Startups and angels: Along the way to success

Starting Startups

So, Paul Graham is a brainiac.  He is a partner in a pretty much exclusively software seed stage fund, Y Combinator that you can read more about. 

He writes challenging essays at paulgraham.com (8 million hits it says!) that are very thought provoking.   Read Want to Start a Startup? carefully.

It's refreshing to see several of these ideas in print.   For instance:

1.  ...A way to fund a startup is to get a job.  This frequently starts as consulting - which is how RTMS, Inc. started.   We worked all day building market strategies for customers while we tried to embody our expertise on software that would expand the company's reach.  (This was 1989.)  Interestingly, the consulting business remained and is a mainstay even today.  They got better and better as the software application got more capable.   There's hardly a major US retailer they haven't worked for.

2.  Some angel groups charge you money to pitch your idea to them.  Needless to say, you should never do this.  Amen.

3.  One of the dangers of taking investment from individual angels, rather than through an angel group or investment firm, is that they have less reputation to protect.  I've seen that more than once, but I thought I was the only one talking about it.  The flip side is true, too.  Individual angels can get sucked into situations that a group's experience might have avoided. 

4.  Angels can allow founders to partially cash out if they choose to.  It's true; we've done this once.  It is very unusul and I wouldn't do it very often, but it's a possibility.

5.  Angels who only invest occasionally may not know what terms they want.  Paul goes on to develop the story of "vanilla" documents prepared by the angel's attorney.  When this happens, (due in part to the need to keep fees low) things get both left out and included that later wisdom will suggest should've been included or left out.  Groups tend to use more standard terms and -- more important -- develop an understanding of what they really do want.

6.  Like VCs, one of the advantages of seed firms is the advice they offer.  But because seed firms operate in an earlier phase, they need to offer different kinds of advice.  Good angel groups, too.  That advice is often both technical and srtructural.  Groups don't all do this.  Be sure and ask - for examples, not intentions.

7. ...the disasters of the Bubble showed that generic business guys don't make such great CEOs (in reference to replacement of founders.)  Yup.  Been there. 

8.  Angels like to invest in deals that come to them through people they know.  Absolutely.

9.  ...being slightly underfunded teaches them an important lesson: cheapness is power.  A low burn rate is a pearl of great price.  It provides lots of options that high burn rates take away.  In Paul's words "Spend little, and work fast."

10.  ...vesting (of founders stock) is a way for founders to protect themselves from one another.  It solves the problem of what to do if one of the founders quits.

Congratulations to Prodesse and Tom Shannon!

The October 7th announcement  of the sale of Wisconsin-based Prodesse for $60 Million is great news on many fronts.

For the Medical College of Wisconsin, who had a 1% stake, there's an immediate payoff.  And, assuming that the original science included a royalty, there may be an ongoing royalty stream as well.  (Could be 3-4% of sales per year.  At $15MM, that's $600,000 annually.) 

For those of us who cheer for entrepreneurs, it's great to see Tom Shannon succeed.  I love Kevin Conroy's comment that "Tom is the best CEO in molecular diagnostics, not because he knew the industry inside and out, but because he's a doer.  He put his head down and said 'I'm going to confront all these problems' without any capital."

It's always the people who lead ventures that make the difference.  There was an inflection point in Prodesse where it would've been possible to walk away and admit failure. Lots of people have done it, and Tom didn't. 

He developed a Plan B and made fundamental changes.  He persevered and realized that the journey is a marathon  and not a sprint.  He managed his capital intelligently.  And he came from outside the industry, brought leadership skills, and applied them.  It's the people like Tom who make the big difference.

It's interesting to note that Prodesse created a lot of wealth in Wisconsin and stands to create more - not only through employment.  If Tom helps more new ventures succeed, and Prodesse investors continue to spot great opportunities, the story repeats itself.

Congratulations to Tom, his investors, and his team.

Does the world need "tough" entrepreneurial coaches?

No.

