Entrepreneurial Leadership and Management . . . and Other Stuff

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13
May

Angel Investing – What I’ve Learned So Far

I made my first angel investment in 1994. At the time, I had no basis for evaluating whether I was investing in a good idea, understanding how the deal was structured or even what the market the company was addressing looked like. It just seemed like a cool thing to do – great founders and a killer co-investor in Brad Feld. As it turns out, that first investment, net.Genesis, was a big success. While I’d like to think that there is some correlation between my choosing net.Genesis for my first investment and its success, I don’t think there is much. Mostly, I was lucky.

After dipping my toe into the angel waters the first time, I continued to invest in more new companies. I made 1-2 investments every year for a while, always going in relatively big in my first round and picking up my pro-rata in at least the subsequent round. For the most part, I still didn’t know what I was doing, but I was beginning to get a feel for things. Since I was only doing a couple of deals each year, I started doing more due diligence, but even this was limited as I had a day job running my own company.

Some companies I invested in succeeded, more failed. For the most part, though, I was doing pretty well, making more money than I was losing and making way more than I could have in the stock market or any other investment instrument I had access to. Still, no one was going to question my amateur status. I was choosing companies to invest in from a very small sample of those looking for money, I didn’t understand the subtleties of deal terms (as I often co-invested with VCs, this lead to problems), and I was still investing in companies addressing markets I didn’t have even a basic understanding of (I’m talking to you, life sciences and healthcare).

Eventually, I got better at judging companies, teams, ideas and markets and being able to change a sea of gray into black and white, especially with respect to the market part. I increased my pace of investing to move up to 5-7 deals/year, but started investing less with each company and not always reinvesting my pro-rata amount in subsequent rounds that I thought were too expensive.

Fast forward to today. While I’m still an amateur, I’ve now done over 60 investments. Not as many as some, and not even close to semi-pro and professional angels. Still, a reasonable number. I finally feel that I have enough data to try to extrapolate some trends and, perhaps, associate some causes and effects. I’m still learning, of course, and since I haven’t made a profession out of it, I still don’t always hold fast to my own observations/guidelines. But, for what they’re worth, I share them here.

The General Stuff

  • You need to put a reasonable amount of money in play especially at the beginning. Nothing pays out for a long time and the feedback loop is huge. A small percentage of investments will return anything, so you have to place a lot of bets.
  • You need to look at many deals before choosing which ones to invest in. It’s easy to get excited about the ones you see, but you have to ask yourself what you’re not seeing. There are a million little companies out there to invest in. What are the odds that the subset you are seeing are the best ones?
  • Network, network, network – get close to as many other angels as possible. The vast majority of angels are very open and are happy to share deals with you, make introductions or give advice.
  • Look at every company from every incubator/accelerator you can find. Meet with the companies if you can. That’s not to say that there are good companies at all incubators, although there are usually one or two in each session, but there are many in one place and they’ll give you a perspective on what’s going on, team dynamics and what others are looking to invest in. They are also good practice for your own discovery skills. Like Malcolm Gladwell says in Outliers, you need to do it 10,000 times to build an instinctive foundation for knowing what has the best odds of working.
  • As in most things, luck remains a significant factor in successful investment returns. When I think I’m getting good at investing, I remind myself to look back and ask myself if the company succeeded because of factors I had predicted, or because of something else. Most often, success is greatly determined by the company being at the intersection of the right place and the right time. Often, it got there because of macro-economic changes that were out of my view and out of my control. Sure, picking the right team in a solid market influences arriving at this intersection, still, there is a lot of luck involved.

What I’ve Learned and My Current Thinking

  • Almost any deal with a good return will take a long time to reach a liquidation event – 6-10 years. While there are exceptions, my home runs all took about a decade to return their first dollar.
  • I used to think I could put a small amount of money into many companies each year and things would play out. I no longer believe that to be true. It’s a hits business. Even with a high-multiple exit, a small investment won’t provide a large enough absolute return to cover losses from failed investments and make a lot of money. Now, I invest more in the first round I participate in and almost always do my pro rata in subsequent rounds to maximize my ownership as the company grows.
  • I try to be somewhat valuation agnostic. That is, the math on successful companies (assuming my home run theory is correct), shows the valuation at which one invests really doesn’t matter much. I try not to overpay of course – if I can’t acquire enough of the company to give me a good return when a logical exit takes place, I’d rather put my money at work somewhere else.
  • There are red flags (real or potential problems) in all deals. I try not to let the existence of one scare me away. It’s the combinations of red flags that matter. If the CEO does not want to take money for fear of being diluted AND won’t create a board of directors, for example, I walk away.
  • I have two fundamental requirements for an investment – the team has to listen well (they don’t have to ever take my advice, but they have to listen to it and consider it), and founders have to have a desire to build a killer, well-rounded team. In my experience, founders who don’t actively listen don’t succeed. Those without solid teams struggle and most eventually fade away.
  • Ideas are fleeting and are almost never unique. Even if the company seems to have a distinct cut at something, someone else with a similar idea will be smarter, faster and have more capital. Speed is the key variable. If the team is willing to work their asses off and take enough money so that they always have fuel in the tank, then they have given themselves the best chance to succeed. This latter part – money – is where I often find problems. Sometimes, founders don’t want to take money for fear of dilution. Because they don’t have enough money, they move more slowly and are overtaken in the market.
  • I hate convertible notes, but after years of therapy, I accept that they are here to stay. Still, they are loaded with pitfalls and I try to avoid them when I can reasonably do so.
  • I only invest in stuff I know, at least broadly. Of course, it’s not possible to know the entire spectrum of products, services and markets I want to invest in, but there are always some I have a better feel for than others. I have lost a ton of money in healthcare and life sciences. I’ve invested in the cure for cancer 3 times. It just goes to show that I have no idea how that stuff works.
  • Does the company have a board? Every company should have a board. I find that often, when startups don’t have a board, it’s because they are worried about loss of control and put that worry ahead of the value that close advisors can bring to the company. This is a huge red flag for me (see above).
  • I don’t invest in a round when I think the company will struggle to create a significant step up in valuation before they need more money. This can happen because the valuation on the current round is too high or the company is not taking enough money to make significant progress before the money runs out. I just wait until the next round to invest at pretty much the same valuation with reduced risk.
  • There are many angel investors who seek out teams in the very early, formative stages of building their companies. As you’d expect, this type of investment offers the potential of lower valuations, a much greater return and, of course, failure. I am not one of these investors. I’m interested in the follow-up investment right after this nascent round if the company makes it that far. Much less risk and less work as well as I tend to follow and not lead, but my experience is that I usually have to invest at 2X the valuation.

