The most challenging task in building an early-stage investment deal together is for the investors and the funders to a degree on the deal valuation. In many cases, it becomes a deal-breaker not because the investors did not like the deal, or believe in the company, yet the economics of the deal need to work out for both sides.
The startup founders always have a tendency to overvalue the company, and investors are always looking to “low ball” so they can get larger pieces of equity. In the past few years, and especially in the recent uncertain economic conditions, the challenge becomes even more significant in the founder’s ability to raise capital.
We recently created a balanced way to bridge that gap. We called it the “Flex-Value” methodology. In early-stage investments, most investors have to rely on projections and guesstimations of what the company’s future performance would look like. By offering a “Flex-Value” method, it can allow investors to mitigate the risk that will lead to a quicker investment decision.
This approach takes into consideration the founder’s financial projections as a baseline for the term sheet. If the founder is able to perform, and deliver on the financial projections, they will be able to maintain the baseline valuation. In the event, the company performs below financial projections the investors get a deeper discount/lower valuation. This approach creates a balance that diffuses the tension by establishing a fair and balanced benchmark.
It is specially applied to early-stage investors, i.e. first money in the deal after FF, which will not be the last round of funding. Typically, startups will raise at least two more rounds of funding at much higher valuations, which by nature, the early-stage investors always get diluted, although early-stage investors are the most important money in the life of the company. So in order to allow the early-stage investors to be treated fairly, the “Flex-Value” is the answer. In other words, it is basically to say to the Founder; “put your money where your mouth is!” Instead of taking a leap of faith, it allows the investors to establish a benchmark of trust, where there is none in order to move forwards.
Let’s say that the founders think that the company is worth $2M, or the market cap on a convertible note type of a deal, and the financial projections indicate that the company will produce $3M dollars in revenue within 18 month – than baseline equation is:
$3M in revenue = $2M company value and or market cap
If the company ends up producing $2.52M dollars in revenue, then the baseline equation is:
$2.52M in revenue = $1.6M company value and or market cap
if the company ends up producing $3.52M dollars in revenue, then the baseline equation is:
$3.52M in revenue = $2.34M company value and or market cap
The reality is if the founders have a high level of confidence that they can meet or exceed the numbers then it’s a better deal for the startup, because the investor will convert at a higher valuation, and the founders get to keep more equity. On the other side, it’s a way for investors to mitigate the risk in the event the startup does not perform. It also creates a fair value for the next round of funding. Inside the conventional wisdom start-ups always want to raise at a higher valuation in order to create a benchmark for future rounds. Although we are in completely different market conditions than we’ve ever seen before. As the saying goes; “extreme circumstances require extreme measures”.
The truth is that it is a tricky situation. These methods may not be applicable for a straight forward deal. It can be a very creative solution that creates a common ground instead of walking away, both from the founders and the investor perspective. We know it’s not a traditional approach, to say the least, yet we tested this several times in the last year and we found that he can work. It is an alternative worth pursuing when both investors and the founders want to make a deal yet, there is still a gap.
From my perspective, both as an investor and as a founder, this approach creates a measure of accountability on behalf of the startup to prove to the investors that their financial projections can hold water. It takes away the investor’s need to make a blind faith decision, which most investors are not comfortable with. At the end of the day, the only thing that matters in business is a bottom-line financial result. This is why the founders got into the business and this is why the investors want to put the money, to make as much money as they can, as fast as they can long for as long as they can.
As an investor, I also find it very interesting, almost like a “Tell Tell” to see what is the level of confidence the founders have in their own ability to deliver the numbers. If you, the founder, are absolutely convinced and confident that you will deliver or exceed \ the numbers, why not go for it, it will work in your favor.
So the question is, how confident are you in your ability?
Different Tracks for Angel Investing
For an investor, there’s no greater thrill than getting behind a promising new business early on and helping to make it a success. Today, there are roughly 300,000 Americans who, as angel investors for startups, attempt to do just that. The amount of active angel investors in the United States continues to grow. The Small Business Administration (SBA) estimates that there are more than 300,000 individual angel investors and growing fast in the United States in 2019, which provides funding for about 30,000 companies per year.
