Yesterday, I participating as a coach and panelist in a program put on by the Kauffman Foundation and The Colorado Office of Economic Development & International Trade (who comes up with these names?) called The Power of Angel Investing. The purpose was to educate various economic development professionals from across the state on angel investing – specifically how it works, what motivates angels, and how to help promote angel activity.
I thought Steve Mercil (note to Steve, if you blogged, I’d read it) did a great job running the seminar, with interesting slides that I generally agreed with and thought were well presented and articulated. As always some of the panelists said a few wacky things (this always happens when a room full of angel investors open their mouths). My favorite was “in general I won’t even consider a deal that doesn’t have rock solid IP protection.” Hey, to each his own.
The most interesting (to me) part of the seminar was when we split out the participants into groups of angel investors and entrepreneurs. The two groups had to try to hammer out a term sheet based on the information provided to them. We explained to the groups that they were not to get “hung up” on due diligence type issues in their negotiations. Just make some assumptions, and see how close you are. They had some financials (actuals and projections) as well as general statements about the industry, due diligence that had been performed, etc. These were real case studies, from real companies. And so there they sat, pitted against each other.
This was fun to to observe/coach. The entrepreneurs quickly valued the company using what they felt was a “standard” valuation using total revenues from year 5. These revenues were about 61M, so they quickly concluded that their company was probably worth about that. According to the case study, they’d been in business for two years, and appeared to be near break-even, although they’d never actually earned one red cent. They bought into their own hockey stick utopian view of the future. It was amazing to watch how quickly they fell right into the role of the confident entrepreneur. My advice to this team was to “go in with some humility.”
Meanwhile, the investors opened with a valuation of “2.5 to 3.5 million” (which, of course means 3.5M in any negotiation I’ve ever been in). They said they were bullish on the company, and felt they were offering a more than fair valuation.
When each party threw out their opening offer, there was clear tension, obviously. A shouting match ensued, with lots of laughter and clear hurt feelings. It was almost like it was real. I figured this one was over, the investors will get up and leave and make the company come back to them – if they’d even speak to them again.
After three rounds of negotiation and much coaching, they parties settled on a valuation of 3.67M and a board observer role for the preferred shareholders.
The real case study was presented, in which a valuation of $2.03M had been arrived at by the actual angel investors. The study then also revealed that the company was doing well, but did not grow nearly as much as the entrepreneurs had anticipated. The angels made about 3x on the deal – not much of a win, but not a loss either.
I learned a couple of things from watching this.
1) Convertible debt sure has it’s place. 😉
2) Entrepreneurs with no experience and no advisors sure look like morons in these types of negotiations. They were off by a factor of 30x from reality, where as people with the same background and experience looked at it from another point of view and were at the right order of magnitude. Hence:
3) Doing the kind of math an angel investor has to do is not hard. You just have to put yourself in their shoes for a second and (just for a second) don’t believe your own wild projections.
This was a fun and worthwhile event, and I’m glad to see these sorts of educational opportunities here in Colorado.
After this event, I rushed home just in time to make the Techstars launch party, which was a blast. It was a long, but fun, day.
David,
our startup (JumpBox.com) just raised some bridgeloan funding as convertible debt. Can you explain the conditions under which you feel debt vs. equity financing is more appropriate from the entrepreneur’s standpoint? We had two people turn us down saying they don’t do loans to startups but at the same time we had 6 people say yes, and ultimately that’s what matters. I’m admittedly green when it comes to the fundraising aspect – at this point our goal was to avoid arbitrarily setting a valuation and hosing ourselves later for a Series A.
thanks
sean
I’d say that if everyone is fairly confident that there will be a VC round in the near future, it’s certainly easier to use convertible debt. It’s a simpler structure and avoids many of the usual arguments on valuation. This lets the pros set the valuation, and typically rewards your earlier investors with a discount in that round or warrant coverage.
To answer your question though, both forms are appropriate from the entrepreneurs standpoint. Often, the investors will drive this decision anyway, and you’re wise to solve for your investors. Often, they’ll have a strong preference given the situation or their personal styles.
In the end, it’s best to get the investment!
Either way, make sure you’re legally represented by someone who specializes in early stage companies and has done plenty of these types of financings. The “real” cost of a bad contract can be very extreme.
Brad Feld has a nice post on his blog about these two instruments and the differences.
According to Brad it sounds like the convertible debt is preferable if you can guarantee that you’ll be doing a Series A. If there is a chance you won’t then the preferred equity route is a better approach for the investors because it makes their upside clear. We have a solid firm for our legal (Wilson Sonsini out of Palo Alto) – I’m comfortable with our representation. Our only real risk with the way we’ve done it seems to be in the event we don’t do a Series A and have to get a 3rd party to come up with an independent appraisal for our valuation. Theoretically we could hose ourselves if they undervalue us, but we’re going to live with that risk instead of the alternative which is complete speculation up front in the absence of customer revenues etc.
Thanks for the link Dave- Brad Feld’s blog is great as is yours.
sean
Yes, and I personally like preferred stock when things are unsure. It keeps everyones motives in line – everyone is looking for a higher valuation. if you think about it, convertible debt holders would rather have a lower valuation at the next round – their money will go further for them in that case. I think the goal of having the investor and entrepreneurs interest aligned is good.
As you said, defer to Wilson – you’ve got quality representation there. No reason to second guess them – they’ve seen way more of this than you or me.
Also, it’s more likely that a “value event” will set the valuation rather than randomly calling in someone to value the company. Examples are another investment round (set by investors/VCs/partners/whoeever) or a strategic acquisition.
David,
In regards to the angel investors’ return on investment in the case study you mention in this article, you write:
“The angels made about 3x on the deal – not much of a win, but not a loss either.”
What was the time frame of the investment? 300% within 3 years of the initial investment equates to a 100% return on investment per year. Even if the time frame for the return on investment is 6 years, that is still 50% per year. Isn’t that a pretty good win for an investor? Or are we in days where ROI per year should be greater than that?
Yes, great point John. This was a period of about 6- 7 years if I remember correctly. So I’d call it a small / reasonable win, but nothing as great as the entrepreneurs had predicted.
Thanks David. Sounds like an interesting session to have attended. Did the session happen to talk about angel investors being more successful with their investment if they invested in companies which were in industries they (the angel investor) had a good understanding in?
Many of the angels there said that they pretty much use that as a filter and don’t reall invest outside their area of expertise. I’ll invite the folks who ran this event into this thread – i’m sure they’ll have more to say here.
The valuation exercise in the angel investing seminar is a particularly strong piece, in my view. I was involved in the curriculum development many years ago. It is interesting to watch how people behave once they know they are either “investors” or “entrepreneurs”. If you are on the entrepreneur’s side, you immediately focus on how fabulous the company is (just like in real life)- sometimes at the expense of reality. Those playing the investors can get real haughty and arrogant (maybe just like in real life?). If the sides finally realize how much more each will gain with a negotiating stance versus an adversarial approach, it is amazing how much progress can be made – there’s a real life lesson there too. Some get it, others never do.
David,
Nice 2c some ‘real-world’ examples and more interesting in that valuation had already been worked out and the ‘exercise/game’ shows how both sides differ in their decisions.
Lal