Startups and angels: Along the way to success

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.  

There's Only a Test if you Sign Up for It

Every business needs cash from someplace.

At RTMS it was from customer revenue.  We had $500,000 in annual sales on the day we opened the door in 1989.  We built the business from there and never had professional investors until ten years later.

We never had to take the "Investor Test," jumping through the hoops of plans and projections, diligent market intelligence, close examinations of our team, and the like.  The closest we came was a personally guaranteed loan from a friendly banker for $75,000.  He asked to see "an outline of the business." 

I did that with six slides.  (Meaning little pieces of film mounted in a paper frame.) 

We grew tenfold in a couple of years and were one of the players in the early CRM business.

By the mid 1990s we were golden.

Great, huh?

I'm teaching undergraduates at Marquette University in a class called "Entrepreneurship for non-business majors" for the first time this year. And I love it.  They are bright, eager, engaged and interested.

But they do ask, constantly, "will this be on the test?"  Somehow they are trying to manage their time and try to remember only those "things" that they will be responsible for.

I think the Investor Test is the same thing.  I assumed in 1989 that since I didn't have to take "the test" since I didn't need any money from investors, I didn't need to study for it or know the answers - or even the questions. 

In the words of Beethoven, dumb de dumb dumb.

We were unprepared for the discipline of rapid growth.  For the complexities of managing a team for success.  The only thing we were really great at was hiring real stars and keeping the target squarely on making money for our customers. 

That was enough for a long time.  Eventually quasi-competition overtook us in the heyday of the late 90s.  We were competing with companies preaching change and talking a good game but delivering...nothing.  A couple went public, and crashed.  One CEO had to return his secondary offering cash - in its entirety - or face the SEC.

While we were smart enough to avoid such lunacy, and stay focused on our customer, I think that if we had taken the investor test in 1989 we would have been a different company - and a better one.

We would have failed, no doubt - and again, and again until we got it right (no failures in life just tests that get repeated until you pass).  But the learning would more than have made up for the work, a thousand times.

BTW the company today is doing great and the exit was fine.

But it could've been "start a foundation great" exit rather than just fine - if we had passed the test.

Not every tester knows what they're doing, of course.  Some ask dumb questions; others ask good questions but have the wrong answers.  But there are those who really do know what to ask, and what the right answers are.

A good deal of this process is well documented.  Bill Sahlman at HBS wrote a great article in HBR ten years ago, "How To Write a Great Business Plan," that is right on.  Critical thinking skills, working from hypotheses rather than assumptions, focusing on the workings of the business model rather than the projections, these are all components of "the test."

Even if you are without need for investment, take the test.  See what you learn. 

Angel Investor Market Trends: Q1Q2 2006

"Angel Investor Market Trends: Q1Q2 2006" (16 min)

Dr. Jeffrey Sohl, UNH Center for Venture Research, discusses trends in the angel investor market in first half of 2006. With about $12.5 billion invested by angels in about 24,500 deals, angel investing through Q1Q2 2006 is consistent with 2005 trends. However, average deal size is up, the possible result of a redistribution of investments by some angels in later rounds, which is likely to reduce funds available for earlier investment stages. The “big three” sectors of healthcare, software and biotech accounted for about 57% of total angel investment. Surprisingly, investment in retail deals rose sharply and yield rates declined to near-normal historical levels of around 10%. With some of the largest amounts of capital in many years accumulated by venture capital funds, some of these funds could be directed to the seed stages, but capital alone is not enough to address the continuing need of entrepreneurs for seed-stage value-add knowledge from angels.

For the download, go to CFI Institute .

Finding "Models That Attract Investment"

Every now and then, a lively discussion coalesces from a group of people with interesting experiences.  I think you'll find this report   by Geoff Bastow fits that description.  (It would be great to find a podcast of the panel; alas, we only have print.) 

While not every example is a pathway, nonetheless these experiences, especially from the vantage point of the Midwest investor, really underline the state of the startup experience in middle America.