Entering the world of Angel Investing can be challenging and exciting at the same time. We have found that there are five identified different ways to invest. Each with different levels of risk-reward. Each investor will have to choose their preferred way to invest based on their personal needs, wants, or desires. It fundamentally a factor of:
- Level of Risk
- Available Capital
- Level of involvement
The fundamental difference is the investor position of the risk-tolerance level. Going from higher risk to a lower risk factor. Although the majority of angel investors invest informally, smart, and savvy investors typically choose an Angel group or Angel Fund.
The Fact in the Matter!
Regardless of which path you will take each investment opportunity will still have to go through the most common 10-steps of the investment process.
Option #1: – Individual & Informal Independent Investment
Success Rating – Very Low
Data indicated that the majority of Angel Investors invest informally. The type and style of investment approach for investors that prefer to be independent are based on the investors’ personality and mindset. This path will require a high level of work on behalf of the investor. The data sources we have collected indicate that the cost of the process for the deal size of $250K and up ranges between $10-20K (Hard and Soft cost) per deal. Independent investors in most cases will absorb 100% of the transaction cost, which is not a very economic way to leverage capital. Although for those investors that planning doing is a full time, might increase the success ratio. It is estimated that only 60% plus of the total Angel investors are doing it informally and independently on a part-time basis, despite the high-risk factor, which goes against business common sense. I guess that sense is not that common after all.
Option #2: – Online through accredited Funding Platforms
Success Rating – Low
There are many online platforms and more coming each day that are offering investment in startup companies from crowdfunding to online groups and syndications. Some are very good and highly credible and some are not.
As with any online platform, there is a level of risk from scammers, criminals, and people that use the internet to take advantage of innocent people, and there are plenty of them out there.
Most of them offer some basic level of support, yet the individual investor is one of many and most likely will not get the personal attention and deep level of support in the investment process. As with any online business model, there is a certain level of bias built-in such as luck and objectivity when it comes to promoting their own deals. The benefit of an online platform is that the entry-level is as low as $1,000 or even less. Although it sounds tempting, it is a drop in the bucket and the upside will not be substantial at best, if at all. There are some good opportunities in some online platforms, what we have learned is that many experienced investors use some online investment platforms, yet they start using them after they gain their investor prowess and experience first.
Option #3: – Accelerators & Incubators Association
Success Rating – Moderate
There are selected groups within the Angel Investor community that use their association with Startup Incubators and Accelerators to start their angel investment career. Independently runs incubators and accelerators, typically breeds new waves of angel investors that are coming from the pool of business professionals and advisors that work within the startup ecosystem and were introduced to various startup experiences. In the case of Incubators and Accelerators run by the universities’ commercialization offices, it creates more Angel Investors that are coming out of the university alumni business community that are connected to the university. Although conventional wisdom tends to think that because their association with a university means high quality of deals, it is not always the case to say the very least.
Option #4: – Angel Investor Groups
Success Rating – High
Most investor groups & syndication are much more organized and some are even more formalized with membership rules and formal structure as a legal entity. Most groups and syndication require membership fees – typically in a range of $1,000 to $2000 per year in addition the group will receive a 10% carry on the portfolio performance of the upside on the investment after the investor recoup their initial investment.
A significant number of the group operate a full-service backroom from deal flow management to a complete investment process management. They are effective and well organized, typically holding monthly meetings where they hear pitches from entrepreneurs in need of capital that are attended by the group members.
Though attending monthly or quarterly meetings might sound like a lot of work, there are some important reasons why the team approach is popular among angel investors. Within a group, you will most likely find investors with different disciplines, like operations, marketing, finance, R&D, etc., and even different industries like automotive, banking, real estate, life sciences, etc. These kinds of investors, in a group, help bring a lot of “brainpower” on evaluating companies and can even help the company afterward beyond the investment. A group made a decision that can help mitigate some risk. Most young companies are seeking more cash than any single investor is willing to put up—often upward of $1 million. By dividing that ownership stake among several investors, an individual may only need to kick in say $25,000 to $50,000 on a single deal.