There are some hugely successful, high-profile angels who can offer more wisdom and informed investment criteria than me. I fully suspect that some very successful angel investors may even disagree with me on one or more points. That said, for those of you who are just getting into angel investing or are looking for some perspective on how others do it, I hope that this is valuable. As always, I’d love to hear what you think.

 May 13th, 2016  
 Will  
 Investing  
   
 4 Comments
27
Apr

Convertible Notes – An Angel Investor’s View

Overview

Not so long ago, when one invested in an early startup, it was almost always through the purchase of preferred stock or equity in the company. An exchange of cash for a small percentage of ownership. Neat and tidy, everything on the table, no loose ends. Then, over time, founders (with the help of incubators and accelerators) decided that these equity instruments were becoming too difficult and time consuming, especially with respect to the negotiation of the price of the round and, to some extent, the preferences required by some investors. The “simplified” instrument that most companies started to use was the convertible note.

Convertible notes quickly became de rigueur in the startup community. They are, ideally, debt instruments that offer the investor interest payments in exchange for cash invested in the company. On the successful achievement of certain milestones, the investment (plus the interest earned) is automatically converted into ownership in the company. The key milestone generally being the closing of a subsequent equity investment round. Allegedly, if the company fails to raise an equity round in a specified timeframe, the investor can get their money back. This is supposed to be the advantage for the investor but is, in fact, a useless provision. If the company can’t raise a round, they have more than likely spent all the cash they have leaving nothing in the till to return to investors.

Initially, convertible notes did make things simpler for the founders of the startup. They could kick the valuation discussion down the road and the paranoid founder could withhold any control and financial preferences from their early investors. Unfortunately, these early, simple convertible notes were minefields of problems for angel investors. Foremost among these:

  • They created situations where investors might only get their money back even though there was a large exit for the founders. Think of an exit that happens before a conversion takes place.
  • They did not specify any control provisions or establish a board (every company needs one). No oversight.
  • They often didn’t recognize the level of risk taken by the early investors with an appropriate combination of discount  and conversion restrictions at the next financing round.
  • Because the investment is debt and not equity, they kept the investors from starting the clock on capital gains treatment for the investment until the conversion took place.

To address these problems, investors negotiated new provisions in the notes to patch the holes which, in turn, made the convertible note documents increasingly complex and ultimately created documents at least as complicated as the equity investment instruments that they replaced.

Now, instead of discussing the valuation of the company and specific preferences of the preferred stock in an equity round, the cap on the note (the maximum conversion price), the discount (the reduction in price upon conversion), and the term of the note (when and how conversion takes place) need to be negotiated (some good descriptions of these can be found here).

Convertible note documents have ballooned into multi-page, complex forms that are not only negotiated just like their equity-based brethren, but now carry legal costs that are similar as well, taking away much of the advantage that was sought when they were widely adopted in the first place. In fact, they don’t even succeed any longer at their primary goal of kicking the valuation discussion down the road since the negotiation of the cap on the note has replaced that pretty much 1:1.

The realization that convertible notes are no longer either cheap nor fast has brought about several openly available standardized equity financing instruments like Series Seed, Techstars Open Source Model and others that promise to make a priced round even cheaper and faster than a current, complex convertible note. In my experience, and sadly, these documents are not changing the landscape much.

OK, that’s my rant. For a while, I refused to invest in converts. I wasn’t the only investor around who felt that way, but most didn’t care or push back. The debt instrument took hold and is here to stay. At least for a while. Now, I see very few seed deals that are not structured as convertible notes. Those that aren’t are generally led by institutional investors who often require an equity instrument to do an investment.

