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.

Far too many of my angel colleagues are fixated on patents as the source of sustainable competitive advantage. While these are often the source of competitive barriers they are by no means the only effective method for generating high growth. In fact, there are many situations where the patent itself provides little growth momentum.

We need to see a potential investment in a business in more holistic terms and especially we need to focus on the way in which the business interacts in the marketplace with its customers and competitors. If you want to drive high growth then you first need a combination of a well defined large niche market, a robust channel to market and a product or service which satisfies a compelling need. The next critical component is to have something which give you a strong competitive advantage. It is this combination which drives high growth. A patent alone, which provides some level of competitive advantage is somewhat meaningless without the other attributes.

Competitive advantage is anything that gives you an advantage against others attempting to satisfy the same need. But there are many points along the supply chain where you can gain such an advantage. You can control the point of purchase by ensuring yours is the only product offered. You might have an exclusive right to a geographical region for the only product which satisfies the need. If there is a unique component, ingredient or area of knowledge required to produce the solution, you might own or control the supply. Your objective is to own the customer solution and there are many ways in which that can be achieved of which patents are only one of many possibilities.

There are of course a number of more obvious barriers to entry including brands, copyright, licenses and patents. But being able to take advantage of significant economies of scale or learning curve effects might give you a cost advantage.

Patents are useful because they are an obvious source of competitive protection, but in themselves really don’t drive growth potential. If we focus too much on the patent element, we are in danger of missing the real growth drivers which are resident in the problem being solved and access to willing and easily addressable customers.

Given that most of the Angel exits are via a trade sale, our focus on competitive advantage and growth potential should be from the viewpoint of the buyer not the venture itself. It is the ability of the buyer to take advantage of the competitive advantage position which results in the higher exit values. This is especially relevant where the venture itself is not able to fully exploit the advantage. For example, a weak open market competitive position may change dramatically for an acquirer which can position the acquired product alongside a strong complementary product or inside a product portfolio. Similarly, a product which can be sold directly into an existing customer base may be very attractive to an acquirer even if it not the best stand alone product in the market.

In evaluating a venture, especially for a strategic value exit, we need to take a broad view of competitive advantage and look at the revenue possibilities of the acquisition from the buyer’s perspective given the buyer’s ability to exploit the underlying potential. In this regard, the ability of the buyer to rapidly deploy and scale the acquired asset or capability is of much more importance than the strength of any underlying patents.

When we’re evaluating a possible investment, it is easy to neglect how the strategic value premium will be determined and how this impacts on what we can expect as an exit value. Our initial focus is generally on target need, customer and competitive advantage but while these protect the business they don’t guarantee high growth rates. It is high growth rates in the hands of the buyer which will determine how large the strategic premium will be.

I recently evaluated a software company which ticked all the normal boxes. It satisfied a critical need, targeted a very addressable corporate market, had a proven integrated solution with considerable deep expertise in its functionality and a proven management team. No question that the business would be successful and they would capture a reasonable market share. However, the key to a high strategic value premium is in the ability for the buyer to rapidly scale the solution in the first two years after the acquisition.

I put myself into the shoes of the buyer and asked the question ‘how rapidly could I deploy the solution?’ Even if the acquirer had access to the prospective customers and the funds to ramp up the marketing, sales and support effort, I could not see how they could scale rapidly.

The problem in endemic to a lot of application software ventures. A highly technical solution requires the business to recruit and train very specialized sales staff, pre-sales consultants and implementation staff. This alone tends to inhibit growth rates. In this case, the solution was also customized which would slow down the sales and  implementation processes. Sales cycles in high value integrated applications are slow because of the evaluation and approval cycles and there is little the vendor can do to speed up the process.  At best, I could see the acquirer doubling the business each year in the first two years after the sale but it would be a stretch to grow faster. If that is the case, the strategic premium would be relatively low.

If the growth rate is limited by the length of the sales cycles and the rate of adoption, the business will increase in value slowly. Thus, it will take many years for an investment to achieve 5 times investment on exit. If the growth rate is constrained in the hands of the acquirer for similar reasons, the value to the buyer is not much greater than if the business were sold as a financial exit. The key to any strategic exit is that the buyer can rapidly exploit the business through their own organization. If that is not possible or is limited, the strategic premium will be small.

An outstanding strategic value investment demonstrates the capability of very rapid deployment within a short period after the sale. Not only do you want the compelling need, the highly targeted niche market and the strong competitive advantage but you want short sales cycles and very low marginal cost of sales. Standard products which can be sold through the internet or easily installed or distributed via high volume channels are what you look for.