\It allows the Investors to split the considerable due diligence work that any major investment requires and be a huge time-saver. A collaborative operation allows the funders to draw on each other’s experience and expertise. The decision to invest in a particular opportunity is still up to the individual investor to “Cherry Pick” their own deals, but in this way, prospective investors get input from others in the group before they decide whether to get involved, as they say: “Follow the money idiot”. One person can be wrong, ten people not so much. A group provides its members with “crowd wisdom”, which can be very powerful.
Perhaps the biggest advantage of joining a well-organized group, however, is being able to learn about more deals and more critically have full stack backroom support with all the necessary resources. Angel investing is by its nature a high-risk high-reward proposition. As such, most experts suggest having a portfolio of at least 12-16 companies in order to protect your capital. It certainly helps to have access to a steady flow of highly qualified and vetted deals – something that’s hard to achieve if you’re going solo with regard to angel investing.
Option #5: – Angel Investment Fund
Success Rating – Very High
The last option represents the more attractive form of investment and it is the lowest risk bracket of them all. There are a few reasons, the first is that all venture funds are regulated by the SEC and enforced by FINRA, and have a very formal structure: the investment decision and management, the accounting, and the audit of the books are being managed by three separate independent organizations to ensure the checks and balances. It is registered as a legal entity that is being managed by the Fund Managers that are supported by an assembled board of advisors. It is required to be registered and reported to the SEC and be audited on an annual basis. So in the risk factor spectrum, it is the lowest risk bracket, there is still a risk factor, yet it is much lower than the other options.
A fund has a typical structure of what is being known in the industry as the 2/20. The fund managers, which can also be another legal entity, are being paid 2% of the total capital under management for managing the fund’s investment activities and 20% carry on the fund performance. The fund management selects which companies receive funding and at what level. In most cases, the fund will not invest more than 5-10% of its capital in one deal. Some “dry power” is reserved for follow on funding should it be helpful and necessary. An average fund invests in 24-30 companies in the life of the fund which according to the Witbank model will ensure a 98% probability of 3.8X return on equity. Most angel funds outperform independent investing in the ratio of 5:1. It typically represents highly savvy investors that are involved in more than one track of investing and understand diversification and risk mitigation very well. Investors in most funds are “passive investors” meaning they do not select the companies nor participate in any way with the company. Some funds welcome participation with the portfolio companies and help match the investors with the appropriate companies.
The Bottom Line
If you’re new to angel investing, it often helps to join an angel fund or a group that can partner up on deals and spread out the due diligence work. In online syndicates, you don’t necessarily need to meet face-to-face with other members to get your crack at early-stage investment opportunities. Some investors participate in more than one of the options, you can allocate some capital to online investing, become a part of an angel group (sometimes more than one), and invest in an angel fund at the same time, many smart investors do.
So, what is your preference?
Understanding Equity Deal Terms
One of the most fundamental tools used by active angels is the term sheets. Yet, not every investor, especially new investors, do not fully understand the language and terminology used in these highly-important documents.
This brief is intended to clarify the following questions; What are term sheets, what do they represent, and why are they so critical for closing a deal?
Although it is a complex subject, we have a relatively simple framework that can help all angel investors develop a deep understanding of the significance and structure of term sheets, retain and apply that competency in real-life deals.
Non-Binding; Summary of Suggested Terms
Most ventures and angel investment come with a “term sheet” or, in some cases, a “memorandum of understanding” (MOU) that summarize the desired terms and conditions of the deal by the company or the investors. This becomes a negotiation framework that needs to be agreed and aligned on before solidifying a deal.
Unless a term sheet expressly states that it contains legally binding terms, early-stage investment term sheets are not legally binding agreements. However, term sheets can be thought of more like a set of notes outlining the principal elements of the deal as agreed by both parties, the giver and the receiving parties. They serve as a basis for soliciting interest from potential investors as well as used by legal counsel as the guidelines for drafting the final binding documents and agreements.
What type of topics the Term Sheet cover?
