Today, more than one third of the United States population falls into a financial demographic known as the “mass affluent”. Unlike the headline-grabbing ultra-rich, the mass affluent are people with assets between $100,000 and $1 million, or annual incomes over $75,000. Historically, the 33 million American households in this category have invested for their future in one of three ways: by putting most of their money into personal hard assets such as a primary or secondary residence; by investing their liquid assets into professionally managed mutual funds or their employer’s 401K program; or, for the more adventurous and/or sophisticated, by investing directly into specific stocks and bonds purchased through (and often recommended by) a large brokerage firm. Read more
I’ve noticed that some entrepreneurs seem to have no trouble attracting investors, while others with a great business plan struggle with it. The reality is that angel investors are humans, and personal traits often make or break the relationship, even before the investment is considered.
On the top line, angel investors look to invest in entrepreneurs that have an almost unwavering passion and sense of urgency. In the business, this is commonly called “fire in the belly.” If you don’t have it, you probably won’t succeed, even with funding. Read more
Today I received an email asking me to clarify what I wrote last month in Why sweat equity often stinks. The person quoted the sentence in italics below and asked “what does that mean, exactly?” I’m including the whole point because the context helps:
Founders work for less than fair value and record the difference between actual pay and fair value as owed to founders, a liability on the balance sheet. This has the advantage of recording real expenses into the financials, so I like it. But founders asking for outside investment should expect to capitalize that and swallow the liability. You can’t use founders’ labor to justify the valuation ask, and then turn around and get it paid too. You know: cakes and eating?
So here’s a true story, an actual case, one I know very well because it was my money and my sweat equity. While I was bootstrapping Palo Alto Software I couldn’t afford to pay myself what I was worth. But I didn’t pretend I wasn’t an expense. I practiced what I preach by recording the market value of my work, month by month, as an expense called unpaid Tim salary. And I balanced every month’s entry into expenses (a debit) with a corresponding entry to liabilities (a credit).
(By the way, important warning: I didn’t report my unpaid compensation as an expense for tax purposes. You can’t deduct compensation to yourself unless it’s paid; and when it’s paid, you have to pay payroll taxes. This is not trivial.)
(Oh, and a disclaimer: I’m neither attorney nor CPA. I don’t give tax advice, accounting advice, or legal advice. I’m just telling you a true story.)
As time went by, I accumulated an interest-free liability that was a serious amount of money, more than six figures, as debt owed to me. And that still on the books years later when I brought in venture capital money.
When that turned up in due diligence, my investors said:
Tim, that’s not going to fly. If we’re investing, you have to swallow that. Capitalize it. Take it off the books.
And so we did. The money owed to me became another version of sweat equity. It was in the valuation we negotiated with the investors. It disappeared. It was never paid.
Would I do that — keep track of unpaid salaries — again? Yes. Would I recommend you do it? Yes. It gives a better picture of real expenses, break-even, and so forth. It might be useful for some future close-in negotiation with partners, people close to you, perhaps divorce court or inheritance tax. But investors won’t want to pay it back.
That’s what I meant. I hope that clears that up
After the idea, it’s all about execution. In fact, it’s not clear that even the idea is all that important. Most investors tell me that an A entrepreneur with a B idea is much more fundable than a B entrepreneur with an A idea. It’s great to be a visionary, inventor, thinker, or a dreamer, but none of these matter in the business world if you are not also a do-er.
According to Professor Sean Wise, who claims to have worked with more than 15,000 entrepreneurs (including many with the popular TV shows Shark Tank and Dragon’s Den), no matter how great the idea and the opportunity, in the end it is only the execution that creates change and generates wealth. Read more
There seems to be a subtle but significant operational difference between many European BANs and US angel networks. This is an attempt to describe those differences.
In general, BANs seem to have two primary focuses:
(1) Soliciting a large mailing list of potential angel investor members (and others, such as service providers) and organizing pitching meetings for them. Members have limited obligations to the group, that is, small or no annual dues, no duty to invest as part of the group (versus pocketing deals for themselves), no participation requirements (attendance, due diligence), no leadership mandate and no minimum investment expectations.
(2) Engaging with the entrepreneurial community, sometimes by providing investor-ready services and pitch coaching, with a focus, for the most qualified entrepreneurs, on inviting them to pitching events.
After the pitching session, the entrepreneurs and investors are left to their own devices to do a deal. There is no organized group deal processing; instead each angel engages with the entrepreneur, finds co-investors (within or outside the BAN), completes due diligence, negotiates a term sheet and closes the deal.
There appear to be two models for the BAN operational platform: (a) a not-for-profit model, often driven by economic development agencies and (b) a for-profit model pursued by experienced investors and funded by success fees and tolls charged to entrepreneurs and investors.
