angel investing an introduction to bill payne warsaw october 6, 2009
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ANGEL INVESTING An introduction to
Bill PayneWarsaw
October 6, 2009
OUTLINE
Capital sources for entrepreneurs with an emphasis on angel investors What angels are looking for business plans key issues in business plans
Angel investing process Angel deals and deal terms
Companies Backed by Angels
Sources of Funding for Entrepreneurs
THE CAPITAL FOOD CHAIN
© 2006 i2E, Inc.All rights reserved
Funding for US High-Growth Companies
0 200,000 400,000 600,000 800,000
40-50,000 Angel Investments
500-700,000 New Companies
<100 IPOs (VC funded)
< 3000 VC InvestmentsTypical Year
Seed/Startup
0
<200
~25,000
Self - First Source of Capital
Bootstrapping the Startup
• Personal sources of cash (or reduced expenses)• New business sources of cash (or reduced expenses)• Extend the runway• Red Flag: Entrepreneurs not “all in”
Personal Bootstrapping
• Keep day job• Working spouse• Delay/minimal salary to self and others• Use personal car/computer/equipment• Mortgage residence• Using savings• Maximize credit cards• Other personal debt
Source of cash
Source of cash
Reduced use of cash
Reduced use of cash
Source of cash
Source of cash
Source of cash
Source of cash
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Company Bootstrapping
• One partner keeps day job• Consulting while starting company• Negotiated delay in vendor payment• Negotiated delay in landlord payment• Advances from customers• Advances from partners• Selling other products1
• Early commercialization2
Source of cash
Source of cash
Reduced use of cash
Reduced use of cash
Source of cash
Source of cash
Source of cash
Source of cash
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1 As a sales representative or distributor for another company2 Quickly developing and selling products to generate revenues for the company.
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Friends and Family Investors
• Pre-seed financing– To develop product– To find customers
• Unsophisticated– Equity? Debt? Gift?– Limit the number of investors
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• Friends, family & fools
• Angels
• Venture Capital
• UnsophisticatedInvesting in a friend, familyPassive1-2 lifetime investments Equity, debt, gift?
• Accredited, savvyInvesting time and moneyActiveInvesting in entrepreneurPortfolio of angel deals
• Limited partnershipInstitutional moneyGeneral Partners activeInvest in companyLarge portfolio
Typical round: <$100,000
Each investor: $ 2-10,000
Annual Investment: $75B
Typical round: $400,000
Each investor: $ 35,000
Annual Investment: $25B
Typical round: $7,000,000
Each investor: $3,000,000
Annual Investment: $25B
Complementary Investors
~1000 First Sequence
source: UNH CVREa
rlyS
tag
eL
ate
$25B
50,000 deals
Half seed/startup
source: NVCA/PWC/VE
Mostly later stage
3,000 deals
$25B
<200 Seed
ANGELS VENTURE CAPITAL
0
50
100
150
200
250
300
2000
2001
2002
2003
2004
2005
2006
2007
US VCs Funding Fewer Seed-stage Companies
Nu
mb
er o
f S
eed
-sta
ge
Co
mp
anie
s F
un
ded
Source: Dow Jones VentureSource
Venture Capital Portfolio Analysis
• Seed and startup companies
• Early stage companies
• Expansion stage
• Later stage companies
2%
18%
60%
20%
VC ($$$) Investments
Angel Investments
Source: PWCMoneyTree 2002 & 2003 data
Motivation: Risk and Rewards
Venture Capitalists: make money
Angels (a blend of the following) Return on Investment Staying involved (sense of usefulness)
Give-back Affection for Entrepreneurs
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Investing Comparison Angels VCs
Dollars ~$25 billion ~$25 billion
# of Investments 50,000 3,000
# Start-up Deals 25,000 200
# of Investors 250,000 1,000
Per round $300,000 $7-8 million
Each investor $25,000 up $2 million up
Typical investment early stage later stage
The Funding Gap
Pre-seed Stage
Seed/Startup Stage
FUNDING
GAP
Early
Stage
Later Stages
Founders
Friends &
Family
Angel Investors
Very few angel deals done above $1 million
Very few VC deals done below $4 million
Venture
Capitalists
$0 $250K $1.5 million $4 million $10 million up
ENTREPRENERS: Go Where the Investors Are
Investment (one round)
Nu
mb
er
of
Investo
rs
$5 million $10 million
AN
GEL
S VCsGAP
• The capital food chain for entrepreneurs has changed in the past decade as VCs invest more $$$ in later stage deals
• Angel investors have become critical players in the food chain.
