It’s that time of year again! RVC’s HyperAccelerator is back for a fresh, new, June 18th installment focusing on Impact Ventures. This is our sixth run of the gamut, this time with the support BSW Wealth Partners and the Colorado Office of Economic Development and International Trade.Take a look at these companies and see if you think they are all “impact” – doing good through social, environmental and economic development. We’ve spent a lot of time thinking about impact and what makes for a good impact investment, so we’re excited to work closely with this cohort of impact companies to push their programs forward with strategy and venture capital funding readiness. You can learn more about how we think about impact investing here. Join us at the Soda Pop Garage (2150 Market) on Monday, June 25th at 2pm for our Demo Day, where our freshly (hyper)accelerated ventures will pitch for you, the public. Register today!

 

Achroma plans to develop a blockchain powered loan platform to help remove underlying bias in the loan system. Using a blend of anonymity and data analytics, this FinTech/blockchain hybrid is hoping to help loan seekers feel sure that the system is working for them.

 

Brainitz is an EdTech company building a platform for teachers to create interactive videos. CEO Clint Knox is a teacher by trade and set out with the goal of streamlining the teaching process by giving students the teacher tools to help them teach outside of the classroom. Brainitz achieves this by integrating questions directly into video lectures.

 

 

EnVision Meditation uses scientifically backed techniques in order to guide users through daily 10 minute visualizations meant to provide empowerment and self improvement. The benefits are meant to reduce stress, fear, worry, and doubt, and increase confidence, motivation, focus and awareness. The company reaches users through its app of the same name.

MFB Fertility creates affordable medical devices and digital health solutions to help women better monitor their own hormonal cycles. The Ovulation Double Check is the FDA compliant, flagship product the company produces to help women understand when they are hormonally prime for pregnancy. MFB is now producing a take home device and an app that will help women monitor their hormones for purposes beyond fertility, such as detecting early stages of menopause. MFB Fertility is a recipient of the OEDIT Advanced Industries grant.

Starfire Energy utilizes clean energy sources to in order to produce ammonia. Using proprietary technology, Starfire makes this process easier to descale and ramp. The company hopes that it can produce nitrate to help power companies generate clean power storage and fuel.

 

Storion Energy. is developing and commercializing advanced batteries for the large-scale storage and delivery of renewable energy. Storion’s redox flow battery provides a blend of economy, performance, and reliability. Storion continues development of next-generation technologies to increase performance and drive down costs. Storion hopes to drive a shift in the energy industry by solving the long known ‘peak hours’ problems of renewable energy.

Synthio Chemicals is a developer and contract manufacturer of fine and specialty chemicals. The company uses novel continuous manufacturing techniques to produce specialty chemicals on a continuous rather than batch basis. Synthio is able to produce chemicals at a price and purity ratio drastically superior to competitors using proprietary tools and techniques. Synthio has broken into the pharmaceutical industry with intermediaries as their opening move. Synthio Chemicals is a recipient of the OEDIT Advanced Industries grant.

 

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!

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.

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

 

Many professional organizations have a certification test of competency that members must pass to demonstrate their knowledge and ability to perform at a high level.  Doctors, Lawyers, CPA’s and other professions must also take continuing education credits as well.

The criterion for being an angel investor, however, has nothing to do with knowledge and does nothing to provide the knowledge that an accredited investor needs to know to both make good investments and to exercise prudence with regard to their portfolio strategy.  Accredited investors qualify to be angels simply by wealth (having assets in excess of $1 million) or income, (having annual income of $200K per year or more, or $300K for married couples)

The SEC has proposed recently that a knowledge based criterion for accredited investors be added.  This would allow people with expertise to participate in angel investments.  The proposal, however, suggested that existing certifications such as a FINRA Series 7 might be a good benchmark.  Having passed the Series 7 test myself, I can assure anyone that the knowledge one acquires to pass that test, though it is significant, has nothing to do with what someone needs to know to be an angel investor.   Angel and venture capital investing has its own set of language and guidelines that have very little overlap with what a Series 7 certificate holder would have.  If the goal of accreditation is to protect the investors from themselves, then providing a certification that tested knowledge that was relevant to the asset class would be most useful.

A good certification test for angel investors would include several parts.  Here’s an overview of what it might look like.

