Democratization of Angel Investing

I had a conversation recently with Alex Mittal, Co-founder and CEO of FundersClub (FC) and decided to revisit my blog post from last fall that was skeptical of crowdfunding for angel investments.  FC is the latest Kickstarter type site to launch to give entrepreneurs the opportunity to raise financing from a large number of individuals.  Some of the current services act on the investment bank model and either facilitate transactions between investors and companies (i.e. Micro Ventures) or provide a secondary marketing between investors (i.e. Second Market). 

FC's approach is much more akin to the deal flow and social proof model of AngelList, with the ability to make small investments in a number of companies.  Since the provisions of the JOBS Act relating to angel investments by non-accredited investors haven't been finalized yet, these platforms are currently only available to accredited investors, who already have the ability to make angel investments.  However, there are many pieces of the FC model that are intriguing.

First, a little background on the company.  FC is a YCombinator (YC) company in the current Summer '12 class that will be pitching at next Tuesday's Demo Day. The site has recently launched and all of the 6 companies on FC are part of the same YC cohort.  Only one transaction has closed to date.  Surprise! Surprise! It is FundersClub, so good to see they are eating their own dog food, in VC parlance.

In many respects, the service is similar to the way Angel Groups operate, or at least the way Sand Hill Angels, where I was a long time member does.  Individuals pool their cash in to a single purpose entity to make the investment in the company.  Individuals can make smaller investments in a number of companies, gaining portfolio diversification benefits.  And the company has only one investor on the cap table but can (if they wish) take advantage of a larger group network. On FC, you can see who else is investing, invest with a few clicks, and see how the round is coming together by viewing a real time thermometer. Very cool!  I had always thought AngelList would go in this direction and this indeed may be on their roadmap.  You can connect to FC through Facebook and LinkedIn, but not AngelList...Investors pay a one-time 12% administration fee on top of the investment amount.  This may seem steep, but is certainly cheaper than the annual 2% management fee and 20% carry of a typical venture fund.  Of course, this is comparing apples to oranges.

One of FC's goals is to expand the pool of investors.  While I will be attending the YC Demo Day next week along with many other Silicon Valley Angels, this is not a public event and difficult to attend for those out of the area.  Anyone can now have access to many of the highly competitive investment opportunities.  In addition, the angel investment process can be time consuming and daunting to those not familiar with venture deal terms.  Now, if you wish, you can make investments as small as $1,000 in several companies in a matter of minutes.

I'm curious as to how the SEC will view FC.  The site was designed with the very simple registration process we are all demanding, including checking a couple of boxes to prove you are an accredited investor.  It is no more difficult to move through this than all of the under 13-year olds who have facebook profiles by checking that they are 13 or up.  I'm guessing (if FC proves successful) that there will be unsophisticated unaccredited investors making investments and that the SEC may see this as a public offering of securities. On SecondMarket, there is a much more rigorous interview process and an electronic signature is required.

I still don't see FC as a place I'll make many investments and the administrative fee seems like it will have a material impact on returns, but could prove a great way to have your own angel investment portfolio with aggregate investment amount of $50K instead of $500K-$1M.  Jury is still out, but I'm excited to track their progress and am optimistic that there will be a successful angel investment crowdfunding platform. 

I wouldn't bet against FundersClub.  Unfortunately, I can't bet on them.  I was on vacation last week and missed out on investing in FundersClub through FundersClub before the opportunity closed.  Perhaps, there will still be an opportunity to invest the old fashioned way, but signing a bunch of docs and writing a check. 

Angel Groups Panning for Gold

ProfessorVC just returned from an Alaskan vacation and was mortified to realize it was almost six months since the last blog post. One of our stops was in Skagway, which became the biggest city in Alaska during the Klondike Gold Rush.  Most of the prospectors came up empty and of those who did strike gold, most lost their new found wealth through bad investments or dealings with swindlers. This got me thinking about the "suckers bet" of angel investing and how most don't strike gold for a variety of reasons.  Interesting enough, it was an entrepreneur (John Nordstrom) who was able to get out of town with his gold and opened a little shoe store in Seattle.
 
