Thursday, January 17, 2008

Touched by an Angel

I think the title of this post is a TV show, but fitting as there has been much debate in the venture community as to the whether angel investors are good or bad for entrepreneurs and VCs. What would the VC corollary to Touched by an Angel, be. Well, you can certainly peruse The Funded for some descriptive terms for investors.

I was on a panel earlier this week with several other investors from Angel Groups in the Valley. The panel was a typical Silicon Valley shmoozefest hosted at a law firm with about 75+ attendees. A partner from the law firm (sponsor, covers the drinks and food) tosses out some softball questions to the panelists, the audience chimes in with Q&A and finally, culminates with the meet and greet where the panelists are flooded with business cards and pitches on the next great thing, which is often very similar to the last great thing. My facebook can beat up your facebook....

The theme of the event was angel investment trends for 2008. One of my comments was that we would likely see more institutionalization of angel groups and syndication of deals among groups. We have already seen the institutionalization of groups evidenced by the growth of the Angel Capital Association (ACA), which counts 265 angel groups and 10,000 individual members, up from probably a handful a decade ago. At Sand Hill Angels, we recently switched our IT infrastructure over to Angelsoft, which built a specialized application for angel groups. While currently free to angel groups, their business model revolves around aggregating the angel investment data.

Speaking of angel investment data, the Kauffman Foundation funded a paper on Returns to Angel Investors in Groups written by Robert Wiltbank at Willamette University and Warren Boeker at University of Washington. According to their research, overall returns on group-affiliated angel investments average to a 2.6X return on investment after 3.5 years. If my math is correct, this is approximately a 31% IRR, which has to beat individual angel investments on aggregate and venture capital returns over the period of the study (1990-2007). I found this data quite interesting and wonder how representative it actually is as most angel investments are not reported.

Back to the panel. There were a couple of comments by other panelists that I found interesting. One group charges entrepreneurs "an administrative fee" to present to the group. Mind you, this is not a $20 fee to cover printing nametags and making copying an executive summary into a book. It is several thousand dollars, which is a lot of cash for a struggling entrepreneur in search of seed funding. Just seems that the guys with the money shouldn't be charging the guys who don't have any....One of the other panelists mentioned that they don't charge the entrepreneurs, but do require them to spring for lunch at a follow-up meeting. I found this amusing as well, but presume the entrepreneurs get to choose and can bring PB&J sandwiches. At Sand Hill Angels, we won't charge you to pitch and will even spring for the food!

Another comment which probably deserves more discussion is around valuation. One of the panelists mentioned that they have gotten very valuation sensitive (nothing wrong with that) and like to purchase preferred stock rather than invest in convertible notes. Again, I see nothing wrong with this, although entrepreneurs often prefer convertible debt as it defers the valuation discussion and leaves the Series A price for the venture firm to set. He also said they typically only invest at a $1 million pre-money valuation or less. He then went on to say that this type of financing was good for the entrepreneur (vs taking VC money) because they got to keep more of the company.

This got me scratching my head and ready to open up a debate. However, there was not any interest on the other side in debating me in front of the group of entrepreneurs, so I'll have to do it here. Valuation at this stage is clearly much more art than science, but I subscribe to the splitting up the pie school of thought. There needs to be enough equity to go around for founders, early investors, later investors, and employees. We typically invest at pre-money valuations between $1 - $5 million, with the sweet spot somewhere in the middle.

At a $1 million, pre-money, with an investment of $500K, that would leave 67% of the company for the founders and initial option pool. Let's say the company hits it out of the park with that $500K and can now raise $10 million at a $15 million pre-money valuation. Keeping this simple with no employee option pool and just founders and investors, investors would hold 60% at this point (20% for angels and 40% for VCs) and founders would have 40%. Under an alternative scenario, entrepreneurs go for VC funding to start and raise $4M at a $4M pre-money. For the next round, assume pre-money stays at $15M and amount raised is $6.5M for a total of $10.5M of funding in both scenarios. Now the investors have 65% (35% for first round and 30% for second round), while founders have 35%. I guess you can make the argument that the founders keep more of the company under the take angel money at a $1M pre-money valuation, but the stars need to be aligned and it is much more likely that initial VC funding in the angel scenario would be at a lower valuation with significantly more dilution. I'm sure I lost all of you, but I feel better now having completed the analysis.

I guess the moral is, make sure you know where the angel is touching you.....ProfessorVCs office hours are now closed. See you next time.

1 comment:

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