The Exit Slide

In the “angel pitches” I see in our meetings, the Exit Slide seems to be frequently a weak part of the presentation. This is unfortunate because the Exit constitutes the major determinant of the pay off that investors may expect.  Why? Because investors typically do not see any return of, or on, capital until the Exit. The valuation of the company when sold will determine the pay out. The IPO case, most likely farther away in time, is much the same as the market valuation would reflect similar considerations.  Let’s focus then on the M&A Exit.

The following discussion involves many generalizations. As with most generalizations, countless exceptions can be found.  However, investors rely on these generalizations particularly to form first impressions in their due diligence. A wise pitcher, then, should be aware of those perspectives and speak to them.

Apart from strategic considerations unique to the acquirer, the M&A valuation of the venture being acquired will reflect the growth rate in sales and earnings (or reduction of losses) as prognosticators of future profitable growth. 

Moreover, the valuation will also reflect some multiple of annual revenues, which number correlates with other companies in the same industry. The correlation exists because that multiple reflects each industry’s underlying fundamental risk.  Some examples:

Rapid scaling of a software, or cloud-based, product or service is relatively easier than scaling a business that requires heavy capital investments. Similarly a line of “fashion” products that depend heavily on the company’s design guru to hit the sweat spot of unpredictable consumers carries inherent risks.  

Ski manufacturers live in a very competitive and concentrated market where product performance is difficult for consumers to measure (few can try before they buy) and where the appeal of the graphic design and style can make or break a sale. This complex and unfavorable state of affairs is reflected in the revenue multiple that applies to most M&A in skis and sporting goods: 1X. That multiple, in essence, says that acquiring companies give a low probability of repeatability of profits' growth. Conversely, medical devices valuations are in the range of 3 to 5 and even 10 times revenues, which reflects that, most often, once they gain traction, they have patents to protect their markets and margins, and can grow more reliably.

To make the case for your venture's projected valuation at the time of exit, present the following

• A few examples (3-4) of recent acquisitions in your space showing names, valuations, revenues and resulting multiples in each case.
• Show an average, perhaps adjusted for outliers or special cases.
• If acquisitions of companies like yours do not exist (seldom the case) use the closest proxies you can reasonably find
• Using the data above, make a supported claim of your valuation under similar circumstances based on the revenues projected at time of exit
• Calculate the investors’ projected return based on the % of your business that you offer to trade for the desired funding. Note: This simple extrapolation works if you project a single funding event to take you to the exit.  If future rounds are contemplated, you have to adjust the analysis for dilution from those events.
• Do not explain the logic in the slide, do that verbally. The slide only summarizes the data the audience needs to follow your explanation.

 Note:  My post AngelCalc elaborates these concepts further and includes a working calculator to do the math for you.  Be sure to understand the use of the factor “Probability of success” as it reflects the maturity of your venture.  If pre-, or nominal revenue, probably no adjustment is needed.  AngelCalc can also be a test for the attractiveness of the terms you offer vis-à-vis investors’ likely expectations.

Marco Messina

Angel Calc Revisited

Do you know when your young business venture is "fit" to attract angel investor financing?

There are many theories and rules of thumb about how angels investors seek their ROI targets. To understand their motivations and ROI targets, let's look at how they work and the risks they face when writing a check:

Experienced Angels are the real Angels you want to work with. Most work in groups to share the heavy burden of due diligence research required to invest intelligently. To vet deals they try to include scientists, engineers and management experts in different industries and technologies. They ask a lot of questions and then more questions and then proof and supporting documentation. They generally do not move fast but cover their bases well. When they invest they will stay involved and help the management team with seasoned advice and working their contacts to help your business succeed. These are true ANGELS to entrepreneurs.

A High Risk Game
Research by the Kaufman Foundation (KF) shows that Experienced and committed angels' returns are on average quite attractive at 2.6 times their investment in 3.5 years. That, however, is balanced by the sobering fact that on average 52% of investments are a total loss and only 10-19% are a home run. Successful deals need on average 7 years to exit.

In my early days in this "bloody contact sport" my mentors cautioned me that a good rule of thumb was to consider a very early stage deal only if I could see a potential to earn 30 times my investment in about 5 years. Later on I tried to reconcile the KF statistics, my experience and the very demanding ROI target I was advised.  Eventually I modeled that all factors can be reconciled if one presumes that the probability of success of a well researched deal is only about 10-12%.

