Angels Posts

todd.jpgTodd Vernon, the CEO of Lijit, has written a great article on raising money from angels. I especially like his taxonomy of angels:

The Family Investor: The Family Investor is likely not really a classic Angel Investor at all but rather a supportive family member that “knows you”. Their motivation is likely out of support (sometimes guilt), but their basic investment thesis is they trust you. For me these are the worst type of investor because you likely have intimate knowledge of their financial situation and whether or not they ‘should’ be investing. Likely, they have no inherent feel if your idea is good or not, but may have changed your diaper at one time or another and have overcome that experience to hand you a check for $25K or $50K. Personally, I like this category of investor the least because the investment is totally emotional and personal – and that sucks in business. But based on the financial situation of the individuals involved and the relationships this can work ok if everyone comes into the situation with their eyes open, but go out of your way to make sure.

The Relationship Investor: The Relationship Investor is probably one or more co-workers from a previous gig or business friends you have known for a while. They may or may not understand what your new company is doing but they have had a track record working with you. They want to be supportive, but are looking for a return. You won’t lose them as friends if things go bad, but the investment for them is likely not ‘trivial’. In my experience these are good Angels to have, again as long as their eyes are open going in. These people can also be wildly supportive of you in terms of finding employees and other resources.

The Idea Investor: The Idea Investor is probably very familiar with the space your company is targeting. These are in some ways the very best types of Angels because to some degree they validate your idea. There investment is based on the Idea and there is little emotion around the table (always good). If you can get them onboard they can open doors into partner relationships and just generally good advice. You will spend most of your time convincing the Idea Investor that you and team are the right people to attack this problem (as they likely don’t have a strong relationship with you or the team). Often an influential Idea Investor makes a good early board member for the company.

The Once Removed Investor: The Once Removed Investor is likely connected through a personal or professional relationship with either the Relationship Investor or the Idea Investor. They likely don’t know you, and they likely don’t have a clue if your idea is good or bad but they have translated the trust in the investment to the person they know. This is a great way to get additional Angel Investors onboard, but without a solid Relationship Investor or Idea Investor it just isn’t going to happen.”

Read the rest of Todd’s article, it’s great.

Via: Ask the VC.

Summary: Here are 3 microhacks for finding a lead investor: (1) If followers have good reasons to not lead, ask them for introductions to potential leads. (2) If you’re early stage, find seed investors who invest in people and high risk startups. (3) If every prospective investor says “we don’t know the market,” find investors who have invested in your market or similar markets.

In Part 1, we wrote,

“Lead investors want at least half the round—and they often want the entire thing. If they don’t want the entire round, they will help you find followers (and some leads will close immediately even if they’re not taking the entire round). They believe your stock is worth more than they’re paying. They don’t need social proof or scarcity to make an investment decision. Like great entrepreneurs, they are mavericks.”

If you’re doing a seed round, you may be able to mass syndicate the financing without a lead. Otherwise, here are three microhacks for finding a lead, in rough order of importance—but you should probably try them all.

1. Ask the followers for introductions. #

If the followers have good reasons to not lead, ask them for introductions to potential leads:

“Can you suggest any firms who would be interested in leading this investment? Why do you think they would be interested in leading? Would you make an introduction?”

This simple test will tell you whether the follower has good reasons to not lead. If a follower won’t make introductions, he doesn’t have a good reason to not lead. If the introduction doesn’t respond aggressively, the follower probably made a half-hearted introduction—he doesn’t have a good reason to not lead. The follower’s level of effort indicates if he really wants to find a lead or he just doesn’t want to say ‘no’. (Caveat: This logic mostly applies to VCs, not angels.)

If a follower doesn’t have a good reason a priori, don’t ask him for introductions at all. Skip this microhack altogether. An introduction by someone who can and should lead, but would rather follow, is a useless and harmful introduction. It’s a strong negative signal. Go get your own introductions.

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Finally, if a follower introduces you to the eventual leader, the leader will rarely cut out the follower. (Investors who don’t accommodate the middleman who gives them introductions stop getting introductions.) You’ll end up with two investors and more dilution. But that’s better than the alternative: zero investors and no dilution.

