For years there has been a pervasive opinion across the entrepreneurial landscape that the US has a shortage of capital required to startup and grow new ventures.  It is suggested that companies cannot find the cash necessary to start new and exciting ventures.  Furthermore during this economic downturn, we’ve heard a crescendo of voices lamenting the lack of startup funding, as communities finally recognize that new companies are the key source of job creation in this country.  But, what evidence do we have of this shortage of capital?

Crowd funding enables entrepreneurs to raise money in relatively small amounts from large numbers of interested investors.  In the sum, substantial amounts of money (as much as a million dollars) can be raised for each startup company.  Recently, entrepreneurs in many countries have been soliciting investment through “crowd funding” websites designed specifically for fundraising purposes.  But, in the US, only wealthy accredited investors* have been allowed by the Securities and Exchange Commission (SEC) to invest in entrepreneurs and their startup companies (without extensive disclosure of the business plan and risks inherent to such new ventures)

One way to categorize startups is as lifestyle businesses versus growth businesses.  Don’t jump to the wrong conclusion.  Both are great for the US economy!

In 2004 James Surowiecki, New Yorker business columnist, wrote the Wisdom of Crowds which recognizes that the opinions of groups is routinely more accurate than those of most individuals in the group.  In particular, the author demonstrates that large crowds consistently outperform experts within the group in decision-making.  I sense that the Wisdom of Crowds defines a winning strategy for angel investors, especially those who are members of angel funds. 

One way to categorize startups is as lifestyle businesses versus growth businesses.  Don’t jump to the wrong conclusion.  Both are great for the US economy!

According to J. Sohl, the Center for Venture Research, about 20,000 seed/startup stage entrepreneurs are successful in raising money from angel investors each year in the US.  An additional 30,000 later-stage entrepreneurs raise angel money annually, many of whom raised seed/startup capital from angels earlier.  Angels seem to be making more follow-on investments in portfolio companies because venture capitalists are making few investments in round size less than $5 million.

One entrepreneur has a company which appears to be scalable to a $30 million exit value in 5-8 years and a second entrepreneur’s venture seems to be scalable to $200 million in exit value in the same time frame.  Yet, at the pre-revenue stage of development, angel investors price both companies at a pre-money valuation of $1.5 million.  It doesn’t seem right, huh?

My wife Ann and I just completed a delightful 6-day visit to Warsaw.  Our purpose was to attend the 11th Annual Congress of the European Business Angel Network (EBAN) and to tour Warsaw and Krakow.

The skewed returns for angel investments report by Rob Wiltbank in 2007 for the US and in 2009 for the UK describe a clear strategy for angel investors:   [1] diversity* - invest in a large number of deals (ideally 25 or more) and [2] scalability - invest only in deals that can scale valuation rapidly (ideally to 20X in five to eight years).

A week or so ago, I posted on a new workshop available for entrepreneurs in Montana - sponsored by Montana State Workforce Investment Board and the Governor’s Office of Economic Development (see Financing Startups – A New Workshop for Entrepreneurs).   Here is some additional information on this workshop:

For the past few months, Liz Marchi and I have been developing a new ½-day workshop for entrepreneurs:  Financing a High-Impact Venture (in Montana).  This new seminar was beta tested in Kalispell at Flathead Valley Community College yesterday morning for 22 enthusiastic participants.  Topics covered included capital sources for entrepreneurs, debt versus equity, exits, business plans, fundable companies, advisors, term sheets and valuation.  Content was punctuated with two lively exercises, the first on capital sources followed later with a case study on fundable companies.  I served as the faculty for this workshop.

As I reported last week (Current Pre-money Valuations of Pre-revenue Companies), I met with a group of 40-50 angel leaders to discuss the valuation of seed/startup angel deals at the Angel Capital Association Summit in Boston, April 4-6, 2001.  We reviewed a survey of angel groups all over the country completed last summer (included in last week’s blog) and concluded that valuations are higher in some regions that others.  We agreed that mid-range valuations for firms at this stage of development in most parts of the country are about $1.5 million.

