A bus stop – but no bus

A bus stop – but no bus

0 Comments

I read an article this morning that got me thinking about exits – though that was not the intention of the article (http://benariltd.com/2017/10/a-happy-ending-when-the-bus-never-comes/)

It describes the situation outside a home caring for those with dementia. Sometimes the residents manage to get out – and a search will ensue.

An employee of the centre got thinking about how when residents escaped, they often managed to hop on a bus. This observation led to a solution. The Senior Centre built a fake bus stop right in front of their facility. A confused resident who manages to leave the centre sees it right away and sits down to wait for a bus. As they sit on the bench at the bus stop they relax and forget where they were going. Soon someone from the Senior Centre arrives and calmly asks if they’d like some tea, and takes them back into the centre and settles them back into their quit routine, thoughts of escape forgotten.

Got me wondering – how many of our companies are building fake bus stops to keep us investors happy, rather than real exits?

In the last few weeks I have seen two cases where it is clear the founders have become comfortable running their business, and have no intention of actively seeking an exit. At best they pay lip service to the concept, making the right noises if and when the investors bring it up.

Its the investors that have allowed this to happen, but not consistently and regularly, from the very first board meeting, measuring company performance against KPIs designed to build acquirer value.

If after making an investment you have ever wondered  “when should be start planning / talking about the exit?” you have probably already fallen into this trap.

The answer of course is – befor you make the investment, and consistently thereafter. Almost every board decision you are involved in – from who to hire and what customers to go after, should be considered against what will add the most value in the eyes of your exit partners.

Otherwise you might be sitting on that bench for a long, long time.

Building Angel Groups / Networks.

0 Comments

Building a new Angel organisation may be divided into two elements, Network Design and Establishment, and Network Manager Training.

The final design of the network will influence the nature of training required for the Network Manager. For example a “manager led” network, in which the manager has primary responsibility for deal sourcing and deal making, will require more in-depth management training than would be required for the manager of a network designed to be more of an introductory service, where the individual members are expected to do the majority of the work in relation to due diligence, deal completion and post investment support.

Any project intended to assist the establishment and angel organisation should help to design the most appropriate structure and operating process to meet the specific needs of the local Angels. Based on local needs the areas of assistance to be provided may need to include:

  • Refinement of the operating budget for the network.
  • Funding sources (membership fees, sponsorship etc.).
  • Development of the network manager’s role and job description.
  • Meeting structures / timing / frequency.
  • Public relations.
  • Establishment of investment criteria.
  • Membership rules / Code of ethics.

The assistance should provide guidance as to how to maintain network momentum and membership to ensure future sustainability. The life cycle between initial investing and successful exits can be long. Depending upon the nature of the investee company, and the form of investment, an exit can take many years, a considerable time to keep members interested and active. Tactics to build long-term momentum may include:

  • Ensuring appropriate attention is given to the social aspects of the network
  • Practical issues such as the timing and location of meetings to encourage membership participation
  • Participation in other wider group activities
  • Ability to leverage the group for personal and intellectual development such as judging entrepreneurial competitions and mentoring young entrepreneurs
  • Active participation of members in the investment process, through membership of screening committees, due diligence teams and participation on portfolio company boards.

The specific activities relevant to any individual new Network will depend upon the nature, motivation, objectives and availability of their members, and may change over time as membership grows and develops.

The level of investment knowledge and skill required at the outset of a Network will depend upon the degree to which the manager is expected to “process” investments and the amount of work individual members are able / willing to take on. This will depend on the nature of the initial members, and may well evolve over time. The following sets out the range of training that we have delivered in the past, depending on specific network needs and available time:

  • Day-to-day operation of the network.
  • Member recruitment & relations.
  • Deal flow management.
  • Investment screening evaluation and post pitch processes.
  • Managing the membership (including how to get rid of inactive/disruptive members!).
  • Building and maintaining the network culture
  • Developing a suitable ongoing training program for the network Angel members.
  • Meeting structures / timing / format.
  • Public relations
  • Getting investments done!
  • The development of various documents and guidelines including (LINC have an extensive library of examples which we will share):
    • Investment screening criteria.
    • Confidentiality agreements.
    • Guidelines for presenting companies / “standard” pitch decks.
    • Scoring criteria for investment opportunities.
    • Term sheets and other legal documents.
    • Due diligence schedules and process documents.

 

Building a viable angel organisation does take time and resource. Given that the prime source of funding for new high growth potential businesses, and the associated economic benefits, are organised angel groups it is appropriate for government to invest in ensuring their viability and effectiveness.

The Great Valuation Myth

0 Comments

Some years ago I was asked to assist a life science start up in Scotland with their valuation. They had an interesting technology, and had received interest from potential investors. There was however a significant difference between the valuation that the investors were willing to provide and the valuation that had been calculated on behalf of the start-up by a firm of professional accountants using a mathematical method.