Understanding Public Markets

The Kauffman Foundation's eVenturing website has put up an interesting series of articles on raising money in public markets.  If you have heard about the London AIM, PIPEs or other alternative public markets, this is a very good series of articles on these topics.

Due diligence: An Entrepreneur's Perspective

Due diligence by an investor, seen from the entrepreneur's point of view, is all good.  Really.  Here is an opportunity to really learn a lot about your business prospects and gain perspective.

Yes, of course, some investors will use this process to see "how much they can get" and be impolite about it.  Fewer than you might think, tho.  And my advice is always "walk."  Money is only money but business ideas - good ones - are harder to come by. 

So think of this as a process of learning - about your venture from a new perspective - about the investor(s) - and about building trust.

The investor is asking if you are trustworthy.  If you have the capability to run this venture.  If you understand when the venture may need new leadership.  (By the way, this issue will always arise.  Talk about it in an open way.  If the entrepreneur agrees to some sort of leadership strategy it'll probably be in the deal terms.)

She also wants to know if you understand the market dynamics for your proposed business, and if you have thought deeply about eventualities and alternatives.  If the entrepreneur is always selling, beyond a certain point this makes investors uncomfortable.  If they have been around, they have all seen deals that had hidden facts, or that were interpreted rosily without providing the investor the benefit of the information.  Our friends in the VC community, of course, will learn an industry fairly well, and will engage experts as well, so as not to miss something.

It is disarming and refreshing when an entrepreneur explains the risks and the plans to reduce or eliminate them, upfront.  The single most important factor for an investor should always be the people and their quality.  The basics - integrity, fiduciary responsibility, and so forth - go without saying.  Next, I suppose, comes a firm grasp of the facts of the market and the competitive environment.  The willingness to be forthcoming and both seek to present the venture and seek investor advice are next. 

Each question, each discussion, each exploration always has two purposes.  One is the content of the question being discussed; the other is the quality of the entrepreneur in their demeanor and response.

At the same time the entrepreneur has the opportunity to see the investor in action.  And to compare the terms and conditions being offered with what the investor has said.  If the entrepreneur cannot get an equal sense of a straightforward and fair relationship developing, ask more questions.  Have more discussions.  If you don't like what you hear, walk.  (Of course, make sure you've gotten some third party you do trust to make sure you understand all of the terms before you decide they are unfair!)

If you do see a straightforward and fair relationship evolving, work as hard as you can to build mutual trust.  And enjoy the success that will follow. 

Where Should Your Startup Funding Come From?

"It is easier for an entrepreneur to win a lottery than it is to get startup capital from a VC."

--Bill Bygrave,Babson College, at the National Association of Seed and Venture Funds.

Bygrave is Frederic C. Hamilton Professor for Free Enterprise at Babson College. He is a principal researcher for the 2002 Global Entrepreneurship Monitor (GEM) and director of the Babson-Kauffman Entrepreneurship Research Conference.  So he should know. 

When asked if there were VCs in the audience, one (John Nice, Venture Investors) raised his hand.  "You're irrelevant, Bygrave told him.  You can go now."

The point of this comment, of course, is the funding gap that exists between the need for startup capital and the ever increasing trend of investors of most stripes - and virtually all venture capitalists - to move upstream to larger investments in later stage companies.

Most startup funding - and almost every startup by definition spends money on something that it did not earn in the anticipated business - comes from friends, founders, and family (and some would add "fools" to the list!)  That's most as in 99% +. 

So where should your startup money come from? 

Where you get it - from whom - is vastly more important than the terms.  Savvy investors can help a company grow - dramatically.  Unsophisticated ones not only become a drag in some cases, but almost always lose faith over time and become impediments to future financing. 

Consider what happens when your otherwise good venture cannot get reinvestment from original investors.  New potential investors worry about why.  Or, worse, if the early guys want to sell to the later guys, that really makes the new buyers nervous. 

From whom you get startup funds is always more important than the terms.

Paul Graham on Funding 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 isn't the rule, 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.

and also...