I just returned from the 2011 Angel Capital Association Summit in Boston, April 4-6, 2011.  It was attended by over 500 angels and associates, including about 60 international angel leaders.  It was an excellent meeting – the best yet of the half-dozen or so US ACA angel Summits to date.

Startup companies seldom have robust governance in place prior to raising capital from angel investors. Boards of directors, if in place prior to investment, typically consist of friends, family members and early employees in the company. These directors tend to meet infrequently and are not skilled in assisting the entrepreneur in growing the venture. One condition of funding by professional investors is that an effective board of directors be installed.

The terms and conditions under which angel investors fund startup entrepreneurs are defined by non-binding term sheets.  Liquidation preferences are a commonly negotiated term and come in several flavors:

Since the end of January, we have posted explanations of five methods for establishing the pre-money valuation of pre-revenue companies, specifically:

 The Risk Factor Summation Method the fifth methodology for estimating the pre-money valuation of pre-revenue companies we have described in recent posts.  Readers may have noted that both the Scorecard Method and the Dave Berkus Method considered a narrow set of important criteria for investment in arriving at a pre-money valuation.  The Risk Factor Summation Method, described by the Ohio TechAngels, considers a much broader set of factors in determining the pre-money valuation of pre-revenue companies.  This method may be less useful as a stand-alone valuation method for investors, but it is my opinion that this method should be one of several methods used by early stage investors to establish pre-money valuation, because it forces investors to consider important exogenous factors. 

This column describes the spectrum of capital sources available to entrepreneurs starting businesses. Since the topic is more worthy of a book than a monthly column, links to complete articles on each funding type are provided. Entrepreneur’s Corner would appreciate feedback on both the usefulness of this column and on additional related topics that might be addressed in the future.

The Angel Capital Association (ACA) has announced the inaugural ACA Silvertip Awards. The award winners will represent the best and most successful ACA member portfolio companies throughout North America. All nominations come from our member angels, with the intention to shine a big spotlight on your star investments – and connect your portfolio companies to potential corporate strategic partners. The winners will be announced in an exciting event on April 5th at the ACA Summit in Boston.

We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors. 

We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors. 

We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors. 

VentureHype just published an interview of Bill Payne in which he describes the value of due diligence to investors and comments that angel investors outside Silicon Valley continue to believe that due diligence is critical to their success.

Wise entrepreneurs and investors use multiple methodologies to establish the appropriate pre-money valuation for pre-revenue startup companies, because no single method is particularly effective at this early stage.  Valuation at the time of investment, of course, is critical in determining the percentage of ownership that investors purchase from entrepreneurs in a round of investment.   I plan to describe, in several posts, half-a-dozen such methods used to determine valuation at the time of investment.  Best practice dictates that a weighted average of multiple methodologies be employed.

I received an email solicitation encouraging me to purchase a new book on starting companies by Elizabeth Edwards about two weeks ago.  Now…without explaining further, you can guess what I do with such solicitation.  That’s right…delete!  But, for some reason, I read the email and promptly both bought and read the book.  Am I glad I did!

When entrepreneurs raise money to start and grow their businesses, this capital generally comes in three flavors: Grants, Debt and Equity. It is important that entrepreneurs understand each, especially the cost of these capital source alternatives.

Startup entrepreneurs need to be aware of The Funding Gap between angel investors and venture capitalists. It is quite well-known that startup entrepreneurs first use their own capital and then seek funds from friends and family in the process of productizing their innovation. Only when customers have been identified who have at least beta tested the product will angel investors be interested in looking at the company. And, normally VCs come along later, when larger sums are required to rapidly grow the enterprise.

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I was recently interviewed on The Frank Peters Show  We discussed my five-month visit to New Zealand during the first half of 2010 and the new workshop I developed since returning entitled Valuation of Early Stage Companies.  Frank drills down on many valuation issues important to entrepreneurs and investors alike.

In a recent discussion in Vancouver, Basil Peters and I discussed the fact that many angels are not making money on their portfolio of startup ventures.  Then, our friend Frank Peters, host of The Frank Peters Show, invited Basil, Mark Skaist and me to discuss this topic on his show. 