2. Find seed stage investors.

Every professional investor’s fantasy investment is a sure thing: zero risk and infinite reward. If you’re early stage, you can circumvent this fun fact by doing a seed round:

  1. Focus on investors who go out of their way to invest in seed stage companies with lots of risk, not investors who say they invest in seed stage companies:
  2. “What seed stage companies have you backed in the last 2 years? What exactly did the company (team, product, traction) look like when you invested?”

    Does your company look similar?

  3. Find non-professional angels whose primary motivation is working with great entrepreneurs, not profit. In particular, talk to folks who already know you well and are willing to to bet on you.

Seed investors increase the probability of raising money from VCs. High-quality seed investors raise your valuation, provide social proof, and obviate the need for extensive due diligence in the VC round. Many companies close a small seed round and do a larger VC round in a few months.

If you want to skip the seed round, mere commitments from high-quality seed investors have a similar effect. And these commitments provide a strong alternative as you negotiate with VCs. Obviously, if you do the VC round, don’t cut out any seed investors you have committed to.

3. Find investors who know your market.

If every prospective investor says “we don’t know your market,” find investors who have backed companies in your market or similar markets.

Educate investors about your market. It’s your job to convince them the market is great. Find successful companies in your market and figure out how they got there, how long it took them to get there, how much money they raised, how much money they’re making, how much money they would be making if they were as smart as you are, et cetera.

Talk to the management at these companies and see if they will personally invest in your business or advise you. Ask if their company wants to be a strategic investor.

Yet more ways to find a lead.

In Part 3, we’ll suggest two more ways to find a lead investor.

Image Source: Funny Treat.

“Those kind of ‘sit on the sideline’ investors are worthless to you if you want to get a financing done… if you are raising a financing of any kind, spend all of your time looking for a lead investor.”

Fred Wilson, Union Square Ventures

Summary: Financings happen when you find a lead investor, negotiate a term sheet, and if there’s room, politely tell followers that they can take it or leave it. Alternatively, if you have a group of seed investors who aren’t asking you to find a lead, you can mass syndicate the round without a lead. Finally, ‘find a lead’ often means ‘no’.

So Bill the Cat writes in:

“We’re out on the warpath, with the aim of raising a Series A round in the $1M range. We’ve had a number of people say they are interested in participating, but nobody wants to lead because they know little/nothing about our market. Is there anything we can do about that, other than just keep searching for a lead? I’m pretty confident that at this point if we found one, we’d be set.”

What’s a lead investor?

From Fred Wilson‘s The “Lead Investor”:

“I got an email from a friend yesterday who… said that he’s got indications of interest from a number of investors but they are all waiting for a “lead investor”.

“I told him that what he has is a bunch of followers who have no real conviction about his business because if they did, they’d step up, negotiate a deal, and get their money into his company. But instead they are going to sit on the sidelines, wait until someone with conviction shows up, and then try to get in alongside the investor with conviction.

“Those kind of “sit on the sideline” investors are worthless to you if you want to get a financing done. They don’t impress the kind of investors who have conviction because investors with conviction are going to want all of the deal for themselves (or their friends they will bring in alongside of them).

“If you are raising a financing of any kind, spend all of your time looking for a lead investor.”

Lead investors want at least half the round—and they often want the entire thing. If they don’t want the entire round, they will help you find followers (and some leads will even close before you find followers). They believe your stock is worth more than they’re paying. They don’t need social proof or scarcity to make an investment decision. Like great entrepreneurs, they are mavericks.

Financings happen when you find a lead, negotiate a term sheet, and if there’s room, politely tell followers that they can take it or leave it.

Lead investors who bet on unproven markets, products, or teams (or all of the above) are rare. If you’re unproven, don’t be surprised if fund-raising takes time.

“Find a lead” might mean “no”. #

“Investors saying that they are waiting for a lead are also saying ‘no’ without saying no… They don’t want to miss out if this thing takes off (e.g., “Hey, we told you we were in, I hope you saved 10 percent for us!”), but they have no conviction and don’t want to say no in case they’re wrong.”

Dick Costolo, Founder of FeedBurner

Instead of saying “no”, an investor might ask you to “find a lead”. Why? He wants to maintain an option to invest. If you find a great lead or the company starts kicking ass, the follower will say he intended to invest all along.

