Enabling Entrepreneurs

The Innovation to Enterprise organization in Oklahoma, headed by Tom Walker, has a new Entrepreneur-in-Residence program to bring national expertise on building and financing new ventures to Oklahoma entrepreneurs.

Here is a recent blog from the Oklahoman on this program:

Entrepreneurship 2.0 — Bringing ‘Best Practices’ to Oklahoma

Kevin is a friend and angel leader in Boise, Idaho.    Dr. Learned is a counselor at the Idaho Small Business Development Center at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital which assists angels in forming angel funds.

Kevin recently wrote a series of articles on the valuation of early stage enterprises, which I believe to be noteworthy.

Part I – Valuing Early Stage Businesses:  The Value of an Early-Stage Company is Related to its Riskiness

Part II – Valuing Early Stage Businesses:   Comparisons

Part III -Valuing Early Stage Businesses:  Understanding Angel Math

Part IV –  New Data on Pre-Money Valuations

Crowd funding enables entrepreneurs to raise money in relatively small amounts from large numbers of interested investors.  In the sum, substantial amounts of money (as much as a million dollars) can be raised for each startup company.  Recently, entrepreneurs in many countries have been soliciting investment through “crowd funding” websites designed specifically for fundraising purposes.  But, in the US, only wealthy accredited investors* have been allowed by the Securities and Exchange Commission (SEC) to invest in entrepreneurs and their startup companies (without extensive disclosure of the business plan and risks inherent to such new ventures).  Those US residents who do not meet accredited standards have been precluded from investing in startup companies.  The assumption made by the regulators is that accredited investors have the business experience required to choose winners and can afford to lose the money if they are wrong.  Consequently, US regulators have discouraged the selling of equity (shares) through crowd funding websites, so online companies, such as Kickstarter.com, offer the opportunity to donate funds to interesting US startup ventures in exchange for the right to become early product users or simply listed on the new ventures’ websites.

But now Congress is considering legalizing crowd funding for equity stakes in private companies by all interested citizens, with limits on individual investments and the total monies raised per company.  This is a rather controversial change in the SEC regulations.  I will describe the pros and cons below.

But, before elaborating on crowd funding, let me share some of what I have learned in my thirty years of experience investing in new companies as an angel investor. 

1.  More than 50% of companies funded by angel investors fail, with most returning nothing to investors.  And, less that 10% of these angel-funded companies are home runs, providing exciting returns on investment to angels.  These home runs often take a decade or more to mature to the point that investors can exit.  Since investing in startup companies is very risky, the only winning investor strategy is to pick well and invest in many companies.  A portfolio of 25 investments in startup companies is considered prudent diversification, providing a reasonable chance of excellent portfolio yields.

2. Angels invest time (sharing business experience) and money in new companies.  Josh Lerner, Harvard Business School, has validated that the mentoring and coaching that angel investors is considered by many entrepreneurs as even more valuable than their financial contribution.

We will circle back on these two “lessons learned” below.

The Pros:  So, why should the “laws of the land” be altered to legalize crowd funding of US startup companies?

• This is a democracy – crowd funding would allow anyone to invest in a company
• Online sourcing of capital would make fund raising much easier for entrepreneurs
• Crowd sourcing, in many cases, can be very fast
• Online fund raising creates substantial buzz about new companies
• Crowd investors could invest in companies at any stage of development, not just startups
• And, as Fidelman points out “given a choice between raising funds through an opaque, arduous and slow Professional Angel route versus a much more efficient, diverse and knowledgeable path, the latter will win every time.”  But, is this true?

Unfortunately, there are some downsides to crowd funding.  Consider the following;

