on the right path, become capital efficient (because you will spend your resources wisely to reach your goal), and then get to a premium exit valuation. Yet, many startups don’t spend sufficient time early on setting their strategic course. This post offers some simple tips in doing this.

Since I am a professional angel investor, many people now see me through that lens a finance guy. People who have known me for some time would think that laughable. “Dan is a techie or a strategist,” would be a much more common refrain. Good angels must help their startups with more than just money startups need the benefit of the experience their professional angels can bring to bear.

The first step in setting a vision for you company is simple sit back in a quiet room and think about what you define as success. Write down all of the statements that come to mind. If there are several co-founders involved, do this as a team activity (or maybe do it individually and then come together and merge your visions). While anything is acceptable, specific statements are most helpful. Examples might be:

Newco achieves $100M in revenue.
Newco is recognized as the market leader in the emerging XXX category.
Newco is acquired by XXX for $300M.
Newco revolutionizes solar energy production with its latest generation of solar cells.
Newco’s proprietary algae system creates the first commercially viable alternative to petroleum for gasoline.
Newco buys Microsoft.
Etc.

Several statements are probably better than one.

With these in hand, think about the date at which you hope to achieve those goals. Then comes the fun part.

Write the front page Wall St. Journal article that appears about your company on that day. Remember several things.

The headline is important; it must reflect the story.
Newspaper stories are written as an inverted pyramid structure. The most important information goes at the top of the story and the details follow.
The total article must set out why the achievement is important in both a business and strategic sense. Why it is a milestone?

This will be fun, but it is often more challenging than it appears to be at the surface. Try it and post your feedback.

For extra credit, put together the time line of headlines/articles that get you there.

If done well, it will point out with a degree of precision where you are heading, what it will take to get there and if there are differences among the founders, or other key stakeholders.

Taking Money from Entrepreneurs Pockets

In a previous posting/rant, I talked about Angel Groups that gouge entrepreneurs (http://blog.drosenassoc.com/?p=13). Some charge over $10,000 for the right to present and that steams me. However, I have not directed my wrath at another group that gouges entrepreneurs even more brokers and small investment bankers. Note to entrepreneurs: Do Not Use a Broker (or small investment bank)!

Such firms typically charge an entrepreneur between 5-10% of the amount raised, in addition to expenses, legal fees, and a retainer. No angel I know wants to see the money they invest in a startup flow out the back door in this way. You do not need to pay to find angels and get them to invest in your company. If you have a good idea and a good business, approach us directly. The staff at the Alliance of Angels gives you far better feedback, based on angels who actually invest, than you will get from a broker. And it’s free!

The Northwest Entrepreneur Network (NWEN) and Washington Technology Industry Alliance (WTIA) offer seminars, networking events, and classes on how to raise money. They are low cost and valuable.

But.. no angel I know likes deals where there are brokers involved. We like to meet with and get to know the entrepreneur, help them get their company going, and build to a success. None of want or need someone in the middle.

Senator Dodds attack on Angel Investing

Senator Dodd decided to take on an overhaul of banking regulations. In his massive 1300+ page bill (http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf), he has slipped in an attack on angel investing. It would impose burdensome and unnecessary new legal and regulatory requirements on startup companies raising angel financing. A recent post by Joe Wallin and Bill Carlton on TechFlash (http://www.techflash.com/seattle/2010/03/congress_attack_on_angel_financing.html) outlines the issues.

My comment:

The Alliance of Angels, through it national trade association, the Angel Capital Association, has been lobbying against similar proposals for the last two years. Sen. Dodd’s bill is by far the most serious threat to angel investing in quite some time.

The change in definition of accredited investor will cause many smaller angels to no longer be accredited. Particularly when angels work in groups like the AoA, the amount they invest in a deal might be small. Limited the capital capacity of a group like ours to help “protect our members” is both silly and dangerous.

But as Joe and Bill point out, the most troublesome part of the proposed legislation is inserting a new level of regulation. Many speculate that Sarbanes-Oxley killed the IPO market for small companies by imposing a new layer of regulation and cost on small companies. Sen. Dodd’s proposal to have the SEC and state regulators involved in angel financing is misguided. Very few startups can afford a 120 filing hurdle – they will run out of cash and go under. This is just absurd.

We urge everyone to write both of our Senators and your congress person to have these provisions removed and save angel investing.

Please act now!

Different Sorts of Energy Companies

There are many types of “green” companies or companies that help save energy. I have two contrasting companies in my portfolio that illustrate this well.

The first is Virticus (www.virticus.com), whose products and services allow owners of lighting solutions to reduce energy and maintenance costs by 30-50%. They sell to parking lot owners (e.g. shopping centers) and cities (for street lights). The Virticus communication and control system enables the management of lights individually and collectively. It is a really cool solution that has begun to get traction in the marketplace. This kind of combined software, hardware, and service solution can make a rapid and substantial difference in energy consumption.