By telling you to find a lead, the follower is trying to extract a subtle commitment from you and manipulate your psychological desire to follow through on your commitments. Negotiators call this a consistency trap. We’ll show you how to avoid this trap in Part 2.

Professional investors (VCs) have two legitimate reasons to not lead: #

  1. Your business is too far away and they want you to find a local lead, e.g. you’re in Shanghai and your investors are in Boston.
  2. The investor’s typical investment is less than half of your round.

In either case, the follower should partner with you to find a lead. His level of effort will tell you if he really wants to find a lead or he just doesn’t want to say ‘no’.

You can mass syndicate seed rounds without a lead. #

Small seed funds that are investing their personal money and non-professional investors like angels may have other good reasons to not lead: they don’t want to deal with negotiating terms and hiring a lawyer, their portion of the financing is too small to lead, they like you but they don’t know the market, et cetera. #

If this is the case, you might not need a lead. If you have a group of seed investors who are not explicitly asking you to find a lead, you should:

  1. Generate a term sheet. Your advisers and lawyers can help with the terms.
  2. Get feedback on the terms from prospective investors at the end of the first meeting. They will ask about the terms if they’re at all interested.
  3. Incorporate the feedback into the term sheet.
  4. Once enough prospective investors have said ‘yes’, circulate the term sheet with a list of investors who have committed to the financing.
  5. Incorporate any additional feedback and send the closing documents to everyone. Set the closing date two weeks out.

How do you find a lead?

In Part 2, we’ll suggest some ways to find a lead if you can’t mass syndicate the round.

Related: VC Cliche of the Week: We are Passing, The Art of Saying “No” Parts 1 2 and 3, and More favorite VC phrases.

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Q: Should I raise money from VCs or angels, all things being equal?

There is no prototypical VC or angel. Instead of pitting VCs versus angels, consider their perceived pros and cons and choose the best available investor.

Angels are perceived to have less money, invest for fun, make their investment decisions quickly, and not ask for control. VCs are perceived to have more money, invest profesionally, make investment decisions slowly, and ask for control.

Seek a VC or angel who has follow-on capital to support companies in tough times, invests like his life depends on it, makes investment decisions quickly, and doesn’t ask for control.

Companies that try to raise money from angels often end up raising money from VCs and vice versa. You can’t tell where this road will take you until you get on it. Many VCs invest in seed stage companies with favorable terms—and many angels invest with onerous terms.

Finally, raise money from angels if you’re hoping to sell your company quickly for $10M, with very little investment, and lots of capital gain for the founders. Most VCs are shooting for $100M+ exits. Either way, seek investors who agree with your definition of victory.

Q: What’s the idea behind Venture Hacks?

We show entrepreneurs how to negotiate better deals with their investors.

First-time entrepreneurs usually negotiate sub-optimal deals that leave millions of dollars on the table. Or worse, they negotiate awful deals and screw themselves.

Entrepreneurs don’t know how their first deal will affect the rest of their chess game with investors—but their investors do. Entrepreneurs play this game once-a-lifetime… investors play it once-a-day.

Startups have one chance to raise money right. You can fix almost any mistake in a startup—but you can’t fix your deal. If you hire the wrong employee, you can fire him—but you can’t fire your investors.

We try to level the playing field with knowledge, so entrepreneurs can do this critical job right. In the words of Francis Bacon, “Knowledge is Power.”

Q: Why should entrepreneurs read Venture Hacks?

Informed entrepreneurs will get better deals. Even a company with a great exit can benefit from a better deal that makes more employees rich.

Entrepreneurs usually get their advice from other entrepreneurs who are inexperienced, investors who are biased, and lawyers who do things right (legally) but don’t know the right thing to do.

Venture Hacks is our attempt to open-source everything we’ve learned from our great mentors and advisors. We strive to be objective but our inevitable biases favor the entrepreneur.

Image Source: Gii.

Summary: Angels make more introductions than VCs because angels need co-investors. You can’t clear the market in series–you can only clear it in parallel. Tranches are dumb–they have zero upside and catastrophic downside. Two investors aren’t always better than one. Finally, a ‘very special’ message to graduating Y Combinator founders: don’t do deals on D-Day and feel free ping us if you want additional help.