I prefer to seek out investments where the acquirer can scale the business 20, 50 or 100 times after the sale. If the strategic premium is generated from revenue in the first two years after the sale, it is the rate of growth in this period which is critical to a high strategic value premium.

With any exit, we need to focus on what the buyer will do with the product or service being acquired. Just because something has a market leadership position does not of itself mean that it will generate a high strategic premium on exit.

Every once in a while, I’m reminded just how harmful overlawyering can be.  I just finished preparing an operating agreement for 3 partners in a new venture.  They have a promising startup with a couple hundred thousand in seed capital, seeking to raise maybe a half million more to fund their initial operations.  I worked with them to prepare a detailed operating agreement, standard founder intellectual property (IP) assignments, and consulting agreements to govern their go forward work for the company.  That’s about all they need at this nascent stage.

All was good until one of the partners decided it would be a good idea to have their personal counsel look over the documents to protect their personal interest.  (After all, I’m company counsel, not founder counsel.)  Unfortunately for the company, founder’s counsel is what I’ll call an “Overlawyer”.  Next thing you know, I have a seven page memo of comments on the operating agreement.  And that’s not counting the four page tax memo that followed.   Or the three separate counsel phone calls I fielded on a completely standard founder IP assignment.

Mind you, most of the memo was written by a third year associate in his vast business experience (nice guy though, kind of sad to see him indoctrinated).  It was then reviewed by a senior corporate partner, and I’d estimate the combined hourly rate of these two lawyers at about $1,000 per hour.  Needless to say, many hours and thousands of dollars later, we are all “agreed”.  About 15 minutes’ worth of the input from Overlawfirm’s tax counsel was helpful.  Aside from that, what do I think was improved in partner’s “deal” as a result of their hiring Overlawyer to represent their interests?  Zero. Nada. Zilch.  The company will function exactly the same as it would have otherwise.

So everybody talks (complains) about the cost of Overlawyers in terms of dollars.  And the financial cost is ridiculous, no doubt.  But people rarely talk about the nonmonetary costs of an Overlawyer approach, which in my book are just as, or even more, detrimental to an entrepreneurial venture.  In the current founder situation, Overlawyer scared its founder client into worrying that certain benign document provisions were detrimental to founder (and somehow only to founder—odd, since they applied to all the founders equally).  That needlessly instilled in Overlawyer’s founder a certain degree of mistrust in both company counsel and in founder’s partners.  That’s a crying shame, because we all will be working together for years to come to build the business, and that’s not the right way to kick it off.

Worse, the business partners have just spent weeks negotiating with one another, rather than working together to advance the business.  The other partners who didn’t hire separate counsel were frustrated by the delay, and they aren’t happy that their partner sought out special protections for themselves rather than just doing what’s best for the company like everybody else.  These things take a toll on founder relations.

Finally, by incessantly prioritizing individual founder interest before the company’s operations, Overlawyer missed the forest for the trees.  Had I not put my foot down, founder would not have properly assigned their IP to the company, and the company’s decision making processes would have been held hostage to founder.  That would have made the company less investable, less functional, and quite likely, less successful.  Ultimately, what serves the founder’s financial interest in the startup context is a well functioning company, and that is a fundamental business truth that remarkably few Overlawyers grasp.

I’d like to say that this experience was unique, but it’s not.  While of course there are Overlawyers at firms of all sizes, I find almost an inverse relationship between the size of the law firm, and how prone they are to utter nonsense like the above.   There are structural reasons for this.  Many lawyers at big Overlawfirms have never done anything in their professional careers but practice law, and as a consequence have little ability to distinguish between salient business risks and theoretical legal issues.  Every business lawyer I’ve ever met likes to claim that he or she is a “practical lawyer,” and 90% of them are full of crap.  The inefficient approach is also inherent in the internal Overlawfirm financial model, which relies on leveraging young, inexperienced associates to enhance revenues at the top of the law firm pyramid.  Indeed, Overlawfirm’s business model depends on its lack of restraint; if every hour is billable, every issue, whether important or not, is revenue.

