Last Part of a Continuing Series on How to Select an Angel Group

In my original Top 10 list of criteria for selecting an angel investor, there were two items that aren’t often discussed, but are worth scrutinizing during the fundraising process:

- Honesty and integrity
- Are they respectful of entrepreneurs

If you talk to founders and CEOs that have gone through early-stage fundraising, many will share their personal stories about dealing with as***le angels. In partial support of this, Frank Peters wrote a recent post on the Top 10 Lies Angels Tell that contains a few chards of truth. On several occasions I’ve observed angels (and not members of the Pasadena Angels) publicly berate entrepreneurs. Probably the most memorable was when a member of another angel group looked a founder square in the eyes and told them in an obnoxious manner they weren’t CEO material—a rather ironic comment, since this angel had probably spent their working life as a service provider and had never been in an operational role, and especially not one in a startup.

Given all the turmoil and upheaval that’s occurred in the Angel community over the past two years, one question that invariably perplexes me: How do as***le angels survive and why isn’t there a self-correcting mechanism that purges them from our ecosystem?  In addition to losing bad angels for economic reasons, it also seems reasonable that the best entrepreneurs would avoid working with them and would force/encourage these angels to ply their trade somewhere else.

According to the Angel Capital Association, approximately 225,000 people have made an angel investment in the last two years, which would somewhat qualify them as angel investors. I suspect the majority of these individuals are decent people. As with other professions—or life in general—there will always be some bad apples.

Based on my experiences as an angel investor over the past seven years, I have three theories about why this occurs:

1.    There’s a significant imbalance between early-stage capital and good fundable companies, which means it’s a buyer’s market for investors, and companies can’t be as discriminating. I’ve talked in past posts about the funnels for most institutionalized angel groups and VCs, and that only about 1% of all the companies that apply get funded. Since this metric was from better times, I suspect it’s now even lower in the current economic climate.

2.    Entrepreneurs hear the hype about particular angel investors and that they’ve done the most deals and/or they’ve been around the longest, and are completely blinded by it. In many of these instances, entrepreneurs have done little/no diligence on these angels and have tended to overlook their negative character traits.

3.    Money talks and entrepreneurs get blinded once the term sheets and money appear, and once again don’t do sufficient diligence on their investors.

In addition to understanding why they survive, it’s also important to understand what created the as***le angels in the first place. For the good angels it’s an opportunity to give back and they enjoy working with entrepreneurs. For the as***le angels, it’s often they’re wanna-be VCs and/or relish the opportunity to express themselves in ways they weren’t able to in their previous careers. Apparently they’ve seen some VCs behaving badly and figure acting this way will give them some VC cred. (note to these types: you’re not really a VC if it’s personal and friends & family money, as opposed to institutional—unless you happen to be Haim Saban).

Even if an angel is on their best behavior during the early stages, you should still do some diligence on their personalities and post-investment reputations. Another good barometer for predicting these behaviors can be found in your initial experiences with the admin staff-or gatekeepers—for an angel group, as these people frequently reflect the attitudes and corporate culture of the angels that employ them.

Given the continued tough financing climate this year, let’s hope you can avoid the as***le angels on your quest for funding.

Question: My partner and I are trying to agree on an initial valuation to establish an equity share percentage for a seed stage company that is not yet operating. I realize there are many factors you take into account, but I am wondering about my partner’s suggestion that we use a multiple of year 4 EBITDA from the B round expansion of the business.

Answer (By Bob Aholt):  The topic of valuation is probably the most talked about, and certainly the most negotiated subject in our Angel deals.

Your partner’s valuation premise is certainly unique.  While it may be plausible, let me come at the valuation question from a typical Angel perspective - - we generally invest in deals that have a realistic chance of a 10x return in 5 years (or a 5x return in 3 years).  If you can work the numbers from a seed round into those returns, you’ll generate some interest.  Here’s how I typically see the numbers playing out:

- $500k raise on a $1.5m pre-money valuation.  Post money valuation = $2m.  Angel ownership = 25% ($500k/2m)
- “B” round at $5m on a $15m pre.  Series A diluted to 18.75% (75% of the initial 25%)
- Series A target 5 year sales price $26.667m

Therefore your goal is to convince the Series A investors that you have a company that can grow in 5 years to a firm that’s capable of being purchased for over $25m.

