In light of the recent SCOTUS ruling, we thought we would talk about an economic model that helps us understand discrimination and voting with your dollar. How your preferences affect the price you’re willing to pay for a product or service directly correlates to a business’s ability to stay open. You wouldn’t go to a burger joint that was dirty or had terrible service if the burger place a block away had the same prices and was clean or had better service, and we can explain it with economics.

Bakers Green and Blue

Anyone who has sat through Economics 101 knows this graph. It’s a basic supply and demand chart with two bakeries and the market of buyers. Bakery Green is charging Y more than Blue Bakery for reason A. In a normal scenario, Green must lower their price or go out of business as Blue takes all the business they can handle (Blue could, in theory, raise prices to match Green, but that model gets complicated as we factor in behavioral economics and the price elasticity of demand.). In the traditional, basic model, Green just has higher costs. Maybe the owner wants a higher salary, maybe the business had to take out loans at a higher rate, with the result being costs that are higher. If that price is as low as Green can charge, then Green will eventually go out of business.

Now let’s abstract a little. What if reason the price is difference, Y, is not a dollar amount? Common examples of this would be that Green is further from town than Blue, or perhaps Blue is able to keep the line short while Green has a 30 minute wait. In this case, we’ll say that Y is difference in beliefs between you and Green Bakery’s management. In some cases business will fail slowly as a result of this type of disagreement as social norms shift, while in some cases firms go out of business rather quickly. For some customers, Green will not have this additional cost Y and will cost the same as Blue. For some customers, Green’s preferences could even align with theirs, adding to business, but so long as a critical mass of Green’s existing customers have beliefs and a demand function like the gray one above, Green will lose business to Blue and be forced to shutter their doors. In this case, hinging on the critical mass of disagreement, the free market at work will reduce business for Green until the day they no longer breakeven.

We see a similar story in the allocation of venture capital. Plenty of research has shown that women executives and female CEOs outperform the indexes of male dominated companies. Women are managing to be a better bet than men by as much as a factor of three, and yet they only make up about 6.5% of Fortune 500 CEOs and only 20% of VC deals, or 2% of all venture capital. They drive additional value, outgrowing their male counterparts by 63% in the case of First Round Capital. In other words, women founders cost VCs less, earn them more, and yet, they still don’t receive equal funding. This is a lot like our bakers Blue and Green. Blue is the VC funds putting capital towards women founders and seeing results. Green is the funds that follow the industry standards and miss out on the returns of investing in female founders. Angels and venture capitalists are suffering a huge opportunity cost in not servicing the demands of female founders.

Various reports of discrimination in the community help to explain some of this. In some benevolent cases, discrimination occurs as an accident, as Katrina Lake outlines in conversation with NPR, pointing out that many VCs have pitch requirements that could exclude the growing industry of so-called mompreneurs. The offices are highly male dominated, with only 6% of VCs being women as recently as 2016.

Compare these averages to the Rockies Venture Club. Of our 31 portfolio companies, over half star female founders running companies ranging from tech solutions for kitchens to FinTech answers for any early stage startup. Enter RVC’s Women’s Investor Network, or WIN for short. Headed up by Director Barbara Bauer, WIN was founded to increase the number of active female Angel’s working with RVC. Something Barbara has identified, and highlights regularly at RVC events and talks, is the need to fund female entrepreneurs to make sure that women have the capital and the experience to be informed Angels. As an experienced entrepreneur with a background and education in science and engineering, Barbara represents the best of the best to lead RVC and the venture and Angel communities as a whole towards a better, more diverse future.

Know someone interested in working with Barbara as a WINtern? Have them send a resume to info@rockiesventureclub.org!

Most interns don’t expect to learn from the Executive Director or their CEO. Fewer get to. Fewer yet get to sit through a five hour seminar on financial strategy with said executive. This is what the analysts at RVC got on Tuesday as Executive Director Peter Adams walked a group of entrepreneurs and investors through a CFO’s role in acquiring funding. From how to build adequate proformas to when to schedule your raises, the RVC Financial Class Cluster threw us into the fire of financial strategy. Sitting in with a group of investors and entrepreneurs alike, here’s a look at what we covered.

Financial Strategy

Diligence is the name of the game at RVC, with every prospective deal getting a full diligence report drafted up for RVC members. For Peter, this means believability and accuracy in the numbers. In the case of financial strategy, this means clearly defining your major milestones, your key hires, when (roughly) you’re going to raise capital, how you’re going to raise it, and the nitty gritty of each of those things. Peter’s philosophy outlines all of these alongside clear exit modeling as fundamental to a success for prospective founders. What stood out in this densely packed granola bar of venture capital knowledge? The paradox of uncertainty.