Earlier this year, I left Sand Hill Angels, the angel group I was actively involved with since 2005.  I've been meaning to share my thoughts about angel groups and will do so in an upcoming post.  In the meantime, I ran across the recent Halo Report on angel group investing prepared by Silicon Valley Bank.

 Some of the nuggets from the report are summarized in the infographic below.

A few of my takeaways:

• Interesting that 81% of deals completed outside of California.  This compares with less than 50% of venture deals being outside of California.  I would guess that overall angel investments are greater than 50% in California, which means that angel groups are active in areas where VCs and individual angels are not.  With deal velocity so great in Silicon Valley along with the large numbers of experienced entrepreneurs and investors, there is little need to associate with an angel group.

• Median pre-money valuation of $2.5 million also indicates a majority of deals being done outside of California, where I would guess the median is closer to $3.5M.  There are a number of reasons for the premium, not the least is the cost of engineering talent.

• Internet dominates total deals while Healthcare received the largest share of funding.  If you add mobile, ratio is greater than 2:1 on deal basis and a little higher on funding.  With the low cost of creating these companies, they are a good fit for angel groups that can move quickly, make a number of bets and have the ability to follow-on.  Healthcare (primarily medical device companies) are very well suited for angel investments.  At Sand Hill Angels, we invested in a number of these medical device companies that had serial entrepreneurs, patents filed, low valuations, and clear paths to exit.  The investment thesis made sense from both sides as funding could get to (or though FDA) and requirement for further funding was low.

Rebuild our Inner Cities one Venture at a time?

As an active participant in the Silicon Valley new venture ecosystem and entrepreneurship educator, I'm intrigued by the recently announced program Venture for America (VFA). VFA is sending high achieving recent college grads into small businesses and start-ups in inner cities.

Conceptually, this is very intriguing and goes against the current popularity of accelerators in start-up hubs (Silicon Valley, New York, Boston, Seattle, Boulder) that are filled with recent grads and drop outs looking to build the next web sensation. I am a big fan of the accelerator programs and while most of the companies coming out won't be successful, many will, and all of the graduates will receive a tremendous education. Many will likely be successful in subsequent ventures and you can't start your second company until after you've done your first.

VFA is taking a different approach to fostering entrepreneurship. It is modeled after Teach for America (TFA), a program that sends high achieving college grads into inner cities as teachers. These have become very high sought after jobs as TFA has been successfully recruiting students that would otherwise be going to McKinsey or Goldman Sachs. Rather than spending 80-100 hours per week on Wall Street, these students spend 80-100 hours per week creating lesson plans and learning how to teach disadvantaged children. While certainly a laudable mission, I question how many of these teachers actually remain in the career vs. using TFA as the golden ticket to Stanford Business School, Harvard Law or other select grad school.

VFA's tagline is "Mobilizing graduates as entrepreneurs" and is "A program for young, talented grads to spend 2 years in the trenches of a start-up with the goal that these graduates will become socialized and mobilized as entrepreneurs moving forward." In an Inc magazine article on VFA, one student is quoted:

I've applied to a ton of companies," she says. "I have this entrepreneurial mindset that I have to work at a start-up and do marketing, but every company I have applied to, whether it was a start-up or not, said they found someone more qualified or I didn't have enough experience."

Nothing against Ashley from UVA, but that is not how you go about finding a job in a start-up. You network! You attend start-up events! You go hang out at the engineering school! You find companies you are passionate about and where you can offer solutions to problems! You don't send in a bunch of applications. Is this the kind of individual that is going to create jobs in inner cities? I don't know, but I'll bet against her.

Couldn't you accomplish the same thing within the university environment? That is what I am doing with the ELAB program at San Jose State University. (Entrepreneurship Lab Provides Students Work Experience in Start-up World) We have had 50 students through the first four offerings of the program and almost 50% have received job offers at the end of the semester for either full time jobs or paid internships. All have received tremendous experience not available in a typical academic setting.

Back to Venture for America. I hope they are successful in creating companies and jobs in inner cities. Clearly, we live in a bubble in Silicon Valley and our economy is rarely in sync with the nation as a whole. If the rest of the country were experiencing the new company growth, hiring challenges, decreasing office vacancies and rising rents that we are in the Bay Area, the economy wouldn't be the top issue in the presidential campaign. In fact, nobody outside of the far right would care about the Republican primaries as Obama's reelection would be a fait accompli. Politics aside, as the Beach Boys sang, "Wouldn't it be nice"...

