What does it take to be an Angel Investor?

This is often a tough question to answer. To the SEC, it means that you are an accredited investor and To the man (or woman) on the street, a minimum qualification would seem to be an interest and ability to invest in early stage ventures. However, that is not always the case as there is no qualification to set out your shingle as an angel investor or form an angel group. I often wonder if saying you are an angel investor is the 21st century version of being a consultant in the early 1990's after the corporate layoffs, a euphemism for someone without a real job.

I attended the ACA Summit in San Diego earlier this month. I ran into a friend who was wearing a nametag from another angel group and I inquired as to why she had never shown an interest in joining Sand Hill Angels. Her response was that we required our members to make investments and the other group didn't....Silly us, with that kind of a requirement. I think this sentiment has given angel groups a bad name. An entrepreneur will pitch their business plan to what they think is a group of angel investors and will get a number of follow-up calls afterwards, but they are pitches for services not investment interest.

The ACA is an interesting organization and is providing support in a number of ways to its member angel groups, from public policy, networking, sydnication, and best practices. The National Venture Capital Association (NVCA) was also represented at the conference and is forging closer links with the ACA. In fact, there are some members of both groups, as a number of angel groups have raised funds (that is an entire discussion that I'll leave for a future post).

Academically challenged

My colleague, Joel West, wrote a blog post yesterday responding to an article in the Financial Times on the looming shortage of b-school faculty. In the post, he raises the age old question of whether business students are better served by traditional academics or those with current, practical business experience. Obviously, you can't just have one or the other...At many b-schools, the faculty with the highest student ratings are rarely the ones with the best record of publishing.

In the post, he mentioned that while he feels I am a lynch pin (Thanks, Joel!) of the entrepreneurship program, I depress the academically qualified ratio. Not immediately grasping the meaning, I assumed that if I'm considered academically unqualified, I must be academically challenged. This sounds like a politically correct term for "stupid". However, when I checked into it, it just means for accreditation purposes, I am "PQ" (professional qualified), not "AQ" (academically qualified).

Thinking back to my b-school experiences at Wharton and UCLA, the best profs I had were a mix of AQ and PQ. However, the academics that were in the group of the best spent a reasonable amount of time in industry and consulting. The lecturers tended to be consistently excellent in the classroom, because they were teaching because they enjoyed it rather than a requirement as tenured or tenure track faculty. The money clearly isn't the driving force!

I have been teaching on a part-time basis for over ten years and enjoy the interaction with students and faculty. However, as an adjunct, I don't have to get involved in any of the politics (and very little of the bureaucracy) of academia. This reminds of a comment from the VP Engineering at one of my start-ups, who is a Brit with a dry sense of humor - "I used to teach at university, but then I realized I didn't like the students". Luckily, that isn't the case for me....

Baby's All Grown Up

It's been a while since my last post and it appears I missed the entire month of March. Not to worry, I was busy working on closing the Series B financing for iControl Networks. We ended up raising $15.5M, led by John Doerr of Kleiner Perkins.

This got me thinking about my role in helping companies grow up. I started working with the founders of iControl at the concept stage, prior to the first $100K of angel financing. For a while, it seemed like we were constantly walking along the edge of a cliff and had several near death experiences. In fact, for a good laugh, I just went back and checked our accounting system, and at the end of one quarter in 2005, we were down to $143 cash on the balance sheet. The CEO and I ended up funding the company ourselves until we were able to scrape together a larger angel round.

Now, the company is poised to change the home security industry, one that is in dire need of change. However, my role changes and I am moving from CFO and member of the executive team to cheerleader and advisor. It is not unlike watching your children grow up. With two teenage daughters, I am becoming quite familiar with the changes as your babies become toddlers, pre-schoolers, enter kindergarten, middle and high school. My oldest won't be off to college for a few years, but will probably happen in a blink of an eye.

