Following on the heals of last week’s post from Andrea Belz, we have another guest blogger, Bob Aholt. Bob is a Director and long-time member of the Pasadena Angels, has been investing in early stage companies for 5 years, and has been held numerous “C” level positions at private and publicly traded companies. Bob also teaches graduate level finance courses at Antioch University.

  By Bob Aholt

To set the stage, as an early stage investor, I look to invest in a “perfect storm” company.  That is, I’m looking for a great Entrepreneur, a great product and a great deal.  I’ll leave the discussion of what comprises a great idea and a great people for another post, but here I’ll give my rational behind what constitutes my version of a plausible deal.

It all centers around Return on Investment, or otherwise known as ROI.  The higher the ROI the better the investment – brilliant eh?

Now for some details.  Lets start with the definition as presented at Investopedia.com (one of my favorite resource sites).

For this conversation, I’m going to focus on gains exclusively from a sale and forgo a discussion on ROI from cash flow.  Not that it’s irrelevant or infeasible, just that early stage investments are generally more exit strategy centric.

So for an example lets assume a $500k investment in a company with a $600k pre money that professes to have an exit plan that will garner a $5m sale in 5 years.  The investor ROI on this is 355%.  [Gain = $5m *$500k/$1.1m], [Cost = $500k].   The gain divided by the cost of the investment is often referred to as the multiple.  In this case 4.55.  Typically, I hear the “multiple” referenced more than ROI in Investor presentations. Since they are derived from the same parameters, they are rather synonymous, but as the ROI calculation includes the time parameter, it’s more relevant to me.

Two other statistics that also come up are Net Present Value (NPV) and Internal Rate of Return (IRR).   Excel quants will be able to calculate these fairly simply, and in this example come to $828k (at 10%) and 35% respectively.  However, from my point of view, really only the multiple or ROI are necessary.  That’s because all these numbers are all based on a rather large set of assumptions.  That’s where I’ll turn my attention next.

Assumptions:  everyone knows how the game is played.  All Entrepreneurs say their projections (from revenue, to expenses to exit values) are conservative.  All investors feel they are, at best, an educated guess.  From what I’ve seen, and what I appreciate most, are a couple of different scenarios – best case, worst case and expected case – with the parameters and assumptions clearly laid out.  If I can buy into a plausible scenario where the exit is approximately a  400% ROI or a 5x multiple in 5 years then I’m willing to go further along in the conversation.

As someone looking for funding, lay out your case as to why your company will be bought for $5m in 5 years (in the above example).  As an Investor, I understand that 5 years out is an eternity for an early stage company, and the scenario has a better chance of being wrong than right, but I need to know the Entrepreneur has thought through the process and that the scenario is realistic.  Sure there’ll be adjustments, course corrections and outright changes to the business model, but my end goal is still a high ROI and I need to know the company understands that perspective.

In the financial part of a presentation, I’m also looking at the company’s validation points.  From inkling to viability my list includes:

- idea – is this all the company has at the moment
- beta – is there a proof of concept to show
- customers – is someone using the product
- sales – have the customers agreed the product has value
- gross margin – can the company make the product for less than its sold for
- operating profit – can sales cover the cost of doing business too
- positive cash flow – a going concern

If the company can present a timeline showing each of these milestones, or at least the ones that get it to the exit point, the story becomes much more plausible.

Since an investor is focused on ROI, the implication to valuation now becomes clear.  All else being equal, the lower the valuation the higher the (potential) ROI.  Using the example above, if the pre money were $1m instead of $600k, the ROI drops to 233%.

A note about subsequent raises and dilution.  If the company is going to need more capital than Angels can supply, that’s ok.  There are plenty of examples of Pasadena Angel companies that have had multiple rounds of funding and provided quite good returns to the investors.  The Entrepreneur needs only reflect the smaller ownership percentage of the initial investors in the ROI/multiple number. Usually the follow on funding is presented in a scenario where the exit amounts are higher, so mathematically, the results could be a wash.  Again, for me transparency, plausibility and clear assumptions are most critical to persuading.

So to sum it all up, an investor’s ROI depends on three things: exit price, the length of time to the exit and the percent of the exit received by the investor.  The first two – sale price and duration – are heavily influenced by the quality of the idea and the people executing (not to mention luck).  Valuation (and any subsequent raises) are casual to the percent of the sale received by the investor.  And valuation is the only variable in this equation that can be controlled at the time of investment – that’s why it becomes such a critical negotiation point.

Hypothetical Example
THE RAISE
Investment    $500,000
Pre Money    $600,000
Post Money    $1,100,000

OWNERSHIP
Founders    55%
Investors    45%

EXIT
Sale Price    $5,000,000
Time    5 years

INVESTOR RATIOS
ROI    355%
Multiple    4.55x
IRR    35%
NPV @ 10%    $828,000

From time to time we have posts from local members of the startup community that provide some great advice from a different perspective. Today’s post is from Dr. Andrea Belz, a long-time member of the Pasadena Angels, a local consultant and one of the brightest people I know (a CalTech PhD–what more can you say).  Although Andrea provides five simple questions to ask when commercializing university technology, these can also be applied to most startups—whether they get their start in academe or not.

     By Andrea Belz

Many entrepreneurs approach Angel groups and VCs with novel technologies and strong technical teams.  Unfortunately, they often “forget” to conduct any marketing research, mainly because they don’t understand how to do it.  Even worse, technical teams with strong resumes may attract plenty of funding, but eventually they may hit the wall (at investors’ expense) once everyone realizes that there is an interesting technology but no interest from the outside world.

This problem can be especially acute when the local community includes a strong research institution interested in technology commercialization.  People often underestimate the gap between the technology’s readiness to exit the university or research laboratory and its readiness for market.  This gap often takes five years to overcome.   Furthermore, technologists almost always underestimate the difficulty in selling anything – the hardest challenge in almost any organization is to get someone to write the first check.

Entrepreneurs should be sure to ask themselves a few key questions before pursuing a plan to commercialize technology, particularly with investors.  Investors can use these questions as a guide to the entrepreneur’s “coachability”.

1. Have you spoken with anyone that might be an end user of the product and lived in their world for a day?
2. Have you listened seriously to his/her feedback without foolishly discarding it (“They just don’t get it”)?
3. Do you tell people about your technology or about the benefits?  In other words, do you sell the drill or the hole?
4. Can you estimate the size of your market and have you found “low-hanging fruit”?
5. If the low-hanging fruit is not the first application you considered, are you willing to shift direction?

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.