Remember, this company did not yet actually exist, other than as a project, in theory, and a few pieces of paper in somebody’s bedroom.

The Mathematical Valuation Method – the accountants had taken the forecasted profits of the company over the future three years, and divided this total by provided by three in order to come up with a “weighted average” profit for the company over a three-year period. They then deducted 60% on the basis that this was a “projection” of profitability. Why 60%? Who knows? There really was no logic to this, just the selection of an arbitrary discount number. It could as easily have been 50% or 70%, (or 100%, given it remains unprofitable to this day!).

The accountants then produced a price earnings value (PE value) arrived from an unnamed and unidentified publicly quoted life science-based company from the London stock exchange. The PE ratio is a calculation of the earnings a company is making divided by the price at which it is currently quoted on the stock market. Fundamentally you multiply the earnings by this number to arrive at the value of the company. They chose a company with the PE value of 8.5. Again this is entirely arbitrary and we have no idea the validity or comparison of this quota company to that of the start-up.

Thy then discounted the PE value by 25% because of “marketability” (i.e. if you invest in the start-up you can’t sell the investment very quickly, whereas you could instantly sell a quoted limited company), and also apply a further 25% discount because obviously the quoted company is “much bigger” (and actually exits, with products, sales  and stuff). Together this amounted to a 50% discount against a quoted company. Why 50%? Again there is no logical reason for this. Purely arbitrary.

The accountants then took the specified price earnings ratio of now 4.25 and multiplied by the discounted projection of profits, to arrive at a “risk-adjusted valuation” of £3.9 million.

A start up, that does not exist, has no employees, has no office, no factory, no product, no customers and no suppliers, was apparently worth nearly £4 million.

This in context the average pre-money valuation of companies achieving funding in Scotland at that time was around £600,000.

The calculation produced by the accountants was clearly absurd. Unfortunately it had been produced by a firm of “professional” accountants and the founders knew no better than to just assume that any investors offering them less were merely ripping them off.

What was required was someone who was not going to be an investor showing the founders the reality of the actual data relating to valuation in Scotland. Showing them data on actual valuations achieved over the last 5 years helped the founders realis the “professional” valuation was simply nonsense. The accountants had done a text book “MBA” valuation, but had not bothered, or did not know how, to reference this against local reality.

In the end the investment was made, at a pre-money valuation of £800,000. Higher than the prevailing local norm of £600,000, and higher than the new angel group who did the deal wished they had agreed to following a few years of slow progress. Down rounds were to follow.

Whatever valuation methods are used the outcome must be tested against the local reality.

Do we know what a Business Angel is anymore?

0 Comments

The conventional definition of a Business Angel has been:

“an individual investing their own capital in an unquoted business with which they have no prior (especially family) connection and to which they make a value-added contribution through active involvement in the business”.

The Global Entrepreneurship Monitor (GEM) survey has blurred the distinction between the ‘classic’ disinterested business Angel investment and kinship and affinity-based ‘family and friends’ money to the extent that no more than 10% of informal investment reported in GEM may meet the definition of classic Business Angel investment.

Local culture also plays a part, with Angels in some countries much more likely to form syndicates with family members, and to invest in business they have a family connection to.

The growth of Angel syndicates and equity crowdfunding has also thrown doubt on the continuing relevance of this definition.  Within European Angel networks, groups and syndicates (and those of other countries outwith the USA) a large proportion of members seem in practice to be relatively passive in terms of both the investment process and post investment support of investee companies. Most of the “work” is done by a small number of “Lead Angel” investors. This, at least in part, reflects the nature of many of the European Angels, who are often still in some form of full time employment and do not have the time to take on the lead investor role. It also reflects the growing number of individual Angels that are now likely to syndicate in any one deal. Too many for all of them to be particularly active in the process[1].

Angel investing is very much a personal activity. An individual voluntarily choses to invest their own money in companies they select.  It is extremely rare to find an individual who is a full time Angel investor (some individuals are full time Angel group / network managers), so the activity is typical practiced on a (very) part time basis, and could be likened to a “hobby”. Angel investing is often also referred to as “informal” investing, and this combination of self-motivation and determination within an informal framework is often a key attraction to individuals to become involved.

Angel investors also have varying motivations. Many Angels do not have profit maximisation as their principal motivation. They may simply like being involved in the process, or being part of the Angel club. As a result, it would be inappropriate to suggest that there is one “correct way” to be an Angel investor, and attempt to enforce a rigid training structure on all. Just because an investor does not adopt a particular technique or strategy does not mean that they are a “bad investor”.  For example, while many would recommend Angel investors mitigate their high risk by having a large portfolio of investments (and this advice is likely to form part of an Angel training program), if the investor is investing for largely non-pecuniary reasons they likely, and to them rationally, don’t care about optimal portfolio sizing. If investors are not trying to maximize their financial returns, then there is no reason for them to have large portfolios. Some may specifically want smaller, concentrated portfolios because they enjoy working closely with the entrepreneurs or just want to invest locally so that they can give back to their community.

