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

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

User Interfaces, Arrogance and Opportunity

Disclosure
In the interest of full disclosure I'll admit to some personal and painful experience with User Interfaces (UI).  They probably colored my perspective to this day.
The first UI we learn as humans is language which allows us to interface with mom and other humans. In the US in particular, most people learn the "language UI" only once - English.  As an immigrant from Italy in 1970 (before English had became the world's global language) I suffered the cost of confronting my UI (Italian) abruptly obsoleted and I had to waste a whole semester studying English as second language before I could start full speed with my real courses (not an inconsiderable penalty considering that I still completed a BA and MBA in 4 years).

Looking back, then I chose to almost completely abandon using Italian in favor of English (the former I would not forget while the latter is still a work in progress). I distinctly remember that bargain: Pay a price to get something valuable for the rest of my life.  The alternatives were to go back to Italy or to limit my future to an Italian language neighborhood: both were easier, neither had ROI.

The cost of UI changes
I think all UI changes reflect the same ROI calculation I did back then. The fact that, despite all the push for Vista and Win7, XP still has a 70+ % market share, in my view, reflects that same calculus:  Why invest effort and incur the cost of disruption (personal or organizational or both) to change to a UI that does not have a compelling, demonstrable unquestionable advantage?  70% so far say NO.

Furthermore, to follow Microsoft into the promised land we'd have to trash perfectly viable PCs that just happen to have an engine insufficient for the new OS.  It is like GM offering you a car that carries no more people, goes no faster, saves no money and requires you to learn to drive with a joystick sitting backwards and looking at the road through a mirror - eventually you'll like it.

Arrogance as a strategy
Todays' announcement that the miraculously uncluttered, minimalist new-design Internet Explorer 9 (IE9) will not run on XP is the reflection of an arrogance we would not tolerate from automakers.  It's tantamount to GM announcing cars wider than the lanes in our roads, for awesome benefits to be sure, like improved cornering stability, or all passengers sitting in first raw, and replying to our objections with "build new roads" (a "let them eat cake" attitude comes to mind).

In the days when most (low power) cell phones can sport an effective web browser, one has to wonder the necessity of dumping viable PCs just because they cannot run Win7 and IE9 - has anyone heard we are in a recession?  Yet the me-too desire for IE9 will prompt many to "eat cake": buy new expensive hardware with a new OS and IE9 to do no more than an iPhone or Android phone would do.  Arrogance may pay off after all.

Opportunities abound
Arrogance however always carries a price to be paid when the American public abruptly switches to alternate suppliers more responsive to their needs: see the experiences of GM and Toyota, Internet Explorer and Firefox/Chrome, Motorola and HTC/Nokia/et al., United/USAir and Sothwest/JetBlue, and so on.

One would be tempted to add to the above list Microsoft and Linux/Ubuntu, but we cannot.  It may be a sea change in the making with Android (an Ubuntu skin), but is not yet here.  Why after 10 years of Linux has it not happened?  It's not the economy, stupid; it's the UI.  Yes, the UI.

Linux in all its incarnations can run better than XP on old PCs (as on new cell phones) and can deliver equivalent or the exact same applications (through WINE) but pigheadedly keeps coming out requiring the user to adapt to a  new UI. If there were a benefit to that UI change users would do it, but since there isn't they just don't change - 70% market shares says so.

Geeks and Linux fans spend much effort touting the greater elegance and whatever many other strengths, but seem to be totally oblivious to the fact that Toyota can pull customers away from GM and Ford ONLY BECAUSE THE UI IS THE SAME and the technical improvements/advantages require NO learning curve.

In the business parlance of the day the saying goes: OUR (business/product) value proposition is...  That's great because it means we understand that a value proposition is key, but we should strive to phrase it in terms of THE BUYER, not in our terms.  Perhaps: FOR CUSTOMERS THAT WANT X we offer Y that does..  It would set the right frame of mind for OUR mind.

So, in closing here is a thought for all of you innovators out there looking for ideas: Produce a Linux that looks and feels (the UI) identical to XP, so that "XP migrants" have NOTHING to learn, make it run like Ubuntu on old PCs (those obsoleted by Win7), with a minimalist looking IE9-style web browser that requires no new PC and OS (Firefox/Chrome?).

Beware - The window of opportunity is closing fast. Android, a garden open to all, will soon deliver a uniform UI from cellphone-to-tablet and eventually to PCs (as Apple promises from pad-to-phone).  If a new option with an XP-UI appears, it can still capture the transition moment, and you can capture a market, else the UI consistency from phone-to-PC promised by Android will be the David's stone that slays the arrogant Goliath.

Either way it will be the UI, not the power, not the features, not the economy, the UI.