From experience I believe that it is a reasonable and not overly pessimistic expectation considering that the typical early stage business reflects most of these characteristics: Little or no sales, limited proof of market, may have lab tested technology, but little or no production, no proof of scalability, little or no delivery and distribution experience. Moreover, any of the following may apply:  a. in "some other garage" a similar or better mousetrap may be ready to come to market, b. the management team may have or may develop unforeseeable weaknesses (e.g. sociopathy leading to financial embezzlement, personality incompatibilities, office love affairs, divorces, loss of key talent due to death, accident, distraction, etc. - Over 35 years I experienced all of them as causes of aborted successful businesses); c. "effective" IP protection may prove difficult to obtain, may be revoked if prior art appears unexpectedly (see my posts on patents), inadequate funds to protect owned patents, exposure to Patent Trolls;  d. government regulations that may prevent or delay market acceptance, unforeseen vested interests that may create insurmountable barriers to market acceptance.

All considered the 10-12% probability may even be optimistic, but it appears to be what angels use implicitly if not explicitly.  To balance this somewhat dark view, we play this game  for the few successes that give us the satisfaction of helping turn dreams into reality, sometimes making a difference in the world and perhaps history while making a ton of money (in only 10% of cases)

So, with all this in mind, below is AngelCalc (copyright Marco Messina 2007-2013). Its intent is to help you test if your business has sufficiently high growth and profitability potential in an industry with sufficiently high exit valuations to satisfy the requirements of experienced Angels.  This is generally unlikely unless you have a unique IP component, market dominance potential, very rapid scalability. If your business cannot meet the angels' criteria, your funding efforts will be better put elsewhere. F&F (friends and family) may be an alternative at least until the criteria may be met.

A different analysis that comes to the same 30X ROI target is found in the section What do angels target for returns?  at page 3 of this KF paper

AngelCalc - Calculating with Angels
This model attempts to explain the finance-ability of a business based on angel investors' required returns.

The prime objective is not to set a valuation, although it can be used to back into or to validate a valuation that investors could live with. Primarily, it seeks to determine whether the relationship among the following factors allows a viable solution that meets investors criteria.

There are two paths each with its own factors:

P/E-Multiple Valuation (as for a public company):

1.  time horizon is 5 yrs, 
2.  future EBITA,
3.  future PE and market cap (from current comparables),
4.  investor's average returns and required return,
5.  the ASK needed to implement the plan
6.  The % equity to give up for the ASK

Revenues Multiples Valuation (most often for M&A sale of the company)

1.  Time horizon is 5 years
2.  Revenues in year 5
3.  Applicable multiplier for comparable companies sold
4.  investor's average returns and required return,
5.  the ASK needed to implement the plan
6.  The % equity to give up for the ASK

With both valuation methods the implied probability of success is 12% because it reconciles the return multiple identified by the Kaufman Foundation research (2.6 times return in 3.5 years) with the rule of thumb often quoted of "30 times the investment".  It can be adjusted to reflect the maturity (de-risking) of the company (e.g. VCs who invest at later stages often target 10X or 38% probability of success)

See input instructions above

Questons or comments? I'd love to hear from you, particulalry if you disagree.

Good luck. May you be so lucky to find a REAL ANGEL.

Marco Messina
The Angel Pitch Guy

A Blind Spot - Reflections on technology and obsolescence

For my friends the young tech-preneurs that follow this blog, I decided to share my 40 years perspective on the growth and decline of new technologies.  It is a personal experience that I hope may help understanding the process at work and may prevent them from repeating some of the blunders I made from incorrect assumptions.

Background
I am 61, grew up in Europe in a family of several generations of entrepreneurs. Went to university in the US ad got a BA in Psychology and MBA in International Business, Finance and Accounting.  From those experiences I developed a curiosity for technology - perhaps I am lazy and I valued technology's leverage to let me do more for less effort. I was blessed to grow up in the dawn of computer technology - I remember at age 9, my father, an engineer, tell me of his wonder at his first encounter with IBM computers and punched cards, etc. in 1960; it was a glimpse of the future and I was sold.  My MBA thesis, 14 years later, would be a FORTRAN program for financial analysis, a box of punched cards (three months of work in 1973 that I replicated in 1983 with Lotus 123 in three hours).
My career as a banker and later as serial entrepreneur was always leveraged by using computing technology from HP calculators to punched cards, to Apple II, to CPM microprocessors to DOS and Windows. I tinkered with these tools sooner and more than most people I knew. I saw the future coming and I wanted to usher it in.