There is just so much fighting of the establishment that one can do and, as such, I’ve conceded that if I am to remain an investor, I have to adapt. That doesn’t mean I have to roll over, though. As such, I’ve created a set of criteria for myself when it comes to reviewing the convertible notes of potential investments. There are certain parts of a note that I like to see and some I don’t like. More importantly, there are parts that cause me to negotiate strongly and, ultimately, walk away if they are not added, removed or modified. I’ve tried to outline each of these below.

For angel investors reading this, I’d appreciate if you’d add your thoughts on what I’ve missed and where I’ve overstepped. For founders of startups, I hope you’ll look at these items as guidelines when you’re putting together your note. My intent is not to create an investor-biased instrument, but to fill the holes left by current convertible notes; to shed light on why some terms don’t work well for angel investors and to suggest how to change them so they work better. I don’t believe that any of the guidance I have or changes I recommend should be detrimental to the founders of the company. Speak up if you disagree.

Discount and Interest

Seed investors take a significantly higher level of risk than later stage investors. Let’s face it, the vast majority of startups fail and most of those fail early. In an equity investment round, the risk level taken by angel investors was built into the valuation of the company. Since this is not part of the note, then the investment risk has to be recognized through another avenue. This is the importance of the discount. A discount rate of 20% is pretty standard, but is it appropriate that the seed investor pays 80% what the next round’s investors pay when there might be a year between investment rounds? Probably not. So, the discount rate needs to be judged alongside the cap on the note. The combination of the two should recognize the risk taken by the early investor. That said, a discount rate of less than 20% is pretty big red flag for me.

On interest rates, I usually see 5-6%. I don’t focus on these too much because that’s not why I’m making the investment. Still, if it’s much outside this range, I’ll want to know why.

Cap

First and foremost, there must be a cap on the conversion. Again, why should an early investor take the risk of an early investment only to have someone else decide on the actual value of that investment somewhere down the road?

There is no absolute on the cap, of course. It depends on the company’s stage and what’s happening in the overall market. The cap should reflect the projected value of the company at the approximate time of the next financing, discounted to take the risk of the market and execution into account. Good luck with that. Really, it’s the number that in combination with the discount will get investors to fill your round. Hopefully, you can begin to see why negotiating this is no more efficient than negotiating an actual current valuation

Events Prior to Conversion

One of the biggest problems with convertible notes from the investor’s viewpoint is plugging all the potential scenarios that can take place between investing via a note and the conversion of the debt to equity. For example, if the company is sold prior to conversion, does the investor simply get their money back without recognition of the value of their investment? This situation is covered naturally in an equity round, but not in most convertible note documents.

As such, the note must specify that any change of control of the company (aka sale of the company or liquidation event) before conversion has taken place triggers a capped and discounted (as per the terms of the note) conversion into common shares in the company immediately prior to the execution of the corporate transaction. What this means is that the investor’s debt will be exchanged for equity according to the terms of the note, making the transaction a proxy for an equity investment round.

If the transaction is for less than the conversion cap, then the investor should have the right to receive a multiple of their investment. This can be on a sliding scale based on the time between their investment and the transaction. I have seen a fixed multiple of 2X applied to cover this gap.

Closing of the Note

The convertible note should not remain open for a long period of time. Sometimes, company founders will create a note and continue to take money under the terms of the note for an extended period of time. Since the terms of the note represent the level of risk taken and time, generally, reduces risk, it’s not fair for later investors to get the same terms as substantially earlier ones. Therefore, notes should be closed within 90 days of their opening to recognize the risk being taken by the early investors. If a note remains open for a long time, many angel investors will do their best to be the last money in which can make it difficult for the founders to raise the cash they need.

Pari Passu with Future Notes

It used to be that the early seed round was done with a note and the subsequent rounds were equity deals. These days, angels are seeing multiple rounds of convertible notes. When this happens, it’s important that the original note holder ensures that any more favorable terms in the future notes apply to the original note as well. Why should the people who took more risk by investing early receive fewer benefits?

To be clear, this does not apply to retrofitting the terms of an equity investment to original note holders. On conversion, the note holder will become equity participants via the conversion and receive the same terms, with some exceptions mentioned below, as the participants in the equity round.

The Major Investor Clause(s)

Many note documents include a class of investor referred to as the Major Investor. The Major Investor is usually granted rights that include guaranteed information, inspection rights and the right to invest in the next round of funding at their pro rata level at minimum. Effectively, the Major Investor clause(s) give the company and/or investors the right to preclude non-Major Investors from getting information or investing in the next round. As an angel investor, this is a huge negative. If things are going well, I may not have the ability to invest further. I’m not sure how that benefits anyone. No such clause should exist. If it does, I’ll ask for a side letter including me as a Major Investor.

I cover this thoroughly here.

A permutation of this that is regularly found in notes covers what is often known as the Requisite Holders. Sometimes, I’ll find the description of the rights of a Requisite Holder at the end of the note buried in the boilerplate stuff that no one ever reads. Here’s an example:

Any provision of the Notes may be amended or waived by the written consent of the Company and the Requisite Holders.

Where the group of Requisite Holders may be defined as the largest investors in the round. So, basically, certain investors may change the terms of the note at any time even to the extent of making the terms of the note different for each investor. The especially bad part of this, as I mentioned, is that this clause is often found at the end of the note, where no one is really paying attention. Why would I agree to this? Does this serve the company?

