Thursday, July 23, 2009

Due Diligence for Angel Investors

In another post in this site, addressed to business owners seeking angel investment, I proposed that, in my experience, Angel Investors fall in one of two groups: "Golf Cart Investors (GCI)" and "Professional Angels (PA)".

GCIs buy into deals pitched on the golf couse by a buddy with supposedly inside knowledge of a revolutionary shure thing.  They generally experience an improving golf handicap, a badly handicapped portfolio, significant loss of capital and a high level of frustration resulting from failures that are perceived as unpredictable and arbitrary.

PAs spend perhaps less time on the course to put more effort in Due Diligence Investigations (DD) of the deals they are offered thereby resulting in fewer deals being done, but with a higher probability of success.

The difference between the two groups is the degree of due diligence they apply to investigating all aspects of a deal before getting into it.
GCIs frequently see due diligence as no more than reviewing financial statements and projections and calculating deal terms that could let them "make a killing" if the deal succeeds.
PAs on the other hand see DD as absolutely required to develop the necessary competence in the business and its technology to decide whether to go on to negotiating the terms of their funding knowing that besides capitalthey may have to contribute advice and expertise to see the vnture succeed.

So, what does DD have to address?

  1. Management team

  2. Technology assessment

  3. Market assessment

  4. Scalability

  5. Potential returns

  6. Exit strategy

In my experience the order of the above list is not accidental because the answers found at each step determine how the following stage may be approached. Let's look at the questions and answers involved in each:

[hana-code-insert name='dd4ai' /]

or check my roadmap.  In either format the above list is only a brief summary for illustration purposes.  A comprehensive DD effort requires a variety of domain experts with an emphasis on determining the scalability of the process and of the company, which is most often the Achilles' heel of new technology businesses. For more information contact the author or SafeTnet Consulting LLC

Friday, July 10, 2009

AngelCalc - Calculating With Angels

Do you know when your young business venture is "fit" to attract angel investor financing?

There are many theories and rules of thumb being bandied around about how angels seek their targets. The reality is that angel investors can be roughly divided in two groups, each with dramatically different decision making processes (and ROIs).

"Golf Cart Investors"These are the ones who buy into a deal on a hot tip, topically received by a buddy on the golf course.  Most often the buddy has done little or no due diligence, has little or no knowledge of the industry and technology involved, and has received the supposedly hot inside information from another buddy in similar fashion.
These angels are dangerous to your and your business' health.  They invest with virtually no understanding of the deal, have unjustified expectations and eventually will prove to have little or no patience to wait for the business to succeed.  Their returns are almost inevitably negative and most often they will do no more than one or two deals before they go back to golfing only. Unfortunately they will tell others that angel investing is a crap shoot and waste of money, thus limiting startup capital availability in the community.

"Professional Angels"These are the real Angels entrepreneurs want to work with.  Frequently they work in groups so that they can share the heavy burden of due diligence research required and they bring to their side of the table scientists, engineers and management experts in different industries and technologies.  They will ask a lot of questions and then more questions and then proof and supporting documentation.  They will not move fast but will cover their bases well. When they invest they will stay involved and help with seasoned advice and working their contacts to help the business succeed. These are true ANGELS.

Research by the Kaufman  Foundation shows that their returns are on average quite attractive (2.6 times their investment in 3.5 years).  On the other hand, a rule of thumb often quoted is that these angels consider a deal if they see a potential to earn 30 times their investment in about 5 years. These two seemingly conflicting perspectives are reconciled if one presumes that the probability of success of a well researched deal is only about 10-12%.  From experience I believe that it is a reasonable and not overly pessimistic expectation considering that the typical business that fits angel investors has many or all of these characteristics:  Little or no sales, limited proof of market, may have lab tested technology, but little or no  production, no proof of scalability, delivery, distribution experience.  Moreover, all of the following may aply: in some other garage a similar or better mousetrap may be ready to come to market, the management team may have or may develop unforeseeable weaknesses (from sociopathy leading to financial embezlement to personality incompatibilites to love affairs - I've seen them all as causes of aborted successful businesses); "effective" IP protection may prove difficult to obtain or worse may be revoked when prior art appears unexpectedly (see the post about patents and RIM's adventure), government regulations may prevent or delay market acceptance, unforeseen and totally unrelated vested interests may create insurmountable barriers to market acceptance. All considered the 10-12% probability may even be high, but it appears to be what angels use implicitly if not explicitly.

So, with all this in mind, below is AngelCalc (copyright Marco Messina 2007-2010).  Its intent is to help you determine if your business has sufficiently high growth and profitability potential in an industry with sufficiently high PEs to satisfy the requirements of the Pro Angels.  Services, generally are unlikely to qualify unless they have a unique IP component and market dominance potential.  If your business cannot  meet the angels' criteria, your funding efforts will be better put elsewhere.  F&F (friends and family) may be an alternative at least until the criteria may be met.

Calculating with AngelsThis model attempts to explain the finance-ability of a business based on angel investors' required returns.
Its objective is not to set a valuation.  It seeks to determine whether the relationship among the following factors allows a viable solution that meets investors criteria.

The factors for a P/E-Multiple based calculation (as for a public company) are:
1. time horizon is 5 yrs,
2. future EBITA,
3. future PE and market cap (from current comparables),
4. investor's average returns and required return,
5. the ASK needed to implement the plan
6. The % equity to give up for the ASK

The factors for a valuation based on revenue multiple (e.g. selling the company) are:
1. Time horizon is 5 years
2. Revenues in year 5
3. Applicable multiplier for comparable companies sold

With both valuation methods the implied probability of success is 12% because it reconciles the return multiple identified by the Kaufman Foundation research (2.6 times return in 3.5 years) with the rule of thumb often quoted of "30 times the investment".

Questons or comments?  I'd love to hear from you,
    particulalry if you disagree.

Good luck. May you be so lucky to find a real ANGEL.