Peter made clear that a company and its founders won’t have a clear date on which they will need to raise the next round, hire that new sales star, or sit down with their dream acquirer. Peter also made clear that a company needs to have an idea of what those events look like, and while precision is not present, they key came down to milestones. Bringing on new team members shortly after key product launches, identifying the scalability inflection point, and raising enough money to pave a long enough runway are his tips for a successful financial plan.

Valuations

Part of diligence is accuracy and reasonable goals, which for valuations means a lot things. One of Peter’s highlights is that while Angels would absolutely love it if their firms all became unicorns, unless that conversion happens in a fairly tight window, doing so isn’t best for the Angel. Rather than lofty goals that may provide a bigger sum after a decade, Peter instead argues for reasonable exit strategies. Acquisition by key distributors or large firms with histories of choosing the buy side of the buy-or-build dilemma, Peter argues, can result in faster turnarounds and safer strategies for both Angels and entrepreneurs.He defines clear ranges with key milestones for reasonable early valuations, and outlined a number of models used at RVC to determine those early valuations.

Peter also faced the audience with a thought challenge. Imagine an entrepreneur trying to raise their first seed round. As the omnipotent spectator, we know this company to have a specific valuation. The question at hand? Is it better for the entrepreneur if the company gets valued at double that valuation, or 10% less than its true value? While the company would be able to raise more money at the double valuation, the answer would be the 10% reduction. Less dilution and a slower, more controlled value inflation would prove advantageous for the entrepreneur.

Proformas

Proformas are integral to the other parts of this class. They are the bridge between your vision as an entrepreneur and the funding to get you there. It is the blueprint of your business and your plans, the pictogram by which you assemble a successful company. This means years of financials, forecasts, milestones and targets, key hires, and more. Good proformas are believable proformas, argues Peter, utilizing reasonable projections and honest numbers to justify their claims and valuation. He argues that VCs and Angels alike would rather see that entrepreneurs have reasonable expectations and goals they know they can reach. In other words, be honest. If your burn is running $15k a month, don’t try to hide it. Instead, highlight where that burn is resulting in growth and is driving value. Show how you can scale back to balance if you need to slow down while seeking funding. Tell prospective investors honestly whether or not you have plans for future rounds. What milestones lead up to it? There are no ruby red slippers to take you back to the quiet farm in Kansas, so build the yellow brick road that takes you to Emerald City of successful exit, no matter how treacherous it may be.

In a panel on angel return data at the Angel Capital Association Summit recently the speaker went back and forth between data using ROI (multiples of the original investment) and IRR (internal rate of return).  These metrics are very different and it is important for angels to have a good understanding of how using each of these will impact their investment strategy – in many cases for the worse!

Why Hunting for Unicorns May not be a Good Strategy for Angel Investors

Angel Investing Unicorn

 

There is a mythology among angel investors about going for “unicorns” (private companies with a valuation of $1 billion or more) in their portfolios.  In many cases, real returns from unicorns may be less than hitting solid singles and doubles that exit at under $100 million. Here’s why:

 

While unicorns may appear to give great returns, our speaker gave an example.  He had invested in DocuSign which is now readying itself for an IPO.  (Initial Public Offering)  After multiple follow-on rounds after his angel investment, his percentage ownership had been significantly diluted, but even worse – it took twelve years for DocuSign to get to exit from the time of his investment.  While he expects to receive an investment ROI multiple of 4.8 times his original investment, that comes out to only a 15.3% IRR. Getting $480,000 back on a $100,000 investment sounds good initially. When the amount of time that the investment takes comes into the calculation, the unicorn doesn’t look as good as some of the same investor’s exits that came along in five or fewer years and yielded $100 million or less.  In fact, his average IRR over his portfolio was 27%, so this unicorn was bringing his average down!

 

Angel Investors should think about their investments from a portfolio strategy viewpoint.  

Smart angels will target 10X their investment back within five years or less – that’s a 58.5% IRR.  After calculating winners and losers over time, angels who invest through angel groups will typically see a portfolio return in the 23-37% range, or about 2.5X.  Getting 4.8X your money back sounds good, until you think about what you could have done with that money if you could have reinvested it after five years.  

 

What if the investor had taken his $100,000 and NOT invested in DocuSign, but rather invested in ten deals at $10,000 each with half of them returning nothing and the returns from the others averaging 2.5X return over five years?  And what if he had reinvested the returns from those investments? At that rate, including winners and losers, he would have received $850,000 at the end of twelve years for an 8.5X return or 27% IRR. Clearly, taking time into account, but also taking the opportunity to recycle exits into the next deal increases profits.  