Crowdfunding - Good Idea or Really, Really Stupid Idea?

Last week, the House of Representatives passed the Entrepreneur Access to Capital Act (H.R. 2930), commonly referred to as Crowdfunding. Since small businesses are responsible for the vast majority of new jobs, legislators believe that these new rules will make it easier for entrepreneurs to raise capital and ramp up hiring. In theory, this sounds like a great idea. However, in practice, this will be very bad.

I won't go into the details of the bill, but at a high level, it allows entrepreneurs to raise funds over the Internet up to a maximum of $1M annually (or $2M with audited financials). Maximum investment from each individual investor would be the lesser of $10K or 10% of annual income and investors do not need to be sophisticated. These investments would be exempt from registration under the 1933 SEC Act.

There is a reason the SEC exists. I can't remember if the SEC was one of the government agencies that Rick Perry wants to get rid of (but neither can he), but it seems like this is the exact type of investor that the SEC was set up to protect. Angel investments are highly risky and I would estimate that over 90% provide no return to equity investors. This is why 25-30 investments are required to achieve proper diversification as an angel. 10% of an individual's income is a very high amount and there will be many scenarios where non sophisticated investors will invest in multiple companies and going over the limit by simply checking a box in an internet form.

You may be thinking, "Ah, ProfessorVC is concerned about more competition in his angel deals". I like the way you are thinking, but not true! At the end of the day, very few entrepreneurs say "I wish I had raised less money"...and very few angel deals are truly oversubscribed, no matter what the press release says. More funding at the seed level is a great thing! Just not from investors who can't afford to lose the cash.

I often speak on panels and am often asked questions about what are the qualifications to be an angel investor. My response (only partially tongue in cheek), is to hold a $100 bill on one hand and a lighter in your other. Light the bill. Are you calm? If so, do it another 5-10 times. If you are still ok, then you are probably fit to be an angel.

Clearly, there are benefits to making it easier for entrepreneurs to raise seed funding. I'm an active participant on AngelList a fan of the excellent accelerator programs (YCombinator, 500 Startups, TechStars, AngelPad, etc.), and an investor in Right Side Capital Management (RSCM). RCSM is seeking to add scale to angel investing through a highly automated screening, evaluation and diligence process.

However, I'm just not comfortable with where this legislation is going. Crowdfunding will likely be well received by scam artists and lead to many startup investment pitches in your spam folder along with those for viagra and male enhancement. More importantly, this could lead us down the road we've already traveled with day traders and real estate flippers...At the very earliest stage, this is the realm of friends & family and if you are comfortable taking investment from your fraternity brother, not so rich uncle or brother-in-law, be my guest.

Card Counting for Investors

How would Billy Beane have done as an early stage investor?

I haven't had a chance to see Moneyball yet, but did read Michael Lewis' book when it came out eight years ago. However, I have seen some blog posts posing the question about whether the same principles of valuing baseball players could be applied to entrepreneurs.

Dan Frommer, in Moneyball for tech startups, interviewed Fred Wilson, Chris Dixon, Paul Graham and Ben Horowitz on the topic. According to Dan, the consensus "seems that this sort of technique is possible. And given that four of the most important tech investors in the world seem skeptical of it, if someone can figure out a good formula that works, they may be able to exploit it".

Well, I think I know the guys that can do it! I've written previously about Right Side Capital Management (RCSM), the latest in my post earlier this year, "How Much Diligence is Due..." (Full disclosure: I am an investor and adviser in RCSM.)

RCSM's premise is that they can reach an investment decision (and valuation) based on an application completed by the founders and take gut feel out of the decision process. Below is a short description of their philosophy:

"The part of our philosophy that makes us most different from other startup investors is that we don't believe gut feel is a reliable indicator of potential at the seed stage. Humans are just not very good at simultaneously integrating that much uncertainty to form a judgement. So we focus on specific aspects of a proposed venture that we can evaluate with minimal ambiguity. Over time, we plan to build increasingly sophisticated evaluation methods based on hard evidence."