• The funding gap ($1.5 to $4 million) impacts both entrepreneurs and angels
• Angel response:– Form angel groups– Fund more “angel only” deals
Early Summary
Beyond Money
How Angels Add Value
ServiceProviders
EntrepreneurshipCenter
Bus PlansEducationNetworking
FundingSources
VCs
AngelsGrantsBanks Mentors
CoachesRole models
ENTREPRENEURS
Sources ofTechnologyInnovations
Product Ideas
Colleges & Universities
Companies
Labs
Talented People
Who are these Angel Investors
• Often successful, exited entrepreneurs or retired business persons – active investors
• Accredited Investors – US SEC definition• Angels invest their own money (not money managers)
• Investing “mad money” (3-10% of net worth)
• Investing in local companies (1 hour from home) • Part time activity
– Competes with golf, travel and grandchildren
Angel vs. Private Investors and VCs• Private Investors
– All stages (early, mezzanine, roll-up, spin-out)
– Investors always passive• Venture Capitalists
– Limited partnerships– Later stages of startups– Investors always passive
• Angels– Investing own money– Active in portfolio companies
Motivation:
Why Become an Angel Investor?
• Return on Investment is the metric • Helping entrepreneurs• Stay engaged – using skills and
experiences to help build a business• Giving back to community or university• An active form of investing –
not just watching markets
Engagement of Angels
• 5 to 20 angels invest in a company– Who will step to the plate?
• Available Time• Vertical Experience• Good rapport with entrepreneur
– How many will be involved• One to four – depending on need• Others on call for special assistance
• Remember: Angels are part-time investors
Angel Roles in Portfolio Companies
• Board of Directors
• Advisor, mentor, coach
– Of CEO, of management team
• Step in during crisis (temporary)
• Assist in raising additional money
– Another angel round
– VC money
• Tee up the company for exit
Engagement from the Angel’s Perspective
• Ten portfolio companies
• Engaged with 2-4– Chairman– Director– Mentor/coach
• Passive with six or more
• Available, if needed
An Angel Portfolio Strategy
An Angel Investing Strategy:
Portfolio Considerations
• 5-10% of net worth (asset allocation)• 8-15 investments (risk diversification)• High tech, low tech, no tech (your choice)
• Variety of involvements– Lead investor– Board, advisor– Passive
• Most of ROI from 1 - 2 of 10 companies
Implications of this Strategy
• Net Worth Requirements
(testing the US SEC definition
of an accredited investor)
• Return on Investment implications
Definition: Accredited Investor (not a merit badge)
• Financial position of investor:• Net worth: $1 million, or• Annual personal income: $200K, or• Family income: $300K
• Assumption:• Self-selection• Knowledgeable – capable of due diligence• Can afford to lose invested funds
• Implications:• Giving up regulated disclosure
Implications:
Angel Investor Net Worth• Typical angel investment ~$25K
• 10 investments = $250,000 invested
• 100% reserves, another $250,000• 10% of Net Worth ($500K/10% = $5 million)
• Therefore:– Minimum net worth for angels = $5 million
Angel Expectations: 25%/yr
Source: Venture Economics, HFRI Equity Hedge Index
22.4
18.7 18.7
16.5 14.913.2
0
5
10
15
20
25
Ret
urn
s
Seed Funds
All Ventu
re
HedgeFunds
Buyouts S & P 500
NASDAQ
Historical 20 Year Returns for Alternative Assets
Implications: Size of Each Opportunity
• 1-2 in 10 investments will produce almost all of the ROI for the portfolio
• These successes must yield 20-30X ROI (Nonbelievers: Do the calculations!)
• And…we cannot pick the winners
• Therefore, all portfolio companies must demonstrate the opportunity for a 20-30X return on investment.
Integrating Exits into Portfolio Strategy
• VCs exit in 3-5 years (assume 5)• Angels invest earlier and expect to exit in 5-7 years
(assume 7)• A balanced angel portfolio contains ten companies. • Consequently, angels should invest in 2-3
companies per year– Build to ten company portfolio gradually– A portfolio of companies in all stages of development– Good balance for investors time
Changing Landscape for US VC Exits
From: NVCA
0
100
200
300
400
500
600
73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 '00
'01
'02
'03
'04
Year
Nu
mb
er o
f Is
sues
M&A
IPO
US VC Exits Since 2000
Source: NVCA
Num
ber
of E
xits
6 IPOs in 2008 is lowest since 1977
What Deals Do Angels Fund?
• business plans
• key issues in business
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Business Plans
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Elevator PitchTwo minute verbal summary
Product, opportunity, differentiation
Attract interest – not closing
Executive Summary
2-4 page written summary
Balanced presentation
Attract interest – not closing
PowerPoint20 minute verbal presentation
Cover whole plan
Find serious investors
Full business plan(write full plan first)
20-50 pages plus appendices
Validation scorecard (due diligence)
Basis for all other plan forms
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Writing Business Plans
• Entrepreneur MUST write plan (no consultants)• Use editors for clarity and brevity• Resources:
– The Business Mentor - www.fasttrac.org– SBA - http://www.sba.gov/starting_business/index.html– Inc. Business Plan Building, Section by Section
http://www.inc.com/guides/write_biz_plan/20660.html
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Evaluating DealsWhat do investors look for?