• Inexperienced investors may see every opportunity as the next Facebook and may not understand the risks inherent in investing in early stage companies.  Bill Clark, founder of MicroVenture Marketplace, Inc. was quoted recently in the Wall Street Journal:  “You have a lot of people who have never made an investment before and they don’t understand what they should be looking for.”  Fifty percent of these companies will go out of business and less than 10% are home runs.  Will crowd investors invest in a sufficient number of companies to reduce their risk?  And, will crowd investors be patient enough to wait a decade for a wonderful exit?
• Jack Herstein, president of the North American Securities Administrators Association points out “The potential for fraud in this area is enormous!”
• Experienced angel and venture capital investors spend lot of time independently evaluating the investment opportunities (a process called “due diligence”).  This due diligence has been shown (by Wiltbank) to radically improve their returns on investment – helping investors pick the right new companies to fund.   It does not appear that crowd investors will have the opportunity or the experience necessary to choose better investments.
• Both angel and venture capital investors anticipate that entrepreneurs will need follow-on investment, that is, the amounts initially invested will not be sufficient to fund the new companies to success.  Will crowd funding sources have both the interest and sufficiently deep pockets to provide follow-on funding for startups?
• Angels and venture capitalists (VCs) have typically been reluctant to fund companies that have previously raised money from large numbers (over 30) of friends and family and other inexperienced investors.  It is not clear that angels and VCs will be willing to provide follow-on capital to crowd funded startups.  Nelson Gray, Europe’s 2008 Angel of the Year, suggests that crowd funding may lead to the “dead-end of an uninvestable proposition.”
• As was pointed out above, Josh Lerner (HBS) has demonstrated what many angel investors have suspected for years.  Angels invest both time and money in portfolio companies, sharing their business savvy with entrepreneurs to enable successful growth.  Many entrepreneurs state that the mentoring and coaching provided by angels is as important as their money.  Unfortunately, crowd investors will not usually be available to provide such support.
• Early stage investors most common complaint about startup entrepreneurs is the lack of feedback investors receive on the progress of the company.  VCs and angels routinely require a seat on the board of directors of new companies.  One function of a director is to provide appropriate feedback to investors.  Crowd investors will not be in a position to demand board representation on new companies and will likely suffer from lack of feedback from funded companies.

Finally, I have heard many pundits suggest that there is a shortage of capital available for startup companies, because banks and other sources are inactive due to the financial crisis.  The assumption is that crowd funding would increase the number of viable startups and therefore be a great source of job creation in the US.  This argument is flawed.  Banks have almost never funded startup companies.  Banks are sources of working capital and fixed assets for ongoing companies with the cash flow necessary to routinely amortize this debt.  However, the normal sources of startup capital for entrepreneurs (“friends and family” and angel investors) appear to be investing at normal rates.  It is not clear to me that a capital shortage exists for viable startup entrepreneurs. 

Summary

For entrepreneurs, crowd funding is an easy and fast way to raise startup capital while creating an online buzz for the new company.  Raising crowd funding may, however, reduce avenues to follow-on funding and access to expert mentoring.

For investors, crowd funding provides easy access to investment in exciting startups in an asset class not previously available for those not accredited investors.  But crowd funding increases the likelihood of encountering online fraud, reduces the opportunity to vet (due diligence) new investment opportunities and probably reduces available feedback to investors on company progress.  Grasping the importance of a diversified portfolio and the need for patience is critical to success.

On the surface, crowd funding sounds like a wonderful new opportunity for John Q. Public to invest in startup ventures and help the US economy create new jobs.  This is a false promise, in my opinion.  Funding startup ventures is very high risk investing and should be left to those with both the experience in validating such investment and the patience to wait for the few potential winners to mature.  As is often the case, the adjectives “fast” and “easy” may not be the best features of capital fundraising sources for entrepreneurs.

*The SEC does make some exceptions for friends and family members of startup entrepreneurs.

During the summer of 2010, I developed a workshop, A New ACEF Valuation Workshop for Angels and Entrepreneurs.  To provide some reference points, I surveyed thirteen angels groups in North American to determine their recent experience in negotiating the pre-money valuation of pre-revenue companies.  See the 2010 data reported here:  Current Pre-money Valuations of Pre-revenue Companies.

Because of the interest in the 2010 survey, I decided to survey a larger number of North American angel groups this summer (2011).  I requested data from the leaders of 46 angel groups in 26 states (plus DC) and 2 provinces.  Specifically, I asked each group leader for the current average or typical pre-money valuation of pre-revenue companies they are funding and the trend in valuation over the past year.

Thirty-five angel groups in 20 states and 2 provinces responded with the requested data.  Seven groups in five additional states answered that they had insufficient data to reply – a total response rate of 91%.  A table of replies can be found below.