I have, twice in the last week, listened to "haven't really been there, but have talked about it" types expound upon how they work with aspiring entrepreneurs (some of them students) and "really make them sweat."  They gleefully tell stories of their fearsome, tough reputations and their critical prowess. A couple were business coaches. And a couple were college teachers (not at Marquette!)

This seems to be some sort of virtue based upon toughening up people for the real world.  Getting them used to dealing with "Shark Tank" type investors (what a bunch of dopes) so these aspiring entrepreneurs can be prepared.

I think that I would never lie to someone about their business prospects or flatter them just to do it.  But I would also never "drill" someone just to "toughen them up."

Entrepreneurs represent the best of America.  They take risks, create opportunities, satisfy customers - the list goes on.  Entrepreneurship is what the rest of the world looks to the US for.  And for those of us who have been lucky enough to get to be around aspiring entrepreneurs, we should realize it's a privilege every single day, not a podium from which to act like a pompous windbag.  

And if my son or daughter came from from college and told me that some teacher had proposed to treat them this way, I'd be, well, perturbed and might find an inelegant way of expressing this sentiment. 

If you're an entrepreneur, expect to be treated with respect by investors, advisors, teachers, all of them. Expect also to be told the truth (not to get the snipe hunt runaround). And tell the amateur shark tank guy to take a hike. 

Lower values, higher risks? Or a paradise for investors?

I'm just reading a post from Wisbusiness.com by Joe Kremer of the Wisconsin Angel Network.  (WAN is a trade group of angel organizations in Wisconsin; I'm on their board.)  Joe, a friend and colleague, is writing about the "great deals" in venture valuations that have been created by economic conditions.  

It's inarguable that valuations are lower.  Relatively late stage pharma ventures, just to cite one example, tend to be doing second and third rounds at depressed values.  

It seems to me there are several reasons for this.  

First, there's less money.  Most obvious, I suppose, is that the investor just has less money to invest.  Thanks to portfolio allocation theory, over-weighted classes get reduced and capital reallocated.  This is a big factor for VC funds.  (They tend to be a lagging indicator of the economy since their investors are allocating resources after they're generally earned,(like wages of workers in pension funds) or in many cases, donated (to the foundation-investor.) So the VC funds have less to invest.

Venture company performance also depresses future new investment as investors use what cash they have to keep worthy portfolio companies alive.

Second, start-ups aren't immune from contextual issues, such as being tied to under-performing sectors of the economy, like housing, or participating in capital intensive high change markets like solar panels or wind turbines.  If the venture with these characteristics is worth investing in, the business is going to take longer and cost more to get to its milestone.

Third, angels in particular have had unpleasant experiences with second rounds that are venture led where down-round terms are painful and expensive.  So one conclusion might be to hold back more than one normally might, creating less money for new ventures.

All of that leads to a tighter money supply which tends to drive down prices.

And, of course, valuation in a start-up is a measure of risk, not a value of the company.  It is the way entrepreneurs and investors agree on what the market value of the risk being assumed actually is. If I'm buying a company, I care about the price relative to the benefit I acquire.  If I invest in a start-up I care about the company's ability to produce a return that covers the risk I assume.

So, while I like and respect Joe, I disagree that "it's a bargain paradise out there."  Risks are higher, exits are slower, (and might be lower) and I have less to invest.  So I pick carefully.  If I am the only one doing that, values won't fall, but if a lot of people pick carefully, then values will come down.  

Are Investors Being Unreasonable?

Take a look at this article from the August 20th Milwaukee Journal Sentinel.  It seems to me this may be a sign of the economic times.  Or, of course, it's possible that Jason Weaver (who I know - and I think Sway is a neat company) is a bit frustrated about the "rules" dictated by the current investment environment.

Now, in some ways, I'm in agreement with Jason.  If the comment about "do enough things to us" is a reflection on potential investors who he thinks don't understand his business or can't help him, he should never do business with them.

Who the entrepreneur takes money from (see this post) is always more important than the terms.   So to the extent that he sees that the quality of the investor and his/her connections and abilities is really what the early stage company is buying, the more Jason and I would agree.