Conclusion

Whew! That was long. If you’ve read this far, I hope it was helpful. I’d like to believe that this is a treatise that will reverse the tide of the use and overuse of convertible notes. Of course, I know it won’t. So, at the very least, if this helps a few angel investors be more diligent about convertible note documents and convinces more to push for equity investments instead of debt, then I’ve done my job.

 April 27th, 2016  
 Will  
 Investing, Startups  
   
 13 Comments
06
Sep

The Dreaded “Major Investor” Clause

I’m a fairly active angel investor. I’ve certainly done enough investing to have seen a broad range of investment paperwork and the preferences of most of the top lawyers used by startups in the country. Generally, the docs are mostly boilerplate. Legally mandated cover-your-ass type stuff. So, rather than wade through reams of paper for each investment, I have key terms that I look for and pretty much ignore the rest. Almost everyone’s intentions are good and all parties involved want all to benefit from the success of the company or to participate equally in its failure. Rarely does someone want an unfair advantage in a deal. Well, mostly.

In about a third of the deals I do these days, I run across the dreaded Major Investor clause. It goes something like this:

“Major Investor” means any Investor that, individually or together with such Investor’s Affiliates, holds at least X shares of Registrable Securities (as adjusted for any stock split, stock dividend, combination, or other recapitalization or reclassification effected after the date hereof).

Big deal, you say, that’s just a definition. True, but why define a Major Investor at all? Because later in the document (usually in the Investor’s Rights Agreement), certain rights and privileges are reserved solely for the Major Investors.

Who are these people? Generally speaking, they are a lead investor in the deal. A single large investor, a family office, a VC, an angel fund or some other investment group. Oh, by the way. Did I mention that the X in the definition above is generally set higher than the level that individual investors are coming into the deal at, leaving the lead investor as the only Major Investor. But, I bet you guessed that already.

What are the rights they reserve for themselves?

  1. Information rights
  2. Inspection Rights
  3. Preemptive Rights (also known as Right of First Offer or Right of First Refusal)

Information rights grant investors the right to receive, at some pre-determined interval, information about the company’s status and finances. Limiting information rights to just the lead investor is just silly. The idea is that it saves the management team time, not having to report to too many people. Why this takes more time than reporting to one party, I have no idea. In practice, it’s just another cc: on the distribution list of the status email.

Some VCs voice a concern that granting such rights to all investors will create a dialog of follow-on questions and comments that will consume too much of management’s time. In my experience, there is almost never much of this going on unless it’s encouraged by the CEO. Often, the angel investors, having mostly run companies themselves, can offer up their situational wisdom when they know what’s going on. This advice is frequently more valuable than the money that was invested.

Inspection rights, which grant investors access to the company’s books, facility and personnel from time to time, is more difficult. I actual agree with limiting inspection rights. This can create a huge time sink for the company and get out of hand when a deal has many investors.

Preemptive rights, which explicitly grant the investor the right to invest his or her pro rata share in the next round of investment is the biggest problem (I wrote about this a while back here). It’s not unusual these days, when a company is doing well and its prospects look good, for VCs to want to maximize their ownership in the company when they decide to invest. Part of this maximization often entails diluting the previous investors in the company. Yeah, that means decreasing the ownership of the angels who invested in the team and idea before anyone was confident of what its prospects were. The one’s that took the most risk. It’s just wrong.

So, Preemptive rights are a protective provision that give early investors the right (not the requirement) to invest more in the company in order to maintain their level of ownership, avoiding dilution. All early investors should have this right, which should be explicitly granted in the investment documents. By keeping this right for themselves, Major Investors are virtually guaranteeing that the angel investors in the round will be screwed in the subsequent rounds of investment if things are going well.

You might ask if this happens in practice. I can assure you that it does. I have fallen victim to this more than once, although not in a while. I know many angel investors who have gotten caught in this trap because they didn’t understand or didn’t take a hard look at the paperwork before making an investment. Recently, I was in a situation where I had to fight to maintain my ownership in a follow-on round even though I had Preemptive rights. The VC investing in the new round demanded of management that all the angels who had previously invested give up their protective right. Several of the angels refused and the deal went through anyway. If there was no prescribed right, you can imagine how it would have gone down.

If you’ve gotten this far, you probably understand my point of view concerning the Major Investor clause. It’s changed my process of discussing an investment with a startup and reviewing the documentation for the investment. My first move is to search for the term “Major Investor.” If it’s found, I check on the rights granted (implicitly precluding the angels in the deal). I don’t really care about Inspection rights and I think that limiting Information rights is stupid, but that won’t prevent me from doing the deal. Preemptive rights is a much bigger deal. I’m simply not interested in making an investment in a company that doesn’t offer me a Preemptive right in return for the risk I’m taking as an early investor. I don’t always invest my pro rata share in subsequent rounds, but I’m not willing to give up my right to do it.

