Training

Is it Angel Training – or Angel Education?

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I have received some comments from experienced Angel investors challenging whether the use of the word “training” is appropriate in the context of developing business Angel investment skills and knowledge.

It is suggested that the use of the word may actually be off putting to individuals who regard themselves as extremely successful business people.

However, the principal challenge to the use of the word ‘training’ relates to the impression it may give that on completion of a “training course” a novice will be fully skilled in all matters required to be a successful investor.

In practice the most significant impactful elements of Angel learning occur as a result of new Angel investors learning from experienced Angel investors while processing a live investment opportunity.

Angel investing is a practical rather than a theoretical activity. The term “training” often seems associated with learning that is done by rote and is somewhat prescriptive. i.e. There is a “right and a wrong” way of doing things.  Such prescription does not apply to the Angel investment environment, where there are many areas of disagreement, even between the most experienced Angel investors.

When Angels gather together there will be frequent discussions, and disagreements, as to the most appropriate forms of valuation (and the extent to which valuation is critically important or not in the investment process) the key factors of due diligence (typically between business opportunity and management team) and forms of investment (convertible notes versus preference stock) to name just a few areas of potential discord.

A preferred term may be “education”, which has a connotation of a continuing (lifelong) process, where the learners are encouraged to think about the concepts presented, and where appropriate to challenge them. Any point is open to discussion.

In developing the skills and knowledge of the Angel community it might be that encouraging education on a continuing basis, rather than suggesting Angels undergo training, which may be seen as a relatively one-off activity, would be more effective. 

The Reason Most Angel Training Misses the Mark

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The key role for “training” in emerging markets should be to provide nascent Angels with an understanding of tactics to deal with high risk, and thus confidence to join with others in making their first investments.

Technical training (Valuation, Financial Modelling, Due Diligence etc.) is a necessary but insufficient component of building this confidence. More vital are the elements that address critical risk factors.  These include the development of investment strategies that look beyond just the initial investment transaction, to the life-long funding requirements of the company, and post-investment support. We refer to this as “Strategic Angel Investing”.

Angel investing is a personal activity. Angelsinvest their own money in deals they select. They are free to conduct their investment activity in any (legal) way they wish.

A program must not try to impose a particular methodology or investment thesis, but rather find ways to support individuals to become confident to make investments in the manner that works for them. This does include using ‘best practice’ examples to demonstrate how others have become successful.

But ‘best practice is still subjective, and definitely needs to be adjusted to take into account the realities of local circumstance – the number of investors, availability of follow on and exits, the nature of deal flow and the like

Almost every aspect of Angel investing, from deal sourcing to exit, is subject to discussion about what methods, processes and techniques are most effective. The most effective learning comes from real life stories and examples, relevant to the region (tales of Silicon Valley are rarely appropriate), delivered by inspirational speakers, who are themselves experience investors. By which we mean not only that they have done some deals, but that they have taken a few companies through to a successful, profitable, exit.

An experienced and dynamic programme delivery team, who can adapt to local circumstance is the critical success factor.

What is Capital Risk for Angel Investors?

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Few Investors (or founders) look beyond the immediate funding round in any detail (if at all). Yet Assessing Capital Risk is critically important when assessing if this is a deal you should do – even if every other indicator is screaming “Yes”.

Every deal I have ever seen has needed more than one round of funding to reach a successful exit. Most need multiple rounds of funding – perhaps 5 to 8 is typical, over 5 to 10 years.

If that follow on funding is not going to be available, or you don’t build something the next round funder will invest in, you are not building a bridge to a profitable exit, you are building a pier to nowhere.

So, asses what is the Capital Model for this deal going forward, and get answers to the fooling questions:

  • How much additional cash will company need?
  • Where will that cash come from?
  • On what terms can we get it?
  • What will Funding environment be like in 18 months?
  • Will we need a VC partner?
  • What terms will the VC offer?
  • What does this company have to have / look like (users, customers, data etc.) to be of interest to those VC’s? Can we achieve any of that on the funds we are about to invest? Is the target of the business plan to achieve those key requirements?
  • Will they need so much capital that follow-on VCs will wipe us out? (Dilution + Preferential Returns).
  • How big an exit will we need to hit Our Target Return – if this company is successful, can it get close to that number?

Risk – Embrace it – It’s where the Profits Are.

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Risk is impossible to avoid in any business. For Angel investors looking at the first rounds of funding going into a start-up the risks are particularly significant.

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. 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 what may seem like 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]. Typically 85% of all returns come from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

It is critical to understand that for Angels a ‘fail’ is not a company in liquidation. It’s a company that fails to return the investment capital and an investment return on top. Indeed, depending upon the local tax regulation a zombie company – one that keeps going but with no likely prospect of an exit for the investors – is worse financially than the liquidated company. At least if a company is liquidated I get to offset the loss in my tax return.

Angels use Due Diligence to assess risk. A due diligence process therefore needs to cover the key risk categories –

  • Management Risk
  • Technical Risk             
  • Competitive Risk      
  • Market Risk              
  • Intellectual Property Risk
  • Regulatory Risk
  • Team Risk

Many Angels however do not spend enough time looking at the two most critical risks – that will kill a return on investment even if everything else is as close to perfect as can be –

  • Capital Risk – how much follow on cash is this company going to need – can it get it, and on what terms?
  • Exit Risk – is anyone ever likely to want to purchase this company – and at what price?

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

Strategic Angel Investing – Rarely Understood

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As an Investor your financial returns will be driven by the following factors:

  1. Initial Valuation (% of company you own)
  2. Subsequent dilution (factor of both future funding amounts and the structure of future deals – do new investors have a preference return ranking ahead of yours?)
  3. Time to Exit
  4. Exit Value

Most founders / investors spend lots of time on item 1 – and almost no time considering 2, 3 or 4.

In determining your financial return the % you have of the company at EXIT is much more important than the % you have at round one. Yet so many investors spend enormous amounts of time focused of getting that initial valuation ‘right’, and no time considering the company’s future funding needs, their ability to contribute to those needs and their resulting dilution.

There is no point in having what looks like a large % at exit, if the other investors have a preference over you. I have seen an exit at $475 million – with the angels getting zero as a result of the preferences.

Don’t let those unicorn valuations fool you. The reality is in the detail of the last finding round terms (which will not be disclosed). Frankly you can claim whatever stupidly high valuation you want – if I have a 3x preference that I will take off the exit table before anyone else gets a penny.

A bus stop – but no bus

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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.