Before providing any analysis, all involved would agree that this is simply a survey and no statistical significance should be applied to this report.

The average pre-money valuation of the 35 responding angel groups was $2.1 million.  Two-thirds of the groups reported pre-money valuations between $1.5 million and $2.5 million.  Fourteen groups reported that the trend in valuation is flat, while twelve reported higher valuations and nine suggested the trend in valuation was down.

Here is a summary comparison of the 2011 results to last year’s survey of only 13 groups:

• The average valuation increased from $1.7 million to $2.1 million
• The reported results ranged from $1.25 million to $2.7 million in 2010 while the range is broader in 2011, from $0.8 million to $3.4 million.
• Groups that provided data in both years showed that valuations of pre-revenue deals are increasing, quite significantly in some regions.

I’ve been asked by many why valuation varies so much from group to group.  In this 2011 survey, ten groups reported average valuation of $1.5 million or lower while seven groups reported valuation of double that or more.  Speaking with many angel leaders, I believe we have identified several possible explanations for group-to-group variations:

1)      Clearly, startup ventures in some business verticals command high pre-money valuations that others.  Biotech, life science and medical devices are usually funded at higher pre-money valuations than, say, software and Internet companies.  Groups focused on the life science sector, as an example, will likely fund deals at higher valuations than those funding a broader set of deals.

2)      Competition for deals in regions, such as Silicon Valley, New York City and Boston, has resulted in higher and, in many cases, rising valuation.  Here is the data for the eight groups in these three areas:

     (a)      Boston (3 groups) – $2.5 million

     (b)      New York (2 groups) – $2.9 million

     (c)       Silicon Valley (3 groups) – $3.1 million

These eight groups all reported typical valuations in the highest 40% of all groups reporting.  We have heard that Super Angels (many in these three areas) do not negotiate valuation as rigorously as do angel groups.  Some Super Angels have been quoted as suggesting that valuation is not particularly important to their strategy.  They intend to invest in as many as 100 companies quickly, looking for the next Facebook or Groupon. 

3)      Some groups invest $2 million or more in pre-revenue companies, while others typically invest less than $500,000 in these very early stage ventures.  Since angel groups prefer purchasing less than majority ownership in these early rounds, a higher pre-money valuation is more likely for larger pre-revenue round size.  This trend is particularly applicable to angel groups who syndicate seed/startup stage deals with a large number of angel groups and seed VCs in their region.  Syndication among angel groups is a real advantage when larger round size is required (at any stage) but can increase the valuation in early rounds.

4)      Finally, a few groups reported that entrepreneurs and their advisors were very aggressively negotiating high valuations based on reports from the national press (stories from Silicon Valley and New York) when no local competition for such deals exists.  In some cases, this resulted in deals done at higher valuations than anticipated by local angels.

At a final disclaimer, this report is simply a survey of angel leaders in North America.  No statistical significance should be assumed from any data included here.  Finally, all analysis and conclusions are those of the author.  Any errors or misinterpretations are his.

Those interested in more information or in participating in the 2012 survey (if any) should contact the author by email at bill@billpayne.com.  More information on the author can be found at www.billpayne.com or by Googling “Bill Payne” angel.

The Flathead Beacon (Kalispell) just published this article:   Angel Investors in Montana

In a recent post, Bill Clark, CEO of Microventures, did a nice job of summarizing the Convertible Debt versus Equity option for startup investors.  Unfortunately he left out the primary disadvantage to investors, which is why you won’t find most savvy angel investors who are part of angel groups using convertible debt.  Convertible debt can substantially reduce returns for angels, which is why I seldom consider convertible debt as an early stage investor.  For more details on this controversy, see the following posts:

Angels: Convertible Debt Is Seldom the Right Security for Startup Investments  and

When is Convertible Debt the Right Instrument for Angel Investments?

Frankly, I wish this controversy would go away and that all angels would simply use a standard preferred (light) term sheet to define their investment.  Here is an example of a Preferred Light Term Sheet developed by Dan Rosen, chair of the Alliance of Angels.

In 2004 James Surowiecki, New Yorker business columnist, wrote the Wisdom of Crowds which recognizes that the opinions of groups is routinely more accurate than those of most individuals in the group.  In particular, the author demonstrates that large crowds consistently outperform experts within the group in decision-making.  I sense that the Wisdom of Crowds defines a winning strategy for angel investors, especially those who are members of angel funds. 