 September 6th, 2014  
 Will  
 Investing, Startups, VC  
   
 Comments Off on The Dreaded “Major Investor” Clause
22
Feb

Handling a “No”

I’ve spent a considerable amount of time playing angel investor over the years which has given me the chance to meet many great entrepreneurs. In general, when an entrepreneur contacts me, he/she is looking for money, advice or both. Generally speaking, I make a quick determination if the people are some that I might be interested in working with; whether or not the idea is something that I can actually add some value too (an increasingly small set of things, as it turns out); and, oh yeah, whether or not I can make any money by investing in it, if that’s appropriate. About a third of the time, I immediately say “no,” because it doesn’t match up with any of my basic criteria.

The other two thirds of the time, I spend more time with the entrepreneur to understand the business as best I can and as quickly as possible. After 35+ angel investments, I should be able to determine the value of a startup quickly, yet, it doesn’t actually seem to be getting any easier. Or, at least, I’m not getting any better at it. Of course, the amount of time I spend coming up to speed with the team depends on my interest and varies quite a lot. In the end, the vast majority of people I talk with ultimately get a “no.” That’s just how the numbers work out. I can’t invest in everything.

In almost all cases – there are those who take a “no” like I said their mother is ugly and are complete assholes about the situation – I do my best to be supportive and helpful in my rejection, explain why I’m not interested and almost always try to connect the entrepreneur up with someone who might be better equipped to help or might be interested in investing. But, it’s still a rejection and it’s tough to take. It’s in how the entrepreneur handles this situation, that I learn more about them than during any of my previous discussions.

Once in a great while, someone will hang up on me or clumsily end a face-to-face meeting with some poor excuse. More likely and if email has been the primary form of communication, I might never get a response to my “no,” which is also a non-response to my offer to hook the person up with another potential advisor or investors. Sometimes, the entrepreneur digs in his or her heals and pushes even harder, thinking that they can force me into changing my mind. Often, pleading, in various forms, takes place.

I’m here to tell you folks, this is all bad. If you’re an entrepreneur (or any one doing business), you should treat each relationship you establish as a long-term, important one. You just never know when you’re going to need it. Sometimes you need it and you don’t even know it – like when another investor calls for an opinion or a reference. I don’t hold a grudge, but I’m not shy about sharing my thoughts about things, especially with people I have an established relationship with (there’s some recursion here, I think).

I’m making it sound like very few handle the situation well. Many actual do handle themselves wisely and professionally.  What do I mean by this?

  • They politely ask “why?” to fully understand my decision without trying to convince me otherwise
  • They thank me for the time I invested and for my consideration of the team and idea
  • They usually ask if I mind if they can engage me for advice or guidance in the future or if they can send updates on what is going on with their new baby.

Yes, for the most part, it’s political and maybe even pandering. It’s also smart. Some people handle it so well, I question my decision not to get involved. Handling it well gives me the impression that the entrepreneur might have the right stuff to be a great CEO. I’ll take that over a great idea any day (although both is nice, obviously). Even if I don’t get involved, that’s what I’m going to tell others when asked.

I’m not trying to be the Emily Post of startup venture engagements here. But handling this basic stuff right can get you very far. There will be MANY more “no’s” in your future. They are always harder to handle than “yes’s.” If you can handle them well, you’ll demonstrate what you can do when things are not so good. A much more important skill than what to do when things are going well. And that’ll get around.

 February 22nd, 2011  
 Will  
 Investing, Startups  
   
 12 Comments
06
Nov

You Gotta Pay to Play . . . Or Not

Last week, I wrote a post about the right of an investor to maintain their percentage ownership in a company through the pro rata rights provision often found in investment agreements. In that post, I referenced another provision that often crops up, pay-to-play. In its most basic form, the pay-to-play term causes an investor to lose certain antidilution protections if they don’t participate in later financings at a pro rata level. This loss can take a variety of forms. These range from a conversion of all the shares purchased by the investor in previous rounds from preferred to common (ouch!) to the loss of the right to participate in future rounds (a mild spanking).

I get why certain investors want this term in there – if a co-investor is not going to continue to invest in the company in subsequent rounds, why should they retain the rights and privileges of a holder of preferred stock? The same rights and privileges that investors investing their pro rata portion.

I understand the logic, but as an angel investor, I find little to like about the provision in virtually any form. If I, as an investor, supported the company early on and took on all the risks involved with an early investment, why should I ever lose the rights that came along with assuming that risk? That was the exchange at the time – money for some ownership and rights associated with the form of ownership. In my opinion, no future acts (legal, up-and-up ones, that is) should cause the retraction of rights I already have (superseding those rights is topic for another day).

When I invest in a company, I always reserve some money for the next round. Since I generally invest in startups, I consider what a reasonable jump up in the A round valuation might be and hold enough in reserve to maintain my pro rata share in the company through that round. If the A round is a large – dollar-wise – or there are rounds beyond the A round that I haven’t reserved for, I can easily find myself in the position of not having the funds needed to maintain my share. A pay-to-play provision, in these cases, would cause a draconian (yeah, I’m biased) removal of the rights I had already paid for through investment and risk. It just doesn’t make any sense.

I could whine or cry and say that such terms are unreasonable or unfair, but that would be stupid. In the end, I can only do one thing when I run across a pay-to-play provision in  a term sheet, treat it as a big negative in my investment decision. I strictly stay away from deals that go as far as converting the preferred shares of those who don’t invest their pro rata percentage in future rounds to common. I treat as a negative, but don’t always walk away from deals with such provisions that are less onerous. Like I said, I understand why big, later stage investors want this term in the agreement. From my point of view, though, it punishes those who took the biggest risk when the company needed it most.