I'm still not convinced that "gut feel" isn't a good way to invest at the early stage, but this can certainly get rid of over-thinking and provides diversification and investments in entrepreneurial teams that would be otherwise overlooked. They have launched a valuation tool that is free to try out. I encourage entrepreneurs to give it a shot and let me know what you think.

RCSM is also participating in the TechStars funding alliance that will be providing an offer of $100K in funding upon acceptance into the program. This will give RSCM the opportunity to test out their process on the large number of TechStars applicants.

Also interesting that some of the guys behind RSCM are professional poker players who have a deep appreciation for odds and statistics. In the trailer below, Brad Pitt in describing the new player acquisition philosophy, says "we are card counters at the blackjack table we're going to turn the odds at the casino"





I look forward to checking out the movie and seeing if RSCM can exploit the odds on early stage investing.

P.S. ProfessorVC is happy to have been included as one of the 50 Best Professor Blogs

Waah...Do I have to build a financial model?

I get asked this question a lot by entrepreneurs (and students). I often feel like a Dad (which I am to two wonderful teenage daughters) when I respond, "Yes, because I say so"...Everyone seems to know someone who has raised huge amounts of venture capital without ever putting together even back of the envelope projections. The objections range from "it's hard", "nobody believes them" to "all hockey sticks look alike". To that last one, there is certainly some truth as the standard time vs. revenue chart in most business plans looks like this:



I'm not teaching Entrepreneurial Finance this semester for the first time since Fall 2007. However, I am teaching the ELAB and a new experimental course (The Silicon Valley Experience) for the MBA program. Since I won't have the opportunity to lecture students on this topic until the spring semester, I'll share some of my thoughts here and perhaps can have a dialog on the topic. High level, building the financial model forces the entrepreneur to:

1. Validate the concept and business model
2. Determine financing needs and key milestones
3. Build credibility with investors
   

I used to also argue that it supports your proposed valuation, but on an early stage deal that is a bit far fetched to get in to a valuation discussion based on your pro-forma projections. The importance is what is behind the numbers. How do you think? What are the key drivers and metrics? Is the model consistent with the business plan? Does the business model make sense? Do you understand the business and market? The process of building the model forces you to answer the difficult questions related to the business model and give a complete picture of the opportunity. Most importantly, how are you going to make money? What did you expect from a long time start-up CFO?

Related to this, I got an email from an entrepreneur this week interested in meeting with me. Unfortunately, I don't have time to take all of these requests, but always try and help where I can so offered to respond by email. Thought it would be appropriate to share his questions and my answers below related to the topic at hand:

The main questions have to do with presentation of documents to VC's.

1.) Does a complicated sales build model make sense for a pre-revenue SaaS company? Analyzing each step of who comes to the website organic, paid, conversions etc

[SB] Having a bottoms-up model is helpful. Of course, this is all hypothesis at this point, but you want to make sure that your assumptions are consistent with market realities for other SAAS companies. Byron Deeter has a good blog post on SAAS metrics.

2.) How should you include market comps? I don't like doing top down models, but I want to make sure the numbers are based on the other people in the markets.

[SB] It is good to have a top down that is consistent with your bottoms-up, so I’d recommend doing both.

3.) How much needs to be shown in the form of a cashflow statement, and balance sheet? Also, do you show accounts payable/receivable in these as they are not accurate or real?

[SB] I include all of the statements in my models to be complete, but nobody should care about this on a prospective basis. For actuals or short-term projections, much more important. When I look at a model, I care most about the assumptions around the business model. I want to get a good idea of the drivers and what is most important for success. I also want to know how you think about the business and how well you know the market, which becomes apparent through how the model is constructed.

4.) Would you put the assumptions/variables on one page that drives the numbers throughout the spreadsheet, or do you put them above each month so they can be altered monthly.

[SB] Ideally, it is good to have all of the assumptions in one tab, so it makes it much easier to do sensitivity analysis. I like to have one tab with assumptions and one tab with summary financials and key metrics. If the model is constructed properly, you don’t really need to look beyond these. I also typically, write a text document summarizing the assumptions, validation for the assumptions and key metrics. However, sometimes (particularly in the early periods when annual is too long a period), you may want to have some of the assumptions on a monthly basis within the appropriate tab. I often do this in the revenue tab.