Part IV of a Continuing Series on How to Select an Angel Group

Several months before Jason Calcanis’ crusade (or jihad—depending on your political affiliation) against for-profit angel groups, I wrote a post about evaluating angel groups and the criteria to use when seeking investment. For those that didn’t see the earlier post, the list included:

1.    Do they charge fees
2.    Do they actually have capital and a track record of investing their own personal funds
3.    How transparent is their organization and investment process
4.    How do they say ‘no’
5.    Honesty and integrity
6.    Rolodex and connections
7.    Advice
8.    Are they respectful of entrepreneurs
9.    Do they help entrepreneurs, regardless of whether or not they invest
10.    Do they support the local entrepreneurial community

Although pitching fees—or pay to play—is a good litmus test for weeding out disreputable angel groups, you’ll also find that for-profit angel groups typically have a poor track record with these other criteria.

Most angel groups have money, and one group’s money isn’t any greener than another’s. Beyond cash, the other ways an angel group adds value to a startup is through great advice and personal connections.

One of the easiest ways to assess an angel investor’s ability to provide advice and connections is to read their bios on their website. High-caliber Angels with a lot of experience at both large and small companies, tend to have strong Rolodexes and skills that can be applied to helping portfolio companies. When reviewing their experience, consider both their work history and the companies they’ve backed as investors.

You can also judge the caliber of the group through your initial experiences, as many Angels provide worthwhile advice and introductions to their networks in the early stages and prior to investing. If you’re further along with an angel group, consider doing more diligence on the group and its members by contacting CEOs of their portfolio companies.

When it comes to connections, one of the most important when evaluating an angel group are links to VCs. Although many of our portfolio companies have told us the Angel round is the last tranche of money they’ll need (and they even say it with a straight face), most startups will invariably require follow-on funds.

A couple of years ago, William Quigley of Clearstone Venture Partners wrote an appropriate blog post, Value of Certain Angel Investors:

As a VC, I divide angel investors into two buckets.  The first group includes angel investors who know the space they are investing in. Perhaps they previously started a company in the same industry or were part of a successful company targeting the same market.  As it happens, angel investors in this category usually know the VCs who invest in their space and can be a great help in introducing a start up to smart venture capital investors. Better still, these angels typically know the going terms for a start up in their market. Accordingly, they can help the entrepreneur get the best deal warranted given the progress of the business.

The second bucket of angel investors are those who have some spare cash to invest but don’t have any familiarity with the target market. These investors are generally not known by VCs active in the specific market the start up is pursuing. In most cases, they can’t help with follow on fund raising. Because they don’t know what the going VC terms are, they often set terms for their investment that make it harder to raise money in the next round.

VCs can’t know everything about an industry. So how do they get comfortable with a new business? They rely on smart people who are accomplished and well connected in that industry. If someone of that caliber happens to already be an angel in your business, raising venture capital just got a lot easier.

Given that Clearstone has invested in one of our portfolio companies—LeisureLink—that’s managed by two of our members, it’s a pretty good bet that the Pasadena Angels fall into the first bucket.

In the current environment, CEOs and entrepreneurs don’t always have a choice when it comes to selecting their investors. However, when you do, it’s important to pick an angel group that can deliver the intangibles, such as advice and network, along with the cash.

On Thursday (10/22) this week, join us for a full day of worthwhile events in Altadena at Tech Week. The morning’s session features a Cleantech program, moderated by Ben Kuo of SocalTECH.com. Along with Ben’s program, there’s a great keynote presentation by Barbara McQuiston of DARPA and a couple of panels featuring Wired Magazine reporters.  [Shameless Self-Promotion Alert]…The last program of the day is the annual Pasadena Angels program on the state of Angel and Venture Capital in Southern California. We’ll have a great group of panelists (no immodesty here, since I’m just the moderator) that afternoon, and I’ll provide some comments and feedback from the event in my next post.