 November 6th, 2010  
 Will  
 Investing, Startups, VC  
   
 7 Comments
29
Oct

No Pro Rata Investment Rights?

I passed on an investment this week because the terms of the deal didn’t include the right for investors in the current round to maintain their percentage ownership in the company, through additional investment, in future rounds. This is usually outlined in the term sheet, in legalese, as “Preemptive Rights,” “Right of First Refusal” or even “Right of First Offer.” Basically, such a right simply allows early investors to keep themselves from being diluted in future investment rounds. There is no free ride in this situation, of course, the investor must pay for their pro rata share at the next round’s price, just like everyone else. What was particularly troubling about the term sheet in question was that it was pretty clear that the lead investor excluded such rights from the terms in order to have the ability to flush out smaller, early investors in subsequent rounds of financing.

I’ve seen this before (although less frequently over time) and it boggles my mind. Yeah, if you have a boatload of little investments the cap table can be a bit complicated, but that’s just math. Generally speaking, smaller investors don’t have any strong voting rights, board seats or other forms of control so punting on them doesn’t improve the speed or operations of the company. It’s treating form well ahead of function.

So why explicitly exclude or inhibit any investor small or large from investing in your next round? Are you afraid that you might scare off a large, future investor who doesn’t want smaller investors involved financially? Think about it. Are there rational people who would take this position? If so, are these people you want to deal with? To me, the fact that existing investors want to invest more money to retain their ownership is a hugely positive signal indicating that the people who know a lot about the company have faith in its progress and opportunities for success. As an entrepreneur, don’t you want to encourage such behavior?

By not explicitly giving investors pro rata rights (keep in mind that this provision simply grants the investor the right, it’s not a requirement – I’ll write a post on “Pay-to-Play” term sheet weirdness soon), you not only create a problem in subsequent rounds of funding, but you also create a problem now, in the current round. If, as a potential investor, I fear that I may not be able to prevent my dilution in future rounds, how anxious a I going to be to get involved. I’m not. Thus, my exit from the deal this week.

As my long-time friend and corporate general counsel, Peter Johnson, always says, “it’s, at worst, giving them the sleeves of your vest.” “Them,” in this case, being the investors you want to have involved in the company now and, hopefully, in the future.

BTW, there are loads of resources on the web discussing term sheets from many points of view. I highly recommend you take a look at Brad Feld’s and Jason Mendelson’s term sheet series as a starting point.

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 October 29th, 2010  
 Will  
 Investing, Startups, VC  
   
 8 Comments
02
Jun

Angel Investing

After yesterday’s phenomenal Angel Boot Camp in Cambridge (MA), I’ve been thinking about a long overdue post on the topic. I did my first angel investment in 1994 and I’m now in the process of wrapping up my 31st (individually, that is, not as part of a fund) – it’s also my third in the past six months. I’ve probably done about 30 more as a limited partner in seed funds and incubators along the way as well. All in, that probably makes me a second tier angel investor, at least in terms of deals done. Third tier if you count the “super angels” who have knocked off hundreds of deals in shorter periods of time. That said, I was recently “voted” as one of Boston’s best angel investors – I think that say’s more about Boston’s investment community than it does about me, I’m afraid.

I invest because I have a blast doing it. It’s about 75% of the fun of running the company yourself with only 5% of the stress. I get to meet smart, energetic people with great visions and boundless energy. It keeps my head in the game, and when I can add value (in addition to money) to help a startup weave it’s way through product, market and management mine fields, I avoid feeling like the least productive member of society for yet one more day.

The difference between a second tier investor like me and the first tier guys (other than brains and talent), is that the first tier investors actually work at finding investments. I’m, dangerously (see below), more passive about it, reacting to the investment opportunities that come to me. I get to see my fair share of of potential deals, but by selecting from a smaller set I not only miss loads of opportunities, but my comparative perspective is likely skewed – the best companies I see may be among the worst potential investments out there.

Fortunately, I’ve been moderately successful with this type of investing. A little over one third of my investments have provided reasonable returns over time with a few big successes doing most of the financial heaving lifting for my “fund.” While my 300 foot yacht with accessory submarine and helicopter remains on the wish list for affordability reasons, I haven’t had much trouble putting food on the table.

While I don’t have any absolutes when it comes to investing, I do have some guidelines that I loosely attempt to adhere to, at least when they’re convenient. Some of them are general and are similar to those used by many angel investors. Others are more personal and, for one reason or another, I’ve picked up over time as a result of my investment experiences.

The general guidelines:

  • “Drill more holes” – I once heard the CEO of Shell Oil speaking with analysts at a conference. When asked how Shell was going to diversify in the coming year, the CEO responded with the statement, “we’re going to drill more holes.” Investing in many companies is the only way to balance the risks of markets, teams and competition. Maintain a relatively large portfolio.
  • Invest in stuff you understand – bright shining objects attract attention (“we have the basis for a cure for cancer”), but the more you know, the less shiny things often look. If you can’t judge the team, market and product relatively thoroughly, it’s probably not a wise investment.
  • Keep some powder dry for subsequent rounds – while the best return in a successful investment comes from investing earlier, holding some cash back to see how the company does and to play alongside any institutional money that comes into the company mitigates some risk and ensures you’re playing on the same terms as the rest of the investors.
  • Everything looks good during the honeymoon – don’t make assumptions that problems you see will go away or that things, in general will get magically better. They won’t. While making an investment, you’re probably seeing the company in its best light. Things will likely get worse before they get better.