Adam Smith from Xobni, a Y Combinator company, calculates that angels made 5 times as many intros as VC investors while Xobni was raising a Series A:

“We spoke with 16 angels and 12 VCs. Angels made 24 introductions; VCs only made four. The average angel introduced us to 1.5 other investors, but the average VC only introduced us to 0.33 other investors. That’s a 5x difference!

“So angels can be helpful even if you’re raising a mostly VC round.”

Read the rest of his great letter to graduating Y Combinator (YC) companies: Raising Money, Some Data and Tactical Advice.

Why do angels make 5x more introductions?

First, angels usually take a small piece of a Seed or Series A. If they like the company, they need to make introductions because they need co-investors. VCs usually don’t want or need co-investors–if they like a company, they want to buy as much as they can.

Second, some angels are followers, not leaders. They find a company they like but they don’t want to lead the investment. So they introduce you to a top-tier firm like Blue Shirt Capital and say to themselves,

“If Blue Shirt wants to invest, the company must be good. Plus, Blue Shirt will do all the work, and I’ll go along for the ride. I know Blue Shirt won’t cut me out since I introduced them to the company—firms that cut out the middleman stop getting intros.”

You can’t clear the market in series. #

Adam writes:

“Our series A didn’t happen quickly. We excited the people we met with, but we were timid about getting started having recently closed a $100k angel round. One firm had interest, so we thought “We better talk to someone else to make sure we’re getting a good deal.” That incremental approach went on for a few months. We were always in late stages with one investor but just beginning the dialogue with another. Deciding to raise money should be an atomic decision; don’t try to just dip your toe in.”

You can’t clear the market in series. You have to do it in parallel. You can’t create an auction by meeting investors one-at-a-time. The only way to get a market clearing price is to meet a lot of investors at once.

On eBay, everybody bids at the same time, over a short and arbitrary period of time. That drives the price up. They don’t bid one-at-a-time over a timespan of ‘whenever’.

As for how to create an auction, here’s the short version:

Jump on your desk, kick your laptop across the room and declare a start to your fund-raising; set up 10 investor meetings for the same week; you will probably end up meeting only 4-6 of them due to scheduling conflicts; tell them “We plan to sign a term sheet in 6 weeks, if we don’t have an offer by then, we’re going back to using sweat equity to build the company“; signal your valuation by saying “We want to raise $X from n investors with no more than Y% dilution, including the option pool,” (Y = 15%-25% per investor plus a 10%-20% option pool dilution). In a tight process with VCs, there are three meetings; one with the original partner you were introduced to; next, you meet the original partner with a few other partners; finally, you go to a partner’s meeting; there may also be an intermediate meeting where some of the partners come to your office to refactor your code and eat your food; if some investors are being slow while others are moving along, tell the slow ones, “By the way, we are on second meetings with three funds.” If things go well, you should receive 2-3 term sheets; reject the ones that explode the next day: “We told other investors that they have until the end of the week to send us term sheets, we can’t break our promise.” Negotiate the offers over the next 2-3 days and get your favorite investor to the terms you want. During closing, keep your other prospective investors warm in case the deal blows up; but don’t break any binding no-shop or non-disclosure agreements in the process.

(We’ll elaborate in a future hack; with apologies to Paul Graham.)

Auctions and artificial deadlines create a positive feedback loop of social proof (“Other people want to invest, don’t you?”) and scarcity (“Hurry up or the deal is going to disappear”). That’s what closes deals. Auctions also force you to fail or succeed in a few weeks. Either way, you will soon get back to creating value for your customers.

Finally, don’t use the a-word (‘auction’) when you’re raising money. Investors don’t like it. Auctions are “taboo” when you’re selling part of your company to an investor, yet perfectly dandy when you’re selling your whole company to an acquirer. Don’t say, “We’re running an auction to get the best deal”, say “We’re looking for the right partner to help build our business.”

Tranches are dumb.

Adam writes:

“Traunching is bad for the company. If your investors exercise the traunche(s) then it means that the company is now worth more than they’re paying you, so you’re leaving value on the table. You might want to raise a smaller round and go to the market again when your valuation is higher.”

Tranches are generally stupid. They have zero upside and catastrophic downside.

At best, tranches give your current investors a right to invest at yesterday’s valuation if your company is doing well. If your company is doing poorly, your investors will figure out how to get out of their obligation to invest. The tranches will probably have material adverse change clauses that allow your investors to get out of their obligation. Almost all tranches are call options for the investors, not put options for the company.

