Enabling Entrepreneurs

Here is some data on capital sources for entrepreneurs and the investment The Funding Gap – that I recently posted on Gust.com.  You will find the total available capital from friends and family, government sources, angel investors, super angels and venture capital.  You will also find new graphic showing round size by the number of available US investors with recommendation on how to avoid attempting to raise funding in ranges of capital where few investor play.

There seem to be two motivations behind the current buoyant enthusiasm in Congress over crowd funding for entrepreneurs:  (1) the democratization of funding for startup companies (no longer requiring such investors be wealthy) and (2) the job creation that is expected to result from creating more startup ventures.  In my earlier post, Crowd Funding – A Critique for Entrepreneurs and Investors, I listed the pros and cons of crowd funding from the perspective of both entrepreneurs and investors.  Now, I would like to provide my perspective on the primary potential benefit to the US economy – job creation.

In 1979, David Birch published The Job Generation Process in which he demonstrated that new companies create the preponderance of new jobs in the US.  This conclusion was validated by many others including the Kauffman Foundation, which at the Obama Jobs Summit 2009 showed that virtually all net new jobs (~3 million per year) in the US are created by companies less than five years old. 

But, we have now found that new company formation is necessary but not sufficient to creating new jobs.  Birch and many others have shown that only 2-5% of startups, the “gazelles,” are in fact responsible for almost all of this job creation.  Gazelles are defined as companies with at least $1 million in revenues that grow at rates exceeding 20% per year, when measuring both revenues growth and job creation. For more on gazelles, see Economists Credit Small Business ‘Gazelles’ With Job Creation. 

I suspect that crowd funding is more suitable for lifestyle companies (such as local store fronts), than for high-impact (high-growth) companies from which the gazelles emerge.  Why?  Because high-impact companies often need two additional resources to be successful:

1. High-impact startup companies usually need multiple rounds of funding to sustain growth.  It appears that the current legislation in Congress will have an upper limit per company on crowd funding.  If the startup needs more funding than the new regulations allow, the company will be forced to seek angel or VC capital.  But, historically angels and venture capitalists have been very reluctant to provide funding to companies with hundreds or even thousands of existing shareholders (for a variety of reasons).
2. High-impact startup companies often attribute their success, at least in part, to finding “smart money,” that is, investors who bring significant experience and network contacts with their investment capital.  Will crowd investors be “smart money” by bringing their experience and contacts to startups?  The very nature of crowd funding would suggest not.  Can crowd funded companies, nonetheless, attract smart money to invest alongside the crowd sources?  It is not clear.

Many of us in the entrepreneurial community believe that crowd funding could be a wonderful new source of capital for lifestyle companies.  But, there is concern that follow-on investors, such as angels or venture capitalists will be reluctant to provide additional capital to startups who have already raised crowd funding.  Furthermore, crowd funding, by its nature, cannot bring business segment expertise or broad industry network contacts to startup ventures.  Consequently, it does not appear to this angel practitioner that job creating gazelles will emerge from crowd funded companies.  This legislation should not necessarily be viewed as a job creation opportunity.

For years there has been a pervasive opinion across the entrepreneurial landscape that the US has a shortage of capital required to startup and grow new ventures.  It is suggested that companies cannot find the cash necessary to start new and exciting ventures.  Furthermore during this economic downturn, we’ve heard a crescendo of voices lamenting the lack of startup funding, as communities finally recognize that new companies are the key source of job creation in this country.  But, what evidence do we have of this shortage of capital?

New Company Formation – According to the Kauffman Foundation, entrepreneurs start about 700,000 companies per year in the US.   Dr. Carl Schramm, Kauffman CEO, recently said that startup formation is stagnant or even decreasing in the US in the second half of 2011.  So, we are clearly not experiencing an upsurge in new company formation today.

Sources of Capital for Startup Entrepreneurs – The primary sources of cash for new companies are (1) self (the entrepreneurs’ resources), (2) government grants, (3) friends and family, (4) angel investors and Super Angels, (5) venture capitalists and (6) strategic investors.  We have no measure of the changes in available capital resources from entrepreneurs and their friends and family, but we have no reason to believe they have changed radically over the past few years.  Strategic investors tend to be later stage sources, and will not be addressed here.  Let’s take a closer look at trends in government grants, angel investment and venture capital financings.

          Several sources (including Startup by Elizabeth Edwards) estimate that $2-3 billion per year is awarded to very early stage companies by federal government grants (mostly SBIRs).  At $100,000 or so per grant, perhaps 2-3000 pre-seed and seed/startup companies receive SBIRs and other government grants per year.  Furthermore, total federal grants to very early stage companies have been increasing over the past few years.

          According to the Center for Venture Research, The Angel Investor Market in 2010 was about $20 billion and funded about 60,000 companies, with about one-third of that capital committed to seed/startup stage companies.  Total angel funding in 2010 was up somewhat, but has ranged from $15 to $20 billion for several years.  The fraction of angel capital committed to follow-on and later stage investing has increased over the past five years.  But the number of seed/startup stage companies receiving angel capital has been rather steady at 20,000 to 25,000 companies per year.

           The Angel Resource Institute recently published the first definitive study, to my knowledge, of Super Angels. While the authors made no attempt to estimate the total impact of Super Angels and their Micro-VC funds, I will attempt to do so.  It appears to me that there are about 100 Super Angels in the US.  On average, they are investing $1 million or more per year into perhaps five companies each, most of which are seed/startup stage companies.  So, we think about 500 seed/startup companies are receiving at total of $100-200 million annually from Super Angels.

          According the MoneyTree© about 2% of venture capital has been invested in seed/startup stage companies (perhaps 400 companies per year) in each of the past five years, with no obvious trend towards a decreased commitment to this stage.  There is anecdotal information suggesting that VC investment (perhaps outside the MoneyTree© survey) in the earliest stage companies is increasing somewhat today.

         In summary, it would appear to me that 25,000 or more companies are successful in raising seed/startup capital in the US annually.  Furthermore, with the recent activity of the Super Angels and trends in government grants, angel financings and VC investment, one could conclude that the total US volume of seed/startup investment is increasing.

We have an additional indication of “money chasing deals” (a lack of fundable startups, not a shortage of startup capital) as measured by the competitive environment in the more active US entrepreneurial communities.  A recent informal survey of angel groups indicated that valuations are highest in Silicon Valley, New York City and Boston, which are arguably the most entrepreneurially active communities in the US.  Furthermore, the survey indicated that seed/startup valuations all over the US have risen in the past year, and especially in these three markets.  As we know from elementary economics, scarcity is one cause of increasing prices – in this case, lots of seed/startup capital looking for investment opportunities with too few qualified entrepreneurs.

It is pretty clear to this observer that the formation of companies is rather steady and the capital available to fund those companies is increasing.  There does not appear to be a scarcity of capital for seed/startup stage companies that can qualify for funding.  Could it be that shortage of capital is only being reported by those entrepreneurs whose ventures do not qualify for seed/startup financing?

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.