Entrepreneurs take action first and then clean up afterwards. Their businesses are duct taped together in their initial 2 years. However, after the initial chaos, each business needs to have the organisational maturity to approach investors. The best time to look for capital is when you don’t need it. Otherwise, investors will slap on a ‘desperation discount’ if they know you lack alternatives.
The focus of this article is on angel investing.
To start, I’ll provide a simple map of the capital raising universe.
There is a hierarchy of preference in capital raising. First seek to bootstrap growth, then examine opportunities to raise debt, and finally look at equity.
If you’re still developing your product, try to self-fund your business as long as possible by doing consulting and one-off projects prior to raising any capital. The valuation of your business will increase dramatically with each new customer and new product release.
If your company needs expansion capital to grow geographically or launch a new product, then establish a straight loan or line of credit with your bank.
However, if your business is not yet throwing off enough cash for the risk-averse underwriters at the bank to extend your company credit, where else can you look?
In this moment of need, an entrepreneur might be tempted to raise money from family and friends. These funding rounds are typically done using convertible debt, leaving any valuation and equity pricing discussions to professional investors in future rounds. I strongly advise against doing this. It is truly a last resort. You run the risk of destroying these relationships forever if your company fails at the first hurdle.
Jason Calacanis, an American internet entrepreneur turned angel investor, likes to boast that his first two investors in Weblog Inc., which he sold to AOL in 2005, were Visa and MasterCard.
However, be wary of using personal guarantees or credit cards. If things don’t go as planned, they can lead to problems that will be difficult to resolve.
Where do you go after maxing out your credit cards?
Equity is expensive. At first glance it seems like the cheapest and easiest option, but over time its cost will be become evident. You will have to distribute your valuable equity to your investors, give them seats on your board (effectively making them your bosses), and as Steve Jobs experienced at Apple, be at risk of being fired by them.
In this article, I will only focus on the early stage business that needs funding to reach sustainability and then scale from there. I won’t consider the need to raise equity to build out an already thriving business. I’ll discuss that situation in a future article.
ANGELS VS. VENTURE CAPITALISTS
There are two main types of investors for early stage companies: angel investors and venture capital firms.
WHO IS AN ANGEL INVESTOR?
An angel investor is an affluent individual who invests his own capital in exchange for an equity position or convertible debt. This has been popularised in the TV shows “Dragon’s Den” and “Shark Tank”.
The Angel Capital Association estimates there are about 300,000 angel investors in the US who have made an investment in the last 2 years. In the UK there are about 18,000 angels.
They are savvy investors and understand that they may lose their entire investment in your company. They know it’ll take a long time for them to see a return, and subsequent rounds of funding will dilute their investments. They must acknowledge that they will have minimal to no influence on the company beyond strategic advisory and mentoring. Never accept money from people who don’t understand these basic yet critical concepts.
Angels invest about 10% of their money on average and see their investments as a means to diversify their wealth portfolio. They may invest GBP25,000-GBP50,000 into 4-6 deals per year and be actively invested in 10-40 startups at a time.
Angels are personal investors. The best time to approach them is after they’ve just sold their company, or they are entering tax season. It’s unlikely they will consider your company if they have just made some investments or large personal purchases.
In contrast, a venture capitalist invests other people’s money looking for a return of 10-100x on investments between GBP2M to GBP100M.
WHAT IS THE PURPOSE OF AN ANGEL INVESTOR?
A company can go through many rounds of funding. In GBP ascending order they are: Seed round, Series A, Series B, Series C, and so forth until you get to an IPO. Facebook went through 11 rounds of funding before finally IPO’ing in 2012. Their angel round of funding came from Peter Thiel, the co-founder of PayPal, for US$500,000 in September 2004.
As more money flows into the venture capital world, Seed rounds and Series A rounds have become so large that a funding gap has formed from initial launch to the seed round which is roughly GBP2-5million. Therefore, the role of the angel investor to bridge this gap is becoming more important.
WHO’S THE PERFECT FIT FOR AN ANGEL INVESTMENT?
Understand that an angel is betting on you and your team to succeed, not your company.
The Angel sweet spot consist of: GBP5,000 to GBP50,000 of monthly recurring revenue, a team of 2 to 10 people working in the company, and an inability to get seed or series A funding.
At this early stage, be able to present an MVP (Minimum Viable Product), and show some early revenue, and traction. The angel wants to grow the startup to the point where he can cleanly hand it off to the venture capitalist. This builds his reputation in order to receive access to increasingly promising deals.
WHAT ANGELS ARE SEEKING
In 5-7 years, angels expect a 10X return on their investment. For example, if you sell GBP1M of equity for a 20% stake in your company, that means you have a GBP5M valuation. Therefore, you’ll need to present a financial model to potential investors with a GBP50M valuation in 5-7 years.
Before raising the next round of funding from them, angels want to see the results you promised or at least strong movement along a path to successfully meeting your milestones.
Because this process can become complicated, it’s essential to keep all deal terms very simple. Any awkward clauses will certainly impact your follow-on rounds. Therefore, be prepared to pay up and sacrifice your valuation to have high-quality investors in your round.