The traditional, “western” definition of an Angel is increasingly being diluted – and this is a good thing. It allows more individuals to be comfortable bringing increased amounts of capital to fund new and expanding ventures.

[1] Bridget Unsworth who manages the New Zealand Angel Co-investment Fund estimates that as few as 5-7% of Angels in groups are truly active Angels.

How Do Angels Deal with High Risk Investing?

0 Comments

Angel investors make decisions to invest under conditions of extreme uncertainty. Angel investors face cases in which uncertainty is so extreme that it qualifies as unknowable: they decide on investments in ideas for markets that often do not yet exist, and they propose new products and services without knowing whether they will work. For experienced Angel investors rather than being undesirable, unknowable risks are deliberately sought, on the basis that it is by investing in companies with unknowable risks that they can find the most attractive, most profitable investments.

Experienced Angels do not seek to maximize each decision but instead seek potentially extraordinarily profitable opportunities and accept a high failure rate. They rely on building a large portfolio to spread risk and accept that the overall failure rate, by number of investments, may be as high as 70%, even in the most developed capital markets[1], with 85% of all returns coming from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

A key role for “training” therefore needs to be providing nascent Angels with an understanding of the characteristics of the Angel market, tactics to deal with the high risk, and thus confidence to join with others in making their first investments.

Experienced Angel educators suggest that individuals new to Angel investing tend to seek out training on subjects such as valuation, looking for the “correct” valuation method or formula, reflecting a desire to reduce uncertainty (and perceived risk). In practical terms valuation training will likely highlight that there is no “right” answer, instead presenting a number of different methodologies, and suggesting that several should be used in each case and the results compared, but that local comparatives are likely to be the most significant influencer. Many of those new to investment struggle with this lack of a definitive answer but gain confidence when they see that all Angels face the same issues.

[1] 2016 Angel Returns Study, Angel Resource Institute, 2016.

Angel Decision Making – How do they get to Yes?

0 Comments

Reading the available  academic research and discussions with experienced Angel investors suggest that “technical” subjects (valuation, financial modelling, technical due diligence) play a relatively limited role in the overall decision-making process, significantly due to the lack of “hard facts” in so many aspects of an Angel type investment. It is not a formalistic driven process. There is no proven formula for success, and no hard data to put into a formula should one exist.

Rather, decision making is based on a mix of technical analysis and intuitive assessment (what Angels frequently refer to as their “gut feeling”), with recent research suggesting that intuitive assessment is favoured over technical analysis[1].

The typical Angel decision making process begins with a subjective assessment as to whether the investment is likely to ‘fit’ with their personal investment criteria rather than a technical analysis. This may include location, amount sought, knowledge of and interest in the sector, and their own ability to add value.

Experienced investors rely heavily on their prior experience and previous investments to inform their present decision making and typically prioritize their intuitions about the entrepreneur over process and “hard fact” (e.g. business viability data).  Finance, in terms of the financial structure of and projections for the venture, is the most important criterion for both nascent and novice Angels but ranks only fourth for experienced investors[2].

The Learning Process

Investors who may now be classified as experienced consistently said that initially investing with other, and then more experienced, Angels had been their most valuable source of learning.  A number added that they had learnt more from failed investments than successful ones!

This suggests that the most effective way to improve the skills of new Angels is through engaging with experienced Angels in actual real investments. How do they get that engagement? Join an existing, active local Angel group, attend their meetings, help with the due diligence and join in a few syndicated deals.

 

[1] Managing the Unknowable: The Effectiveness of Early- stage Investor Gut Feel in Entrepreneurial Investment Decisions, Laura Huang and Jone L. Pearce, Johnson Cornell University, 2017.

[2] Heuristics, learning and the business Angel investment  decision-making process, Richard T. Harrison, Colin Mason & Donald Smith, 2015.

Nelson at the Peru VC Conference June 2017

0 Comments

A fantastic experience talking at the Perue VC Conference – Amazing people and a fantastic location for the event

What Is It Worth? Valuation of Investments

0 Comments

Valuation is probably the most emotive issue to be addressed in any investment negotiation.

Both entrepreneurs and investors seek reassurance that they are not agreeing to an inappropriate (unfair) valuation that will result in them receiving an inadequate share of the anticipated future exit proceeds. Both seek to find definitive valuation techniques that will give them the “correct” valuation. Both are often attracted to the more mathematical, formula based valuation methods involving discounting future values of potential exit values to present day money values.

