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lenged by their career. For them, direct investing can satisfy by once again



No middlemen


You can hit a “home run,” unlimited upside potential


Satisfyting experience


One of the few investment arenas in which the investor
can influence the outcome of the investment

Exhibit 6.2 Advantages of Direct Venture Investing
Source: International Capital Resources
122 UNDERSTANDING THE ANGEL INVESTOR


being in the early stages of a company™s birth and development, develop-
ment that can require the investor to wear many hats, become involved in a
number of different activities, and confront a number of challenges missing
in the larger, more structured, bureaucratic organization. And last, and per-
haps most important, by getting deeply involved, direct venture investing is
one of the only investment arenas in which the investor experiences the sat-
isfaction of knowing he or she has personally influenced the outcome of the
investment.
If, as we have estimated, 2,000,000 households have the net worth po-
tential for early-stage investing, why is it so difficult to find an angel? Part of
the reluctance of many high-net-worth investors to enter the direct, private
equity market derives from a host of disadvantages: illiquidity, high mortal-
ity rates, the anxiety factor during long-term hold, the lack of diversity many
times associated with an early-stage portfolio, and the time-consuming na-
ture of active investing. Although the many success stories of astronomical
returns are ballyhooed all over the media, the more astute investors remain
cognizant of an underlying process inherent in direct investing, a process that
drains time, energy, and money: developing deal flow, prescreening deals,
conducting due diligence research, investigating, analyzing financials and
valuation, negotiating legal terms and conditions, structuring deals, and
monitoring and mentoring investments for years to liquidity and returns.
Not all investors are suited to long-term, active investment. They may lack
the discipline, vigilance, patience, or perhaps recognize that they lack the
necessary skills required to attract co-investors, and intervene in and add
value to a deal on an ongoing basis.
For every one of those news stories of sky-high returns, investors have
heard many horror stories that read like a book of Murphy™s Law: investors
who fail to return targeted multiples, unmet financial projections, revenue
projections sooner and greater than actual, expense projections later and less
than actual, the need for more capital than expected and sooner than
anticipated, and more rounds of financing needed than planned for by
the founders.


THE PRIVATE INVESTOR™S CRITERIA

Understanding investors™ criteria means appreciating some of the common
sense rules that apply to early-stage, private equity investing.
Generally, most angels agree that when they get involved with direct in-
vesting, they have to know something about the business, or at least the un-
derlying technology and market, to conduct their proper due diligence on the
people, the market, and the technology. They need to plan on having suffi-
123
What Do Private Investors Look for in a Deal?


cient reserves for future rounds so that they are not hindered by dilution; in
addition, they must make every effort to avoid drowning in deals with unre-
alistically high valuations and an unclear path to liquidity.
Whether in technology or nontechnology, the private investor in this se-
lect group has investment criteria. As Exhibit 6.3 suggests, he or she is
steeped in the excitement of this type of investing. To the investor, these feel-
ings figure as prominently as ROI. Remember that a part of this excitement
comes from the infectious enthusiasm of the entrepreneurs themselves.
These private investors search for investments that include a proprietary
advantage, that is, a unique technology, making a leap in innovation, a sig-
nificant competitive advantage that can act as a barrier to competition. And
private investors look for other qualities in their investments, such as a cost
advantage. They also want to understand the industry, or at least understand



EXHIBIT 6.3 Private Investor Criteria

• Exciting, fun (it is also fun to make $$)
• Proprietary advantage or unique technology
• New features recognized competitors don't have that result in significant barriers
to competition
• Cost advantage
• Something investors can understand (not too complex)
• The possibility of new markets
• Potential for fast growth and share of the market
• Potential for ROI, 5-10 times investment with solid financials, BS, IS, CFS, and
assumptions spelled out
• History of profitability, if applicable, or a borrowed track record
• Not just an invention, but a plan for profit
• A management team with the following attributes:
”Perseverance
”Decency
”Competence
”Track record
”Personal financial commitment of their own net worth
”Burning desire to succeed
• Comfortable with level of active/passive involvement required
• In their price range (affordable loss)
• Geographically close (within 300 miles)
• Allows for incremental funding based on performance
• Allows for due diligence
• Must have a clear exit strategy