Again, Jason Calacanis recently spoke into what he desires to see from a founder. I paraphrase: “Stop going to fancy conferences. Don’t get distracted. Instead talk to your customers, design a more valuable product and figure out how to get more money from them. I look for a founder who is frugal, grounded and has a strong sense of what he or she believes uniquely about what is wrong with a market and how it can be fixed. This individual will be mission driven to see the product in the market more than to make a quick buck.”
The secret to getting the best out of investors and building long term relationships is understanding their motivations and aligning your interests before you cash their check.
CAPITAL RAISING DOCUMENTS NEEDED FOR AN ANGEL INVESTMENT
The process of preparing your fundraising documents will improve your strategic planning.
The core documents needed are a pitch deck, term sheet, 5-year financial projections, a demo video (live working product), executive summary, and a FAQ page. These constitute a sales brochure and are meant to secure an initial investor meeting.
The pitch deck is a high-impact, short presentation used to attract investors into your company. It’s the most important document and it must be perfect. Make sure it’s flexible and customisable to adapt to different lengths of meetings and investor groups. Have a master pitch deck of 20-30 slides and a key pitch deck of 10-12 slides. The investor will have a portfolio of 100 companies to consider, so make your pitch standout with professional and beautiful design.
A term sheet outlines the material terms and conditions of your capital raising arrangement. In an angel round, you bring your own term sheet to the table. Angels want you to make the first offer. In a VC round they present you with their own. Work with a good start-up attorney to create a term sheet that’s straightforward and fair.
The best time to look for capital is when you don’t need it
The financial plan must show your cash runway and when you’ll run out of cash. That’s the #1 thing angels are interested in. Start meeting with potential investors 6-9 months before you need the cash. It’ll take roughly 3-6 months to raise the funds, that’ll provide a 12-18-month runway.
Keep your financials simple and concentrate on these five metrics in the early years: CAC (customer acquisition cost) and LTCV (lifetime customer value), cash burn and runway, and total hiring. Your projections will be wrong, but investors want to examine the quality of your thinking.
The key items to present are a summary income statement for the next 5 years, a month by month income statement for the next 18 months, and a simple 1 pager with your business’ key drivers and assumptions.
The Demo video should be a high-end 2-3-minute video in which you show how your solution solves a problem that currently exists in the market.
Create a 2-page executive summary, which consists of a description of your business, target market, go-to-market strategy, competitive advantage (UPS), traction, and team.
Your FAQ document should only be 2 pages in length. Each question gets a 1 paragraph answer and should alleviate any obvious objections or questions the investor may have prior to your meeting.
Always be on the lookout to build your investor list. The 3 best areas to find angels are: your network; angel groups, syndicates, seed funds, crowdfunding platforms; and pitch competitions and tradeshows.
Equity crowdfunding platforms can consist of online angel groups that review deals. Kickstarter has been effectively used for marketing a startup and raising small amounts of capital using customer funding. Seed Invest and Republic are building strong reputations as go-to platforms for startups to raise from both accredited and non-accredited investors in the US. Indiegogo has a reputation for lower quality deals and lots of flameouts.
Be willing to travel to pitch at large conferences and tradeshows. It’s all about the investors in the crowd that might see you and like you.
Keep your financials simple and concentrate on five metrics in the early
Angel groups are sometimes considered country clubs for investing in startup companies. They have bylaws and strict rules of operations. Angel groups get deals from referrals, from their networks and through their website via a formalised application process.
There’s an initial screening of each business prior to the pitch to the broader group. Meetings are conducted at regular intervals every month. 3 companies from a larger group get to go to their monthly dinner where they pitch for a few minutes and answer questions. This allows the entrepreneur to broadcast to 100 angels who they are and what they do.
The entrepreneur’s job is to maintain engagement post-dinner, to form a long-term relationship, be responsive to questions, be proactive throughout the due diligence phase, and close the deal by acquiring an investment.
Increasingly, angel investors are organising themselves into syndicates and angel networks to pool resources and provide advice to portfolio companies. You’ll be able to raise between GBP500,000-GBP1.5 million from individual angels but angel syndicates are pushing these amounts higher and are now participating in seed level financing.
Because they have little time to perform due diligence, they will invest as syndicates or attach themselves to larger investment companies that have a team of analysts. They prefer to only invest in a market they know and understand, which is most likely the same industry they conquered with the company they sold.
The advantage of a syndicate is that you’ll only deal with one person, one term sheet, one valuation discussion, and have 1 investor in your capitalisation (cap) table. The cap table details the names and percentage equity ownership of all your investors.
Unless you raise funding through an angel syndicate, you’re involved in a numbers game. Angel investors are investing GBP25,000 to GBP50,000 at a time for you to reach a raise of GBP500,000. In essence you’re looking for 10 to 20 angels each time.
Make sure you reference check every prospective angel. Ask to talk to current or past CEOs of their investments. Good investors will show you their roster of CEOs and give you the option to call any of them. Finally check with your startup lawyer. He or she will know the few bad actors in your city to avoid.
I’ll conclude this topic in my next article. In it, I’ll discuss how to approach your first meeting with an angel. I’ll go over the correct mindset when pitching, the due diligence process, and how to consistently communicate and report to your investors.