On a less cynical note, there are many honorable Overlawyers who are not trying to churn billable hours.  They truly (but falsely) believe that they best serve their clients’ interest by advocating for them in this way.  I would like to see law firms teach their corporate attorneys that their number one goal is to facilitate their clients’ businesses, while acting ethically and protecting against undue (not all) risk.  Instead, big Overlawfirms tend to drill into their attorneys that their number one priority is to avoid missing anything, always turn over every stone, never make a mistake.  Risk avoidance at all costs.  This leads Overlawfirms to the conclusion that overlawyering is good lawyering.  It’s not.  And it can be fatal to an entrepreneurial venture.  Whereas Overlawyers seek to avoid risk at all cost, the very essence of all business, and most certainly venture backed business, is calculated risk taking.   Shy away from too much risk, and you choke the opportunity.

The Overlawfirm model is broken, period.  It works for few businesses at all, and almost never for entrepreneurial companies that must be nimble, practical and cost-efficient in their operations.  Entrepreneurs, if you find yourself with an Overlawyer, overfire.

Seeing last week’s Venture Capital Dispatch in the online Wall Street Journal, When Venture Capitalists Let One Slip Away, reminded me of Jim Armstrong’s (Clearstone Venture Partners) comment last year about false negatives. “You can afford to have a false positive; you can afford to invest in things and fail, but because the big ones are so rare, you cannot afford a false negative. You cannot afford to be looking the wrong way.”

Some VCs, like Bessemer and their Anti-Portfolio, list their best false negatives on their website. As Bessemer puts it, “Whatever the reason, we would like to honor these companies, whose phenomenal success inspires us in our ongoing endeavors to build growing businesses. Or, to put it another way: if we had invested in any of these companies, we might not still be working.”

If you think VCs and Angels have had some of the biggest investment oversights, here are some of the bigger and more amusing ones from outside the VC community:

“We don’t like their sound. Groups of guitars are on the way out…You really should stick to selling records in Liverpool. Electric guitars are now old hat. (Mike Smith, Decca A&R manager, turning down the Beatles in 1962)

“There is no reason anyone would want a computer in their home.” (Ken Olson, president of Digital Equipment Corp. in 1977)

“You ain’t goin’ nowhere son. You ought to go back to drivin’ a truck” (Jim Denny, manager of the Grand Ole Opry when he fired Elvis in 1954)

“You’d better learn secreatarial work or else get married” (Emmiline Snively, director of Blue Book Modeling Agency to Marilyn Monroe in 1955

“Rembrandt is not to be compared in the painting of character with our extraordinarily gifted English artist Mr. Rippingille.” (John Hunt, 19th-century art critic, on Rembrandt)

“You’ll sink, not like a lead balloon, but even faster, like a lead zeppelin.” (Keith Moon, drummer of the Who, when Led Zeppelin was forming)

“(His) compositions are deprived of beauty, of harmony, and of clarity of melody.” (German music critic in1737 about Johann Sebastian Bach)

“Far too noisy, my dear Mozart. Far too many notes.” (Emperor Ferdinand of Austria after a performance of Mozart’s Marriage of Figaro in 1786

These examples should give you a pretty good idea why Angels and VCs don’t typically invest in music, movies or other forms of content.

Over the last few years I’ve written extensively on strategic exits and encouraged Angel investors to concentrate their investments where a strategic exit is highly likely.  I have focused on strategic value investments as I have found convincing evidence to show that these have higher ROI, shorter investment periods and lower execution risks. I have observed that more Angels are now discussing strategic exits, but find that there’s some confusion as to exactly what is a strategic exit.

I don’t believe there’s any confusion that a strategic exit does not occur where a single individual buys a business to manage it themselves. There are no benefits which accrue to the buyer beyond the boundary of the firm. Any return the buyer receives on their investment must come from the revenues and profits generated by the assets and capabilities of the acquired business. However, we would anticipate that a smart buyer would bring additional knowledge, funding, networks and experience to the business thus improving the return on the investment. In fact, knowing they could generate higher profits from the business through their own contribution, they may be prepared to bid higher for the right to acquire it. This is clearly a financial acquisition rather than a strategic acquisition. Therefore, the sale is a financial exit.
On the other hand, a business which is bought solely for its IP by a corporation and which has no revenue history or sales capability and will never be managed as a stand alone entity is a strategic acquisition. The buyer anticipates bringing the acquired IP into their own organization and leveraging their extensive capabilities, funding and distribution channels to generate new revenue. This would be strategic sale.