Interesting post on Jason Calcanis’ blog this week (also picked up by Ben Kuo and SocalTECH) with further thoughts on Angel groups charging startup companies to pitch. All of his posts on the topic are not only good reading, but accurately describe what goes on within some Angel groups (e.g., These pay-for-play scams remind me of the “modeling agencies” that charge people for representation, acting lessons and to have their headshots done.). Although I’ve written on this topic and share Jason’s ire,  I’m not yet at the point of ‘jihad’ (crusade maybe) or calling out particular Angel groups. Other than what Jason and I have already mentioned, the only other advice I can give is beware of for-profit angel groups based on a franchise model–as those are typically the ones that charge companies. If they don’t make money the old fashioned way and exclusively through investment returns, then they aren’t worth talking to.

As I was writing another installment on what the Pasadena Angels look for in company pitches, I came across a good post from Steve Blank about sufficiently understanding your customer and target markets and decided to use that instead. Steve’s observations are pretty representative of what we regularly see when companies pitch.

Lastly, Jeff Sheldon, a longtime member of the Pasadena Angels and well respected IP attorney and litigator put together a good reference on Patenting Inventions.

Have a great weekend. Patenting Inventions

I recently reviewed a set of investment ready criteria published by a respected Angel Group (not the Pasadena Angels). All the usual factors were there–what problem was being sold, the extent of competitive advantage, the experience of the management team, size of market, etc.  You could quickly infer from the questions that the objective was to find a high growth potential venture to invest in. No doubt the intention was to fund the company,  establish a market position, grow market share and then somehow harvest the venture. What I found remarkable was that the question of possible exit path wasn’t on the list.

Perhaps I shouldn’t be that surprised.  I recall conducting a study 5 years ago when I and a colleague reviewed several hundred VC websites to ascertain the extent to which exit strategies were discussed or requested in investment proposals. Even then I was surprised to discover that over half the sites had no mention of exits and not one had an explanation of the various forms of exit and an indication of what information the VC firm would like to see on the proposed exit strategy. Five years on and I had hoped that we would have gained a much better appreciation of the importance of the exit to the investment evaluation.  It seems I was wrong.

What I find distressing is that we still seem to be locked into a business concept from the 70’s and 80’s where the dominant VC model was to grow a business to a point where it could be taken to an IPO.  In those days the pent up demand for hardware and software meant that any reasonable product could fuel significant growth so an IPO was a real possibility.  Then along came the internet boom followed by the biotech boom and that simply reinforced the conventional wisdom. However, it is very clear now that the days of easy IPOs are gone and so is the conventional VC model.

In the present environment our liquidity options now are very limited, basically the best and most likely path is a trade sale.  If that is the case, then why are we still fixated on building out the business. Surely the question we need to ask is – what form of trade sale is the best harvest option for this venture?  Only then can we deal with the other criteria. Is it not the case that the exit method drives the development of the business?

Before we get tied up in legal and financial due diligence we should be working out the exit. We should be ascertaining how the venture will create value and what type of acquirer wants what they have?  Since there is a fundamental difference between a trade sale based on inherent revenue and profit generation from one based on exploiting an underlying patent or other form of IP, these are critical to an evaluation of whether the venture can be prepared for sale.

Asking about market share, distribution channels, management experience, R&D pipeline and so on, before ascertaining the exit path is clearly asking the wrong questions.

I’m off to Asia, so today’s post will be briefer than usual. Earlier today I came across an interesting post by the BBC (yes, that BBC), The Problem with PowerPoint.  Although they have a great global perspective and I listen to their Internet radio extensively, I don’t typically expect to see much coverage of our landscape. Their brief article provides some good advice for the PowerPoint junkies in our world, as well as any entrepreneurs pitching investors. It’s also a good complement to the other articles/videos on investor presentations we’ve had in earlier posts from David Rose and others.