Business plans have many forms. When entrepreneurs come to the attention of potential investors, they may be invited to make verbal presentations to a select group of investors. This is commonly accompanied by a PowerPoint presentation. Click here for the content that should be included in your PowerPoint pitch to angel investors.

Last September, Peter Thiel made an audacious offer to student entrepreneurs less than 20 years of age:  $100,000 each to 20 entrepreneurs to drop out of college to pursue high tech entrepreneurial ventures.  Personally, I think this is a poor message to university students.  Sure…Bill Gates, Michael Dell and
Mark Zuckerberg did it and were wildly successful.  But, the odds of success are miniscule.  Statistics show that a college diploma has tremendous value to the youth of our country.  Why suggest an alternate route to our brightest and best?

I have written a lot recently about entrepreneurs’ business plans.  Here is an article on the various forms of business plans and when to use them and another on the content of business plans.  But, as Richard Perry recently pointed out, I have not discussed video pitches.  Ok…here goes!

Basil Peters is acknowledged as the first to recognize and document the importance of an early exit strategy to entrepreneurs and early stage investors alike.  In the past few months, Basil and I have developed a ½-day workshop, which has now been delivered on several occasions and is ready for your community.

Rich Karlgaard, publisher of Forbes magazine has it exactly right in his blog, What Grows an Economy.  Economic growth in the US is a result of entrepreneurial activity.  Entrepreneurs create all the jobs.  In the past fifty years ours has become an entrepreneurial economy.  The US must start thinking more about encouraging entrepreneurs and less about stimulus packages to bail out big businesses.

In September, I mentioned I spent my summer developing a new ½-day workshop for the Angel Capital Education Foundation on establishing the pre-money valuation of pre-revenue startup companies.  This workshop has now been delivered several times to rave reviews from audiences of entrepreneurs and angel investors.  Let me tell you a little about it.

A business plan is a comprehensive description (20-50 pages) of a commercial venture including a description of the product or service, the management team necessary for success of the business, the sales and marketing techniques to be used by the management team to find and delight customers, the pro forma financials for the business, key operating issues for the company and a growth plan for the future. A brief description of each of these features of business plans are described below.
 

A recent article in Forbes references, two studies that support my ongoing opinion that transfer from US universities into both existing businesses and startup ventures is really, really difficult to do, currently ineffective and surely in need of a major overhaul.

Everyone who understands the capital food chain for entrepreneurs is aware of the huge capital gap that has appeared in the past decade.  Very little capital is available in the US for rounds of $1 million to $5 million.  Angels have for decades funded deals of $200K to $1 million.  Until the late ‘90s, VCs funded round of funding from $2 million and up.  But, for a variety of reasons, the minimum rounds size for most traditional VCs is now about $5 million.  The gap is well-know and quite troubling.

I chuckle when I read Silicon Valley pundits attempt to generalize on the characteristics of US entrepreneurs and their source of capital based of information gleaned from surveys of Silicon Valley folks.  Such is the case with the Dorsey and Whitney (D&W) survey, “What Really Matters to Startup Entrepreneurs” released last month.

Last week, Tom Foremski  suggested that the angel strategy of commercializing innovations and then rather quickly selling the startups was stifling innovation.  In doing so, Tom referenced Max Levchin’s recent blog in which he suggested that while this strategy makes money for the angels, it tends to discourage building breakthrough companies.  The implication is that early exits to the buyers such as Google, Apple and Cisco limit the full exploitation of such innovations.

“I have often heard investors state that they do not read business plans, implying that entrepreneurs need not write them. I disagree. Entrepreneurs need to write business plans.”  See Bill’s recent article on business plans.

 Super Angels are high profile entrepreneurs-turned-investors, mostly in Silicon Valley, doing rapid-fire investing in startup entrepreneurs.  For many, 10-20 investments per year is the objective.  They are now raising small VC funds to finance even more ventures.  Are Super Angels a positive influence on the entrepreneurial economy?  Let’s take a look at the pros and cons.

With all this excitement about Super Angels investing in Silicon Valley startup ventures, are they beginning to dominate, dare I suggest, take over the world of angel investing?  Or, even the world of seed/startup stage investing?