The issue is that they can be elaborate and complex. Term sheets can cover a variety of subjects. They can be written in very heavy business jargon or many legal terms, so they can be quite intimidating for less-experienced investors.
You will see every kind of provision from price, size of the round, composition of the board to liquidation preferences, drag-along rights, and anti-dilution protection, and many more, we have seen them all. The bottom line is that there are no rules as far as what can or can’t be included on the term sheet. It is up to both parties to decide on how complex or simple they want it to be.
The Five Key Areas of Concern for Investors
These documents do not need to be overwhelming and challenging. All term sheets can be grouped into five basic areas of concern. Within those areas, the specific provisions can be thought of as a set of tools representing the balancing of risk allocation between the concerns of the founders and the concerns of the investors in that basic area.
So, what are those five key areas?
- The Deal Economics – Investors want to ensure they are able to get a large enough equity position to make the investment worthwhile on a risk-reward basis. To make sure they get paid back first at the time of an exit, and to put a time-clock on the founders. To guarantee that the employee options don’t dilute them inappropriately.
- Investor Rights & Protection – Most investors structure the deal to ensure that no future financing deals include terms which will diminish the value of their investment or lead to other investors moving into a superior liquidity position, without paying appropriately for that right.
- Investment Management Governance & Control – Investors want to be informed on what’s going on in the company on an ongoing basis, having a say in critical decisions when the size of the investment merits it, and be protected against founder business behavior that could be damaging to the company.
- Liquidity – Investors want to make sure they maximize the chances to get their money back in all possible capital event scenarios (positive or negative), even if they have to force such a situation to occur.
- Exit Strategy – Experienced Investors would like to ensure that there are a clear pathway and a set of triggers for an exit. To know, that based on the event of certain financial indicators, the founders will be willing to exist in a form of investor buyout, partial sale or wholesale of the company within a particular range of time. They also want to know the company has identified a number of possible acquirers that are active in their business sector.
Fair, All Things Considered
Those terms and conditions may strike an outside observer as greedy or aggressive, yet, they are not really when you consider how equity investment deals work. Unlike lenders, and other forms of financing that come by nature with a legally-enforceable right to be repaid and often further secured by collateral or guarantees, early-stage investors purchase equity on no-recourse terms. If a company fails, its investment is gone. In cases of fraud or misdeed, equity investors have no right to be repaid. Although, investors are assuming 100% of the risk of failure of the venture, in proportion to the amount of money they put into it. The only way they get their money back is for two things to happen:
- The company performs and becomes more valuable, the valuation increases for an exit or
an opportunity arises in which investors can sell their stock/equity in the company to a qualified buyer for more than the original purchase price of their equity. (the expected multiples of 5X and more)
- In another way, equity investment can be thought of as a loan or a debt that the ultimate qualified buyer of the company is expected to repay at some point in the future, typically expected 3-5 years out.
Hard Lessons- Learned
Looking at it from this point of view, the many provisions of a term sheet begin to make more sense and seem reasonable. They provide protection for the company “Rollercoaster” ride that many investors are expecting somewhere down the road. Whether a term sheet is negotiated with a perfectly fair compromise is a function of the market and investing dynamics around a particular company or particular market sector at a particular point in time. All the same, the term sheet negotiation process is always a constructive way to address the structural-tension between the investors’ concerns and the founders’ concerns.
During negotiating terms, the founders have their own set of concerns and thinking about a different set of issues.
- Lose control of the company, either by selling too great a percentage of their company or by agreeing to overly powerful contractual control provisions.
Economically washed out by selling too much of their equity too early and too cheaply.
- Lose ownership of their shares/equity if they are fired or resign.
The company runs out of money and will shut down.
They prefer to not give personal guarantees or put up their home or other assets as collateral; and
- The fit with and value-add from their investors – smart or dumb money.
Investors interfering with the company operations or direction.
The Value In The Term Sheet Process
So when investor concerns collide with founder concerns, you can potentially develop a strong tension between the two sets of concerns and positions. The most important role in the formation process of a term sheet is to identify all the key issues and allocate the various risks and balances between the parties. If it is done successfully, you will come to a middle ground on the various issues to everyone’s level of satisfaction.