If your investors back out of a second tranche, you will need to figure out how to manage the negative signal that your current investors don’t want to invest in your company, even at yesterday’s valuation. Remember the Golden Rule:

“He who has the gold rules.”

Get the gold while you can. If your prospective investor wants tranches, say:

“Currently, we’re focused on raising this round, not the next one. Let’s negotiate the next round at the next round.”

Two investors aren’t always better than one.

We disagree with one claim in Adam’s article:

“… you want to have more than one major investor. If one firm is out of line then the other firm will be there to say “This is unreasonable”. You’ll get more varied inputs. Having more than one major investor means you’ll take a little more dilution, but I think it’s worthwhile.”

Yes and no. There are good arguments for bringing on one or two investors. We don’t have a strong opinion either way.

If you have two investors, you can play them off each other during closing if one of them is being slow or demanding, you can split them on the board so one of them votes your way, you can split them when they vote their protective provisions, et cetera.

But, the additional dilution of two investors is usually significant, about 10%-15%. And you don’t need two investors to remove the unreasonable terms that Adam wants to avoid, you can just run an auction:

“We have an offer that doesn’t include [egregious term X]. I hope there is some flexibility on your side because I would really like to work with you but I have a fiduciary duty to our shareholders.”

It’s easier to remove unreasonable terms when investors are fighting to win a deal–they’re more likely to collude if they’re co-investing.

Graduating YC Founders: Don’t do deals on D-Day.

Me: Dude, we should offer to help the Y Combinator companies with their term sheets.

Naval: Don’t we already have a blog for that?

Me: Yes, I’m sure both of our readers are well educated by now.

Naval: It doesn’t matter anyway… the good YC companies will get snatched up on demo day–savvy investors will force quick decisions.

Me: What’s the rush? The YC founders should spend a week to get multiple offers. Good investors compete with their merits, not exploding offers.

Naval: Why are you telling me? Get the word out…

Presenting… a very special message from Venture Hacks to YC founders:

  1. Take your time. If you can get one offer, you can get two. And a better deal.
  2. Send any questions to nandn at venturehacks dot com. We’ll keep them in confidence and help as much as we can.
  3. We’ll hold office hours on Friday August 17th to discuss fundraising–details are coming.

Good luck! And let us beseech the blessing of Adam Smith upon this great and noble undertaking.

“You cannot clear the market in series.”

– Office Hours

“Investors move in herds that are steered by scarcity and social proof.”

– Office Hours

Summary: This article includes audio and notes from our first office hours. Topics include selling 51% of the company, dead equity, and setting good terms with angels.

Yesterday, we held our first office hours via teleconference. Office hours are an opportunity to ask questions and discuss raising capital.

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Here is an edited MP3 of the discussion:

Venture Hacks Office Hours, June 7 2007 (mp3) (length: 18:43)

The questions and discussion were great. We had to stop early due to technical difficulties. Next time, we will do it via Skypecast which I hope will be flawless. We will post the time, date, and link for the next meeting soon. Please submit any ideas for office hours in the comments.

Finally, here are some edited highlights of the discussion. Please excuse any bad grammar, these are rough notes.

Control

Entrepreneur: We have an offer of $1M for 51% of the company. What do you think?

Venture Hacks: I wouldn’t take the 51% deal. At that point it is no longer your company. You are an employee. And you are no longer doing a startup. And you killed the entrepreneurial drive.

Investors who would like to buy 51% of your company don’t know how to invest. Especially if it is early stage. They think they are buying an asset that someone is going to run for them. But what they have done is killed the entrepreneurial drive.

Reject that deal out of hand. I would rather go back to eating Ramen noodles and working out of my parent’s basement. It is equivalent to selling your company for a little bit of money and going to work for your investors. Continue looking for another deal.

Don’t even talk to these 51% guys if they come back with a better offer. They have already made their intent to own 51% of the company clear.

Valuation

We want to raise $1M for 20% of the company or raise $2.5M for 30%-40%. How do we do it?

I don’t know what your company is worth. That is driven by the market. There is no right or wrong valuation. It is driven by your team, product, market, salesmanship, etc.

