Last summer, Jason McDowall wrote a guest post about his own personal experiences raising angel capital (not from the Pasadena Angels) and some of the challenges that followed. I recently re-read Jason’s post from June ‘08 and thought it would be a good lead-in to evaluating an Angel organization and the process of finding ‘smart money.’  Based on past conversations with Jason, my own personal fundraising experiences and discussions with other entrepreneurs, I’ve come up with my Top 10 criteria that entrepreneurs should consider when deciding which investors to work with. Although these criteria are rather self-explanatory, I’ll be doing some further posts on some of these topics over the coming weeks.

Top 10 List

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

 [Editor’s Comment] In a previous post, we mentioned recently meeting Dr. Tom McKaskill (aka Dr. Exit) and were impressed with the vast knowledge and wisdom he’s shared over the years with entrepreneurs and startup companies around the world. Beginning with today’s post, we’d like to welcome Tom as a regular contributor.  Check out his website at www.TomMcKaskill.com.

I am continually amazed at how little entrepreneurs know about building value in their business as part of a process of selling their business. Not that I should be that surprised having spent many years now educating business owners on how to best prepare their businesses for sale and how to generate a premium on sale. But the thing that constantly amazes me is the fact that their professional advisors and business brokers know little better.

Fundamental to the sale process is understanding the value which the buyer will extract from the business. Without question, this comes in the future not the past. That is, the value of any investment is derived from a future stream of income. That being the case, why is it that advisors and brokers force business owners to use past profits to value a business – normally using an industry EBIT valuation model which is more guess than science.

When you think about this a little more seriously you can see that a business which makes the effort to provide the buyer with a different, more positive, more profitable future for the business being sold, should get a higher price than simply a multiple of past earnings. This can lead to two possibilities: the buyer can extract more from the existing business than the seller or the buyer can utilize the assets and capabilities within a much larger business thus exploiting the underlying assets and capabilities much more than the seller could.

Clearly, the process of extracting value is to find a buyer who can exploit the business better than you can. The objective is to create future potential for the business way beyond the current owner’s capacity and capability. By finding multiple potential buyers who can generate greater value in the business in the future than that which could be generated by the current owner, the seller can readily achieve a premium on the sale.

If you are a business owner, you need to break away from the past and concentrate your preparation on what the future of the business might look like in the hands of a much more capable and better resourced buyer. Then go find those buyers who can best exploit the potential in your business. By setting them up in a competitive bid, you will be able to extract the best price for your business.

However, a word of warning. Make sure your buyer can deliver on the potential – otherwise you won’t be believed and their lawyers will come after you wanting to get the money back because they (and not you) failed to deliver on the potential.

The current recession presents you with an opportunity to upgrade your sales team.  Many high quality salespeople are out of work, and base salaries have come down.  If you are fortunate enough to be hiring, now is the time to be aggressive.  If you don’t have open hires, think hard about eliminating poor performers and replacing them with new staff.

We are all struggling to do more with less, as companies reduce their workforces, VCs  (and Angel Investors) get tighter with funding, and customers are stingy with orders.  You can make real progress by upgrading your sales team, no matter how large or small.

In our own hiring and in anecdotes from other managers, base salary expectations are down 20% or more from just a year ago.  More importantly, many skilled sales people have been let go in the waves of layoffs that have dominated the news.  Salaries down, supply up—in short, a buyer’s market.

The opportunity is obvious if you have open positions, but what if you don’t have budget for new hires?  Take a hard look at your current team—we all tend to hold on to underperformers, particularly if they are selling something.  I know I often hesitate to fire that marginal performer, because they do add top line revenue, even if it is not as much as they should.   Now is the time to turn over marginal team members, and upgrade with new hires.

I don’t want to duck the ethical dilemma here.  Firing a marginal colleague in the midst of a severe recession is not a pleasant duty, and will make for some sleepless nights.  There is only a little solace in the thought that you are also creating an opportunity for someone else, hopefully of higher caliber.  The bottom line is that you owe it to yourself and the rest of your team to take a hard look, and then make the tough decisions.  Upgrading now increases your company’s chances of making it thorough the current recession intact.

In a previous post, I mentioned a visit to New Zealand to share some of our local startup and investor experiences. Mustapha Baha, one of my colleagues at the Pasadena Angels had a similar trip to his native Algeria to meet with local angel investors. As with New Zealand, I wouldn’t have predicted such a trip 10 years ago—which shows how global the early-stage investment community has become.  For those unfamiliar with Angel investment, there’s a good overview by Tom Taulli in Business Week.

In preparing for his trip, Mustapha compiled data from a variety of sources, including the Angel Capital Association/Kauffman Foundation, PricewaterhouseCoopers MoneyTree, the National Association of Seed and Venture Funds (NASVF), and the Center for Venture Research at the University of New Hampshire. The annual estimates below for a typical year are for start-up funding in the US. Although these estimate are probably subject to some margin of error, they still show that 85% of the outside equity for startups comes from Angel investors.

Annual Sources of Start-up Funding

Venture Capital        ~$3 billion

State Funds              ~$0.5 billion

Angel Investors        ~$20 billion

These estimates also indicate there are at least 250,000 angels active in the US, funding over 50,000 small companies a year.  Some of the more noteworthy companies backed by Angel Investors over the past 15 years include Google, Yahoo, Amazon, RedHat, Cisco, PayPal and Starbucks.

There’s a high degree of concern about the impact the current economic climate will have on angel investing in the 2009. If we look at the numbers for the past year and assume a pessimistic 40% contraction, that still means 60% of the prior investment funding will continue next year—or $12 billion—and that many companies will be funded.  Later this month we’ll have more posts on the current state of the angel/VC investment landscape and what companies can do to increase the odds of getting funded.