It is the direction of the benefit that determines what type of sale occurs. If the benefits of the acquisition are to be generated from within the acquired firm, even if the buyer puts additional resources into it, this is a financial sale. So even if the buyer provides trademarks, IP, new processes, new management, additional funding or excess demand to improve the performance of the acquired firm, it still remains a financial acquisition. The return on their investment is received solely through the performance of the acquired firm.

We might also argue that costs which are outsourced to the buyer, such as head office and services costs, do make a difference to the profitability of the acquired firm but this hardly makes it strategic. The acquired business still operates substantially as a stand alone entity from a product/market interface and the ROI must be generated through its revenue stream.

Moving to a different scenario, I would classify any acquisition as generating strategic value for the buyer if the buyer’s revenue, separate from that generated by the acquisition itself, was either protected (threat mitigation) or enhanced (opportunity exploitation) by the acquisition. Any situation where assets or capabilities are passed to the buyer to exploit within the buyer’s organization and which changes the buyer’s future prospects should be considered as a strategic value acquisition.

There are situations where the acquired business continues in operation, improved or not, with assets and capabilities passed back to the buyer’s organization. This would still be a strategic acquisition as additional benefits are being derived by the buyer beyond those which can be generated within the acquired firm.

This classification is critical for preparing a business for sale. A business which achieves its highest value on sale through its own revenue and profit potential needs to be structured for a financial sale. The bulk of the sale preparation effort needs to be put into revenue and profit growth, risk reduction and identifying growth potential which the buyer can execute on within the business. Any marginal strategic value or buyer synergies enhances the potential sale price but the major thrust of the sale preparation strategy remains with revenue and profit growth.

Alternatively, a business which achieves its highest value on sale by providing a large corporation with a means of mitigating a significant revenue threat or exploiting a major revenue opportunity through the transfer of acquired assets or capabilities, should be prepared for a strategic sale. The value of the strategic acquisition to the buyer is mostly determined by the size of the threat or opportunity within the buyer’s organization and not by the revenue and profit generating power of the acquired firm. In this case, the existing or even potential revenue and profit/loss of the acquired firm may be entirely irrelevant in determining what the business is worth to the buyer. You would prepare a strategic sale by concentrating resources on ensuring that your strategic assets and capabilities are structured so that the buyer can rapidly exploit them within their own organization.

We should not confuse the source and size of the value generated with the price paid to the sellers. The sale price achieved often has much more to do with positioning, preparation, negotiation and competitive tension in the deal. Any high growth potential firm suited to a financial sale, if handled effectively, can easily achieve 3 to 5 times a conventional (EBIT multiple) sale value. On the other hand, a venture suited to a strategic sale can often achieve a sale price equal to 20 to 100 times their net asset or revenue values.

A premium on sale to a corporation may be due to the inherent potential in the acquired business rather than synergistic or strategic benefits accruing to the buyer. Just because a corporation buys a business at a premium over the industry norm EBIT multiple does not make it a strategic acquisition. Rather it is only where additional benefits are achieved outside the boundaries of the acquired firm which determines it is a strategic acquisition and thus a strategic exit for the sellers.

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.

With everyone facing budget cuts, does it still pay to go to major industry tradeshows?  I am returning from one of my industry’s biggest, and the answer is an emphatic “Yes”.

We were going to a major trade show that drew more than 4000 attendees in better years, and were concerned by reports that many friends and clients that attended in prior years were not going in 2009.  Attendance was down to 2000+, but our sales productivity was high, in spite of the reduced numbers.

Why?  The pattern was clear:  companies cut their delegations in half, sending only the key decision makers.  All of the junior staff that normally attended were left home, so we could focus on the right individuals more easily.  As a bonus, the weaker competitors were also gone.  We had our best show ever, hands down.

What were the lessons learned?

1. Prospects are will attend the best trade shows, but weaker ones are languishing.  Focus your efforts.
2. If your business generates revenues for your prospects, like ours, you will be very popular at shows.
3. Your prospects are sending only their most senior staff.  Send your best people.
4. Cut costs.  Our senior team shared rooms, and we kept our entertaining to a minimum.  Those tradeshow breakfast and lunches aren’t great, but they are free.  And you can network at the cocktail hour just as easily as you can in an expensive restaurant.
5. Frugal is the in thing.  Get rid of the corny trade show goodies, and focus on helping your prospects succeed in their business.  They will take you more seriously, and you will avoid offending with any signs of excess.

Trade shows are still a great sales asset, even in tough times.  Find the budget for the key ones in your industry, even if you have to cut back elsewhere.