If you’ve hit 10 investors who make it a habit to invest and you haven’t gotten good responses and you can’t get a term sheet or verbal terms, you aren’t likely to get a term sheet if you talk to 20 more people. There is probably something wrong with the company and you should take a look in the mirror.

The #1 reason people are not able to raise money at the valuation they want is because the team is incomplete or does not appear up to the task. And that is tough feedback for a prospective investor to give. And if it isn’t the team, it is the product or traction.

How do I get a market clearing price?

You cannot clear the market in series. You have to do it in parallel. Set up 10 meetings to all happen in the same week. Some of them will flake out and you will end up meeting with 4-6 of them. Tell them all that you plan to sign a term sheet in 6 weeks and if don’t have an offer by that time, we are going to go back to the drawing board and using sweat equity to build the company.

You have to create that time limit.

If you go to market, go to market. The only way to get a market clearing price is to talk to a lot of people at once. I often see people go down the path with one or two investors. That is a mistake. Focus on the fund raising and get it done or go back and fix what is wrong with the company.

Don’t use the word “auction” with your investors but you need to run an auction. An auction is a double win for you. First, you focus your fund raising on a short period of time so you can get back to your customers. Second, it creates a positive feedback loop of scarcity and social proof. Those are the things that close deals.

Check out a book called Influence. Scarcity means “Hurry up or the deal is going to disappear.” Social proof means “Other people want to invest, don’t you?” Investors tend to move in herds that are steered by scarcity and social proof: “Sequoia is investing? I’m in.”

Dead Equity

If one founder has a (non-patented) idea and doesn’t add much value beyond the idea and the other founder does all the work, how do you split the founder’s equity?

It ranges from 1% – 10% of the founder’s equity. If someone has the idea, follow the Einstein maxim that “Genius is 1% inspiration and 99% perspiration” and give them 1% of the equity. If someone is active and helps you get started and has industry connections and stays active over time, you can give them closer to 10%.

Ideas are a dime a dozen. There are more good ideas than time. Ideas constantly change and you almost never end up doing what you started doing.

50-50 splits are unstable and the company falls apart. 2 years after the founding, one guy is still in the garage and says “Oh my God I’ve put in all this work, the idea has changed 5 times, and this other guy who is doing nothing has 50% of the company.” It is dead equity.

The percentages we are talking about here are the split between the founders.

Angels

I probably need $.5M to get my company off the ground. How do I set my terms with angels so it doesn’t screw me up down the road?

First, don’t give a huge discount if you expect to raise your Series A soon after the seed round. VCs don’t want to pay a big markup between the seed and the Series A unless time has passed (say 6 months) and traction has occurred. Typical discounts are between 20%-40%. Put time and traction between your financings.

Second, if you raise equity from angels they will probably have to approve the Series A. If you have a nasty angel, a “fallen” angel, who is trying to make money on just this one deal and doesn’t have a reputation to protect, he can try to hold you hostage on the Series A and veto your Series A until you give him some kind of good deal such as letting him put more money in at a good price. That’s a rare scenario but it does happen and the only way around it is to pick your angels carefully. If you raise debt, don’t give debt holders veto rights on the next financing.

Third, don’t give your angels perpetual warrants that don’t expire. If the company is a big hit, you don’t want your angel to come in right before the IPO and dilute everybody 10% at a very low cost. Avoid warrants in general, but if you do use them, set a short expiration.

A really clean debt agreement between you and experienced angels is the best way to get the company going. It leaves you with a ton of control. Check out Yokum Taku’s debt term sheet.

Approaching Investors

How do I approach VCs and angels?

You approach investors through people who know them. The best approach is through an entrepreneur whom they have backed and been successful with. Next best is probably someone who works with them such as an angel, or someone who sends deal to them, or someone who is associated with the industry. Third is probably your accountant or lawyer.

Fund-Raising Schedule

How do I time the fund raising?

In short, focus. Hit all the contacts at once. In your head, declare a start to the fund raising. Set up all your first meetings to happen in the first week.

If some investors are being slow while others are moving along, tell the slow people, “By the way, we are on second meetings with three funds.”

In a tight process, there are three meetings. One with the original guy you made contact with at the firm. Second, you meet the original guy and some of his partners. Third, there will be a partner’s meeting. There may be an intermediate session where some of them come to your office.

(Image Source: Office Space)

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