The second is Modumetal (www.modumetal.com). I have written about Modumetal’s technology and potential before. One of the founders of Modumetal, John Whitaker, gave a recent interview (http://www.pfonline.com/columns/0210end.html) about their novel, nanolaminated Thick Thermal Barrier Coating (T-TBC) technology and its application for higher operating temperatures to improve diesel engine performance, give better fuel efficiency and lower emissions and noise. The Modumetal T-TBC will insulate critical engine components such as piston crowns, valve faces, and cylinder heads. This is expected to enable higher operating temperatures and protect against abrasion and temperature-accelerated degradation in diesel engines. It is innovation like this that is likely to have huge impact on energy consumption.

While neither of these are the kind of companies that one typically thinks of when you hear about energy or green companies. But these two companies point out that we should change our thinking.

More Startups Die of Indigestion Than Starvation

I am often asked, as I was today, what are the biggest mistakes that startups make that cause failure. Among them is a lack of focus that can be characterized by the phrase: “more startups die of indigestion than starvation.” It is hard to raise money. Therefore common wisdom would indicate that “starvation” is the biggest risk. However, years of experience show that this is only a part of the truth. Very often when a startup runs out of cash, the root cause is a lack of execution against its plan that was brought on by trying to do more things than their plan or funding allowed.

Usually this is done for the best of reasons. For example, a large customer will ask for more features than were originally planned. Or, as the product develops, it becomes clear that the product can do lots of things that customers really do want. Or it will be harder to develop the product, so the company will try to do something different. Or the original marketing plan is harder to execute that originally contemplated, so the company will try to build a different products. Or

Bottom line: the company will try to do more than it possibly can, given the funding it raised.

And, understand, these words are easy to say, but hard to live. They always have been. In certain economic cycles, lots of VC funding has helped keep companies alive, but not necessarily better outcomes for investors or entrepreneurs. In the current economic cycle, markets are unforgiving. So, I have the following recommendations:

Be realistic on you initial plan. See counsel from experienced entrepreneurs or business people.
Be a great cheerleader externally, but keep a strong sense of realism about what is really happening with the business. A good, strong independent board and advisors help. But you must be willing to listen.
Stick to the plan. Not blindly, but be careful not to churn plans.
Don’t stop thinking about new ways your business can meet new customer needs, or ship new innovative products or technologies. But.. rather than trying to alter your plans, keep a notebook with each of the ideas. Review those ideas with your board and advisors and have a process that you agree to before going off plan.

While all of this may seem a little to regimented for a startup, the alternative leads to “indigestion” that can be fatal.

Comments?

Home AV Control

You have to be kidding! OK, I’m a geek and during a recent remodel, put in a new AV system that one of my friends dubbed “geek heaven.” Up until the point where I needed a control system. The firm that did my custom installation said I needed a $10,000 Crestron control system, which was between 25-30% of the cost of the system a number I considered ridiculous. And besides, I really didn’t want a proprietary solution which would be both difficult to extend (as standards advanced) and hard for me to program by myself (as I wanted changes or added equipment). So.. I decided to do my own.

With that I learned both how difficult the CE manufacturers make it to control their equipment and how little middleware exists to make this a doable solution. Granted, my system was pretty complex, using a 4×4 HDMI (1080p) matix switch, BluRay, a Media Center PC (with 8GB fast memory, 1.5TB hard drive, and HDMI (1080p) native output), a 1080p projector, 4 video end points, and lots of speakers.

The CE manufacturers should all be ashamed of how difficult they have made it control their equipment. Many now have web connections to their equipment, but don’t use this connection for control.

So.. what did I wind up doing? Because it was a complete remodel, I had wired everything with extra cat5 cable for control. Therefore, I was able to put either RS232 or IR control to each component. This was helpful, allowing me to bring control necessary but not sufficient.

After lot’s of work and research, and trying to use a individual components and software, I threw in the towel and decided to use a Philips Pronto Pro system: TSU9800 (living room/home theatre), TSU9400 (bedroom), and RFX9600 (serial controller in the equipment rack). While more expensive than trying to integrate my own, they had the middleware and software with the control codes available. And it uses WiFi, Ethernet, and a variant of java script. And the ProntoEdit software is pretty straightforward and functional (with LOTS of room for improvement). Even still, I never got the RS232 control to work, so had to try to do everything via IR, which means no feedback on power sense or volume levels.

Even still, the CE manufacturers don’t expose all of the IR codes via the remotes. If you intend to take this on, you will need to know about Remote Central (www.remotecentral.com), which is a community with lots of codes, formats and discussion boards.

In the end, I’m generally pleased with the result, but the process was no fun at all. And even in the end, I still haven’t been able to control the lights, the solar screens, or fireplaces.

