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

The Crisis of Credit Visualized | BusinessBlogs Hub

In the public interest: this is the best explanation of the debt crisis that I've seen in non-technical terms. It took ten years to create a financial industry bomb, will it take ten more to fully digest the consequences? The optimist says yes, only ten: plan accordingly.

The Crisis of Credit Visualized | BusinessBlogs Hub

The Magic Ten

Sales are the only unquestionable proof that anyone on the planet values and wants what you make (or plan to  make).  Therefore it is the only proof that your business has any potential of being a viable,  even a successful venture for you and your investors.
Of course your business may still fail for a thousand reasons some related to you (management skills), some beyond you (timing and economic cycle).  But if no one wants to buy, it is proof that there is no potential - change what you make or go invent something else.
 
The trouble is that this sales "acid test" is almost never performed soon enough.  Innovators waste untold  resources on whimsical notions that  the world needs X because they thought so and without ever asking anyone if it is true, except perhaps for overly sympathetic family and friends.  The genetic make up of the inventor/innovator is to instinctively seek solutions to perceived problems, then develop total belief in the solution found, often with smug disregard for the opinion of the less innovative.  Unfortunately, those less innovative folks are the customers that should buy your product (BTW they probably innovate in their domain just as much, just do not appear so to you). Because their focus is elsewhere, almost always they will have different perceptions than you. BUT, if they do not like your offering, your product is crap: beautiful, genial, elegant perhaps, but business-wise it is still crap.

Before investing a great deal of energy developing prototypes, let alone finished products, do yourself a great favor:
1  Get out of your office or garage
2  Look for 10, TEN, not two, TEN prospective buyers of your product

3  Find a way to explain in 45 seconds: what you offer, and its value proposition 

4  Continue to search until you have found ten that say they would buy whatever you intend to make
5  After TEN people say they will buy at the price you envision, go prototype your product.
6  Then go back to validate with your ten prospects if they would still buy it.
7  If less then ten would, use the feedback to explore design modifications and
8  go back to searching for prospective buyers until you are back to ten
9  Repeat the loop for every prototype iteration
10 If you have less than ten fans or buyers go back to look for more - Remember TEN

Clearly this formula calls for good walking shoes and door knocking stamina far more than an MBA.  The latter in fact will give you countless excuses to stay in your office to over analyze your own questionable notions of reality until, eventually failure will lead you to forget the textbooks and fancy formulas codified years ago, then get good sneakers and go talk to customers about what they want NOW.
It is a simple formula: TEN

Oh, and you can bet heavily on this outcome:  If you can show your prospective angel investors that you have done this field market research, or better yet you have actually sold something to somebody, you'll be in a class apart from all the funding seekers they see - you will have the beginnings of a proof of market

Marco Messina

Business organization for your startup

Thoughts from business experience.  For legal opinions, consult your attorney and tax accountant.

Do not start as a sole proprietorship
This is the only recommendation sure to have no dissenters. All else following is meant as a general guideline to use in questioning your attorney on the best course for your particular circumstance.

The LLC - quick, easy, inexpensive
Many would agree that on a minimal budget this is the best alternative to get limited liability protection cheaply and quickly.  Most states now have web sites where name availability may be checked and reserved, sample minimum articles of organization are provided, applications may downloaded and filed by mail.  If you are in business alone in most states you can be in business in a few weeks, for $100 or less, and have little else to worry besides doing business.  Your local SBDC or SCORE chapter will help you free of charge to get it done.

A more complicated picture
The picture of course gets complicated as soon as you propose to add partners and investors. These are my rules of thumb:

Operating Agreement (OA)
Also called Partners Agreement and other similar names, this not required to organize an LLC in many states, but it is required by common sense: If you have even a a single partner, spouse included, you owe it to yourself to have an OA that spells the rules of engagement: how key decisions are made: e.g. sale of the business, personal guarantee of loans, call for incremental investments from founders, approval of financial control processes, access to records, management compensation approvals, etc.
Most importantly you should agree in writing to how you will part ways if needed (spouses included) - who can buy out whom when and how, how to value the business, etc. To promote fairness, strive to implement the old "parting the cookie" technique " (one cuts the cookie, the other picks which half).  It is much easier to agree when you are friends than when you will want to separate, probably because of irreconcilable differences   If in this negotiation process you learn something about your partner and your partnership dies and untimely death, you won't be the first - better early and with less pain now, before committing time and treasure, than later.