 

The likelihood of any one investment being a unicorn is something like 1,800 to 1, but the most prolific angel investors I know have portfolios of maybe 100-150 deals.  On the other hand, getting a 2.5X in five years on a ten company portfolio is fairly common among angels. Unicorn hunting, even when successful returned almost half the cash that the diversified angel did.  Using IRR instead of ROI helps angels to understand the best way to think of their strategy.

How do Venture Capitalists Differ from Angels?

Venture Capital funds often talk about how they need to go for the big multiples “because they need to return large amounts to their Limited Partners.”  This is partly true, but not for the reasons they would have you think. Angels have the same return targets as VCs, and, when they invest in groups, they tend to outperform Venture Capital funds by a good margin.  Over the past fifteen years VCs have been hunting for unicorns and missing out on the singles,doubles and triples that angels enjoy, but their returns averaged 9.98% – less than half of what angels have earned during the same period.

 

VCs are limited by time in their investments.  The average VC fund lasts for ten years, and many funds have a policy of not “recycling” their returns into new investments, so they are motivated to get large multiples of ROI rather than focusing on quick returns with high IRR.  It’s better if a fund can recycle its returns into new investments, with the caveat that they must return all capital to Limited Partners within ten years.

 

VCs also shy from using IRR to measure their fund’s performance because of the “J Curve” which refers to the shorter period between investment and failure compared to the longer period between investment and large-multiple success.  Using IRR can make the fund’s performance look sub-par early in the fund’s lifecycle.

 

Finally, the institutional investors that are the VC’s Limited Partners often earmark their funds for long investment periods and the last thing they want is to get a 30% IRR on an investment that comes back in the first year.  They would rather deploy the capital for longer periods for larger returns. Because institutional investors have a high cost of analyzing investment opportunities, it’s not as easy for them to re-deploy as it might be for angels.

 

So, angel investors differ from VCs in investment strategy, and if they invest in groups and pay attention to using IRR as their performance metric, they can outperform VCs and create significant returns for their own portfolios.

If you’ve read ANYTHING about cryptocurrencies and ICOs (Initial Coin/Token Offerings), you’ve read opinions from people who believe that the value of these coins will go up 100 times and others who believe that they will all crash to zero because there is “nothing there”.  If you believe either of these groups, you’ll be in big trouble if you’re an entrepreneur or angel/venture capital investor in this space.  Some cryptocurrencies will indeed go to zero and others will likely rise by 100X, but out of thousands of deals, how would you know how to pick the right ones?

It’s not just cryptocurrencies that have a lot of uncertainty today.  We’re seeing unprecedented change in blockchain, artificial intelligence, Internet of Things, self-driving cars and more.  These trends are all going to become a big part of our future, but which companies are the ones we should invest in?

Experience can be a guide in helping decipher the trends in fast breaking industries. The cryptocurrency ICO market reminds me a lot of all the dot.com startups in the 1990’s who were going public without having much more than a URL like etoys.com, socks.com, pets.com, etc.

What happened during the .com boom?  Lots of companies got funded quickly and at valuations that didn’t make sense.  It kind of looks like the ICO boom now.  When companies get too much money too quickly, they tend to accelerate their failure rate because they haven’t figured out their product-market-fit or how to scale up quickly.  We’ll certainly see some of that in the current ICO boom, but, just like in the .com boom, we’ll also see some VERY BIG winners. Google and Amazon looked crazy in the 1990’s  but now they are today’s biggest companies.  We will see the same thing with blockchain, cryptocurrencies, AI, IoT, intelligent cars and more.

The people who predict wholesale failure or wholesale success are bound to be wrong.  The people who are diligent in digging into who the winners and losers will be with a futurist attitude will succeed.  Investors who think like the hockey player Wayne Gretzky who famously said “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” 

Great venture capital investors have to be like great hockey players and invest where the market is going to be.

Predicting the future is hard, but we’ve got some help for you.  The upcoming Angel Capital Summit, produced by the Rockies Venture Club will be focusing on Funding the Next Wave of Innovation.  We’ll be interviewing CEOs of companies that have gone through major trends in social networks, cyber security and more in order to learn how to identify and ride the trends.

The Angel Capital Summit will also feature 16+ companies that are riding the trends of their industries, pitching to angel and venture capital investors.  The event is open to the public and is free for RVC Keystone and Active Investor Members.  (If you’re not a member yet, click HERE for more information).

The Rockies Venture Club is the oldest angel investing group in the U.S. and is a non-profit organization focusing on furthering economic development by educating and connecting angel investors and great startups.