The second article worth reading is from Mark Cuban (yes, and unfortunately that Mark Cuban). Although as a Lakers fan I don’t have a very favorable opinion of Mr. Cuban, this article provides a good example and analysis of a an email received from an entrepreneur that will eliminate any chances of getting funding and is very similar to the 4-6 emails received each week by the Pasadena Angels.

A few years ago, Joe Torre (when still managing the Yankees) wrote an article for Business Week (Joe Torre on Winning) that’s well worth reading. One of the lines in the article pretty much sums up one of the hardest things for Angel investors to do and something that happens on a regular basis: “I have had to release guys I loved, and keep players I didn’t necessarily care for.”

In the world of startup investing, Angels invariably come across a lot of great entrepreneurs that they get to know on a personal level and think the world of. Unfortunately they sometimes have to say “no” to these individuals because they aren’t completely comfortable with the company’s market space and/or technology. Conversely there are company founders that drove us crazy, where we ended up investing in their companies because we knew the venture had a very high likelihood of success. What also makes saying no particularly tough is knowing that many of these entrepreneurs have leveraged themselves to the hilt through credit cards and second mortgages and have given up well-paying jobs to pursue their dreams.

In an earlier post I mentioned that 1-1.5% of all applications submitted to the Pasadena Angels get funded. Realistically—and with a finite amount of time and investment dollars—our group can do a maximum of 12 investments each year. In our world, that means saying no to many entrepreneurs.

As you work with Angel groups (and also VCs), there are three pieces of advice related to this topic worth considering. Since fundraising can be a real (but necessary) timesink with a substantial opportunity cost, focus on getting a quick yes/no from prospective investors. Even if the answer is no, you’re way better off getting a quick answer and not consuming time with those that are not likely to invest.

Secondly, look at how the group says no to evaluate them as investors. Although this won’t make a lot of sense at the time you’re rejected, it’s worth doing since you may have another venture in the future where they’d potentially invest.. For reputable investors, the experience should be constructive, positive and polite.

Lastly Bill Burnham, a former VC, has a series of great posts on The Art of Saying “No” and goes into considerable detail about the process and some of the unsavory tactics used by VCs.  In his third post, Bill summarizes the four reactions he typically gets from entrepreneurs when hearing “no.” The best advice I can share is always make sure your reaction is #4– Thanks, this has been helpful.  Let’s talk if we raise another round.

Over the course of this week I’ve come across some great articles and blog posts that should be required reading for any entrepreneur looking for funding—including those that have done it before. Starting with The Entrepreneurs Report from the law firm Wilson Sonsini Goodrich & Rosati (WSGR) there are two articles from outside contributors on Perfecting Your Pitch and How Do I Get Meetings with Investors. For the first piece you can pretty much substitute ‘Angel’ for ‘VC’ and it’s right on the money with respect to the Pasadena Angels. One word of caution, however, when reading the WSGR report, try not to dwell on the VC financing trends. The good news in all this is that although Angel and VC financings are down, there are still good companies getting funded as we speak.

A couple of other good posts/videos that I’d highly recommend are Tony Tjan’s the Great Entrepreneur’s Secret and 10 Things to Know Before You Pitch a VC for Money by David Rose which do a good job of covering the intangibles we look for in entrepreneurs and pitches.

By now everyone has seen the infamous Sequoia presentation, R.I.P. Good Times. From what I can tell traveling around the US and overseas, it looks like these slides have circulated faster than the Paris Hilton video (sorry, no link on this last one–you’ll have to find it yourself). If you’ve already seen the presentation, there’s a good post worth checking out from Silicon Alley Insider that provides a few more details on what was discussed at the all-hands Sequoia meeting.

There’s also a good post from last week by Jason Calcanis of Mahalo, What to do if your Startup is About to Fail. Although it’s vintage tell-it-like-it-is Calcanis and a little disparaging of investors (VCs), it provides some further thoughts and granularity for dealing with the current tough times.  Although Jason’s been in the news this week for not fully vetting a prospective employee and accidentally hiring a felon, don’t discount the worthiness of his advice. Even though we may not agree with his explanation and apology for this recent mis-step, I can vouch for the quality of his advice having been on the other side of the table in a number of startups.