P.S. I loved my birth language UI, I changed it because of the ROI, but cannot forget the price I paid
Ciao
Marco Messina

Fishing for Angel Fish

The scarcest resource of entrepreneurs is not money, is time.  Money, when you can get it, is just a means to increase available time by hiring outsiders to do for you whatever you are smart enough to delegate and manage.  Conversely, all the money in the world will achieve nothing more than the going rate of interest in a bank account (3%) unless one puts it to work with time and energy. SO, NEVER WASTE  TIME.


One way I see many entrepreneurs wasting time is chasing funding from angel investors with propositions that do not come close to having any chance of success.  It is like going fishing for the wrong fish in the wrong pond with the wrong bait - most unlikely to make dinner tonight.

So in the interest of better fishing let's study the angel fish.  It is easy because: 

• these days most angel fish school in groups 
• most states and regions have well advertised (web) ponds, 
• the fish have the kindness to spell out in advance what bait they will strike

Here is an example taken from "one billboard at a well known California pond":
      Tech Coast Angel members invest in southern California companies, only. We look for products and services that can achieve rapid adoption in very large markets. Some of our criteria: 

• Scale: annual revenue potential of at least $50 million
• Market: a compelling, well articulated strategy for capturing and defending a significant market share
• Barriers to entry: patents or proprietary technology
• Team: a strong, not necessarily complete, team
• Exit strategy: some idea of who will eventually acquire your company
• How we fit: a desire for advice and coaching
• Valuation: you must fit within our risk/reward expectations

At other ponds the billboards list:

• specific industries (because the fish have expertise in them)
• level of business development (no pre-revenue plans)

So, figure out what business (bait) you have and decide if you stand a chance to catch angel fish.  If not, go fish for other species that bite on different bait, presumably the one you have. Here are examples:

Friends and Family:  this species bites on you personally and your trust factor with them.  Returns are hoped for but often the motivation is to help you along with the world changing idea you shared with them.

Banks: They still have money and do lend it if your business is the right bait for them. You'll need collateral and cash flow to have an chance. Beware of lines of credit that appear to be a strike, but you cannot count on for very long. 

Factors and Receivable Discounters: They bite on (and take a good chunk of) invoices you carry as receivables from financially reliable customers (they bite on someone else credit). 

There are many more, each specialized in different aspects and needs of your business.

Back to that favorite species: the angel fish.  The words that carry value with them (shiners in the fishing parlance) include:

Scalable: 1. the business can grow into a big business, 2. you and your team are capable to grow it

Market size and dominance: "1% of the world" is probably meaningless, "80% of left handed investment bankers with an income over 500k" is a concept one can measure and relate to. Attractive markets have size and allow some level of dominance.

Early Exit: a plan with an Exit is a requirement (remember: angel fish get to eat only at exit time). Early Exit is golden. More on this in a forthcoming post.

Barrier to Entry: the stronger your position, the less spooky the fish will be

Risk: This is the monster from the dark depths that scares angel fish away. They know it is part of the game, but they hate it. To manage their fear, show that you have identified fall back positions and fail safe conditions at every step; be able to simulate the cash flow projections accordingly. 

BE BRIEF: this is the most impatient fish in the world 

Happy fishing.  There is fish in that pond for the right bait. Do not waste time otherwise.

Marco Messina

Be Mindful Of Your Audience

Entrepreneurs must be able to SELL. Selling, of course, involves all the steps leading to closing a deal such as: understanding the customer's need, presenting a solution, explaining features and benefits, articulating a value proposition, etc. Most entrepreneurs become quite skilled at selling their products and services.
Raising financing for the business, however, involves selling the idea and future prospects of the business to investors.  The entrepreneur must sell a small piece of the company to outsiders to finance its growth.  The process is similar, not the same and angel investors routinely confront skillful business owners who do a poor job of selling the investment deal.Why?  I believe this happens because most often the seller is not mindful of his/her audience.

Let's look at the parameters of  two "Acts" that occur in the "Play" of business building and financing:

Act 1:  Entrepreneur E is pitching Product/service P to prospective Customer C

E understands C's problem well
C understands well and is painfully aware of his problem
C appreciates the difficulty of solving the problem (it is yet fully or partly unsolved)
E has put a lot of time, effort and creativity to find his proposed solution
E is particularly proud of the obstacles encountered and overcome along the way to create the solution being proposed, and explains them in detail to C who is interested in and understands the details and is impressed by E's competence
C is looking for reliable continuing long term performance and support in the solution he buys
E  promises to be around forever to service C's needs in a continuing relationship

Note: Over time Act 1 is repeated regularly, frequently and profitably thereby creating a practiced habit which makes its performance easy and almost automatic.

Eventually when financing is needed to grow the business the Entrepreneur must perform in a new Act with little or no prior practice as follows:

Act 2 - Entrepreneur E  pitches Business B to Investor Group IG

IG need a vehicle to invest their cash at as good a return as they can find
IG decided that buying a piece of a good business (B ?) run by a good operator (E ?) will give them good returns

IG, looking at business B,  are focused on: how fast it will scale, how profitable it is, or will be, and how fast they get their money back, and how many times over

IG, in the first presentation, do not have,  individually, the technical competence to assess or are interested in the minute details of business B's products
E is expected to make his pitch to address the interests of IG.