Denver, CO – Rockies Venture Club (RVC), one of the largest and most experienced Angel investing organizations in the country, led and closed 15 funding rounds over the past year. RVC has created a community of accredited investors who are passionate about helping early stage companies raise the capital that they need to grow.

This trend of early-stage investing in Colorado is encouraging considering the fact that there has been a downward trend in early-stage activity worldwide. A November 2017 report by TechCrunch shows that despite record levels of Venture Capital being raised, the number of funding rounds has been cut in half since 2014. This indicates that capital is being concentrated into larger, later-stage companies. With this being the trend, it would seem that Rockies Venture Club and more largely Colorado as a whole is providing its companies the capital they need to grow.

According to RVC Executive Director, Peter Adams, “One of RVC’s leading principles is to be as diversified as possible when investing in companies. We believe that investing in a variety of sectors allows our Angel investors to diversify their personal portfolios while having fun learning about industries they don’t have past experience in.” This is something that the Angel group truly puts into practice if their 2017 portfolio is any indication. Among the 15 new companies that RVC backed in 2017, there was industry representation within CyberSecurity, AgTech, FinTech, Medical Devices, and Consumer Products; just to name a few.

In addition to engaging local capital through its network of over 200 active Angel investors, Rockies Venture Club also syndicates many of these deals with other Angel groups from across the U.S. Dave Harris, RVC’s Director of Operations, states, “RVC has been working to develop strong partnerships with other Angel groups for several years now. This allows companies to more quickly and easily close their funding rounds, bring deal flow to other areas of the country, and ultimately results in a greater amount of capital being invested directly in Colorado companies.”

Among the 15 deals, RVC led the seed-round in the female founded, Fort Collins company, The Food Corridor (TFC). TFC is the first online marketplace for food businesses to connect with available commercial food assets. Food businesses can find and book commercial kitchens, equipment, commissaries, processors, co-packers, and food storage spaces. CEO Ashley Colpaart put together a $550k round through Rockies Venture Club, Rockies Venture Fund, and other Northern Colorado Investors. Peter Adams stated, “I believe that RVC investors were especially interested in this deal due to Ashley’s deep industry knowledge and the promising early traction they have gained with food entrepreneurs and commercial kitchen spaces.”

RVC Angels also invested in CirrusMD’s $7 Million Series A Round. CirrusMD is a company that gives patients immediate access to providers via secure chat so healthcare organizations can excel in a value-based care environment. This was the third round that RVC has participated in, having first invested in the company in 2014. Since then CirrusMD has expanded access to care to over a million of patients and formed strong partnerships with some of the largest health systems across the country.

Beyond closing the 15 deals, in 2017 Rockies Venture Club created the Women’s Investor Network(WIN), an initiative created to address the lack of diversity in Colorado’s investor community, launched the Rockies Venture Fund, an early-stage VC fund that invests alongside RVC’s Angel investors, and collaborate with the Colorado OEDIT to create the OEDIT HyperAccelerator, program that helps Advanced Industry grant recipients raise the necessary matching funds.

Looking forward to 2018, the club will be hosting the 11th annual Angel Capital Summit (ACS) in March. The Angel Capital Summit is the largest Angel investing event in Colorado, bringing together over 300 investors, entrepreneurs, and community members together under one roof. This year the conference will focus around current, past, and future waves of innovation that have had or will have lasting impacts on the venture capital industry. RVC is excited to announce that there will be two keynote speakers at ACS this year: Divya Narendra, and Colorado’s own Andre Durand. Dyvia is the Founder and CEO of SumZero, and co-founded ConnectU, the inspiration behind Facebook. Andre is the Founder and CEO of Ping Identity who lead the company through a $600M+ acquisition by Vista  Equity Partners in 2016.

How Angel Experience Can Help Social/Environmental Impact Companies.

The paradox in impact investing is that a large percentage of impact investors are hurting the very companies that they want to help.  Neophyte impact investors have not yet figured out the difference between philanthropy and Impact investing, resulting in a confusion that causes serious damage to the Impact business community.

There is a big difference between philanthropy and Impact investing.  The organizations receiving funding are focused on doing good in the world and it doesn’t matter whether they are for-profit of not for them to do good.  In fact, many for-profits outperform non-profits on execution and core metrics for outcomes.  Impact investors should understand their motivations for investing and they should have clear financial and non-financial metrics that they use to create their investment thesis.

 

A non-profit, by definition, does not make a profit.  It is also owned by no one and when it has come to its end or fulfilled its mission, all assets must be donated to another non-profit.  Value creation is strictly focused on mission and core metrics include outputs as well as key ratios between operational costs vs. direct program delivery.

