28 Mar What Angel Networks Want
Without a doubt, the most common question I’m asked is, “Why won’t angels invest in my business?” While every business is different, two answers apply to 90+% of the entrepreneurs asking this question. The irony is that one answer holds real hope for the vast majority of entrepreneurs — though it isn’t the answer they are expecting. The less common answer is the one they fear, and where relevant, it is serious and problematic.
Angels vs. angel networks
First, consider that the majority of angel investing occurs outside the tech sector. The venture-tech frenzy of the past 5 years notwithstanding, most angel investing occurs in traditional business deals: real estate partnerships, restaurants, retail stores, and so on. The returns are “low” compared to venture capital — investors target returns between 10%-30% per year, although many of these investments return significantly more. The perceived risks are lower; the angels know the management team personally, are familiar with the industry, and can clearly and objectively define the operational model.
Angel networks represent the minority of angels in a given economic community, despite the PR they generate (seven of the first eight hits in a Google search of “angel investing Wisconsin” deal with angel networks, and the eighth is a mis-hit). After all, one of the purposes of an angel network is to deflect attention from investors who prefer not to get 50-page business plans faxed to them in the middle of the night.
Many networks are formed with some motivation to support the local economy. These networks often focus on high tech, because of the potential for high-wage job creation and other benefits to the community. The upshot is that while the networks get the majority of the PR, they are not interested in the majority of available investment opportunities.
This is, believe it or not, good news. The networks aren’t designed to go after the moderate-growth, traditional industry businesses, or even tech-based lifestyle companies. There’s nothing wrong with such companies—management is simply targeting the wrong financing market. These companies, in every area from cosmetics to HVAC to limited use medical devices, may still be appropriate for angel financing, but not angel network financing.
These companies need “affiliated angels”—friends, family, friends of family, family of friends, and friends of friends. These independent, individual angels usually have industry experience, and are identified through family, friends, and service providers. This is part of what Michael Porter (and locally, John Torinus) would refer to as “clustering.” Successful entrepreneurs and businesspeople are more likely to fund opportunities when they can identify and measure the risks involved. Entrepreneurs should always try to find knowledgeable, affiliated angels.
Angel networks targets
Fully 60-80% of companies that apply for angel network financing don’t match the target profile. But once we filter these out, the networks will invest in less than 10% of the remaining applicants. Why? In my last column I talked about decreased availability of angel capital, which does play a part. But the current problem is more complex.
Many companies don’t have a clear, focused business model — is it a product or a customized solution? What is the target market niche? Entrepreneurs often state that they are targeting multiple markets with numerous value propositions. This is not maximizing potential return — it’s minimizing the likelihood of success.
Sometimes the management team has too many holes. A good management team, even at the early stage, should have expertise across key functional areas: technology, leadership, finance, marketing, and operations. Directors can fill some of these areas, but too often we see entrepreneur-technologists, with the best intentions, holding the company back by failing to bring in needed talent.
Certainly, we see operational and sales team flaws, and many other problems. Fundamentally, the angel networks are actively looking for what Michael Porter referred to as “ long-term sustainable competitive advantage.” Patents may meet the criteria; “first-to-market” usually does not.
The bottom line is that the angel networks are generally looking for businesses with the following positive characteristics:
• A management team strong enough to take the business through the early stage growth process (remember, most angels invest in people, not technologies or businesses),
• A well-defined IP portfolio or clearly established product innovation,
• A competitive environment and market strategy that will allow the venture to succeed without an expensive, dedicated national sales structure, and
• The potential to achieve early milestones that will demonstrably increase valuation.
At the same time, the best targets for the networks also have the following weaknesses:
• A financing requirement greater than can be supplied through friends, family, and affiliated angels, and
• A value proposition (including management, technology, and market opportunity) not strong enough to immediately secure quality venture capital or bank financing.
The real problem — the deal
But the most common problem we find is the deal itself — terms and structure.
The withering of venture funding has increased the negotiating power of the VCs. So angels are taking pre-emptive measures to protect their investments.
First, they are demanding lower valuations — much lower. An actual investment in 2000 with a $5M pre-money valuation had a prototype, $250k invested, and a strong management team. In mid-2002, a company with $3M in SBIR funds already banked, $1M in cumulative sales, a strong management team and WARF-protected patents got a $4M pre-money valuation, and gave warrants as well. And the general sense is that this may still have been too generous.
Second, angels are demanding more carefully designed structures. Angels are taking pages from the VC books: convertible debt with conversion discounts, voting power over future financing, refusal rights, and warrants. Entrepreneurs without a clear sense of the current market will not get to the negotiation stage — they may not get to the presentation. And complex structures designed to protect the founders or seed investors at the expense of the angels are non-starters.
The real role of the networks
The networks, in effect, may be the financiers of last resort. Rarely are the network angels familiar with the minutiae of a given opportunity. They look to negotiate deals that offer returns commensurate with this added risk of unfamiliarity. Angel networks should demand tougher terms, and lower valuations, than affiliated angels.
This may be a surprise to the minority of companies that are network targets. A network allows an entrepreneur to get in front of numerous angels quickly, which can be helpful, but it also generates leverage for the angels. And the Wisconsin networks have gotten tougher — turning down inappropriately priced deals.
Companies “trailing” the valuation market will probably have to bite the bullet eventually, especially if they’ve already done rounds at unsustainable valuations.
Two years ago, Terry Sivesind and I presented at a WIN luncheon event. Someone asked Terry what the number one problem was in angel financing, and he replied: “valuation.” I agreed with him then — I think his response is still correct now.
Adam J. Bock is the research manager for Early Stage Research, an angel network, and a regular contributor to the Wisconsin Technology Network.