Venture Financing - Reality Versus Rumors with Dick BrownA few weeks ago, I read this request in one of LinkedIn’s discussion groups:
Does anyone know where I can find angel investors for our project that requires $500,000 funding?
It was at the end of a good week and I was in a winsome mode. I responded:
Go to NYC. Book a room in the Plaza. At cocktail hour go to the Oak Bar and order a beer. 90% of all the people in that bar can afford to fund your project. Bring your lawyer to cover the details.
After writing this, it suddenly struck me that it was literally true and if you were at the Plaza and could interrupt the noise and loud conversations and quickly throw up a PowerPoint presentation, you might get the funding right there.
According to Ask.com and Wikipedia, one in 125 Americans was a millionaire in 2004, or roughly 2.3 million people. In a later report, by 2008, roughly 1.0% of high-net worth individuals (HNWIs) are those who reside in households with a net worth or wealth of $30 million or more. There are approximately 95,000 ultra-HNWIs in the world with 61,600 or 64.8% residing in the United States and Europe.The report is compiled annually by Capgemini for Merrill Lynch.
Today, we’ll categorize all these as potential angels, discuss their characteristics, and, give some tips as to finding and capturing them.
Today’s AngelsToday, angel groups play a major role in financing smaller ventures. Many VC companies have moved upstream and only finance deals over $5 million. Angels have filled the gap the VC’s created by their upstream move, and many concentrate on start-ups and smaller, emerging companies. A detailed look provides some surprising and somewhat reassuring statistics.
In 2004, angel investing first totaled $30 billion in comparison to $30 billion to $35 billion in venture capital investments, depending on how you count them. Those angel investments also went into an order of magnitude to a greater number of companies: 50,000 versus fewer than 3,000 VC-backed companies.
One investor analyst argued that "angel core values are back in vogue" as people with industry experience take leadership roles in backing new entrepreneurial ventures. He also noted that the "capital gap" between high-end angel rounds and low-end venture capital has grown to between $2 million and $5 million in financing as venture capital firms continue to increase median deal size and angel investors hit an upper limit of what is practical in a single round of financing.
Another analyst argued that the 50,000 angel-backed firms fall in the same categories as VC investments, i.e., software, hardware, biotech. These are not restaurants and dry cleaners. Also, he underscored that the $30 billion figure is sound. But with these statistics, questions remain for more research, such as: what happens to the angel-backed ventures that don't receive VC funding? Many grow and succeed; others fail.
“In 2004, only 3,000 new firms were founded by VC’s, while an estimated 48,000 businesses received start-up capital from people that identified themselves as angels.”
This can get a bit confusing since many, many different kinds of organizations can qualify to be called angels. For example: “Clubs, Groups & Associations.” Almost every area of the US has associations meant to attract or help entrepreneurs.
In California’s San Francisco Bay Area, there are a number of such organizations. These would include general organizations such as The Churchill Club in Campbell and the Software Forum in Palo Alto. There are also “national” groups such as the Asian Business Association in San Francisco and Monte Jade in Santa Clara that promote the business interests of Asians, both those living in the US and Asia.
No matter where you live in the US, you’ll find groups whose charter is to nurture entrepreneurs. When in doubt for where to look, start at the business schools of your local universities or your local Chamber of Commerce. There are the pure angel associations, such as Rocky Mountain Angels and New York Angels.
Investment Clubs & Rank AmateursThere are small, investment clubs that pool together a few thousand dollars from their individual members. These clubs usually invest in the stock market. A few dabble in start-ups and other risky ventures. From your view as an entrepreneur, they are amateurs playing with “anxious money.” They rarely make any significant investments, but drive you (or your CEO) crazy with constant naive questions and near-daily suggestions.
There are other amateurs: “Green Angels,” the noveau-riche that just made a killing on some deal or stock option and are investing for the first time. Having them in your company is similar in pleasure to a root canal.
A Real World Example: Once I was trying to raise second-round money for a venture. One of our directors said he had an investment group (5 people) of MIT faculty that was interested. He booked a private room in Locke-Ober’s for dinner. (This is still one of the most expensive restaurants in Boston and home to many of “Old- Boston’s Power Elite.” At the time, they still didn’t allow women in certain sections.)
When they arrived (late), the oldest looked to be 17-18. I found out they were all students at MIT, not teachers. They proceeded to order the most expensive appetizers, lobster entrees, wines and fancy liquors on the menu.
However, they had done their homework on our venture. I sat for hours while they asked an endless array of questions, ranging from the very basics to minor details. At a break, and going against the prior advice of my friend (not a very good salesperson), I finally asked them how big their fund was and how much they might invest in our venture.