Tax Liability
In most cases, with proper elections filed with the IRS, your LLC will not require separate income tax filings and members report their share on Schedule C of their personal return. Advice from an accountant will cost little and ensure no bad surprises - make it mandatory.

However, regardless of how taxes are filed, members will take the tax liability impact of the LLC's income or loss, so the Operating Agreement should include a requirement that cash be disbursed to cover the members' tax liability.  Otherwise you risk having a tax bill due with no cash to pay it.  Partners with very different financial postures may have very different perspectives, so agree in writing ahead of time.

Complexity increases further as the number of members and investors increases. In particular, outside investors, angels and VCs, are likely to have a very different tax exposure, cash position, needs and objectives from the founders.  Of late many attorneys advertise that an LLC can be set to be govern and to function internally as a C corp with the "proper" Operating Agreement.  Perhaps so, but in my experience managing the different needs with amendments of the Operating Agreement will  become cumbersome, costly and beneficial only to the attorneys.

Furthermore the flexibility of defining the Operating Agreement however one wants is a two-edged sword that impacts investors' due diligence workload and cost.  Corporations' governance is much determined by state statutes which local corporate lawyers know well.  LLCs with complex Operating Agreements require careful review because only what is written governs and what is written could be unusual or unexpected and whatever is missing may be litigated later. Many angel investors simply avoid this risk but investing only in a C corp.

Switching to a C Corp.
At some point, switching to a C corp organization may be a desirable option.  Professional advice from tax and corporate lawyers is mandatory.  Mistakes can have dire consequences.

If you come to this point, be prepared to encounter a painful reconciliation of diverging interests of the owners.  This will be particularly so if along the way some "family and friends" investors extorted or were offered a "non-dilutable" clause or "unanimous approval" of funding decisions or changes in organization.  You may have % majority interest, but veto power trumps and is costly to remedy and there may not be statutes to help you out.  In any event this step will require time, and the less time you have the more leverage the competing interests will have against you - allow plenty of time.

Starting as a C corp
This option is of course preferable if you can afford it and particularly if you start with a business vision that includes angel investors, VCs, many shareholders, IPO, publicly trading stock, etc.  In this case you'll face significant differences relative to an LLC including:

• Higher organization costs
• State corporate filing requirements
• Income tax filing requirements
• Corporate governance statutes 

Details on these points are beyond the scope of this post. However, with respect to tax liability management, in the early stages of your startup you may personally benefit from any tax losses by electing to have the corporation taxed as a partnership (S election). The election can be reversed (only once) later when you no longer benefit from that method of taxation or your corporate needs change (e.g. IPO).

With regards to corporate governance, I have mentored many a budding entrepreneurs (mostly MBAs) much concerned with "preferred states of incorporation" (e.g. Delaware, Nevada, etc.). I am certain a case may be made and supported for their relative advantages. However I subscribe to KISS: In all states there are thousands of corporations that manage to do business successfully subject to their local statutes.  Relative differences among states become relevant primarily in cases of proxy fights and similar circumstances which are unlikely to occur with a startup (you better figure how to avoid them).  Instead, incorporating out of your state of primary operation is sure to require additional costs such as for multiple state filings, "domestication" into the state where your head office is located, retaining a registered agent, and more.  In my view, when your business makes it to be part of the S&P Index and you develop high concerns for proxy fights, you'll have the cash to relocate it then whatever state is desired.

In the end all agree: avoid sole proprietorships.  Beyond that, be ready to adjust your corporate organization to match your budget requirements of your shareholders and investors.  

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

Brevity again... The One Page Term Sheet

In my continuing search for KISS answers - Keep It Simple & Short, I read Basil Peters' proposal for a One Page Term Sheet. I've been following Basil's blog for years now and I think it's one of the best sources of experienced and clear thinking about angel investing. It will be a wonderful day when this becomes a best practice because it will set owners and investors much closer together at the start of a negotiation by establishing shared expectations. In a few words we will start from a known point and negotiate the variances required by the specific circumstances.

As an investor do I believe all the terms in here ideal? I do not pretend to argue that point here. In time the industry (angel investors and funds) will refine it and the sooner the better.