E instead remains true to his well practiced past presentations:
E focuses on product minutiae that go right over IG's head - IG is confused and bored
E demonstrates his creativity by the complexity of the solution and all the things that went or could go wrong with it, that E had to master - IG is scared by complexities as opportunities to lose money
E is proud of his business plan to create a business that will grow, change the world and last forever - IG see their investment locked inside a business, never to be returned

This performance becomes the concluding Act of a "Tragedy of missed opportunities". Missed opportunities for both the Entrepreneur who gets no funding and for the Investors who were bored and scared away from a business that possibly had real potential.

The fix is for the Entrepreneur to learn about the Investors audience as diligently as he learned about his customers.  Then speak to them on their own terms:

• KISS - make complexity simple and brief (Elevator Speech and One Page Summary)
• The company is the object of the pitch not the products - Investors assume the products work, at least in the first presentation.
• Scalability is the key to big ROI - Convince, why it is possible and likely
• Specific parameters of  profitability and scalability yield ROI and return multiples that interest angel investors  Few types of businesses can do it (see AngelCalc post) at the right size of investment, do not waste your time otherwise.
• Business does not happen, a team (more than a founder) makes it happen.  Sell the team, have a team that can be sold, evolve the team it if necessary.
• If there is no competition, you have not found it yet. Even if true, doing nothing is always an alternative.  Investors are afraid of competition that has not yet been identified, so should you. 
• Investors love simple solutions to serious painful immediate problems, are leery of solutions in search of a problem and markets needing years of gestation, or of new standards to be created to coerce the world to do it your way.

Mostly, practice KISS: know your audience, speak to them on their terms.

Marco Messina

Calculating with Angels - Angelcalc

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

There are many theories and rules of thumb being bandied around about how angels seek their targets. The reality is that angel investors can be roughly divided in two groups, each with dramatically different decision making processes (and ROIs).

"Golf Cart Investors"

These are the ones who buy into a deal on a hot tip, topically received by a buddy on the golf course. Most often the buddy has done little or no due diligence, has little or no knowledge of the industry and technology involved, and has received the supposedly hot inside information from another buddy in similar fashion.

These angels are dangerous to your and your business' health. They invest with virtually no understanding of the deal, have unjustified expectations and eventually will prove to have little or no patience to wait for the business to succeed. Their returns are almost inevitably negative and most often they will do no more than one or two deals before they go back to golfing only. Unfortunately they will tell others that angel investing is a crap shoot and waste of money, thus limiting startup capital availability in the community.

"Professional Angels"

These are the real Angels entrepreneurs want to work with. Frequently they work in groups so that they can share the heavy burden of due diligence research required and they bring to their side of the table scientists, engineers and management experts in different industries and technologies. They will ask a lot of questions and then more questions and then proof and supporting documentation. They will not move fast but will cover their bases well. When they invest they will stay involved and help with seasoned advice and working their contacts to help the business succeed. These are true ANGELS.

Research by the Kaufman Foundation shows that their returns are on average quite attractive (2.6 times their investment in 3.5 years). On the other hand, a rule of thumb often quoted is that these angels consider a deal if they see a potential to earn 30 times their investment in about 5 years. These two seemingly conflicting perspectives are 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 business that fits angel investors has many or all 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, delivery, distribution experience. Moreover, all of the following may aply: in some other garage a similar or better mousetrap may be ready to come to market, the management team may have or may develop unforeseeable weaknesses (from sociopathy leading to financial embezlement to personality incompatibilites to love affairs - I've seen them all as causes of aborted successful businesses); "effective" IP protection may prove difficult to obtain or worse may be revoked when prior art appears unexpectedly (see the post about patents and RIM's adventure), government regulations may prevent or delay market acceptance, unforeseen and totally unrelated vested interests may create insurmountable barriers to market acceptance. All considered the 10-12% probability may even be high, but it appears to be what angels use implicitly if not explicitly.

So, with all this in mind, below is AngelCalc (copyright Marco Messina 2007-2010). Its intent is to help you determine if your business has sufficiently high growth and profitability potential in an industry with sufficiently high PEs to satisfy the requirements of the Pro Angels. Services, generally are unlikely to qualify unless they have a unique IP component and market dominance potential. 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.


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

Its objective is not to set a valuation. It seeks to determine whether the relationship among the following factors allows a viable solution that meets investors criteria.

The factors for a P/E-Multiple based calculation (as for a public company) are:

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

 The factors for a valuation based on revenue multiple (e.g. selling the company) are:

1.  Time horizon is 5 years
2.  Revenues in year 5
3.  Applicable multiplier for comparable companies sold

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".

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