They said they had a total pool of $10,000 and might go as high as $2,500 for us if they liked all my answers to their questions.
I don’t think it occurred to them that the cost of the night’s dinner would eat up a substantial part of their entire contribution.
As we were leaving, one had the balls to ask me: “What do the other members of your team do while you’re out having fun like this?” I was very proud of myself that I didn’t hit him. I made my friend pay for the dinner.
Still, you may find some potential in certain investment clubs. People that have common social associations such as friends, neighbors, colleagues or other persons who pool money for the purpose of making investments most often form these. If your business offers a potentially high ROI, and you are willing to trade off some of your ownership future for current cash, you might consider these. Beware of the fact that each of the individuals in these clubs will consider themselves to be your most important stockholder for very a long time.
Internet Investors and NetworksAgainst any/all current wisdom, I have never had any luck finding investors through “Listing Exchanges” over the Internet. I have met some interesting people and followed numerous opportunities, but have never been able to get a check from anybody.
I think there’s a basic underlying fallacy with the Internet or other such “matching” services. They all list entrepreneurs (mostly for a fee) and hope that investors will look at the listings contact the entrepreneurs and make a deal. Many of the services also ask investors for some personal information similar to that required in a “Sophisticated Investor” letter. Thus, the potential investor gives away some of their privacy before they even begin.
I would bet that the people looking for funding via the Internet matching outnumbers potential investors by at least 500 to 1. I have a tough time imagining an investor with loose-change spending hours searching for companies on the Internet. It’s a lot of work and it’s much easier for this person to invest in a stock, bond or VC fund. Also, I have found that many of the companies on the Internet that respond to investor inquiries are naive and incredibly ill-prepared.
To make matters worst, many of the “matching” home pages now beginning to charge both the companies seeking funds and the potential investors through a “membership dues” ploy. As a potential investor, I may now be further inconvenienced by having to spend my money just to look for investments. Further, I may have to wade through many “screening menus” to get to certain potential investment categories.
On the other hand, a few years ago, I had a business meeting with the principals of a venture in Fremont, CA. Their president swore he got $50,000 from an investor in Thailand after two e-mail exchanges. I didn’t see the check, but I have no reason not to believe him.
College Venture NetworksStanford, MIT, UCLA, UNH and other universities have matching services that pre-date the Internet. I have tried them. My experience is similar to such services on the Internet.
Partnerships and Dependent Joint VenturesInstead of looking for pure investment funds, you might consider forming partnerships or joint ventures with complementary companies. Generally, in these structures each partner puts up capital (or other assets) to form the company. Each partner agrees to hold a certain percentage of ownership in the company and is to be paid part of the profits, depending on the degree of ownership held.
Often, this structure initially seems attractive since the individuals bring complementary assets. For instance, a beef supplier or bun baker partners and invests in a hamburger shop.
The degree of ownership will usually depend on the money invested or individual experience, skills and/or effort. The original entrepreneur may own a larger piece than the pure amount of money invested. Or, sometimes they invest no money and become an equal partner for their concepts and expertise.
On the dark side, every dollar of profit has to be split between you and your partners. Further, partnerships have the very highest failure rates, since all the partners may not have the same goals. The result is often that the people don’t get along well and since they are partners, all share in the decision-making. Bad personal relations may end up souring the entire partnership with no easy remedy.
Be aware that actually choosing a partnership as the legal form, you may never be able to get new, outside investors. For instance, many partnership agreements automatically terminate upon the death or loss of a single partner and no outside moneyman will accept such arrangements.
“Entrepreneur Showcases”The schools and organizations above also sponsor periodic “showcases” of new ventures and businesses. They are well attended by potential investors and the climate is very conducive to deal making. I would urge you to be an exhibitor at any of these you can find. Societies such as MIT, Asian Business Association and Monte Jade also host such meetings. The latter are fascinating since many VC’s from Taipei, Hong Kong and Singapore attended, actively looking for US investments. Where else can you make your pitch to a qualified audience (they have the money) that have also traveled some distance and paid to listen to you?
Family Investment CompaniesA number of wealthy families in the United States and Canada have set up foundations and corporations for investment purposes. Typically, family members pool their resources into a company and have it managed by investment professionals. More and more family fortunes are being made available as seed capital for new and emerging enterprises.
Venture Capital Executives as AngelsMany of the senior managers of VC companies that I’ve known will take personal flyers on deals that they absolutely refuse to consider for their funds. Basically they like the people or the idea and may throw their own money into the deal.