Rockies Venture Club Impact Investing - Exit Focused!

 

 

Social and Environmental Impact investing, on the other hand, creates value on three ways.  The business generates a profit.  It creates measurable positive social and/or environmental outcomes, plus it creates positive economic outcomes for investors and founders.  The fact that the company creates these positive economic outputs doesn’t in any way diminish the company’s need for capital nor does it diminish the impact created by the company’s operations.

To help clarify how investors and CEOs should think about impact investing vs. philanthropy, I’ve put together a sampling of six common arguments that some, mostly new, impact investors put forward, and some responses to those arguments which I hope will clarify the power of impact investing and a more productive attitude towards profitability and liquidity events.

Six Common Arguments from New Impact Investors

Argument: “I don’t want to invest in a company that is just interested in selling out, so I advise companies I invest in to never have an exit strategy.”

Even non-impact investors are wary of investing in a CEO who appears to be in it just for the money, or is planning for the quick flip.  These CEOs likely w

 

on’t have the grit it takes to overcome the many obstacles in their way and will quit half way through, losing everyone’s investment.  There’s a fine line between the quick flip mentality and the strategic CEO who is looking for ways to maximize value and leverage that to increase outcomes for all.

CEOs who hear this argument sometimes change their strategy to exclude an exit strategy, which often means that the net impact the company will have is DIMINISHED because of the short sighted demands of the Impact investor who wants to feel good about themselves in the way that philanthropy makes people feel good.  By focusing on data oriented approaches to strategy, investors can come to understand the exit as a way to expand outcomes, not diminish them.

Argument:” If the companies I invest in are acquired, the acquirer may have different values, thus hurting the beneficial impact that the company creates.”

This argument suffers from a lack of understanding how exit strategies and execution work.  The exit strategy entails identifying the best acquirers for whom the company will provide the greatest value.  This exercise naturally involves understanding the values of the potential acquirer and seeking to build relationships with acquirers who share the impact company’s values and will likely expand on them after acquisition.

So, a company that does not have an exit strategy is more likely to be acquired by a company who has misaligned values and may fail to carry on and expand the mission of the company.  Rather than decreasing the risk of a values misalignment, the impact investor increases the chances of misalignment by refusing to support talk of an exit strategy.

Argument: “Impact companies should just focus on creating a positive impact and growing a significant company and not on an exit.”

 

This is one of the weakest arguments against an impact company’s focus on exit, and it is one that is commonly waged against tech startup CEOs, leading to confusion and underperformance in many cases.

Let’s start by remembering the Second Habit of the Seven Habits of Highly Successful People – “Begin with the end in mind.”  This habit is just as important for impact companies as it is for people.  Those who focus on the end and develop a clear path to get there are 65% more effective in achieving those goals than those that try to “just build a big company.”

Impact companies create value in three ways, and I don’t just mean the Triple Bottom Line.  Impact companies create value through creating a valuable good or service which is able to compete in the market and create revenues and profits.  Impact companies create value because their goods or services themselves create positive social or environmental outcomes.  Finally, Impact companies with exit strategies understand how to create value for their acquirers, and those acquirers are often willing to pay a multiple of revenue to get it.

RVC Impact Investing Return vs. Impact

 

 

Any company needs to understand its core value proposition for its customer.  What smart Impact CEOs and their investors will do is to ask what the value proposition is for its second customer too – the customer who buys the whole company.  That value proposition is not always the same as the value proposition for the first customer and having a clear understanding of those differing value propositions can be the difference between success and the walking dead.

So, companies with an exit strategy are 1) more likely than others to be successful and 2) will create wealth for investors and founders which can 3) be reinvested into new Impact companies to create an evergreen cycle of positive social and environmental impact.

 

Argument: “You can’t control the exit, so it’s a mistake to try to pretend that you can.”

People who don’t believe they can control the exit, may also believe they can’t control the market or the customers for their products.  They might just as well stay in bed – they can’t control anything and are fairly weak leaders of companies.

Great Impact leaders create their futures.  They may not be able to control all aspects, but they can create an environment in which their thesis succeeds.  Great leaders will drive towards scenarios that align with their values and

business goals.  Just because you can’t control every externality does NOT mean that you must throw up your hands and refuse to plan for the future.  It is exactly because of the uncertainty of the future, that exit planning is imperative.

Argument: “Social and Environmental Impact companies are not acquirable, so they should just focus on impact.”

Companies should BEGIN with the end in mind and create all three Impact value propositions (profit, impact, exit).  Companies that create profit and

impact should be highly acquirable, and by thinking about it from the beginning, value of all three kinds can be baked into the core strategy.