Hope that was some helpful advice from ProfessorVC. Feel free to chime in with your thoughts.

I'm heading up to the mountains with the family this evening and should probably get ready for that other common Dad question coming from the back seat, "When are we going to be there?"

One final note: After labeling myself as "the last blogger in Silicon Valley", I am now doing the same thing on twitter. Wanted to make sure it was going to catch on...You can follow me @professorvc, and hopefully will comment more frequently than this blog.

How much is enough?

Financing, that is...I had mixed emotions when I read the the press release on the recent funding of iControl Networks.

I was the founding CFO for iControl and spent over 4 years with the company (the reason I call myself a part-time CFO and not interim as I tend to remain longer than most permanent CFO's...) Since the iControl system chronicles all meetings, I was able to find the automatic picture snapped from my first meeting with the founders, Reza Raji and Chris Stevens on April 22, 2004.

Now that iControl has raised over $100M, this got me thinking back to our original business plan. One truth of start-up financing is that it generally takes twice as long and twice as much money to accomplish your milestones. I took a look back at our original financial model we presented to VC's in 2004. The business model (OEM through broadband and home security companies for mass distribution) if not specific product functionality has remained largely the same. But of course, the model had us requiring only $10M equity to breakeven and to achieve $185M in revenues in 2008 (the magic Year 5 in all business plans).

I am no longer an insider, so don't have any view into current financials, but do know that total financing is now 10X the original plan and at the current accelerating growth rate, revenues will still not hit that $185M until 2012 or 2013, so double the time. And this is a company that has managed to get an A+ list of investors and is executing very well. Most companies don't come close to their rose colored financial models prepared when going out for Series A financing.

There are definitely some lessons in the story for entrepreneurs and angel investors, but before discussing, I thought I'd share a bit about the early financing history for iControl. Before the $52M Series D, the $23M Series C, the $15.5M Series B and the $5M Series A, there were angels writing checks with many less 0's. In looking back at the old financials, at the end of Q2 2005, our cash balance was a whopping $546. At this point, Reza and I were funding the company to keep the lights on and servers running. We had spent the $275K raised from our original angels and were actively speaking to any and all angels and VC's we could convince to meet with us. In fact, since the iControl system was busy taking pictures of all entering our conference room, we could put together a photo album of all these meetings.

At this time, we had secured a term sheet from a co-investor from one of my other angel investments (Thanks, Graeme!) offering to invest $75K if we could find another $250K by September 30, 2005. We managed to pull together an angel syndicate and close $450K on 9/30 after working the phones the last few days and anxiously waiting for signature pages to show up on the fax machine and wire confirms to hit the bank account. Less than a month later, we received a term sheet from Charles River Ventures for the Series A and as they say, the rest is financing history...with investments from Intel, Kleiner Perkins, Cisco, GE, Comcast, ADT, Rogers, and others.

So what does this all mean. As I said up front, I have mixed emotions about the financing. While my ownership stake in the company has been diluted through these financings (and the merger with uControl), my carried interest (paper value of my equity) has been going up with each increase in valuation. However, each financing resets the clock as new investors are looking for a multiple of their investment on exit.

Entrepreneurial finance (I should know since I teach the course) is all about options. Staged financing gives investors options in deciding whether and when to invest more and gives entrepreneurs options in how much to raise and when to think about exiting. While bootstrapping, there are multiple options from doing as a side project, changing the business, raising angel or venture, etc. Once you raise a small angel financing, you still keep many of your options, but are now committing to a growth path with an eye towards eventual liquidity. A talent acquisition or bootstrapping are still options, but need to include buy-in from the investors. Once you raise venture capital, you are forced on a path to spend ahead of the business and seek the highest growth business model options. In iControl’s case, there were exit options at different stages, but now with more than $100M invested, the only options where investors will be happy will be an IPO or $1B+ acquisition, which greatly limits strategic options.

Is $120M enough capital to reach these exit goals? I sure hope so, but we'll have to wait and see how the founding team and angels come out at the end of the day. Stay tuned...