My Personal Guidelines:

  • I don’t like convertible debt – the investor takes on an inordinate amount of risk with a convertible note which he/she is generally not compensated for. Think about a note holder who waits 18 months before a conversion is triggered with an equity investment at a higher valuation. For a small percentage (8-10%), the “investor” takes all the risk in funding the company without participating in most of the potential uptick in valuation. Some strange debt instruments are being created now to fill this and other holes, but for all their complexity, the company should just do a seed round.
  • Team over idea – Ideas are cool, but quality teams are cooler. A great team can make a mediocre idea soar or morph the idea into a better one over time. Often, mediocre teams struggle to create success even starting with a great idea. I have to believe that the team can knock the ball out of the park. Only then do I consider the idea itself. As a corollary to this, I need to trust the CEO. Surprisingly, I find this to be a real issue from time to time.
  • There has to be a grownup involved – for all the energy, drive, brains and talent in most startups, there’s often a dearth of wisdom. Someone needs to be involved to provide it and be a sounding board for the startup team. This person or these people, should be on the company’s Board of Directors (check out Every Company Needs a Board of Directors – Startups Too). They can come from inside or outside of the investor group (inside preferable). If I’m the best qualified person for the job, I’ll step up. Usually, though, it’s someone else involved.
  • I hate leading a round – someone has to be in charge of representing the investors in the seed round. Negotiating the fine points of the deal, working with lawyers, getting everything signed, communicating every step of the way, etc. I hate doing it, but once in a while, I draw the short straw. I like investing along side seed or angel funds as a result. They’re pros and do it all the time. It’s not even heavy lifting for them. Most importantly, they’ll do all the herding of the investment cats required. It’s often a real pain in the ass.
  • You can’t and don’t even want to try to tie up every loose end – as much as you’d like everything in the investment to be taken care of, completely thought out and totally bulletproof, it ain’t gonna happen. Stuff is going to change along the way anyway.  The investor and founding team need to feel like they will make adjustments together as warranted.
  • Friend’s before business – this is a personal rule of mine that have broken more than once. Fortunately, it’s never backfired on me. I take both my friendships and my involvement with companies seriously. As such, the potential for conflict is high if I mix them – things never go the way you plan. There are always going to be situations in which the investor needs to support either the company or the management team. Can you support the company over your friend? Your friend over the company? Why even put yourself in that position?

This is hardly a definitive list of any kind, of course, but hopefully it’s a starting point for anyone wanting to get involved in angel investing and for anyone looking for an angel investment. Keep in mind that none of these guidelines have anything to do with the actually business criteria used in selecting an investment. I’ll leave that for another post.

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 June 2nd, 2010  
 Will  
 Investing, Startups  
   
 17 Comments
17
Aug

Ignoring Red Flags in Investing

I’ve been an active angel investor for about 15 years now.  Like most non-professional investors, I go into each investment fully and unrealistically expecting it to return some huge multiple of my original money.  While I’ve certainly made enough investments to know better, having high expectations for every investment I make is only one of the relatively frequent mistakes I make when investing.  I’m a slow learner.  Very slow.

Don’t get me wrong, in the end, my investments have delivered relatively nicely.  Way more failures than successes (way more), but with enough successes to more than cover losses and provide a reasonable return. Some might even say a good return.  That said, I’m pretty sure that no one who knows what they’re doing in terms of investing is gonna ask me for advice any time soon.

Back to the mistakes part . . . this week, we closed down the company I most recently invested in (names will be withheld to protect the innocent, not that anyone involved is innocent).  Looking back, there were loads of signs that the company was going to fail or, at least struggle, from the beginning.  I ignored them all.  In the end, I can only blame myself.  Not for the company’s failure, of course, but for being involved in the first place.  If you have stumbled on this post via a search or have read this far and actually think you can learn something from me or my experiences, here is a list of obvious red flags that I ignored in making this investment that resulted in my losing a bunch of money relatively quickly.