When it comes time for exit, it’s not a cop-out or sell-out of values.  I think of it more like a “commencement.”  Just like when someone goes through Commencement at the end of high school, it doesn’t mean that they’ve ended their path towards education, but rather it means that they’re graduating to a higher level of execution by going on to university.  Few would say that commencement in any way diminishes the quality of the person going through graduation.

So too with a company going through an exit.  By being acquired the company can further its mission tenfold or more by leveraging the capital, sales channels, R&D, brand and other resources that the acquirer can bring to the Impact company.  The net result is the opposite of a cop-out, but is rather a commencement of something even bigger and the Impact investor should be right next to the Impact CEO, helping them to achieve that end.

RVC Impact Investing

Investors who believe that making a profit is bad should stick to philanthropy.  If they need to lose money to feel good about themselves, philanthropy is a quick path to 100% financial loss.  Even a zero interest loan to a non-profit results in a profit of zero which is 100% more than a philanthropic gift.  Investors who have a problem with Impact companies being profitable should stick to philanthropy rather than dragging down promising Impact startup CEOs and limiting the evergreen effect of reinvestment.

The more that Impact investors focus on achieving positive social and environmental outcomes along with value creation, the more capital will be available to support Impact startups and the more good will be done in the world.

Impact investing is at an inflection point and is growing at an astronomical rate.  The global market for impact investments is expected to top $300 Billion by 2020.  Capital is chasing Impact deals because of a new breed of Fund managers who apply the discipline and expectations of venture capital to Impact.  The more we see of this kind of investing, the better the Impact Investing space will be for everyone.

We’ve known for years that Colorado has more startups per capital than anywhere else.  Yes – per capita.  It’s a great location to start up a company and maybe you’re wondering if there’s a Venture Capital infrastructure to support that?  Well, now there’s incontrovertible evidence for Colorado’s leadership position in MicroVCs and it all comes down to … beer.

Just check out this CB Insights research relating MicroVC Tech Deals to Microbreweries.  That’s right – the more microbreweries you have, the more MicroVC deals you get.  And take a look at Colorado’s number 3 position in Microbreweries – what does that tell you?

 

Yes – a vibrant MicroVC community is brewing here in Colorado.  We’re seeing a huge influx of MicroVC and NanoVC funds as the state begins to mobilize its local capital to support its burgeoning startup community.

Ok, maybe that’s just a facetious stretch of statistical comparisons – but there is definitely a rapidly moving trend in Micro Venture Capital and Colorado is feeling the benefits of new sources of capital coming on-line!

This trend mirrors a national trend in increasing Micro VC firms.  Following the drastic drop in VC firms from over 1000 to just over 500 after the economic downturn in 2008, MicroVCs have flourished.  There were fewer than fifty active MicroVCs in 2011 and today there are over 550 in the U.S. A tenfold increase in just a few short years and many of them are in Colorado.

MicroVC is changing the venture investing landscape and is responding to the needs of startups who need small amounts of capital to prove their product market fit and grow big.  MicroVCs offer a scale that the big firms can’t efficiently provide and they get companies up and going quickly and efficiently.

MicroVCs aren’t just for small companies though.  Check out these results from MicroVCs who are growing a new crop of Unicorns (private companies with valuations of $1B or greater)  It’s not just the big funds that are hitting the grand slams – the Micro’s are slamming it home as well.

MicroVCs are creating a huge impact in the startup world and Colorado is the place to see this transformation taking place on a rapid pace.

You can learn more about MicroVC, NanoVC, and how accelerator VC funds are changing how startups get funded, and how angel investors can get involved in new ways previously unavailable to them.  You’ve got just a few days to sign up for the Colorado Capital Conference coming up November 6-7, 2017 in Denver, CO.

Visit www. coloradocapitalconference.org for more

information and to register.

The conference is hosted by Rockies Venture Club, the longest running angel group in the U.S.  Membership is NOT required to attend the conference, but if you’re an entrepreneur or angel investor, this would be a good time to look into the savings that RVC members enjoy on conferences, angel groups, workshops, masterminds and classes.

 

 

 

 

 

 

 

 

 

 

 

 

Rockies Venture ClubAs the cost of starting a tech company has gone down, VCs have moved upstream, funding bigger and bigger deals while angels and angel groups have taken up the sub-five million funding space. Meanwhile, accelerators and platforms have also taken a place with funds to jump start companies going through their programs.  MicroVCs are venture capital firms with assets under management of less than $100,000,000.  That sounds like a pretty big fund to angel investors, but in the big picture venture capital world, these truly are micro venture capital funds.