Possible insights
My fascination with digital technology led me to always overestimate how quickly the "computing future" would come, how fast the masses would adopt and how fast "older stuff" would be abandoned. The reality is that except for early adopters, the masses are slow to abandon old habits and do so only when the process of change is easy.  The change that to me was challenging, fun and satisfied my curiosity, to most others was hard work, so broad based technology acceptance was always late.

This blind spot probably was the root of all business failures or slower-than-hoped successes I had. It was really unjustified since I was privileged to insight to the contrary. Shame on me; here is one example:

In 1983 I worked for a company in Seattle, DP Enterprises, that had two existing product lines: 1. selling IBM minicomputers and 2. maintaining the left-over key punch machines still needed to run the first generation mainframes. I was product manager of the minicomputers line, I disdained the old junk keypunches, and longed to transfer to a new upcoming initiative to sell the new-on-the-market IBM PCs (floppy disk only, XTs would come later).  Ed Benshoof, the owner, was making money faster than he could count it and built one of the biggest and nicest office buildings in town, overlooking Lake Union and with his penthouse on top of it . I heard that the profits were coming disproportionately from the "junk dealer business" of scavenging parts, refurbishing and reselling keypunches to companies with very old mainframes that could not afford the conversion costs to migrate to "my" newer minicomputers.
Duh! Even my seven year old son could have drawn the right conclusion. Not me. I was smitten with the future, only too soon.

Countless other ventures followed with too-soon-technologies that would eventually be applauded when I had moved on to.  Some of the ideas I followed paid off well enough, but I could have saved myself a lot of troubles if that blind spot had not been there.

Lessons learned

• Do not bet on fast mass adoption of anything that requires learning, work or effort. It's not that people are dumb, they just have better things to do with their time.
• Fast adoption happens only with super-intuitive products that require virtually no learning (all benefits no costs), like smart phones of the iPhone and Android generation (not the earlier Palm Pilots), or like the iPad and Android tablets (not the Windows tablets of 2002-3)
• Particularly for small businesses (cash strapped) and very large enterprises (logistically bound), obsolescence does not mean that the obsolete product goes into the garbage can.  It will continue in use if no effort or cost is involved in its continued use. It may be re-purposed if the required effort is minimal (e.g. a PC passed down to children, secretaries, assistants, warehouse staff, kiosk, etc.)
• Where complex or critical systems are involved the cost of changeover will be accepted only when the benefit is substantial. The more complex, mission critical the system the slower the changeover
• For most products, changes in User Interface (UI) are very risky as they require users to learn something different: 1. unlearn the familiar and 2. relearn the unfamiliar. If it is hugely beneficial they will do it, else they will resist.  That is why 30% of PCs still run XP after 10 years that sales stopped, that is why it took years for Windows 7 to get market penetration equal to Vista (the epitome of a dog failed product), and why Windows 8 is getting no traction.  It is also the reason why all cars still have steering wheels, sticks to put in gear automatic transmissions !?, keys to start, knobs to control A/C, radio, etc.

Marco Messina

Patents - Great News and Not So Great

Today, the news below is GREAT news.  One of the worst Patent Trolls (it's synonymous with scum bags) has finally been thrown down the toilet where it belongs along with all its peers "non practicing entities"

The Web’s longest nightmare ends: Eolas patents are dead on appeal

Web pioneers united to stop "interactive web" patents at an East Texas trial.

For entrepreneurs pitching investors the glories of their patents, filed and issues, however, the news has also another slant. It reminds investors that even issued patents can be disallowed if prior art is brought to the PTO. It is a tough and expensive battle, so a patent is still well worth having.  However from the many instances similar to this one (some reported in this blog) investors have learned that patents have also real costs beyond filing and prosecution. They need to be defended, and that is expensive, or they need to be enforced, even more expensive.  Are they ready to see their investments re-purposed to IP litigation fees?  Probably not and certainly not before our company has grown very fat cash reserves.

Conclusion: if you have a patent it is better than not, point it out as an asset, but (outside the pharma sector) do not count on it making the impression it used to.

Marco Messina

Startups, Sales, and Sales Hires

You have a startup, you seek funding and your investors appear singly focused on your sales. If only you only had more sales! If only you had a sales person. May be so, but it more likely not.
The best case made that I have read in this regard is reprinted below from Matthew Bellows, CEO of Yesware.
Beware the Sales Hire.To address the concerns of your investors you may need more results from a "Cofounder/Selling CEO" as referenced below. If you cannot do it, then find one, but it is a very different talent that a Salesperson.  Read carefully

You're Not Ready for a Sales Hire: 4 Reasons 

Hiring a salesperson too early is a good way to distract your team and waste money. But there are three signs when it is time.