Angel networks* in the US (and in some other countries) are primarily focused on recruiting members and managing deal flow for those members. Education, social engagement, pitch coaching entrepreneurs and other activities may also be important functions.
(1) Members are recruited to join the group, appealing to accredited investors with the deal flow and best practices offered by the network. Members are often required to sign a rules of membership agreement stipulating their expected engagement (meeting attendance, participating in due diligence, annual investment numbers, etc.) and committing neither to “steal deals” nor to solicit entrepreneurs for consulting or members of business.
(2) Entrepreneurs are solicited to pitch to the group, through websites and other networking activities in the community. A small group of members or staff pre-screen deals for presentation to the members. Investor-readiness training is seldom provided by US angel networks.
(3) Once an entrepreneur has pitched to the members, a due diligence committee of members (and perhaps staff) is initiated, representing the group. The deal lead negotiates a single term sheet for the round of investment with the entrepreneur. Once the term sheet and due diligence are complete, the deal is offered to all members of the network for investment. In some cases, very popular deals may offer a limited investment amount or time, on a first come, first served basis. Members are investing for their own accounts, consequently members can invest larger or smaller sums, or pass on a deal.
There are several models for managing angel networks, including both member management and manager management. The angel network does not make investments or recommend investments to members, rather members make their own decisions based on the shared due diligence and term sheets.
Both the BAN and the US network models result in entrepreneurs receiving funding from angel investors. To outsiders, the models may seem quite similar but, to members and entrepreneurs, the two models are quite different.
*About 20% of US angel groups are organized as angel funds in which monies are pooled in advance of need and members vote up or down on deals. Generally, the processing of deals by angel funds is similar to US angel networks.
One of the big advantages of being an entrepreneur and starting your company from scratch is that you get to set the culture, which is much easier than changing the culture of an existing business. The challenge is how to do it, and how to do it right. Why not learn what you can from companies like Apple, who are leading the way with great growth and a great culture?
Jim Stengel, in “Grow: How Ideals Power Growth and Profit” chronicles a ten-year study of the world’s fifty best businesses, including Apple, and concludes that those who centered their businesses on a culture of improving people’s lives had a growth rate triple that of competitors in their categories. Read more
A couple of years ago, Paul Graham (Y Combinator) tweeted “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”
The truth is convertible debt has not won. Many sophisticated angel investors and angel groups refuse to invest in convertible debt in seed/startup deals. Why? Because convertible debt investment undervalues this very high risk capital. As Adam Fusfeld has pointed out, there are multiple issues involved in choosing between convertible debt and a shares deal, but I’d like to focus on one – the issue that seems to be most important to most angels – the impact of valuation on returns.
Why is convertible debt so popular? It is inexpensive to do a convertible debt round. Plus, convertible debt does stand ahead of all shareholders in case of liquidation. Personally, I believe it is popular because the press made such a big deal out of Y Combinator and other accelerators doing pre-seed deals using convertible debt.
Note I said accelerators do pre-seed deals…. Yes, most entrepreneurs entering accelerators are pre-seed – and many do a significant pivot while in-house, before graduating. Most angels invest later, in companies at the seed/startup stage, companies that are pre-revenue (with customer validation) or are beginning to generate revenues. (Of course angels invest in much later stage deals, as well.) It is very difficult to negotiate a valuation on a pre-seed deal that is likely to pivot soon while the valuation of startups that are beginning to ramp revenues is more obvious. Comparing accelerator deals to typical angel deals is really comparing apples (pre-seed) to oranges (seed/startup).
So what is my beef with convertible debt? The primary concern of most angels is that, if and when our debt eventually converts into equity, it will do so at a valuation that is too high, higher than can be justified for the risk involved in a seed stage deal. Proponents of convertible debt will counter that the notes stipulate either a cap on the conversion valuation or a discount on the valuation negotiated by the subsequent investor. Unfortunately the conversion cap is seldom as low as the typical valuation of the equivalent seed/startup deal. The discount, while perhaps as high as 30% off the valuation of the subsequent round, may or may not result in a valuation that fairly rewards the earlier angel investment. There is no quicker way for angels to reduce their return on investment than to invest in a convertible debt round that eventually converts to equity at a high valuation.
According to Wiltbank, angel returns are very skewed with less than 10% of funded deals providing virtually all the upside return on investment. It is very important that we angel investors really capitalize on our winners because very few angel investors fund more than 20 deals in their lifetime. Investing in convertible debt which eventually converts to equity at a high valuation reduces the return on that deal, compared to investing at a fair seed/startup stage valuation. If that deal is one of the few home runs in our portfolio, returns for the portfolio will be radically reduced.
Fortunately, cooler heads seem to be prevailing (regardless of the Paul Graham quote above): According to the Fenwick and West Seed Finance Survey 2012 just released, we are seeing a significant decline in convertible debt financings and an increase in preferred shares offerings for seed stage of deals. Hallelujah!