Every time any VC ever turns you down, always ask him/her if they’d be interested personally and/or if there are any other VC’s that they know that might also be potential angels.
Other Alternatives and Variations Thus far, we’ve discussed various sources of equity deals. A few variations:
Angel & Venture Capital LoansIn some cases, investors may loan entrepreneurs the necessary capital. These are sometimes only guaranteed by stock in the company as collateral. These deals sometimes work out very well for the VC’s.
In June of 1997, Benchmark Capital of Menlo Park, CA made two loans of $750,000 to a small, online auction company, eBay, Inc. The founder and another employee pledged 6.9 million shares each as collateral. In January of 1999, Benchmark called a clause in the agreement, gaining 13.8 million shares of stock. In April of 1999, the stock was worth $171.75/share or some $2.4 billion, a 160,000% return!
Venture Capital/Angel Guarantors (Loan/Line Guarantees)Some venture capital firms or private investors will guarantee all or part of an entrepreneur's bank loan or line-of-credit in exchange for equity or other, non-cash, compensation.
This allows the entrepreneur to get a sizable bank loan while maintaining his business assets separate from his personal assets. He does not have to pledge personal assets or make personal guarantees. The actual investor may obtain the same equity share for a loan guarantee as for a direct investment of cash.
In these cases, the guarantee could be very costly to you in both in terms of ownership and the future profits. Further, you are assuming debt very early in the life of your company and this may lock out the possibility of bank or other debt financing later in the cycle. On the other side, guarantees are a more attractive form of investment for the venture capitalist because they have no immediate cash outlay and they also have a call on the assets that back your guarantee.
Venture capitalists may guarantee such loans in exchange for up-front fees, a percentage of the entrepreneur's future revenue, warrants on future stock, or any number of different combinations.
Venture Capital/Angel Lease GuaranteesIn many cases, start-up ventures just need certain equipment to get a venture or expansion off the ground. This equipment could be vehicles, heavy construction equipment, data processing equipment, computers, machinery, laboratory equipment, and even real estate. An investor may guarantee your lease with a bank or leasing company to allow you to lease the equipment. You must ensure that you fully understand all the leasing terms and are able to handle the monthly commitment of the payback without any problem.
In exchange for their guarantee you give the investor a portion of the profits at the end of the year and/or you sell them shares in the business. There must be a binding agreement between you and it must be clear in the agreement how and when the money will be repaid. You’ll need a good lawyer.
The disadvantage in this example is that should you run into financial trouble you could very well find a bailiff at your door to seize your equipment.
The 3F's and Green AngelsAlmost all new entrepreneurs take money from the 3F’s (Friends, Family, Fools.) Clearly, in the first two categories (family and friends), it’ll be very embarrassing if you lose all the money invested by your grandmother, favorite aunt or former co-worker. However, that’s your call, based on the love and stability of these relationships.
Having fools invest (family or unsophisticated outsiders) gets to be a more serious problem. Most have never been in a venture before and are the same kind of problem as “Green Angels.” They are playing with “anxious money” that they really can’t afford to lose.
They eat up an enormous amount of your time by constantly calling you, making naive (e.g., stupid) suggestions, conducting investigations or demanding changes. Your personal relationship with them may also make it very hard for you to abruptly cut them out. When in doubt, don’t take their money. Ever!
Angel Professionals (Doctors, Dentists, Lawyers & Accountants)A great source of smaller funding. The first two, doctors and dentists, have money and tend to live on the outer fringes of the world of entrepreneurs. Often they will invest just to have the experience of being an “insider.” Unless your product or service is medically related, I suggest that you only approach medical people as “targets of opportunity.” Limit your list to people that you already know, or are “friends of friends.”
On the other hand, your lawyers and accountants depend on you to be successful so that you can continue to pay them. It’s only fitting that you ask them to be investors. One of the other reasons for having large organizations provide you with professional services is so you can “pass the hat” through the organization when you need funding.
I once was able to raise a very quick $500,000 through a friend of mine that was an investment banker. When we had the closing and received all the individual checks, I looked at the names on the checks and recognized that he had merely “passed his hat” (for me) amongst the people in his investment firm and to my own lawyers and accountants.
The type of financing finally accomplished is limited only by the characteristics of your investors and your mutual imaginations … and, your tax situations … and, an array of federal and state securities laws, meant to protect the naive and “widows and orphans."
- More Later on VC’s and Angels -
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VENTURE FINANCING - REALITY VERSUS RUMOR: Angel Investors - What They Are, Part II
