Three Days of Angel Investing Insights
What a great week we just had for Northwest regional angel investors. Checkbooks were left untouched but minds were impacted by many insights shared among both highly experienced and new investors. Importantly, the insights shared by angels are just as valuable for entrepreneurs since a highly functional partnership between the two is critical for success. The approach to deal negotiation was that of helping the entrepreneur with his or her wealth accumulation goals.
Why is this important from a policy perspective? According to the Kauffman Foundation study in December of 2009, companies less than five years old created 40 million jobs over the past 30 years while large companies netted zero new jobs.
Investing and entrepreneurship are clearly two sides of the same coin. Investors won’t make sufficient returns to compensate their risk-taking, and entrepreneurs won’t meet their personal goals if a venture is not successful. Angels and entrepreneurs, along with some luck and timing, are both necessary for success. This week drove that notion home over two events covering three days.
Starting last Wednesday at the Northwest Energy Angels event, members from six regional angel groups enrolled to hear Bill Payne, the ultra-experienced angel investor and mentor. He led the Angel Capital Association’s Power of Angel Investing Workshop which focused on the importance of the due diligence process and determining reasonable valuations for investment. Angels need to know how to conduct thorough due diligence that is prioritized on the critical factors yet not overwhelming to entrepreneurs. Research shows that the amount of due diligence effort conducted by angels is highly correlated with returns; the more due diligence is conducted, the better the success rate. However, the key is to focus on the relevant issues that really matter for a particular venture and not get stuck in the weeds of too much detail.
The workshop started with a panel of experienced investors and attorneys including Dan Rosen, Chair of the Alliance of Angels, Geoff Entress, Partner at Voyager Capital, CJ Voss, attorney at Stoel Rives, and Kiki Tidwell, board member of NW Energy Angels. Rosen emphasized the importance of critical analysis of the alternatives a venture’s customers have as substitutes for the venture’s product or service. Entress pointed out that customer calls are critical to validate why they purchase. Understanding customers’ decision-making criteria is just as essential for entrepreneurs as it is for investors. The issue of founders’ share vesting is important for both investors and the other founders to manage precious equity if one of the founders decides to leave shortly after the funding. Retiring some of that founder’s shares is necessary to compensate future management. Voss remarked that focusing on the important due diligence questions is necessary to manage time. And, change of control provisions embedded in contracts are important to make sure relationships continue in the event of an acquisition to optimize the long term value of the contract. Clearly, entrepreneurs need to keep these thoughts in mind when entering into long term agreements so as to not jeopardize value. Tidwell emphasized the selection of board members who can help guide the entrepreneur and build value for investors.
When considering valuation, the entrepreneur needs to understand that angel investors need to return 30X their money if one deal out of 10 succeeds to get a 25 internal rate of return or about three times capital over five years. The implication is that ventures need to be able to scale which should be important to entrepreneurs too. Patience is required because “big returns take time to develop.” Conversely, “lemons rot faster than plums ripen” according to Luis Villalobos, a well-respected entrepreneur and angel. The typical pattern is as follows: belly up happens in three years; 10 times return takes 6 years; and 30 times takes 8 years. Performing solid due diligence, industry experience, engagement with the venture, and investing at the right valuation can help improve the odds of success.
The Angel Capital Association Northwest Regional Meeting over Thursday and Friday provided similar insights but with a wider range of angel groups. Furthermore, there were additional insights into important national policy developments the association has had a hand in helping shape for the benefit of angel investors and job creation. The ultimate sale of a venture (“exit”) is critical for the entrepreneur and investor to be clear about at the beginning and prepare for well in advance. Fortunately, the ACA’s efforts helped to extend the zero capital gains tax for investments made through the end of 2012. Tom Alberg, partner at Madrona Venture Group, is on President Obama’s National Council on Innovation and Entrepreneurship, and provided an update on efforts to improve policy for driving investment in innovation and job creation. One shift is in the Small Business Administration’s growing understanding of the difference between businesses that scale and those that are simply “main street” types. Investors, entrepreneurs, and policy need to come together to provide the perfect “petri dish” for growing a dynamic innovation economy in the United States which is globally competitive. Spending three days with entrepreneurs and investors demonstrated we certainly have the will.