At times, I do miss being part of a team that takes a company from infancy all the way to IPO and beyond. I have been tempted at various times to join one of my companies as full time CFO, but have decided that is not in the best interest of either party (me or the company). As the company grows, it is more important to have a CFO that is both strategic and skilled in process, rather than a "seat of the pants" entrepreneurial CFO. I personally enjoy the earliest stages and building a portfolio of start-ups and entrepreneurial teams.

The cheerleader role isn't all bad. Anonymizer, a company where I was an early investor, advisor and board member, just got acquired by Abraxas Corporation for a very nice multiple. Rather than home security, these guys are helping with our nation's security. Anonymizer raised a small amount of equity and was able to build a business that became very profitable. It took almost a decade from the initial investment, but in the end, worked out well for all involved. Come to think of it, this will help pay for those college tuition bills that will be coming....

4 Lessons of Entrepreneurship

For golfer's, Ben Hogan's Five Lessons is a classic. While the golf courses and equipment have certainly changed over the five decades since this was published, this tutorial is still relied upon by professionals and amateurs worldwide.

As I mentioned in the previous post, Jeff Fluhr (founder of StubHub) recently stopped by my Entrepreneurial Finance class to share his 4 Lessons of Entrepreneurship with the students. I was glad to see he didn't try and upstage Mr. Hogan by adding another one.

1. Do you have the right make-up to be an entrepreneur? You need to be true to yourself and many people aren't cut out to take the personal and professional risk associated with being an entrepreneur. There are going to be a lot of tough times and perseverance is essential.
   
2. Challenge the Status Quo - StubHub entered an industry dominated by a couple of large players who had a vested interest to block the legality of their business of providing a marketplace for the sale of tickets in the secondary market. In the early days, Jeff spent a lot of time with state legislators to get beyond the stigma of "ticket scalping" and change regulations. He definitely had a lot of people tell him that it couldn't be done.
3. Go with Your Gut - This certainly goes hand in hand with challenging the status quo. Jeff founded StubHub during the dotcom bust and funding for consumer Internet companies was disappearing rapidly. His gut told him the opportunity might not be there in a year and he dropped out of business school to launch the venture. He raised less financing than originally planned but was able to launch the site and was running a business by the time his classmates graduated 9 months later.
4. It's Ok to Exit a Little Early -StubHub was experiencing great growth and hitting it's metrics when Ebay acquired the company in early 2007 It is quite possible that Jeff could have gotten a higher price for the company by waiting, but felt there were a number of benefits to exiting when they did. Besides the natural fit with eBay, he wanted the buyer to feel good following the acquisition and certainly the investors in StubHub were happy. All of this only helps for the next venture.

Here's another bonus lesson. Be passionate about whatever it is you are doing. Any start-up is going to be all consuming and will require a lot of personal sacrifices, so make sure you believe in what you are doing. Dan Gordon, founder of Gordon Biersch, came by my class this week. Prior to founding the brewery, Dan spent five years studying beer in Germany and not the way most college students partake in this particular study. He was the first American in 30 years to graduate from the 5-year brewing program at the Technical University of Munich, the highest technical degree in brewing engineering. Upon graduation, he knew he wanted to open a German brewery restaurant in California and the passion and determination drove a lot of the early success. Brewing a great beer certainly doesn't hurt, which the students got to taste at the brewery after the class.

Buyer's Remorse

Wikipedia (where else would you look....) defines Buyer's Remorse as "an emotional condition whereby a person feels remorse or regret after a purchase" and "a natural human reaction, rising out of a sense of caution". I certainly remember the feeling after buying my first house. The feeling is fleeting and then you go about making the house into your home.

I have noticed this same feeling when making a venture capital or angel investment. While spending time with the entrepreneurs and championing the deal through the group, you tend to become emotionally attached. Of course, rigorous diligence is performed, the team is challenged, and assumptions are tested. Once the point is reached where you want to move ahead, we put the sales hat on and convince our partners about the incredible opportunity that we are lucky enough to be able to invest on the ground floor. However, once the deal is completed and the wire hits the start-ups bank account, all the warts seem to jump out. In most cases, the entrepreneur hasn't hidden anything, it is just buyer's remorse kicking in and the realization that the hard work is beginning. As early stage investors, our goal is to eliminate as much risk as possible with the least amount of cash spent.