Maybe someday, this will work the way it should. If any CE executives read this blog, please work harder to satisfy your customers.

Avatar

I had a trip cancelled on Thursday at the last minute. Since my calendar was clear, I did something out of character I decided to see a matinee movie instead of working. So, I decided to see Avatar in 3D/IMAX. After going to the Pacific Science Center in Seattle and being told it was sold out (for 3 days!), I went to another theater (Lincoln Square in Bellevue) to see the movie.

I was blown away! First of all, I didn’t expect that the 3D would be much more than a gimmick. The previews disabused me of that idea! By the time I watched the preview for “Alice in Wonderland,” I understood that the new 3D (compared to what was done a generation ago, primarily in horror movies with cardboard glasses) was for real. It not only increased the immersive nature of the movie, but was integral to telling the story by the director.

As you know, Avatar, is a sci-fi tale set in a distant world. The story was very typical (but good) for the genre. But the experience was exceptional. The combination of the IMAX, 3D, and sound caused the me to feel like they were there, which caused an emotional connection to characters, the plot, and world Cameron created.

Not only was Avatar a movie worth seeing, but it also shows me part of the future public entertainment. I really didn’t expect to like 3D so much. But in the IMAX format, with exceptional sound, Avatar shows the immersive potential of films in a theatre, taking the suspension of disbelief one step beyond. I’m happy to have been part of this transition. I will certainly see more films in IMAX/3D

Modumetal and other category creating companies

I’m often asked about what I look for in startup companies. There really are two answers to this question.

On one hand, for most of my investments I seek a good solid company, with a great management team that can build a good revenue stream in an uncrowded market, which can be acquired at a good premium.

But the ones that get me really excited are those few, rare opportunities to define a completely new category with a world-changing technology. At any point in time, I like to have at least one such company in my portfolio and the current leading candidate is Modumetal (www.modumetal.com). Modumetal owns a category called nanolaminate composite alloys. In essence, they have found a way to make laminated metals that can take advantage of properties that occur at a nano scale. As you can read on their web site:

Modumetal is a new class of nanolaminated materials that will change design and manufacturing forever. Modumetal is going to change the way that engineers make parts, not just by affording the ultra-high performance of its nano-materials, but also by a process that we call Modumetal by Design. This process allows engineers to bridge design and manufacturing to realize large-scale finished parts from nanoscale building blocks. Modumetal is a revolutionary nanolaminated alloy system that is stronger and lighter than steel AND can run longer and hotter than nickel-alloys AND is more corrosion resistant and costs less than stainless. Modumetal will replace today’s metals, ceramics and composites in applications, starting with military armor – proceeding to cars, planes, buildings and consumer goods. It is the next generation material that represents a sea change in the age-old tradeoffs between cost, weight and performance.

It is still early in the life of the company, so there is still a great deal of risk. The excitement of being part of company that can change the way things work may not be the most disciplined way to do angel investing, but it sure is what I enjoy. Stay tuned.

Startup Company Boards

Startup companies need good boards. But they often don’t have them.

There are many reasons. First, there really aren’t that many experienced people willing to serve on a startup company boards. And those that are experienced, skilled, and bring a lot of value, generally want to be compensated, which startups can’t really afford.

VCs will serve on boards, but generally when their fund owns 15% or more of the company, so their compensation comes from the fund and the upside from a huge amount of stock.

In contrast, individual angel investors usually only own a very small (<2%) of a company and there is no ready mechanism for their co-investors to compensation.

So.. what makes a good board member? Many startup CEOs believe that the most important factor in choosing a board member is industry experience. I disagree. Industry experience is valuable on an advisory board, but needs to be resident in the company. Some degree of industry experience is, of course, beneficial. But, the following experience is more important on a board:

Experience on other boards for high-growth companies;
Having been through financings of various sorts;
Experience in acquisitions and IPOs to understand the inflection points and needed metrics;
A good rolodex relevant to the company;
Good chemistry with the CEO and other board members; and
A willingness to be direct and outspoken about the company, even if that position is unpopular with management and the board.

To get good board members, a startup company must be willing to compensate board members (as they do management). I’ve spoken with a number of angels and angel groups around the US and found that board stock compensation seems to vary widely. On the West Coast (primarily the Bay Area) and Boston, compensation seems to follow the VC model no additional compensation is required. However, in much of the rest of the country, options are generally routinely given.

I’d recommend the following package for a pre-A round company: 1% of fully diluted stock, vesting over no more than 2 years. Shorter vesting is generally a very good idea for board members in order to make sure that board members don’t try to act to save their board position rather than do what is right for the company. Of course, if the company is already financed and has suffered the dilution to do so, then the percentage would be less.

I believe that the Angel Capital Association, the Kauffman Foundation, and/or a university business school should conduct a survey on this.

Dan Rosen