The Angel Investor – Golden Rules!
As with any other investment Assets Class in order to build a high performing portfolio, investors will be more effective following some Golden Rules to ensure there is an acceptable level of risk management. Although the Angel Investing Assets Class does not have a robust base of historical data and not too many investment models and tested algorithms developed as we see in other assets classes, there is enough data collected from active angel investors to provide some kind of Critical Guidelines to serve as safeguards to protect the investors from making simple mistakes that can be costly at the end.
Here they are:
- Do not invest more than what you are willing to lose! – The common sentiment is to invest no more than 10% (15% if you are an aggressive investor) of your overall investment portfolio. Invest only the capital you can live without and if lost, will not have a dramatic impact on your financial stability and lifestyle.
- Use capital you can live without – Venture and early-stage investments are not liquid investments, such as stocks and bonds that have a high level of liquidity. In most deals, you need to know you will “park” this capital for 5-6 years and in some deals even longer. You will not be able, or it will be a lengthy process to liquidate your investment at the time of need.
- Diversifying your investments – Make small investments in larger groups of companies instead of large investments in smaller groups of companies. The three pillars of diversification of a venture portfolio; the number of deals, stage of deal, and size of the deal in order to build a balanced portfolio that will have a high probability of higher exit value.
- Join an Angel Fund or a Syndication – It is much more effective, and has a higher rate of return to join a fund or a group or both to mitigate your risk. By being a part of a group of investors, such as a fund or syndication an individual will have access to the “Crowdwisdom” and voice of reason that in most cases offers a higher value-added.
- Invest as a legal entity – It is commonly ignored that it is highly recommended to invest as a legal entity or a trust, if such exist, and not as an individual. This is because of the risk in venture deals and the fact that in the event that there is a legal action against the company, attorneys will go after all stakeholders, especially investors that appear as the deeper pocket, having another layer of legal sheld, make it more difficult.
- Adapt an investment discipline – As we say, adapt the opportunity to your process and not the process of the opportunity. Developing a screening, qualification and a repeatable due diligence process is key to increase the quality of your deals and the performance of your investment portfolio.
- Create your preferred risk profile – Define your comfort zone. What is your number – i.e the total amount of available capital you are willing to risk. You know or at least should know yourself and what is your natural risk tolerance if you are a risk-taker or risk-averse. It is important given you will be in a deal on average of 5 plus years that it will not be a constant source of stress and concerns. After all, you want to enjoy it while making money.
- Separate your personal preferences and your emotions from the deal – You need to look at each deal on its own merits. Personal preferences and emotions tend to have biases and can cloud one’s judgment in selecting the right opportunity, and it can be more challenging when doing it on your own.
- Build and establish your advisory team – It is highly important to build and establish your network of advisors that will help you cover all of the areas of business operations to help you make sound decisions. Business success is more than just the financial aspects, there are many other moving parts and you need to ensure you have readily available access to other professionals with a variety of business expertise and competencies that you can trust.
- Define your level of involvement – In order to be a value-add to your portfolio of companies, you will need to define your level of involvement that will fit your personality and lifestyle. Whether you are an active or passive investor, it establishes a benchmark of the expectations from the start. Some companies welcome active investors and others seek passive investors. It is a personal decision based on one’s needs, wants, and desires. You need to make sure you choose opportunities that will fit your choice, so you will not be dragged into undesirable and uncomfortable situations.
Just a note, Angel and Venture investing comes with certain levels of risk, more than the traditional conservative investment strategies, yet the risk-rewards ratios are much higher than all other Asset Classes. It is not for everyone, although there is a romantic notion that you can hit the jackpot and make lots of money, in most cases it is the opposite and if it happened it is probably somewhere in the 1000:1 ratio.
Investors who adopt a set of guiding principles can reduce the risk to a manageable level and increase the success rate by 10X.
Note: This document was prepared with the information required from the following Data Sources:
Wikipedia, Investopedia, Seraf, TechCrunch, Forester, Ann Arbor Spark, Michigan Angels Community, ACA, MVCA
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