Source: International Capital Resources
124 UNDERSTANDING THE ANGEL INVESTOR


the underlying technology. They will be acutely conscious of whether the
venture”its product or service”is something they can identify with and be-
come excited about.
In addition, their investment decisions often hang on a salable product
or service entering a receptive market, satisfying a real market need. Private
investors will scrutinize the possibility of new markets”behind which must
exist a driving force”and a potential for fast growth, leading to a significant
share of the market. Products that require “missionary selling” are not as de-
sirable. This clearly defined market for the company must be without large
players already firmly entrenched. Management can be changed; the market
cannot. Who the competition is must be clear in the business plan.
Private investors also look for solid financial forecasts with sufficiently
supported assumptions as they seek a return of 5 to 10 times their original
investment. With credible projections and supporting assumptions, the in-
vestor aims for a minimum return of 30 percent ROI. They also want to see
a history of profitability in operating companies, that is, a track record that
demonstrates financial success. The venture needs to be able to show its po-
tential to deliver the size of returns that investors are targeting.
These private investors want to invest in businesses, not ideas; they want
to separate business plans from strategy, have a differentiation strategy based
on some element beyond cost, for example, creative product engineering, or
proprietary technological leadership. In the wake of the dot-com debacle, a
strong business plan is mandatory.
As our study findings support, angels see business plans as a necessity.
The business plan demonstrates in writing management™s hypothesis about
those elements in the business over which it claims control. The logic, strat-
egy, and support provided for the plan reflect management™s assumption that
there exists some cause-and-effect relationship: If management does X, Y is
likely to occur. Without a business plan, however, due diligence to determine
the feasibility of management™s assumptions becomes even more subjective
than it is. For example, assessment of the market potential, which drives all
cash flow forecasting, becomes sheer speculation. The caveat is this:
Everything that works is simple; but achieving simple is difficult. The busi-
ness plan is essential because it assesses the true workability of an early-stage
venture.
Because experienced, sophisticated investors find risk distasteful, they
minimize it in every way possible. Nothing minimizes risk more than the
business plan. But the business plan also works to the advantage of the en-
trepreneur, enabling him or her to achieve two critical goals: recruiting tal-
ent and raising capital. The business plan achieves these two goals because
nothing better explains the entrepreneur™s concept and vision. It helps cap-
ture the attention of the investor, defines the argument, and forces the entre-
125
What Do Private Investors Look for in a Deal?


preneur to define the opportunity, strategy, resource requirements, and risks
of the venture.
The business plan acts as a resume for the venture. In the entrepreneur™s
absence, it sends a host of messages to the private venture investor, messages
about the management team™s grasp of reality, its ability to assess opportu-
nity and risk, its clarity of thinking and communication, and its overall ef-
fectiveness. The business plan helps the entrepreneur define goals and
strategies, while it helps the investor evaluate the company™s potential.
A clear, professional, realistic, and comprehensive business plan is indis-
pensable to entrepreneurs for raising capital, generating investor excitement,
and getting their foot in the door for meetings with prospective investors. We
refer the reader to Appendix A on how to draft an investor-oriented business
plan and how to deliver an investor-oriented presentation.
The quality of the management team”its perseverance, possession of
requisite skills and good judgment, decency, competence, track record, per-
sonal financial commitment, and desire to succeed”rewinds itself in the
minds of private investors as few things do. As we pointed out in our
fund-raising strategy, hardly anything is more important. Also indispensable
to the team members from the investor™s viewpoint is their burning desire to
succeed. The spark must glow; else the entire venture soon dims. Extraordi-
nary management who listen and who can work constructively and collabo-
ratively with investors, who exude enthusiasm, who are trustworthy, and
who can weather a due diligence background investigation are important to
getting financed. The investor, at bottom, has to like you personally, for peo-
ple have always sought relationships with those who improve our image of
ourselves. This is what we mean when we call an entrepreneur “acceptable.”
In addition, investors need to feel comfortable with a particular level of
active/passive involvement. They look for something in their price range,
that is, a venture carrying not only affordable losses but a venture affordable
in current and later rounds without undue dilution. For some investors a
venture needs to be geographically proximate (within 300 miles). The crite-
ria of private investors must also allow for incremental funding based on per-
formance. A subset of this criteria is that the deal not be subject to high levels
of capital intensity, meaning that the requirement that large amounts of cap-
ital be invested before proof of the concept and customer acceptance.
Another requirement involves reciprocal due diligence on the part of both in-
vestor and entrepreneur.
These investors are interested in early-stage ventures with the potential
to develop into significant entities that will ultimately be attractive to either
the public marketplace or acquisition by or merger with an operating com-
pany. These investors are also interested in sustainable companies that can
pay back investors from cash flows and retained earnings over time.
126 UNDERSTANDING THE ANGEL INVESTOR