  • I fell in love with the technology – this one is a classic.  I saw the technology (image processing), did a minor amount of due diligence and thought it would change the world.  My passion for photography drove me here.  That, by itself, isn’t a bad thing, but as soon as you feel love, you better find someone who knows what they’re doing to look at it and give you an objective perspective.  I didn’t.  At lest not enough.
  • I didn’t have a solid grasp on the market – while this was a software play (broadly, something I actually know a  little about), the target market was cell phones.  Cool, right?  Made sense.  A zillion devices sold every year, cell phones replacing compact cameras, more processing power moving to phones, etc.  Life looked good.  I didn’t understand what a dog-eat-dog world the mobile device ecosystem is.  Handset producers, carriers, sensor manufacturers, it’s a mess out there.  I shoulda found all this out before I wrote the check.
  • The valuation was too high – duh!  Well, I suppose that is a red flag, but there’s nothing subtle about it – it’s more like a fact.  In investing, one runs across valuations that are out of whack all the time.  Depending on the situation, you pay the price or not.  The real red flag was something more subtle.  The other investors in the deal (all with more money in it than me), who had already set the price, were all relatively unsophisticated investors.  That’s not to say that they weren’t good business people, but they were newbie investors.  Note to self, avoid deals crowded with investors who have not invested much before, especially when they’re taking the lead on terms.  Stupid, just stupid.
  • When I invested and took a board seat, the other two outside investors were from the same company as the two lead engineers, making 90% of the employees coming all from the same place –  let me be clear, each one of these people was excellent and the company never experienced the problem that I initially feared of the group steering the company’s direction.  The issue here is simply a judgment call by the CEO which I disagree with.  If you’re trying to do something new, why load up with something old?  Maybe involving one person from the other company would make sense, but four?  I questioned this when I came on board and chose to let it slide.
  • While being “recruited” as an investor and board member, the team made some claims that they couldn’t fully substantiate when questioned about them – now you’re saying, “well you’re an idiot for investing if that was happening,” and you’re right.  See the first bullet.  Shame on me.
  • The founder/CTO was unproven – A bright guy with an unremarkable credentials.  Not that every startup CTO should have cured cancer before their new endeavor, but for a guy his age (not a kid any more) he should have had a track record of successes, even if they weren’t entrepreneurial.  This one’s not a slam dunk, but it was another flag that occurred to me and I chose to ignore.
  • Company management didn’t see startup activity the same way I do – work hard, juggle lots of plates without dropping any, take pay cuts when required and sacrifice most of the rest of your life while getting the enterprise going.  From the outside, the management team seemed to treat their work in the company like a job, not a commitment.  To be fair, I really didn’t see this, and other problems like it, until after I had made the investment.
  • I had previously invested in a company founded by the CEO where I had lost a load of cash – again, itself, not a reason to avoid the opportunity, but it should have created more dissonance in my thoughts than it did.  I didn’t even spend time to consider the causes of the previous failure and how they related to the CEO.  In retrospect, it’s still a little hazy, but taken in concert with all the others, it should have been a bigger deal to me.

Yeah, yeah, I’m an idiot.  It’s not unusual to run across a red flag or two when looking at a new venture, but when the list is long enough to enumerate, well . . . In the end, it was easy for me to dismiss each of the issues individually.  I neglected to look at them as a whole.  My bad.

Obviously, the sum of the issues and their meta-meaning wasn’t quite as clear to me before I made the investment.  My point is, though, that it should have been, especially given the number of investments I’ve made.  I feel like an moron.  I suppose the only good thing about it is that I didn’t let it run its course.  The company will return its remaining capital to its investors once all obligations are paid out.  It’ll be a small percentage of the funds invested (less than 25% of what was invested), but at least it’s not zero.  I just hope I learned something from this experience.  As my good friend Brad Feld likes to say, “I’ll only make that mistake three more times.”  I’ll tell you next time if I even learn that quickly.

 August 17th, 2009  
 Will  
 Investing  
   
 9 Comments
23
Oct

The Changing World of Angel Investing

I read two interesting posts on angel investing this morning.  The first, by David Cohen over on Colorado Startups blog: Do you believe in Angel Investing?  And the second by Jeff Cornwall over on The Entrepreneurial Mind Blog:  Are Angels Changing Their Strategy?

As a recipient of angel funds earlier in my career and an investor of such funds now, I’m fascinated by the dynamics of Angel investing and the correlation between investment criteria and solid returns.  While I’d like to think of this as an academic interest, I think it’s more likely that I’m a greedy bastard and want to know how to make more money.

David Cohen posts about his discussion with Kimball Musk and Brad Feld concerning whether or not angel investing works at all – shouldn’t any company with a solid future be taking big money right away?  An interesting perspective, for sure, although one I have a difficult time with.  In the end, the three end up agreeing that there are more scenarios where angel investing doesn’t make sense than when it does, but there is a fairly clear situation where wise Angel investing seems to apply:

“Companies that don’t need to raise much money ($250k-$1m) before they can grow and accelerate, but are likely to later need an institutional round.”

This point makes a lot of sense to me and, in retrospect, is fairly highly correlated to the successful angel investments I have made and seen made by others.

Jeff Cornwall’s post questions data showing the decline in angel investing.  He makes some sound arguments why it’s difficult to determine just how many ventures are being angel-backed these days.  Among his points:

“Angels that do smaller deals are off the radar. They are hard to get data on in the first place because there is no formal reporting mechanism. Add to that their intense desire for privacy, and it is no surprise that we are seeing mostly the larger deal angels working in networks.”

This makes a lot of sense to me.  I’m seeing a lot of angel investing going on, but it’s much quieter than the deals being done by angel funds and, of course, well submerged below widely publicized VC deals.  FWIW, I discussed my views on startup funding strategies and the choices between angels and angel funds in my post, Show Me the Money.

Both David’s and Jeff’s posts are worth a read if you’re thinking about funding your startup with angel funds or you’re an angel investor.

 

 October 23rd, 2006  
 Will  
 Investing, VC  
   
 1 Comment