This is part two of my two-part series on angel financings. In part one, I provided the following five tips for entrepreneurs: (i) push for the issuance of convertible notes; (ii) understand the key business terms; (iii) diligence the angel(s); (iv) never subject yourself to personal liability; and (v) comply with applicable securities laws. Below are five additional tips for entrepreneurs to help them through the angel financing process. Obviously, this is still a difficult environment in which to raise capital; however, I am confident that 2010 will bring greener pastures.
Tips for Entrepreneurs
1. Get Your House in Order. Most angel investors will perform due diligence on the startup prior to any investment, including a legal due diligence investigation. Accordingly, it is imperative that all of the company’s organizational documents and agreements are in order and that there are no significant potential problems. Indeed, I discuss this issue in the acquisition context in my post “Selling a Company: Ten Tips for Entrepreneurs” (see tip #3) and point out that: “An easy way to instill confidence in prospective buyers is for the selling entrepreneur to deliver (or make available) a complete, well-organized set of diligence documents.” The same advice applies to angel financing.
Remember: angels may have hundreds of potential investment opportunities each year, but will only choose a select few. Thus, if the legal documentation demonstrates a lack of credibility, the angel(s) will more likely just move on. To demonstrate its credibility (and sophistication), the startup needs to button-down certain fundamental legal issues prior to approaching the angel, including (i) organizational matters (e.g., incorporating in Delaware); (ii) founders’ stock issuances and vesting; (iii) IP issues; and (iv) compliance with applicable securities laws (all of which I discuss in detail in my post “Launching a Venture: Ten Tips for Entrepreneurs”). Needless to say, any red flags that are raised as part of the legal due diligence investigation will adversely affect the entrepreneur’s chances of getting funding. (This is one of the primary reasons I warn entrepreneurs against playing lawyer and/or utilizing web services like LegalZoom to try to save money.)
2. Consider Angel Groups Carefully. There are a number of angel groups throughout the United States that invest in startups. As noted in a white paper from the Ewing Marion Kauffman Foundation (one of the world’s largest foundation devoted to entrepreneurship), “[t]hese groups have several characteristics: loosely to well-defined legal structures; part-time or full-time management; standardized investment processes; a public face usually with a Web site and public relations activities; and, occasionally a traditionally structured venture capital/angel investing fund.” Here, in California, two of the largest groups are the Band of Angels in Silicon Valley and Tech Coast Angels in Southern California. (Incidentally, I have attended a couple of Tech Coast Angels events, and they have some impressive members, including John Morris of GKM Ventures, the past Chairman.)
The good news with respect to these groups is that, generally speaking, they are a solid source of smart money for entrepreneurs, and they often have strong relationships with venture capitalists and other investors. The bad news is that each group has its own distinct set of policies, procedures and form documents, which can make the process onerous, slow and at times frustrating. Moreover, there are certain angel groups that are exploiting entrepreneurs by charging them excessive fees in connection with pitching and are otherwise taking advantage of them. Jason Calacanis, the founder and CEO of Mahalo.com, has done an extraordinary job of calling-out these groups — and he has recently launched his own angel group called “Open Angel Forum,” which allows entrepreneurs to pitch for free.
Accordingly, my advice to entrepreneurs with respect to angel groups is two-fold: (i) do your due diligence (e.g., at a minimum, you need to talk to other entrepreneurs and founders who have dealt with the particular group in which you are interested) in order to obtain a deep understanding of the group’s processes, including the timing and fees; and (ii) recognize that you will have little negotiating leverage in connection with their standard deal structure and forms — e.g., very few angel groups will agree to the issuance of convertible notes, in lieu of preferred stock (which I strongly recommended in tip #1 of part one of this post).
3. Try to Create a Competitive Environment. There is nothing that will give an entrepreneur more leverage in connection with any deal negotiation than a competitive environment (or the perception of same). Indeed, every investment banker worth his salt understands this simple proposition in connection with selling companies. Accordingly, if an entrepreneur is seeking angel financing, he will clearly have more negotiating leverage if the prospective angel investor thinks that other investors are interested in his startup. Competitors can be played-off of each other and, as a result, the entrepreneur will be able to strike the best possible deal. (I briefly discuss this issue in Lesson #3 of my video post “Lesson Learned in the Trenches of Two Big NYC Law Firms.”)
Needless to say, this game must be played carefully and is better-handled by an experienced entrepreneur (or attorney). The last thing an entrepreneur wants in this difficult fundraising environment is to end-up with no investment at all. One final related point (which is the flip-side of this tip): do not appear desperate. Angel investors are often savvy deal guys who can spot desperation a mile away; and if they think you’re desperate, they generally will either walk (thinking something must be wrong) or they will roll you.
4. Develop a Game Plan. There are no “standard” deal terms or “standard” documents in an angel financing. Indeed, every deal is different — different players, different negotiating leverage, different risks, different timing. As I noted in the introduction to part one of this post, I have been involved in a number of angel financings, and they run the gamut: from an angel handing a check to an entrepreneur and instructing him to “send the paperwork when it’s ready” — to an angel retaining a large, aggressive law firm and insisting on shares of preferred stock, with all the “bells and whistles.”
It is thus imperative that the entrepreneur sit down with his transaction team (lawyer, accountant, co-founder, etc.) and strategize to develop a game plan in connection with the financing. The entrepreneur must communicate to the team, among other things, his deal-breakers, wish-list and potential problems. For example, maybe one of the deal-breakers is preferred stock, as opposed to convertible notes; or maybe the entrepreneur only wants angels who have industry contacts or operational experience; or maybe there are IP issues that need to be disclosed and a strategy must be devised regarding timing, etc. The bottom line is that entrepreneurs should treat angel financings like it would treat any other project: build a strong team, develop a game plan and then execute.
5. A Great Angel Trumps Every Tip. The final tip of this series is pretty simple: if a superstar angel is interested in investing in your company, don’t worry about all of the other tips and take the money; a great partner trumps all rules. Indeed, as Roger Ehrenberg (a smart angel investor and the founder of IA Capital Partners) advises in his recent post on taking venture money: “[H]aving the right deal partner is critical, regardless of whether you are talking about the seed round, the A round, B round or beyond. A strong deal partner can help materially de-risk a business through sound mentoring, prudent board leadership and valuable connections.” Mark Suster (another smart investor and a partner at GRP Partners), gives similar advice in his post “Raising Angel Money”:
“As an entrepreneur you should raise money from the most experienced people possible – period. If you have the opportunity to raise a small amount of money from a group of experienced investors who have a track record of helping companies get from that tricky idea stage to being a well-formed company with a good product and solid market-entry strategy[,] I would take the money – even if it were priced. Worrying about giving up an extra 10% of your company at this stage can be meaningless if the ultimate outcome is either success or failure. Even VC’s think this way, which is why Fred Wilson when describing his decision to syndicate a portion of his invesment in GeoCities to another investor says, ‘I learned that good partners are worth every penny of returns you give up to get them’.”
VentureHacks, one of the best websites for entrepreneurs, recently put together a list of top angel investors, including such stars as Jeff Clavier, Dave McClure, Aaron Patzer, Matt Mullenweg, Peter Chane and others. In short, if any of them want to invest in your company, just roll-out the red carpet and take the money.