What’s all the hubbub about Super Angels?  Well, some high profile entrepreneurs-turned-investors, mostly in Silicon Valley, have been doing some rapid-fire investing in startup entrepreneurs.  In the process, they began to accumulate some nice press (see our recent post) and lots of attention.  And, wanting to do more investing in startup ventures, many of these well-known Super Angels raised small pooled funds from friends and others to invest in very early stage companies.
 

As many of you know, high-growth entrepreneurs seek capital from three generally non-competing sources:  Friend & Family, Angel Investors and Venture Capitalists.  F&F often invest up to $100K in idea-stage companies (no product, no customers).  Angel investors provide funding in amounts ranging from $100K to $1 million to companies with at least a prototype product which early-adopter customers have tested and want to purchase.  Venture capitalists (VCs) invest $4 million and up to companies with revenues and sometimes for biotech companies for FDA compliance testing.

I spent my summer developing a new ½ day workshop on the valuation of pre-revenue start-up companies for angel investors and entrepreneurs.  It is now complete and will be delivered in Tucson, Grand Forks, ND and Philadelphia in the next six weeks.  This was a volunteer project I completed for the Angel Capital Education Foundation.

Have you noticed all the great press given to Super Angels by the Business Week and the Wall Street Journal?

As you may have read in my last post, I believe entrepreneurs should write business plans – for themselves and for investors.  You’ve probably also noticed that business plans come in several flavors.  Let me describe them and explain how, as an investor, I suggest that entrepreneurs use business plans.

Too often you read about investors who suggest to entrepreneurs that business plans are unimportant and they never read them.  I think this is poor advice for entrepreneurs, because business plans are not just written for investors.  Writing business plans forces entrepreneurs to think through and then describe in writing all aspects of their business.

In my last post, I poked fun at Eric Ries and Steven Blank for an article posted by the New York Times suggesting that “lean startups” are a fresh new approach, which is likened to bootstrapping. I pointed out that we outside of Silicon Valley have been bootstrapping our startup ventures for decades because venture capital is not nearly as available anywhere in the world than it is in Silicon Valley.

In all of my travels, I explain to audiences that there are only two places in the world for entrepreneurs starting companies and seeking capital – (1) Silicon Valley … and (2) everyplace else.  Except for those in the Bay Area, almost all the rest of us live and work in fly-over (or fly-around) states and countries.  The innovation in Silicon Valley is amazing and the sources of capital to support startup based on this innovation has been quite robust.  But, sometimes our friends in the Valley need to get out more…and see how the rest of us start and fund companies.

A summary report from the interns that carried Bill Payne's bags while in New Zealand

Ann and I have truly enjoyed our five month visit to beautiful New Zealand.  Lovely country and really friendly Kiwis – what a wonderful place!

I think tech transfer (TT) out of publicly-funded research organizations is really, really hard to do.    Here are a series of bullet points expressing my point of view on TT:

My friend, Brad Feld, is a prolific angel and venture capital investor.  More importantly, he is really smart and a genuinely right-minded proponent of entrepreneurs.  Brad wrote an insightful article on June 2nd for Business Insider entitled After More Than 75 Angel Investments, Here's What I've Learned.  This is must reading for all angel investors and entrepreneurs seeking angel capital.

I was a solo angel investor from 1980 until 2000 and made a significant fraction of my 52 angel investments during that period.  Solo angel investing is just plain hard work.  I found that, as a solo angel, it was difficult to complete adequate due diligence and very time-consuming to provide sufficient mentoring to portfolio companies.  Furthermore, soliciting financial investment from other accredited investors was limited to those in my personal network.

Dean Greg Whittred (UABS) interviewed Bill to discuss angel investing and the environment for entrepreneurs seeking capital in New Zealand

As has been reported in an earlier post, angels with a diversified portfolio of invested companies should expect to earn about 25% IRR over a decade or so of angel investing.  A frequent question from new investors is: “but what is your return on time invested in portfolio companies?”

A frequent question from entrepreneurs is “how much ownership do angels expect to purchase with their investment in my start-up venture?”