  • Portfolio strategy. The presumed reason for the accredited investor guidelines is that people of high wealth have excess money to lose and can withstand a complete loss.  Just having money to lose isn’t really a great way to build a portfolio strategy.  Smart investors will allocate approximately ten percent or less of their investable portfolio into the angel investing asset class.  Within that ten percent, they will be invested in a minimum of ten deals and preferably twenty or more.  That means that a marginally accredited investor with a $1 million in investable assets will create an angel investing portfolio of about $100,000 which will be in at least ten $10,000 deals or even twenty $5,000 deals.  Someone with a $5 million investable portfolio will put $500,000 to work in angel deals, perhaps with twenty deals at $25,000 each.  Some angels really spread out their risk with fifty or more deals and it’s generally agreed that the more deals you can get into the better.  Finally, angels should understand the difference between making a “one and done” investment in a company vs. follow-on investments and how they can benefit a portfolio.
  • Exit strategies. Angel investors have only one way to get their money back and that’s through an exit. Anyone investing in this asset class should have a sophisticated knowledge of how exits work, how to analyze the market for exit potential, what typical exit multiples are and what the typical exit amounts are for startups in any particular industry.  An angel who doesn’t understand exits will not likely do well as an investor and may end up investing in a lot of great ideas that never see a liquidity event.
  • There are some who say that “valuation doesn’t matter”.  These are the VC hacks who think they can make up for any valuation by investing only in “unicorns” ( private companies that reach a valuation of $1 billion or more).  That’s a great theory until you realize that only one in several thousand deals results in a unicorn deal and most that exit at all will exit for under $50 million.  For these, understanding valuation and putting together a fair deal is critical.  A smart angel should have a valuation toolbox under their belt with several different valuation methods available to them.
  • Due Diligence. Smart angels know that the more diligence you do, the better your chances for investment success.  Just having lunch with a startup CEO and getting excited about their passion and commitment is not a good way to do diligence.  Investors should thoroughly investigate the market, the team, the product, IP and legal landscape, valuation, comparable transactions, financial projections, competition, exit potential, key documents and agreements and much more.
  • Term Sheets. Investing requires good knowledge of the terms used in negotiating the deal.  These terms are far from obvious and many that sound similar can result in a difference of millions of dollars when the company exits.  g. “preferred liquidation preference” or “participating preferred”.   I’ve seen angels who have caused serious problems for themselves and the companies they invest in by creating situations that make follow-on investment by VCs all but impossible.
  • Securities and Tax Law: Angels should be familiar with the various points of securities law to understand the registration exemptions that offerings are using, and to know the boundaries of proper securities offering processes. They should understand the difference between Regulation D 506B and 506C registrations, the proper filing of Form D, numbers of investors allowed, and verification of accredited investor status.  They should also understand tax law as it applies to angel investment including Section 1202, 1244, and 1045 as well as state breaks for economic development and federal breaks for research and development.
  • Proformas and financial analysis. Like it or not, there’s a lot of finance knowledge required to be a good angel investor.  Being able to look at a proforma and understand if it’s believable, or just a “hockey stick” graph someone put together to make it look good.  A proforma is a treasure trove of information about the company, its strategy and how it expects to operate.  Even though it’s never going to be right, the way that the information is presented gives the investor a window into how the CEO and team thinks.  Finance risk is significant for most companies and understanding how many future raises will be required, how big they will be and what the cumulative dilution to both founders and investors will look like is critical to assessing the potential for the deal.
  • Market Analysis. Understanding the trends in a market, competition, actual pain points and return on investment for customers is one of the most important parts of understanding the viability of a deal.  These require sensitivity to the particulars of specific industries and are not easy.  Many startup founders are technical wizards and they may have some insight into the needs of their markets, but many have no idea about how to create a go-to-market strategy, assess which channels are appropriate for their market, or how to allocate scarce resources to create the lowest Cost of Acquiring a Customer relative to the highest Lifetime Customer Value.  Many startups are blind to their competition and claim that they “have no competition.”  This should cause any investor to run from a deal.  Creating “virality” is an art that is lost on many tech or healthcare founders and angels should be able to assess the viability of the market strategy.
  • Post Investment Management and Serving on Boards. The work of the angel investor is just beginning after the check clears.  Managing the investment after the check requires expertise to help ensure alignment and to guide the CEO towards the best exit opportunities.  Serving on boards carries fiduciary responsibilities.

Unlike the questions for the FINRA Series 7 exam, most of the knowledge required for angel investing certification centers more around principles, definitions and best practices rather than distinct points of law.  Only about 10% of the angel certification test is about specific regulations and point of law, yet the knowledge the test represents is what angel investors should know.  This ratio represents the ratio of technical to legal know-how in other professional exams and would represent a step-up in the professionalism of angel investing.

The SEC has set income and asset limits to the definition of accredited investors with good intention.  Unfortunately, simply having wealth does not make one qualified to make good investments and there are plenty of stories of wealthy people making imprudent investments that resulted in disaster.  Better to allow a criterion based on knowledge, so that investors understand how to balance risk and opportunities through diversified investments and well accepted principles of successful angel investing.  We hope the SEC will consider this certification as a means to becoming accredited, and open up angel investing to a broader audience while accelerating American economic development through greater investment in our job creating startups.

 

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