Of course, the opposite of buyer's remorse is exercising too much caution and not making an investment where your gut was saying yes. I've found that the opportunities we let pass often stick around longer than many that we do. I started thinking about this yesterday when Jeff Fluhr, founder of Stub Hub spoke at my San Jose State class. I first met Jeff about 8 years ago when he was finishing his first year at the Stanford GSB and was beginning to raise money for a business plan he developed for a secondary market ticket exchange. This was the beginning of the dot com bust and getting a consumer deal through the partners at my venture firm was next to impossible. I liked the founders and considered making a personal investment, but ended up passing.

However, I was glad to see they were able to raise financing and launch the service. I used it as a buyer and seller on a number of occasions and rooted from the sidelines for their success against the Ticketmaster, state regulators and others trying to knock them down. Jeff was able to build a profitable company and a successful exit when Ebay acquired Stub Hub for $300 million early last year. Jeff shared some entrepreneurial lessons with the class and I may include in a subsequent blog post.

Of course, I'm not the only one to feel this way. I was listening to a podcast recently on Venture Voice with legendary VC Tom Perkins. When asked the question about the worst investment he ever made, he turned it around to mention the one that got away, Apple. Kleiner Perkins had looked at a few other computer start-ups and weren't interested, so didn't even take a meeting with the Steves. Bessemer Venture Partners lists an anti-portfolio of investments they passed on that includes Apple, Ebay, Intel, and Google.

Now, back to that house in Mountain View, California. Hard to believe you could buy a nice house like that in the Bay Area for only $300,000....

Is the Grass Really Greener on the Dark Side?

The spring semester of my Entrepreneurial Finance class starts tomorrow. During the next four months, we will examine over a dozen entrepreneurial ventures from a diverse mix of industries - technology, service, food & beverage, and fashion. We will also look at a variety of financing methods including venture capital, angel investing, licensing, franchising, roll-up, venture debt and my old favorite, bootstrapping. One thing that strikes me every time I teach the course and in my investing activities is how much easier it is to critique someone else's idea than build your own. In addition to the case study analysis, the students also have the opportunity to develop a business model and financial model for a new concept, which always proves a lot more challenging.

I think this same concept plays into what I've seen happening a lot more in the venture community: partners at VC firms jumping back into entrepreneurial ventures. There used to be a fairly standard career path in the venture capital industry. After a successful career in a technology leader (Intel, Microsoft, Cisco, etc.) or one or more exits as a start-up founder, you were enticed to become a partner on Sand Hill Road, or as some call it, jumping over to the dark side. With a limited number of these opportunities and 10-year fund cycles, there wasn't a lot of transition among partners in firms. In fact, most partners that left VC firms either cut back to a non general partner role and/or to personal investing and other activities.

However, over the past 5-10 years, we have seen a lot of changes in the make-up of firms, expansion and consolidation in number of firms and partners leaving to join other firms or more interestingly, to start companies or join other start-ups. I thought about the differences a lot when I spent several years as a venture partner. I had been considering moving towards a full time role as a VC, but decided I enjoyed the company side better and participating as an active member of the team rather than strictly an advisor, coach and board member.

Perhaps, this is partially driving some of the jumping across the table, but certainly the performance metrics of funds and individual partners has also played a key role. An argument can also be made that money remains the key driver and given the increasing competitiveness in the VC business in both raising funds and investing, that start-ups are now seen as the more lucrative route.

I'm going to continue to follow the paths of entrepreneurs turned VCs turned entrepreneurs again and see how it evolves. As an angel investor and start-up CFO, I should have a good vantage point.

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.