"If "near you" doesn't mean the Bay Area, Boston, or Seattle, consider moving.  It's not a coincidence you haven't heard of many startups from Philadelphia.  Or any humble California software guys.  Not everyone can be perfect.

Helping Startups Get Growing

A lot of us  seem to continually be asking how to help early stage entrepreneurs get going.   

Of course, we expect early opportunities to be incomplete.  They often have a compelling product concept, but most of us are not deeply knowledgeable about the specifics of a proposed market and often, truth be told, the venture isn't either. 

Lately, I've been talking to technology entrepreneurs who want to be able to spin-off an idea - a very difficult task, to be sure, but not impossible - look at all of the technology transfer coming out of universities.   (A Tech Transfer VC I know, tho, always says, "No garage science," meaning non-academic inventors carry a high risk of not knowing the scope of the science, and therefore can get blindsided.)

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Here's an article from the Milwaukee Journal Sentinel about a local company with a spin-off idea: Brandt Innovative Technologies.  It strikes me that a perfectly legitimate investor position is "the problem is that Brandt isn't focused on (this product.)"   After all, if an angel sees him or herself primarily as a screener, then the investment opportunity skill is primarily about interpreting plans and making judgments about levels of risk and reward.  Most of the angels I know think that way. 

Now I have yet to talk to Kurt, but I think there is an alternative way for an investor to approach ideas like this.

If the idea/venture "checks out," why not treat it more like a technology transfer opportunity?  Can angels help put together the components required for it to be successful?   That's a tall order - the angels need a lot of talent and a darn good rolodex.  But it's also one way to develop deal flow and use the skills and talents of the people in the network. 

Perhaps early stage pre-investment incubation belongs somewhere else; our group's track record has been so-so in trying to help companies get going.  But it is an approach worth thinking about.   

A budget discussion with an entrepreneur

When you get to the point in the discussion where projections are relevant, there is a drill-down method here used by virtually every investor.  Some may be subtler than others, but I guarantee you that the thought process is exactly the same.

At the end of the discussion, the investor wants to know:

1.    What must go right for the plan to succeed;
2.    What can possibly go wrong;
3.    What it costs if it does;
4.    Whether it is fatal or not.

In general, the first part of the discussion runs to whether or not your numbers are tied to metrics with an underlying set of assumptions, or if they are simply a function of  a mathematically applied growth rate.  Do you have assumptions about how long it will take to achieve each order?  What it will cost?  This cost and timing can easily be laid out in a matrix that may yield to testing easily.    In other words, if you are forecasting 100 orders in the next quarter, at $10,000 each, I’d ask how many potential orders there are in the market, whether there is any existing competitive experience, and how you derived your timing.   Timing relates to cost and I’d like a sense of the total cost of each of those 100 orders.  This includes selling costs, marketing costs, and so forth.  I’d want to know that you had an “in the ballpark” sense of what this all might cost.

(Of course, it goes without saying that no one would bottom-up an expense budget then fill in revenue to make it “come out,” right?)

Then, on the expense side, I’d like to begin to understand how the growth in the business will drive costs as complexity increases.  Growth involves, in many businesses, more customer service, product development, support, marketing and so forth – in addition to more R&D. 

I’m going to ask about ratio analysis based on what you know about what others spend in similarly situated companies, and where your data come from. 

So, if all of your costs rise smoothly in direct proportion to sales, I would suspect you built these costs for the first month and then just scaled them going forward.  That’s longer a budget; it’s a math exercise.

Out of the many facets of this discussion, a savvy investor will get a feeling for your understanding of the market you are in – or entering – and your level of experience about the planning process.   

All of that is antecedent to assessing your reaction to the process of discussing the assumptions.  I’d like to quickly begin a conversation about how “we” will go about finding validation for those assumptions or gaining new information that will help us change them. 

This takes a lot of risk out of the business process.

In our first startup, my partners and I built a customer acquisition model and tested it.  We pinched and scrimped to do that on our own money (about $75,000 in 1989 terms, which lasted us six months).  By the time we were done, we proved the model and gained enough new business that we didn’t need venture capital for almost a decade.