MicroVCs have taken on a huge role in filling the gap between seed and angel funding and big scale unicorn-track venture funding.  If you think about basic fund structure, a $100 million fund will invest about half of committed capital, or $50 million into its first round investments.  The fund will want to diversify to twenty or more investments, so you might see an average of $2 million for a first round.  Then they’ll have the remaining $50 million to continue investing in the top winners from the portfolio.  $2 million is a great amount for a post-angel round, but is far less than the $10 million that an average VC deal is doing today.

The MicroVC area is more understandable if we look at what kind of entities fill this space. There are sub $25 million funds, also known as NanoVC Funds which operate very differently than $100 million funds.  Then there are the accelerators which are actually MicroVCs.  Also, more and more angel groups are creating funds (Like the Rockies Venture Fund) and are moving upstream a bit to do larger deals.  Finally, angel groups are syndicating actively, so they can move into larger and larger deals.  Some examples of the power of angel groups leveraging their investments by working in syndicates include Richard Sudek’s work at Tech Coast Angels who syndicated a $10 million raise via syndication and similarly Rockies Venture Club Participated in a Series F syndicate for PharmaJet locally.  These are not deals that we would typically expect to see angels playing in.  This means that angels, when working together can start filling the space occupied by the MicroVCs.  Rather than competing, we’re seeing angels investing alongside MicroVCs at an increasing pace.

There are other considerations, however.  MicroVCs will typically hold back half of their fund for follow-ons, while angels are less predictable and many still use a “one and done” approach to their investments.  Even with MicroVC follow-on investment of up to $10 million, this is still not enough to propel some companies to the scale they’re shooting for, so they’ll still need to engage with traditional VC once they get big enough.

Angel investors should help startups to figure out their financial strategies so that they can work on building relationships with the right kinds of investors from the beginning so that they don’t paint themselves into a financial corner by working with the wrong investors.  Similarly, startups need to understand the goals of any type of VC so that they don’t waste their time barking up the wrong tree.

 

To learn more about the evolving role of MicroVCs, consider attending the RVC Colorado Capital Conference.  It’s coming up November 6-7th in Denver, CO.  Visit www.coloradocapitalconference.org for more information on speakers and presenters.  This event is on of Colorado’s largest angel and vc investment conferences of the year and there are great networking opportunities.   We hope that  the audience will come away with an idea about how all these types of capital are evolving and the different strategies that companies can take in choosing who they want to pursue for their capital needs.

Peter Adams

Managing Director, Rockies Venture Fund I, LP
Executive Director, Rockies Venture Club, Inc.
 Buy Venture Capital For Dummies on Amazon

 

It seems like a majority of pre-Series A deals are done with convertible debt these days and I’d like to point out a few reasons why this is a bad thing for entrepreneurs and investors alike.

Just to get definitions out of the way, we’re talking about the decision to raise funding for startups by either equity investment in stock of a company, or in a convertible debt instrument.  Equity is pretty straightforward – invest money, get stock.  Convertible notes, on the other hand are not widely known to those outside of startup investing.  Convertible debt works like regular debt in that there’s a promissory note and an interest rate.  The interest is rarely paid in cash for convertible notes though, and it’s usually rolled into equity when the note converts into equity.  There are usually a few “triggers” for h

RVC Convertible debt vs. equity

aving the note convert to equity, but the most prominent one is that there is a “qualified financing round” which is usually around $1 million.  The idea is that the professional investors at that stage know how to value the business and set the terms. The first early investors who invest will convert at the terms set by the VCs, but usually with a 20% discount in price to compensate for investing earlier.  Convertible notes today also have a “valuation cap” which is equal to what the equity valuation would have been if the deal had been a stock transaction in the first place.  So, when the qualified round causes the note to convert, it converts at the lower of the 20% discount or the valuation cap.

Ten Reasons to Avoid Convertible Debt

Reason 1:  Convertible Notes do not qualify for Section 1202 QSBS Tax Breaks<a href="http://www.freepik.com/free-photos-vectors/business">Business vector created by Dooder - Freepik.com</a>

Angel investors get a 100% capital gains tax break if they invest in equity in early stage companies that meet certain criteria such as being a C Corp., being under five years old, under five million in revenue and they hold the 

 

 

 

investment for five years.  Convertible notes don’t qualify for this tax break, so if all things were equal, the investor makes 20% LESS on convertible note deals since they have to pay capital gains tax on the investment, whereas investors who invest in equity do not have to pay any tax at all.