Do you work in a start-up? Do you look around every once in a while and say, "You know what we need? We need to hire a salesperson to really get this company off the ground?" Well, you're probably wrong.

It's strange for me, a lifelong salesman who started a company to help salespeople, to advocate not hiring one of my own. But that's exactly what I'm suggesting, at least until you and your company are ready. Here's why:

1. Salespeople need something to sell.

Some thing—not a concept or a prototype. In general, salespeople stink atproduct development. They excel at revenue development. If you are envisioning a great salesperson rounding up customers for your idea, your beta trial, or your brand new service, then you are dreaming . Good morning sunshine!

2. Salespeople are expensive.

The better a salesperson is, the more expensive he is. If a salesperson feels your product isn't ready to bring to his contacts, she will hold back. Experienced salespeople are more protective of their contacts than the memory of their high school sweetheart. So for every day that your new sales gun thinks your product isn't awesome, she is paying a big opportunity cost by working at your start-up.And she is going to charge you for it either in money or in frustration.

And if you find a salesperson who offers to work for equity, ask her how many times she's blown away her quota.  Chances are she never has.  Don't make the hire. If you do find the exception to the rule, that person isn't in sales—she is a co-founder. Give her equity (that vests). 

3. Salespeople are hopelessly optimistic.

If you hire a salesperson, he is going to run at the job like a pole-vaulter. Heknows he'll clear the pole. But it's a rare salesperson who can keep the energy up if he doesn't get quick, positive feedback from potential customers. After a couple of weeks of failing, most good salespeople are going to start thinking about other poles they could be clearing. And the ones that just want to hang on to the job? Well, there's no quicker way to murder your company vibe than listening to your new salesman get dinged on 60 cold calls a day.

4. Salespeople are mostly risk-adverse.

Call it the curse of the fat bonus. A salesperson who has made $200,000 or $300,000 for a few years in a row is going to be counting the days until she can make that again. There just aren't that many money-really-doesn't-mean much-to-me-it's-the-work-that's-important kind of salespeople. 

So please, don't hire a salesperson to figure out what your customers need or whether they will buy some future product that might have some certain set of features. That's the job of the founding CEO. Yes, it's your job, even if you are an engineer.

How do you know that you are ready to hire a salesperson? Consider these three things: 

1. There's enough opportunity.

It will vary by company, but $1 million is the number I use. There has to be another $1 million in revenue that you can identify but that you cannot pull into your company because you are too busy selling to other people. If you can identify $1 million worth of prospects, it's a great time to hire a salesperson.

2. Your product is awesome.

What does that mean to a salesperson? It means you have reference clients—paying customers who the salesperson can leverage. When she sees your customer list, you want her to think, "Oh man, if the founder can get these customers, I am going to KILL IT here."

3. Your culture can handle an influx of sales energy.

If you have a tight, technical team, bringing in salespeople is going to change the atmosphere like a high-pressure system moving into the tropics. Batten down the hatches.

Hiring a salesperson too early is a great way to distract the team, waste your money, and bury a company. Hiring one too late means you won't grow as fast as you otherwise could. It's best to be on time, of course, but given the risks and rewards, it's much better to wait until you, your product, and your company have reached some of the milestones I've mentioned. Then make that first sales hire.

Matthew Bellows is CEO of Yesware, an email service that helps salespeople track conversations, create sales templates, sync emails with CRM and much more. @mbellows

Working Backwards

New entrepreneurs seeking funding from angel investors often appear surprised by the multitude of considerations and requirements they must satisfy to get funded. If they can keep both the big picture and the details in perspective, the puzzle is not so difficult to solve.

Working backwards from the investors' requirements and preferences one can create a proposal that will "sell" provided that all the underlying reasoning, projections and plan are supported and convincing. Conversely, if you cannot make a credible case that your venture meets the investors' criteria time may be better spent seeking other forms of financing.

You can navigate the roadmap below opening  and closing various branches to look into the details and reasoning behind them, or hide them to stay focused on specific HOW and WHY of various aspects of the problem.

I am experimenting with this method of communication. It allows you to switch between details and summary views.  Your comments would be greatly appreciated. Is this method effective for you or not? In either case why? Thanks Email me

Working Backwards