As an entrepreneur pitching your deal to angels, you can only hope they pitch back to you something this clear and straightforward. Now, read and hope.  If you have guts, present it as the guideline you positioned your company by and for: at a minimum you might just impress your angels as the first instance they encountered in which the "seller" appears to have made an effort to understand the "buyer" - what a concept.

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The 'One Page' Term Sheet for Angel Investors

This is not a theory or academic exercise. This term sheet is in actual use today by angel funds in BC.

This term sheet is based on exchangeable shares. This simplified term sheet is based on the underlying assumption that an effective, independent board is in place and that the board will make the best decisions for all shareholders. It also assumes the company is built on a fair and equitable structure.

Term Sheet offered to the"Company"

This Term Sheet has been prepared for angel investments made at an early stage by "the Angel Fund". The terms have been simplified to match the stage of investment and are offered for consideration and acceptance.

Offer of Investment

The Fund will purchase, together with any syndicated investors, (collectively the "Investors"), common shares (the "Shares") at a price of $* per Share. The total round for all Investors will be $* of which the Fund will invest $* to acquire a total of * Shares. So long as the Investors hold their Shares and until a liquidity event, they shall have the right to exchange them for the same kind and class of securities issued by the Company (the "New Securities") in any follow on financings should such New Securities have rights superior to the Shares. The Investment will be made pursuant to an Investment Agreement made between the Investors, the Company and certain of its principals (the "Principals"). The capital structure on closing will be as described in the attached Share Register.

Board of Directors

The Fund believes that early stage investments need strong mentoring and governance provided by a high quality, engaged Board. On the completion of the investment, the Board will be comprised as follows:

• a total of five members, being the CEO, one nominee of the Fund and three nominees independent of management that the Company and the Fund agree on; and
• each director must have made a meaningful investment in the Company.

Share and Option Vesting

The Fund believes that it is important that the Principals' interests align with the Investors. In this regard the parties agree that all stock options and all nominally priced previously issued shares will vest on the following basis:

• 50% of the shares will vest daily and linearly over a three year period; and
• the other 50% will not vest unless and until there is a sale of the Company.

All share and option vesting will accelerate on a sale of the Company. An Escrow Agreement will be entered into to provide for the vesting.

Liquidity Event

To ensure that a return can be provided to all of the Company's shareholders when an opportunity presents itself to sell the Company, the Fund will require a "drag-along" right be added to the Company's constating documents to allow the holders of 51% of the issued shares of the Company to cause the sale of all of the shares of the Company.

Reporting to Shareholders

The company will send a CEO Update monthly to all shareholders. Financial statements are also available upon request.

Investor Rights

Investors have the right of first refusal to participate in future financings.

Any changes to the capital structure, new shares, options or debt requires the approval of the majority of the investors in this round.

General

The Company will pay the legal costs of the Fund not to exceed $6,500, plus taxes and disbursements thereon. The Company will keep confidential this Term Sheet and all discussions with the Fund for a period of two years.

Binding Nature

This Term Sheet will terminate on *[date], unless terminated earlier by the Fund. The Company will not seek alternate financing unless and until this Term Sheet has terminated or been terminated by the Fund. The confidentiality provisions will survive termination of this Term Sheet. Acknowledged and agreed to by the Company and by the Fund this * day of *, 200* by: [Signatures]

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Yes! That is all of it!

Comments will be greatly appreciated.

Marco Messina

Talking to Angels - The Executive Summary

I said it many times in these posts, but it is worth repeating. If you want to communicate to Angel Investors, your challenge is to be brief and exciting at the same time.  Angels read dozens of plans and pitches a week, thus develop a short fuse stretched to its limit and a deja vu mindset. Every single word you use should be valued as an opportunity to break that fuse and lose your audience.  Furthermore, the specific words used must strike a balance between creating "excitement, belief, opportunity-to-change-the-world,  high expected returns" and projecting a perspective of "naive, smoke-and-mirrors, improbable deal, too-good-to-be-true".
Angelsoft is the software most angel groups now use to manage deal flow, presentations, investors collaboration, etc. They developed a great template for an executive summary. If you apply to present to a group that uses Angelsoft you'll end up supplying information in that format.
The same template, however is great for writing your executive summary of any deal regardless if presented to an angel group.  Here it is

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