Reason 2: Equity is cheaper than convertible debt

You may have heard that it’s cheaper, faster and easier to do a convertible note, but the fact is that convertible notes are going to end up costing the company approximately 25% MORE than an equity deal.  The reason for this is that when the note converts, then it converts into EQUITY.  That means that the company pays twice for the legal: once to do the note and another time to do the equity.  So if a convertible note cost $2500 in legal fees and the equity deal cost $10,000, then the convertible note all-in is going to cost the company $12,500.  Why not just do it right in the first place and put all that money to work for the company?

Reason 3) 80% of Angel Investors Prefer Equity

If you’re selling something to a customer, wouldn’t you want to sell them what they want and not some more expensive and inferior product?  The American Angel Survey shows that investors prefer equity and I suspect that if the remaining 20% of angels read this blog, they’d prefer equity too.

Reason 4) You can lose your company if you default on a convertible note

When you take out the note you’re confident that you’ll have a qualifying follow-on round within 18 months, but many times it takes longer and the note comes due and payable and you’ve already spent the money and can’t raise any more.  You’re in default and investors can take your company from you.  Most investors don’t want to do that, but why go through the heartburn and stress of facing the potential loss?

Reason 5) Investors have to pay tax on interest they earned but never got

As interest accrues on convertible notes, interest is due.  Investors need to pay tax on those notes, even though they didn’t actually get the interest in cash.  So, if someone invests $100,000 in an 8% convertible note, they have to pay $2640 in cash to the IRS on that income.  Nobody likes paying taxes on money they never got and also, BTW, there is no tax due for equity investments.

Reason 6)  You have to come up with a valuation for convertible notes just like equity.

Many people think that using convertible notes lets them “kick the valuation can down the road.”  Nothing could be farther from the truth.  Every convertible note has a provision called the “valuation cap.”    The formula for calculating the valuation cap is as follows:

Valuation Cap = Equity Valuation

This means that when someone invests in a convertible note, they should never have to pay more than what the company is worth today.  If the valuation cap were higher than equity valuation, that would mean that note investors would have to pay more than the value of the company.  Just because it may convert at a higher valuation some time in the future does not mitigate the risks that the early stage investor has today.  In fact, the only way that the higher valuation comes about in the future is that the angel investor puts in the capital early, when risk is highest, so it doesn’t make sense that they should pay more than what the company is worth.

Many companies get confused about this.  One company told us that the valuation would be $5 million, but it would be $7 million valuation cap “because it’s going to convert at $12 million some day.”   It’s crazy to think that somehow using a convertible note makes a company worth $2 million more than one that uses equity. This kind of thinking makes no sense and hurts the startup community.

Putting valuations on early stage companies is something that is done every day and there’s no magic to it.  Seed Funds and Angel Groups have well established valuation methodologies that work well on pre-revenue companies.

Reason 8) Entrepreneurs get diluted with convertible notes

Entrepreneurs should be cautious about the cumulative dilution that paying interest which will be rolled into equity will create.  The longer the note goes on, the more startups will be diluted with the interest that they have to pay in the form of equity.  It would be better to preserve that equity for future growth.  Founders who chose equity over convertible debt don’t have to worry about interest accumulating and diluting their shares.

Reason 9) Equity creates better alignment between investors and founders

When convertible debt is used, there is a misalignment between investors and entrepreneurs.  Founders want to use high valuation caps or worse, no valuation caps, and prolong the amount of time before conversion, so that investors get the short end of the stick.  Some founders openly state that they want to use convertible debt to preserve their equity.  Those are founders that every investor should avoid – not because they want to build a strategy that preserves equity, but that they want to create unfair terms that preserve equity at the expense of investors.

Reason 10) Equity deals have all the terms defined

With a convertible debt deal, the conversion price is negotiated, but all the other terms which are extremely important to the relationship between the founders and investors are left open.  This represents a risk to investors and also leaves many matters unsettled.  One example is that there are usually terms about board representation which are not found in convertible notes.  Investors in early stage companies can offer much more to companies than just a check if they can serve on boards and help move the company along.  While there’s nothing to say that companies with convertible notes can’t have boards, in fact many don’t and that’s bad for both investors and entrepreneurs.

Last Words:

With all that being said against convertible notes, they can still be useful for the FFF rounds with friends and family who don’t know how to value a deal and who are investing primarily to support the entrepreneur.  Convertible notes can be better than some of the amateurish deals that get put together for early family investors who are often non-accredited that can make follow-on investments difficult or even impossible for the company, thus limiting its chances for success.

Visit www.rockiesventureclub.org to learn more.

 

Peter Adams

Managing Director, Rockies Venture Fund I, LP
Executive Director, Rockies Venture Club, Inc.
 Buy Venture Capital For Dummies on Amazon