If a company is seeking "angel capital" it almost always wants people who can and will be helpful beyond writing a check.  This, in our group, has included providing industry knowledgeable directors, or connections to other groups, or other types of expertise the company wants.

But what about his comment about "ridiculous terms?"  The biggest single failure of terms set by angels is the opposite, historically, of what Jason calls "ridiculous."  The problem has been that too-high valuations and too generous terms have spawned painful down rounds that squash the entrepreneur and his early investors. 

New money, usually VC money, comes in and crams down those early investors and takes substantial shares from the entrepreneur.  This happens more often as the "second round" exceeds the amount early investors can raise, is often a somewhat unexpected round, and usually is associated with missed milestones.  At the same time the company is running low on cash.  This is a confluence of bad events.

Ask any of us who've experienced significant down rounds based on some or all of these things, and one begins to understand the cautionary nature of deal structures.  So in today's environment, caution is the watchword.  No one wants to begin a relationship with a company that is contentious, especially when the investor has no requirement to invest. 

In the case of Sway, it sounds like they are doing ok without investment right now.  And that's an important point.  If the entrepreneur can bootstrap the business, it will always be worth more to the entrepreneur as well as future investors, if any.  It provides more freedom for the entrepreneur.  And more choices.  (People I know are tired of hearing this, but we did bootstrap RTMS, Inc. up to $10MM in revenue.  It gave me a lot more freedom.  Some would argue it also didn't force me to make hard choices that caught up to us later, but that's a story for another time.)  So, I'm a big proponent of bootstrapping and the benefit it provides to entrepreneurs.

So, one of my questions for Jason is really if investors terms are "ridiculous," or even if they're not, shouldn't bootstrapping provide a much superior outcome for the company than equity investment? 

Another thing for the Halos to think about is the inherent difference between VCs and Angels.  VCs have an absolute need to find companies to invest in, and to do it on a schedule.  This is fundamental to their business model.  And it is unarguably what has driven valuation bubbles in the past.   Because they only get to raise a new fund if their latest results are good, they are pretty gun shy on terms right now.  And who can blame someone for trying to keep his job? 

Angels, on the other hand, largely do this for the enjoyment of working with entrepreneurs, socializing with each other, and generally being engaged in the community.  They play for their own money, not the money of investors, so they don't have time pressures or minimum investing requirements.  Many I know will actively seek deals to work on that are run by fun, engaging people who are eager to grow the business and know what they're doing.  The best seem to have a propensity to ask for help.  Here's an example: Flex BioMedical, run by Sal Braico.  Here's a guy (sorry Sal, don't mean to sign you up for more work!) who could give the talk about how to lead an angel negotiation with style and grace.  And a good outcome. 

On valuations, if an angel-backed company can get to the goal line without future rounds of funding, the question of current value is much more manageable. When there is the prospect of future rounds, sometimes evidenced by misses in the past, deal structures become more caution-driven.

So, I don't quite see how Jason's thought about "If they turn enough of us down or do enough things to us, eventually they're going to run out of people to do the work," fits.  If these are funded companies in his group, are they unhappy with the terms they took?  Or is it really the "turn down" part that's the issue?

Just by sheer volume, every would be investor passes on 95% of what comes by.  Our group sees 250+ opportunities a year, many quite good.  We pass on a lot of stuff that we like.  We just don't have the capacity to do more.  We try to provide fast feedback to everyone we talk to, and we try and talk to most everyone who contacts us (at our website). 

So, perhaps a positive use of these group meetings would be to discuss how people did get funded (ask Sal to speak for one!) and what the current requirements seem to be. 

Real angels, as I've mentioned, don't have to invest in anything, and all of us see lots of opportunities from people we know and trust.  Most won't struggle much with difficult situations pre-investment.

I hope perhaps a dialog might get started around these topics that will help everyone - entrepreneurs and angels - come together for their mutual benefit - and satisfaction.