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Angel Rating System
0-30%0-25%0-15%0-10%0-10%0 - 5%0 - 5%
Management teamSize of opportunity
Product & technologySales channels
Competitive advantageSize of this round
Need for more funding
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Fundable Management Teams
• CEO– CEO experience– Vertical experience– Coachable (very important)– Leadership
• Team– Balance and complete– Experience working together
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Size of the Opportunity• Scalable
– $30 million (min.) in revenues in 5 years
– (VCs look for >$100 million)
• High gross margins
• Large niche market
• Unfair competitive advantage
• Ready for customers
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Five Mistakes to Avoid
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1. Don’t take dumb money!
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Look for smart money – investors eager to invest money and time in your company, bringing their skills and experiences to help you grow successfully. Check the references of possible investors before signing a term sheet.
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2. When pitching investors, don’t elaborate in describing your product/technology.
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Investors want to hear about your business, not just your product. What is the competitive landscape? What is the size of the opportunity? Will IP be a useful barrier to entry? How much money will it take to achieve positive cash flow? How do you know you can make the product? Provide investors with a balanced presentation of your business.
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3. Don’t overestimate the
size of the market.
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Accurately determine the addressable market - the size of the opportunity for your product sold to your customers. Hypothetical example: An entrepreneur in the sheepskin seat cover business estimates the size of the opportunity to be $200 billion per year – the size of the automobile market! Don’t fall into this trap…investors can see right thru this deception.
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4. Don’t “ball park” revenues as a percentage of the total market.
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Many entrepreneurs develop proforma revenues as a percentage of the addressable market. “The total market is $350,000,000 and we will capture 0.5% in year one ($1.7 million) and 10% in year five ($35 million).” This simply won’t fly with investors. Build your revenue plan from the bottom up – define which customers will buy how much in the first year… second year…etc.
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5. Don’t press the first mover advantage.
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1st mover advantage is usually a fraud. It is frequently the 3rd or 4th company in the space that is successful. First-to-market often demands missionary sales (developing entirely new markets), requiring huge amount of money and expertise to thrive. Accurately access the 1st mover advantage, if any, and especially how much it will cost to penetrate this market.
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Lessons for the Day for Entrepreneurs
Raising money is difficult and time-consuming. Spend the time necessary to understand the capital food chain for entrepreneurs. Learn what motivates investors to fund companies. Pursue funding as smart entrepreneur. Time spent preparing will save substantial time in raising money.
Why Angels Join Groups
Solo Angel Investing
• Process is time-consuming– Deal sourcing– Reading plans– Due diligence
• Due diligence is difficult – Finding vertical experience – May require using outside experts
• Legal support is expensive
60
Number of North American Angel Groups
Sources: Center for Venture Research (pre 03 data) and Kauffman Foundation/ACEF (04-08 data)
0
50
100
150
200
250
300
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Investing through Angel Orgs• Dividing the work eases the pain
• Variety of vertical experience available
• Standardized processes and term sheets
• Deal flow encouraged, entrepreneur-friendly
• Pick and choose the deals you like
• Great camaraderie among the like-minded
• Bill Payne: All future angel investment through angel organizations.
The Angel Investing Process
Average % Equity
0
1
2
3
4
5
6
7
8
9
105
%
10
%
12
%
15
%
20
%
25
%
30
%
33
%
35
%
40
%
Groups
39 groups reporting (Caution: source data is incomplete & unverified)
Board member representative
helps grow company and
seeks attractive exit.
Submissions(100% PlansPer Month)
Pre-screen emailed
submissions
Screening TeamReview
(25-30% PlansPer Month)
Screening team votes on which
companies to invite to
general meeting.
General MeetingPresentations(1 – 3 PlansPer Month)
Champion identified,
diligence team volunteers (or is recruited)
and begin term sheet
negotiations.
Manage Investment
Deal lead presents
company to group and
helps entrepreneur
close the transaction.