Angel investors invest time and money in seed and startup companies.  Since the mid-90s, many angels have discovered the efficiency of investing as part of an angel group.  There are two types of angels groups (see Models of Angel Organizations):  Networks in which member angels screen and scrub deals together and then make individual decisions to invest for their own accounts.  Angel funds, on the other hand, pool their monies in advance, screen and scrub deals together and then vote on making an investment from the fund.  The Frontier Angel Fund (Kalispell) is an example of an active angel fund and one for which the strategy suggested by the Wisdom of Crowds might be quite useful.

To quote Surowiecki, “Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromising.  An intelligent group, especially when confronted with cognition problems, does not ask its members to modify their positions in order to let the group reach a decision everyone can be happy with.  Instead…the best way for a group to be smart is for each person in it to think and act as independently as possible.”

Surowiecki’ s message for optimizing returns in angel funds is that members need to be as independently informed as possible on each deal, debate the pros and cons of each investment and then vote to make the best collective decision.

Drug development is interesting and important R&D but, unfortunately, very few regions of the world can attract the venture capital necessary for commercialization.  Read my June column in the Flathead Beacon (Kalispell, Montana) at http://www.flatheadbeacon.com/articles/article/montana_drug_rd_good_science_but_no_commercialization_funding/23243/

One way to categorize startups is as lifestyle businesses versus growth businesses.  Don’t jump to the wrong conclusion.  Both are great for the US economy!

Lifestyle Companies (build to keep)  Lifestyle companies are usually owned and operated by an entrepreneur and his or her family, or a small group of partners.  They tend to grow revenues slowly without investor capital and most do not need a substantial number of employees. Examples of lifestyle companies could be:  single store retail outlets, software developers, restaurants, franchisees, lawyers, plumbers and many others.  As the company matures, lifestyle companies can become quite profitable, allowing the entrepreneur to earn a handsome income over as many years as the company thrives. The equity value of lifestyle companies is modest compared to growth companies because the smaller revenues and earnings of lifestyle companies equate to a lower valuation. But the potential salaries for entrepreneurs can be quite high and these high salaries can extend over decades, depending on the nature of the business.  And, lifestyle entrepreneurs can later choose to sell their companies (perhaps at retirement) without investor pressure to sell in a defined time frame.  The entrepreneurs singularly control the direction and future of the company.

Growth Companies (build to sell)  Growth businesses, on the other hand, usually require professional investors and demonstrate that they can rapidly increase revenues and often the number of employees.  Examples of growth companies could be:  software product companies, medical device companies, electronic product companies and many others.  The entrepreneurs and investors reap the benefits of their efforts by selling the company five to ten years after startup.  The Board of Directors (entrepreneur, investors and others) controls the direction and future of the company.

Angels (and VCs) invest in growth companies, which they often arbitrarily quantify as startup ventures that can grow annual revenues to $20 million (or more) in five years. These are ventures that grow sufficiently rapidly to allow capital sources to harvest their return on investment (exit), usually by selling the company to a larger public company, within five to ten years.  About half of growth companies fail in the first five years.  And, less than one in ten of angel or VC funded companies are wildly successful home runs.

In the end, lifestyle companies can produce very attractive salaries for entrepreneurs over many years.  The primary motivation for growth company entrepreneurs and investors is to build equity value and harvest their investment of time and money thru the sale of the company in a relatively short period of time.

Of the estimated 500,000 new ventures started in the US every year, over 90% are lifestyle companies.  If these entrepreneurs need outside capital to start these ventures, friends and family are their primary source.  Lifestyle entrepreneurs use these sources of capital and bootstrapping techniques to achieve positive cash flow.  As the company matures, banks can provide the capital necessary for operations and growth. Less than 10% of new ventures annually qualify for investment by angels and VCs:  About 25,000 new companies are funded annually in the US by angels and about 1000 new companies are funded by VCs.

This differentiation of lifestyle and growth companies is, by its nature, a generalization. Many growth companies have been started by bootstrap entrepreneurs and their families and grown using internally generated cash (from earnings) without investor capital to huge companies over time.