Editors Note: This is the first of two articles about the pros and cons of “angel” investing. Jim Verdonik is a principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A. Walter Daniels, a founder and principal of the firm, will offer his views on Thursday.Credit Mel Gibson for bringing back images of the devil on the wide screen.
Whatever your beliefs about the recent controversial movie, however, can we all agree that angels (as in angel investors) are of more immediate concern to the local tech community than devils?
Now, don’t even go there. Do not, I repeat, do not start down the road of how venture capital investors are devils. That’s not productive. Yes, VCs may be difficult to deal with at times, but no, they’re not sons of Satan. Some of my best friends are VCs.
Still, it’s impossible to talk about angel investors without taking the professional VC industry into account. The current scarcity of angel investors is related to what professional VCs are doing.
In the recent past, angel investing was so common, you could find angels practically everywhere:
CED meetings . . . the Club . . . the supermarket . . .your local bar . . . .
Not so these days.
So, did VCs kill all the angels?
No. It’s more like an environmental problem than a murder case.
Angels and VCs inhabit the same eco systems. In fact, when the overall environment is healthy, they have a mutually beneficial relationship. Angels help companies develop to where they can usefully deploy large amounts of capital. VCs fund growth through a successful exit. When angels make money, VCs make even bigger money. Unfortunately, when VCs lose money, angel investors lose money, their shirts and eventually their interest in playing the game.
So it is today, that angels have become an endangered species. But are all the angels dead?
No. It’s more like they migrated south (further south than North Carolina) to winter in a warmer climate until the investment climate again becomes conducive to angels.
When they return, will you be ready? Or has it been so long that you’ve forgotten the fundamentals of finding, wining and dining angel investors? If so, here are ten things to remember and practice before the angels return.
(1) Dilution: Everyone prepares to fight the last war. What killed angels in the last war? DILUTION. . . DILUTION . . . DILUTION. Sure some angels did invest in companies that were . . . how shall we put it . . . Incredibly Dumb Investments? Yes, but dilution hurt angel investors even in good companies. To make your company attractive to angel investors you must build a credible dilution avoidance strategy into your business and finance plans. Don’t even consider talking with angel investors until you have a strategy for dealing with concerns about dilution.
(2) Liquidity: Telling someone they won’t see any return of capital or profit for ten years is a hard sell these days. Ask your professional advisers to recommend innovative deal structures that provide angel investors some liquidity.
(3) Finding Repeat Investors: Roughly 20% of wealthy people have invested in young companies, but fewer than 5% do so on a regular basis. Your job is to find the repeat investors. How do you find repeat angel investors? Repeat investors often know one another and often co-invest with one another. One repeat angel investor can usually lead you to other angel investors. Other good leads to repeat angel investors are other entrepreneurs, accountants and attorneys, who have done early-stage investment transactions. Also, for a fee, informal investment bankers called placement agents can assist you to find angel investors. In tough investment environments, it’s worth paying a percentage of the money raised to a banker. Before you sign any agreement, however, make sure they have a good track record closing deals and make all or most of the compensation contingent on closing a deal.
(4) Investor Assessment: When you meet someone whose wealth would qualify them to be an angel investor, determine whether to invest your time pursuing this individual. The most important factor in making that determination is whether the person has previously invested in a company like yours. The second is whether the person made money in the prior investment. If the answer is yes to both questions, focus on that person. Business experience in the same industry is also a useful indicator.
(5) Spouses: People will often seem genuinely interested in investing in your company, but you never quite seem to be able to close the deal. Never overlook the influence of the investor’s spouse. In many cases, you have to sell both the investor and the spouse. If the spouse has a lower tolerance for risk, it may be impossible to close the deal. This has never been more true than it is today after investors have lost substantial amounts in prior deals. There’s been a lot of “pillow talk” about losses and risk in recent years. Often, investors won’t tell you their spouses won’t allow this investment. You have to read between the lines. When dealing with reluctant angel investors, either move on to other targets or make one last attempt by making your pitch to both the investor and the spouse.
(6) Deal Size and Schedule: The amount of money you need to raise affects valuation, dilution concerns and the amount of effort required to close a deal. If your goal is to raise $500,000 you usually have to find anywhere from several to a dozen investors. This can make raising angel money a lengthy and time consuming process. Plan for a six to twelve month effort.
(7) Deal Structure: Many angel investors don’t have an established deal structure like professional VC investors. Be prepared to put a specific deal structure on the table, but also be ready to change it to meet investors’ needs. There is no one deal structure that fits all situations. It’s important to keep the terms simple so that investors understand the deal and to keep transaction expenses low. Deal with experienced professional advisers and ask them to be creative to fit the dilution and liquidity goals of your investors.
(8) Tax Considerations: No one likes paying taxes. Tax considerations motivate some angel investors. For example, whether an investment in your company will earn the investor a tax credit under North Carolina law. In other cases, investors may want to be able to deduct the losses of your company from their income. In that case, they may want a Subchapter S company or a limited liability company, which may not be consistent with your long-term goals.
(9) Valuations: Valuations in angel deals can vary widely from one investor to another. Some angel investors put more weight on subjective factors then others, while VCs tend to use the same “objective” valuation formulas. Unrealistically high valuations in seed capital rounds from angels can cause problems in raising larger amounts of capital in future rounds and are a major cause of dilution in the later VC rounds.
(10 Disclosure: Disclose all the risks of investing in your company more explicitly when dealing with angel investors than with professional VC investors. Most VCs have already invested in your industry and know the risks. Many angels don’t. Disclose both because its required by law and because it will help promote better relations with your investors over time.
Angel deals are challenging but not impossible in the current environment. To close a deal, however, you have to be prepared, creative and flexible.
Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Jim Verdonik’s practice focuses on representing technology companies and investors in venture capital, securities and other corporate matters. He founded and operates two websites with business and legal resources www.BoardStrategies.com and www.TecCoach.com. Questions or Comments can be sent to firstname.lastname@example.org.