Diligence & TermSheet Negotiations
Source: J. Geshwiler, CommonAngels, Boston
ME
ET
ING
E X
I T
Deal Flow Statistics
• Prescreening• Screening• Due Diligence• Investment• OVERALL
1 in 4 to Screening 1 in 3 to DD 1 in 3 to Inv. Meeting 1 in 2 raise money 1 in 72 who apply receive
investment
(assume 1%)
From: San Diego Tech Coast Angels
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Understand the Process
• Read how angel groups work (Cutting-Edge Practices in American Angel Investing, by May & O’Halloran or
Definitive Guide to Raising Money from Angels by Payne)
• Look on the website of your local group
• Network with those familiar with the process
• Know what to expect
• Be open and honest with investors
• Remain patient
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Understand the terms
• Start-up funding terms are unique• Study these terms
– Read Term Sheets & Valuation, A. Wilmerding– Talk to your advisors– Consult with experienced entrepreneurs
• Stay flexible on terms, especially valuation• Understand common practice (your region and business vertical)
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Closing
• Read and understand the closing documents
• Remain patient with investors
• Communicate regularly with possible investors, use friendly persuasion
• Pursue low hanging fruit
• Get the deal closed…and execute the plan!
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For more information…
Definitive Guide to Raising Money from Angels, B. Payne (2006) from www.billpayne.com $97 free for you! State of the Art: An Executive Summary Briefing on CuttingEdge Practices in American Angel Investing J. May & E. O’Halloran (2003) $35 from www.amazon.com Term Sheets & Valuation – A Line by Line Look at the Intricacies of Venture Capital Term Sheets & Valuation, A. Wilmerding (2003) $10 from www.amazon.com The Art of the Start, (2004) G. Kawasaki, www.amazon.com
Angel Deals and Terms
www.billpayne.com
Typical Angel Deals (p1)
• Management team has– Integrity– Experience (management, business vertical)– Identified key advisors/directors– Key players in the wings
• And…CEO is coachable
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Typical Angel Deals (p2)
• The business will scale– Build revenues to >$30 million in five years
• The business serves a large niche market
• Large gross margins can be expected
• M&A exit are feasible within 5+ years
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Typical Angel Deals (p3)• Company has prototype ready to show
customers.
• Customers have been identified and have been shown the product or prototype.
• Customers can validate that the product is a pain killer, not a vitamin pill
• Company has unfair competitive advantage
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Typical Angel Deals (p4)
• The business model can be validated
• Reasonable sales channels are available
• Customer acquisition costs are low
• Competition is fractured (Microsoft is not lurking around the corner)
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Typical Angel Deals (p5)• Entrepreneurs is flexible on terms
• 20+X ROI is possible
• Valuation is reasonable
• Structure of deal allows input/control by investors.
• Board representation is available
• CEO is willing to step asidewww.billpayne.com
Typical Deal Terms (p1)
• Two classes of securities– Approval of both classes required for
significant activities (raising money, M&A, etc.)
• Balanced Board of Directors
• Employment contracts for team
• Information rights for investors www.billpayne.com
Typical Deal Terms (p2)
• Anti-dilution protection (down rounds only)
• Liquidation preferences
• Registration rights
• First right of refusal, drag along rights
• Redemption rights
• Confidentiality, no shopwww.billpayne.com
SUMMARY• Angels are an important component of the
capital food chain for entrepreneurs• Many angels join groups to institutional the
angel investing process. Easy access for entrepreneurs.
• Angels invest in good teams and scalable businesses with specialized term sheets.
• Entrepreneurs: Learn about angels, the deals they prefer and the terms you are likely to be negotiating.
www.billpayne.com
What Models of Angel Organizations are
Proliferating?
Angel Organizations Models
Manager-managed
Member-managed
Time commitment
Dues
Carry (preferential
return)
Individual investments
Group investments
Angel Funds
Angel NetworksX
X
X
X
X
X
X
X
x x
X
x x
X
Manager-led Funds• Pool money in advance
• The manager– Leads the process– Provides administrative support– Is paid thru dues and/or “carry”
• Vote of members determines investments
Manager-led Networks• The manager
– Leads the process– Provides administrative support– Is paid thru dues and/or “carry”
• Engages members in process
• Members invest in deals they like
Member-led Networks and Funds
• Members elect leaders
• Administration support hired
or provided by local benefactor
• Members divide the work of the process
• Members invest in deals they like
• Dues pay for organization’s expenses
Side-by-Side Investing
Manager-managed
Member-managed
Time commitment
Dues
Carry (preferential
return)
Individual investments
Group investments (LLCs,
etc.)
Angel Funds
Side-by-side
Individual Investments
Angel Networks
Side-by-side
Funds
auto
mati
c
X
X X
X
X
X
X
X
Automatic Side-by-Side Fund
• No manager, no carry• No fiduciary responsibility• Typical investment:
– 30-50% match, if
– 6 angels in network
invest at least $300K
• Diversified portfolio
10 to 20 investments
• Leverage to angel group• Angels can diversify• Other accredited
investors can invest• Fees could offset costs
of angel organization• Possible to engage
governments as investors