While many of these methodologies have some merit, it is appropriate that whatever valuation they suggest, that this is sense checked against what is happening in the local market at the time of the deal. Always compare proposed valuations with other comparators in the local market. If you and the company are not based in Silicon Valley then Silicon Valley valuations are largely irrelevant.

Bill Payne carried out a valuation survey of US angel groups collecting pre-money valuation data for pre-revenue company investments from 35 angel groups in 22 states. He found that valuations ranged from $0.8 million (Boise Ohio) to $3.4 million (Silicon Valley), with an average valuation of $2.1 million. The survey showed wide geographic variance, with, perhaps not unsurprisingly, Silicon Valley, New York City and Boston showing the highest valuations, and Idaho, New Mexico and perhaps surprisingly, San Diego at the lower end.

There are a number of factors that likely result in these regional variations. The nature of the business will have an influence, with Biotech, life science and medical devices typically funded at higher pre-money valuations than, say, software and Internet companies. Increased competition among investors for “good” deals will tend to drive up valuations. Valuations in Silicon Valley are driven by the need to have much larger investment sizes because of the significantly higher cost of operating a business there.

However the size of the investment round seems to be one of the most influential factors.  Some investment rounds can be for £2 million or more, while others may be for £100,000 or less. Since angels typically prefer purchasing less than a majority ownership, a higher pre-money valuation is more likely for a larger round size. 2016 valuations may have been up at $3.6m (notably down from a high in 2015 of £4.5m), but the Angels still took 22% of the equity

The Angel Resource Institute’s annual report (The HALO report) on Angel activity in the USA constantly shows that while valuations vary both by geography and by year, the amount of equity taken by the Angels remains remarkably consistent at between 20% and 30%.  So a higher valuation does not result in less equity dilution of the founders.

Having empirical data on local valuations will provide extremely valuable in the negotiation process, providing a “reality check” to both aspirational values put forward by entrepreneurs and “scientific” valuations produced from mathematical formula. Angel groups should seek to cooperate in collecting and sharing local valuation data to ensure their own investments start out on a solid foundation.

“Investor Ready” is not enough

0 Comments

While numerous enabling programs exist, offering services in business planning, technical development, market analysis, financial forecasting, etc., few enabler managers or entrepreneurs have been through the fundraising process.  As such, most “Investor Ready” programs fail to prepare entrepreneurs for the actual capital raising process.

Entrepreneurs are left facing various challenges, including:

  • Inability to identify an appropriate source of capital
  • Lack of understanding of common investment instruments
  • No understudying of, or preparation for, the investment process. What happens after a pitch?
  • Misalignment of priorities between the investor and entrepreneur
  • Limited knowledge on due diligence requirements
  • Misalignment of structure and valuation
  • No focus on the exit event for investors

The lack of preparation and ability to effectively engage investors contributes to a perception of poor quality “deal flow”, which is a hindrance to attracting individuals to become Angel investors, or to consider investing in certain locations.

Additional training is needed to help prepare companies not just to be able to pitch to investors, but to prepare them for the investment process – screening, due diligence, valuation, deal structuring, the content and impact of the legals, and critically, the post investment relationship with the investors. Such sessions should also help to break down the barriers resulting from lack of trust some founders have in potential investors, a lake of trust significantly resulting from a lack of understanding of the process.

The Myth of the VC Series A for Angel Funded Companies (or any others)

0 Comments

Very few Angel investments receive follow on funding from venture capital firms.

According to the University of New Hampshire, Centre for Venture Research there were around 75,000 Angel investments in the USA last year. Yet the PWC Moneytree report recorded just 5,004 VC deals (of which 33% were in the San Francisco area). So even if every VC deal had previously had Angel funding, that would still be a tiny fraction of Angel backed companies going on to secure any form of VC funding.

CB insights reported that 68% of USA and European successful technology company exits had received no VC funding before the exit.

These numbers are supported by the research in Scott A. Shane book “Fools Gold? The Truth Behind Angel Investing In America”, (Oxford University Press, 2009). “Fools Gold? is possibly the first book to bring together hard data on angel investing within the USA from multiple governmental and academic sources, including the Internal Revenue Service, the US Census Bureau, the Federal Reserve, the Kauffman foundation and many others. The book so encourages Angels to invest as part of an Angel group, and encourages policy makers to invest in supporting the creating of angel groups. This to facilitate a portfolio style of investing and the pooling of investment funds to provide larger amounts of funding over a longer period than would be possible as a solo investor.

Fundamentally Angel investors need to plan for the Whole Life funding of their companies. They cannot just assume that future funding will be provided by some as yet unidentified VC. They must therefore crowd in as many investors as they can into the first and other early rounds, even where this means each individual investor investing less into each deal than they could, or would like to. Only in that way will there be sufficient future reserves of capital to fund the likely 4 or 5 rounds typically necessary to get to a successful exit.