In the last post, I described the two most important characteristics of a fundable deal, that is, the entrepreneur/management team and the scalability of the business model.  So what are the additional features that can make or break an entrepreneur’s business plan?

The two most important attributes of a fundable deal for angels is the quality of the entrepreneur and management team and the scalability of the venture.

In an earlier post, I addressed the issue Is a Respectable ROI an Achievable Metric for Angels? and concluded that, under certain conditions, reasonable returns could be achieved from an angel’s portfolio.  My conclusions were based on a study by Professor Rob Wiltbank at Willamette University (near Portland, OR) Returns to Angels in Groups.  Please allow me to elaborate on my earlier work to provide an example of what might be expected from such a portfolio.

Over the past couple of decades, angels have consistently chosen to invest in software deals, more frequently than ventures in other sectors.  Software companies generally scale quickly and produce high gross margins.  When coupled with a great management team and a significant head start, software companies can produce wonderful returns for entrepreneurs and investors alike.

In his recent blog Don't Take Angel Investments From VCs, Bill Burnham cautions entrepreneurs not to include venture capitalists among investors in an angel round.  His premise is that these same VCs may choose to offer the entrepreneurs an onerous term sheet (low valuation, etc.) at the point the entrepreneur need to raise more capital.  If the entrepreneur chooses to ignore this “low ball” offer, the VCs may then attempt to dissuade other investors from making an offer.  Burnham’s logic is sound – it is possible that a VC could choose this strategy for taking control of the company.

Bill Payne has the perfect retirement job. The United States angel investor remains active in his first passion, business, while also having time for fishing and golf. An advocate for angel investing, Mr Payne speaks to business reporter Neal Wallace.

Derek Sivers points out a critical issue to startup companies:  Intellectual Property has LITTLE OR NO VALUE without execution by the entrepreneur and management team.  Here is his blog:

Professional investors, angels and venture capitalists alike, often stipulate that companies in which they invest establish a second class of stock (preferred, in addition to ordinary or common shares) and that the investors then purchase preferred securities.  What are the advantages to investors of preferred shares?

Angel investors are important capital sources for entrepreneurs, providing cash as debt, some of which may be converted later into equity, or more commonly to purchase equity interests in the company.  Seasoned angel investors favor funding seed and startup companies by purchasing preferred shares, rather than simply owning common (ordinary) shares or convertible debt (see: Angels: Convertible Debt Is Seldom the Right Security for Startup Investments and When is Convertible Debt the Right Instrument for Angel Investments?)

It seems everywhere I travel I find another “center of excellence” in Biotechnology and Life Science.  R&D in these arenas seems to grow and flourish.  Those with a focus on commercializing this science are then quite disappointed when angels express low enthusiasm for their particular projects.  Let me explain why.

Bill Payne, a prolific US investor who has set up four Angel investment networks, is in New Zealand for five months to offer his expertise as the BNZ University of Auckland, business school entreprener in residence.

The Australian Association of Angel Investors (AAAI) held their 3rd annual meeting in Adelaide last week.  Attendance was over 125, showing a steady increase over the past three years.  The messages of interest were consistent with what we are learning around the world.

To provide members with a broad selection of opportunities to invest in quality start-up ventures, angel groups encourage and are prepared to manage rather high deal flow.  Here are typical deal flow statistics for angel groups:

I read a blog post by Bill Burnham this week entitled Don't Take Angel Investment from VCs.  He gave the following example to make his point (my paraphrase):  An angel/VC that invested in the angel round tried to pre-empt the Series A fundraising in a company with a low-ball term sheet.  The entrepreneur thought he could do better and politely told the angel/VC “thanks, but I’d like to test the market”.  The response was swift and furious.  The angel/VC told the entrepreneur he had to accept the offer or the angel/VC wouldn’t invest in the Series A round  -  dramatically reducing the chance of raising money because other VCs would assume that the angel/VC wasn’t investing was because there was something wrong with the company.

 Back in the ‘70s, David Birch of MIT startled the world by reporting that US government data showed the predominance of new jobs in the US were created by startup companies.  Most mainstream economists scoffed at these results, since “everybody” knows that big companies create new jobs.

