Tuesday, February 26, 2013

An entrepreneur’s quick guide to working with angel investors


by Deanna Pogorelc

The number of angel investors in the U.S. has jumped 60 percent since 2002, and the number of dollars they’ve invested in companies has gone up even faster. Not to mention that a few new angel groups have sprouted just within the last year to invest especially in life science companies.
Given all of this activity, Cleveland non-profit entrepreneurship group JumpStart Inc. (disclosure: JumpStart is an investor in MedCity Media) gathered a panel comprising two local technology entrepreneurs who have raised angel funding and the manager of an angel fund to talk about how entrepreneurs should prepare for this kind of investing and what they should expect when a deal goes through.
There’s no one “kind” of angel. Some investors will want to know lots of details about the progress of the company; others will want to be involved in only the big-picture things. Iron out all of those expectations in the beginning. “We’ve created an internal blog where we’re posting everything and we give access to them, so they’re able to figure out on their own whether they want to come in and see what we’re doing,” said Bryan Chaikin, a co-founder of eFuneral.

Take their advice as just that – advice. A good angel will give you more than just money. Soak that up. If you follow every suggestion or critique an investor offers with, “yes, but…,” they will eventually stop offering suggestions, noted Adam Roth, president of StreamLink Software. But at the same time, you shouldn’t try to follow every piece of advice given by every angel you pitch to. “They have a lot of good knowledge but probably don’t know your business as well as you do.”

They want to hear about who you’ve hired. For companies that are on an otherwise even playing field, it’s the management team that makes the different. “We know that the business plan you present to us will be different than 12 months from now,” said Clay Rankin, manager of North Coast Angel Fund, which invests in early-stage healthcare, advanced materials, information technology and energy companies. “It will be different because they have run into obstacles trying to get the product to the market or trying to develop their product in the first place, but it’s the successful management team that can figure out how to overcome those obstacles that’s most important.”

No matter how early stage you are, have some intelligent thoughts on funding down the road and an exit. “We try to not only look at the environment right after the money is put in, but also where is that company going? What kind of financing is going to be needed down the road, and who is likely to provide that financing?” Rankin said.
And if you take angel or VC money, make sure you’re on the same page about how you might exit and who the potential exit partners could be. “They’re looking for their return; they’re not in it for a lifestyle kind of situation. It’s just not the way those kinds of investors are thinking.”

Make the most of your friends and family money. “If you have money, but you know you don’t have enough money and you’re wanting to valuate your business, don’t burn all your capital before you go get that investment,” Roth said. “Get a lead investor, get the terms so that you have preferred shares and then invest in preferred shares, because it doesn’t matter how much money you put into the company before the investment. You’re better off taking that dollar and putting it in after there’s already a value set so you can actually buy real shares with that money, as opposed to buying sweat equity.”

If your company is very early stage, consider convertible debt. That was the best option for eFuneral when the company was first ready for funding, because there was no way to put a valuation on the company just yet. “One of the benefits of doing it that way is you’re giving the company the opportunity to move its business far enough along that there is clear value in it, and it’s that value that allows you to attract outside investors,” Rankin said.
“I wouldn’t diminish those frilly things that add some value to it — the warrants or stock options. The reality is that a 7 or 7.5 percent interest rate is not commensurate with the risk you’re taking as an investor. This is huge risk at this very early stage, so what you’re doing about getting the warrant or getting an option for additional stock is to recognize the fact that you came in early, you took that early risk, and you’re entitled to get a little extra kicker when others come into the picture with equity.”

But, again, all angels are different. Some angels may not favor convertible debt because they want to know what their ownership in the company will be up front. “If we wait and wait and wait (for a valuation), the limited amount of money we’re able to put in as an angel fund becomes smaller and smaller as a percent of the value of the company, so your ownership ends up being tiny,” Rankin said. “Then if there are future rounds, your ownership is more diluted after that, so we do like to get the oar in the water.”

Plan on the process of getting an investment being at least six to eight months long. For North Coast Angel Fund, Rankin and his associate screen all of the opportunities and send one or two per month to a screening committee. If that committee likes what it sees, the company is invited to present to the full membership about a week later. If the membership approves, around three months of due diligence will follow. “Once the due diligence process is complete and the team comes back and recommends an investment in the company, it is not uncommon for it to take another month to negotiate the final deal documents between lawyers on both sides,” Rankin said. Of course, there are always exceptions that could speed up or slow down the process.

Break up your fundraising, if applicable. “If you’re worried about the perception of how long it’s taking you to raise capital, I think you could set goals for yourself – short-term goals, mid-term goals, long-term goals – and define how much capital you need to get to each stage and break your raise down into those buckets,” Roth said. “If you do that ahead of time, when you’re talking to your investors and you’ve got that laid out, I think they’ll be impressed with your thinking about how you’re trying to be capital efficient as opposed to how you can’t just get a bunch of capital in the door.”