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.
Q: What is the No. 1 milestone that new entrepreneurs must accomplish to become successful?
A: Though no single issue is paramount, acquiring enough cash and utilizing that cash to achieve positive cash flow from revenues is a metric that we investors watch carefully.
According to J. Sohl, the Center for Venture Research, about 20,000 seed/startup stage entrepreneurs are successful in raising money from angel investors each year in the US. An additional 30,000 later-stage entrepreneurs raise angel money annually, many of whom raised seed/startup capital from angels earlier. Angels seem to be making more follow-on investments in portfolio companies because venture capitalists are making few investments in round size less than $5 million.
Sohl also estimates that angels in the US invest about $20 billion annually. According to the Angel Capital Association, the average angel seed/startup round of investment is about $300,000, with about ten angels investing $30,000 each.
So…with all this capital being invested annually in the US in startup entrepreneurs, what is an entrepreneur’s chance of success in angel fundraising? Unfortunately, it is not good. I gathered this data from Southern California’s Tech Coast Angels several years ago, showing that 1 in 72 entrepreneurs (1-2%) who applied for funding were successful:
PRESCREENING: 1 in 4 deals proceeds to SCREENING
SCREENING: 1 in 3 deals proceeds to DUE DILIGENCE
DUE DILIGENCE: 1 in 3 deals proceeds to an INVESTMENT MEETING
INVESTMENT MEETING: 1 in 2 deals raising money
OVERALL: 1 in 72 companies who apply for funding are successful
Some angel groups are less likely to fund deals than are others. I have heard funding rates of less than 1% from a few angel groups, while other groups report funding rates as high as 5%. . And, I think the measures of funding rate vary from group to group. For example, some groups regularly co-invest with neighboring group who have already completed Due Diligence on the deal, increasing the funding rate for the co-investing group. Other groups may not count a deal as funded unless all the investment in the round came from their group. But, I think it is safe to conclude that probably about 2% of entrepreneurs seeking funding from angels are successful – a pretty low probability of success.
Here is my June 2011 column published today in the Flathead Beacon on models for angel organizations.
One entrepreneur has a company which appears to be scalable to a $30 million exit value in 5-8 years and a second entrepreneur’s venture seems to be scalable to $200 million in exit value in the same time frame. Yet, at the pre-revenue stage of development, angel investors price both companies at a pre-money valuation of $1.5 million. It doesn’t seem right, huh?
But, it is…and here is why. It is possible to grow a company to a valuation of $30 million on one or two angel rounds of investment. But, the working capital and management team necessary to grow a company quickly to sufficient revenues to justify a $200 million valuation will require raising lots more capital. So, the angels who provided the most valuable and risky financing for the gazelle that can grow to a $200 million valuation quickly are going to get diluted by subsequent investors, probably by three to five-fold. They may own 30% after the first round of funding but will probably own less than 10% at exit. So, angels simply must value both ventures at about the same price.
Scalability is a critical factor for angel investment. Because of the risk inherent in funding pre-revenue companies, they are unlikely to invest in any venture that cannot demonstrate the potential to scale to a $20-30 million in valuation in a reasonable time period (5-8 years).
So, angels won’t fund a deal that doesn’t scale sufficiently to justify investment and then tend to value all pre-revenue stage companies at about the same valuation, which is currently about $1.5 million in most parts of the US. Although there may be some variation among business sectors, this is essentially true for software companies, medical device companies, life science ventures, electronics companies and alternate energy deals, regardless of the long term potential.
Last week Ann and I attended the 11th annual Congress of the European Business Angel Network (EBAN) in Warsaw. I was asked to present a summary of our five-month visit to New Zealand in 2010, where we shared experiences with angels and entrepreneurs. Here is a link to my EBAN talk, Sharing Angel Experiences in New Zealand.
I was interviewed early this month by Gareth Price of the Warsaw Business Journal about my experiences as an entrepreneur and angel investor, and about what angels look for in fundable deals. See link.
My wife Ann and I just completed a delightful 6-day visit to Warsaw. Our purpose was to attend the 11th Annual Congress of the European Business Angel Network (EBAN) and to tour Warsaw and Krakow.
The EBAN meeting was attended by over 500 delegates from 38 countries. The presentations and panel discussions were of high quality and the networking opportunities, especially the dinners at the Palace on the Island and at the Grand Theater (National Opera), were exceptional.
Our Warsaw sightseeing experience was orchestrated Wojciech Jablonski of Around Warsaw City Guide (email: info@around-warsaw.pl). Wojciech (pronounced Voytek) not only gave us the flavor of the city, but he fulfilled our many requests, providing a stress-free vacation. Wojciech had a written itinerary for us at least 24 hours in advance, yet he was flexible and could change plans if the weather or our whim dictated. He always carried out his duties in excellent humor, with quiet enthusiasm and was always on time! Wojciech’s English is quite good. He energetically answered our questions and translated the written word efficiently into English. Wojciech is well-mannered, well-educated, and 100% dedicated to providing an exception Warsaw experience.
We were quite impressed by Wojciech’s knowledge of the great Polish men and women of history as well as politics, culture and Polish rulers, the people and the times. He also knows the geography of Warsaw and Poland, as boundaries have changed over time like for no other Western country.
As an added bonus, when my wife requested a dress-shopping trip, Wojciech deferred to his wife and business partner Marta. She researched in advance to choose shops of interest to my wife. Ann commented that appreciated Marta’s sweet manner, helpfulness and excellent command of English.
Ann and I enthusiastically recommend Around Warsaw and Wojciech Jablonski for touring services in Warsaw!
The skewed returns for angel investments report by Rob Wiltbank in 2007 for the US and in 2009 for the UK describe a clear strategy for angel investors: [1] diversity* – invest in a large number of deals (ideally 25 or more) and [2] scalability – invest only in deals that can scale valuation rapidly (ideally to 20X in five to eight years).
A logical challenge to this strategy would be to suggest that startup companies that plan to scale to only 2X-3X over five to eight years would be less risky than those that scale to 10X or 20X or even 50X in the same period of time. But, when viewed strictly on risk of failure, it does not appear that highly scalable ventures (software companies, for example) have a higher failure rate that low scale ventures such as retail outlets and restaurants. Anecdotal data suggests that funded software companies and restaurants both fail at relatively high rates, about 50% or more. So, I have postulated for several years that ventures chasing large opportunities (highly scalable) are no more risky that ventures pursuing much smaller markets.
If, as Wiltbank has shown, only 1 in 10 angel investments will provide all of investor upside (return on investment), then that home run must achieve an ROI of 20X or more for angels to achieve portfolio returns of 25% IRR or more (justifiable returns for these risky investments). If we need 20X home runs to achieve reasonable investment objectives and we have no idea at the outset which one of ten investments will provide us with our home run, then clearly all angel fundable deals must show the potential at the outset to scale to at least 20X. To invest otherwise risks substantially lower portfolio returns.
What number of angel investments is sufficient diversification? Clearly, skill and luck enter the picture. But, generally, one would expect that 8-10 startup investments would represent the minimum diversification and 15 or more investments would reduce the risk of low returns. Nonetheless, I am suggesting that angels consider 25 or more lifetime investments to substantially reduce risk and increase the likelihood of meeting investor portfolio IRR expectations of at least 25%.
*in this case, diversity in numbers of deals is the critical issue, not diversity in a variety of business verticals.