In my last post, I confessed that a decade ago I was skeptical about the value of national organizations of angels and angel groups, but I was wrong.   Despite my doubts, I participated as a member of the organization committee of the Angel Capital Association in the US.  Since then I have been engaged with AANZ (New Zealand), AAAI (Australia), BBAN (UK), NAO (Canada) and EBAN (Europe).  

In recent posts, I have described the growing US capital gap between typical angel and VCs round size.  US angels generally invest in rounds of $200K and $1 million, while VCs have moved from rounds of $2-3 million in the ‘90s to rounds of $7-8 million today.  This gap is quite troubling for entrepreneurs seeking investment between $1 and $5 million and for us angels who provide seed capital for their startups.

In an earlier post, I reported that angels in some US groups are investing in more angel-only deals, that is, startups for which less than $1 million in funding will provide sufficient runway to achieve positive cash flow.  Angels are electing to seek out and invest is such deals because venture capital in the range of $1 to $5 million is less available than in the past.  As I pointed out earlier, the world of venture capital in the US is changing rapidly – and not for the better.  VCs are funding fewer deals with a higher fraction as later stage deals.   US VCs are investing larger sums in total in each venture and waiting longer, hoping for larger exits.

I have been suggesting for some time that the US VC model is, indeed, broken.

In my last post, I described the trend among angel groups in the US to fund more angel-only deals, primarily because of the changing world of US venture capital.  I did so without really describing the characteristics of angel-only deals.

Because the US is a large country with huge demographic variety, venture capital has thrived in a few regions and is virtually unavailable elsewhere.  Venture capitalists prefer not to travel to portfolio companies, investing instead close to home.  Consequently, while angel groups in a few regions do a high percentage of their deals with VCs, most angel groups seek and fund deals that will not require subsequent VC funding – “angel-only deals.”

In my last post, I concluded that convertible debt securities are seldom appropriate for angel investments.  My primary conclusion was that using convertible debt was likely to substantially reduce the ROI of “smash hits,” those 7% of angel investment that provide 75% of our ROI.

Just after the Internet bubble burst in 2001, many of us angels were “crammed down” unmercifully by subsequent investors in our portfolio companies.  These new investors were funding our companies at valuation far below the pricing we had agreed to earlier, resulting in substantial dilution to our ownership.  To avoid these “cram downs”, some angels began investing in startups using debt instruments that convert to equity at the same time and under the same terms as subsequent investors, with a small discount in pricing, based on the greater risk in our earlier investment.  While there are some advantages to using convertible debt for early stage investments by angels, I dislike these instruments and seldom use them.

Until the mid-‘90s, the quality and consistency of term sheets offered by angels to entrepreneurs varied considerably.  Some were sophisticated while most were not – as if written on the back of an envelope.  Angels and entrepreneurs did other deals with only a hand-shake - no term sheet at all!

I’ve been asked for thirty years if due diligence on angel deals really pays off.  Are we angels better served spending substantial time with entrepreneurs before investing or should we simply to throw darts at a list of deals to pick companies in which we invest?  Frankly, I didn’t have a quantitative answer until November 2007.

Bill Payne, Entrepreneur in Residence at The Kaufman Foundation, says that most start-ups fail due to a lack of execution.

 I’ve been funding startups as an angel investor since 1980 without having a good answer to this question.  Early stage VCs seem to earn over 20% IRR (annual internal rate of return), so my thought has been that angels should earn even more.  After all, we generally invest earlier with more risk than do seed VCs.  My own portfolio has done well, but one cannot base any conclusions on one lucky chap.

Wait a minute. Before describing why I think It’s a GREAT Time to be an Angel!, let’s level the playing field. Just what is an angel investor? Wealthy investors have been providing funding and advice to new entrepreneurs for thousands of years. In 1983, Professor Bill Wetzel at the University of New Hampshire recognized the analogy between “Broadway angels” – those who funded new plays in New York City – and “business angels” – those who fund and bring business savvy to new business ventures, hence the term “angel investors” (or business angels in some regions of the world).