COMMON REASONS WHY ANGELS REJECT
AN INVESTMENT
Just as investors ardently scan a venture hoping they find certain features, they
assiduously avoid others. These investors have shared their reasons with
us, reasons that span the range of weaknesses inherent in this type of invest-
ing. For one thing, avoiding a mistake in this type of investing is more impor-
tant to the private investor than picking a runaway winner. Since these
investors make only about one to four investments a year, a single poor in-
vestment can collapse heavily on the investor. Unlike a venture capital firm,
which makes perhaps 15 investments in a year and can absorb a hit, the direct,
private investor must take great care with each investment. Therefore, the
philosophy of the venture capital firm does not apply to our private investor.
Obviously, investors want a return on their investments, with a mini-
mum return in today™s market of 30 percent. If a venture does not show
enough potential, if the margins simply are not there, the risk/return ratio is
not adequate to attract investors. In some instances, as we indicated earlier,
people get funded, not business plans. Therefore, if chemistry or mutual re-
spect is lacking in the management team, if credentials seem weak, if no track
record exists, an investor™s rejection is almost sure to follow.
Remember that these people want to enjoy making money, so they are
looking for something different, not boring. If they do not understand the
business; if, for them, the venture is too technical; if they cannot embrace the
technology, wrap their arms around it”these too are reasons for not invest-
ing. The venture has to strike their fancy. Although not all investors feel the
need to have a deep familiarity with the industry, many do wish to invest in
areas they know and understand, be it in the technology itself, the applica-
tion of the technology, or the market the technology is aimed at. Their unfa-
miliarity with the business technology or the technology market can be a
reason for rejecting a venture. And some investors, especially the socially re-
sponsible (described among the types of investors in the next chapter), may
not see any value to the venture.
Private investors also reject possible investments because entrepreneurs
often overvalue their venture. In a VentureOne study of median premoney
valuations by round class, analysts found that valuations have diminished
across all financing stages. By 2002, seed round valuations had declined to
$3 million, and first round financings were down to $9 million premoney.
These valuations were on completed deals.
Today it is unrealistic for entrepreneurs to have expectations of inflated
valuations, given losses investors suffered from investments made in the late
1990s at inflated valuations. Such unrealistic valuation can lead to a dis-
agreement between the entrepreneur and the investor on the price of the
127
What Do Private Investors Look for in a Deal?


transaction. Some entrepreneurs, aided by the omnipresent spreadsheet pro-
gram, develop cash flow projections on which they forecast exorbitant re-
turns on investment. Such forecasts are driven by wishful thinking. These
poorly developed assumptions, used to drive discounted cash flow estimates
of value, are a major reason why private investors reject financial propos-
als”and the accompanying ventures.
Private investors reject investment opportunities for additional reasons,
referred to in connection with investor criteria. Entrepreneurs who lack
the fire characteristic of people who believe in their venture will face disap-
pointment. These investors want to see a spark waxing, not waning. Also,
for some investors, the proximity of the venture to their home or business
figures prominently in accepting or rejecting an investment. The need
for missionary selling can be a reason why investors reject investments.
Lastly, these investors must believe there is a market that will support the
growth of the venture, that will provide a worthwhile rate of return within a
reasonable time.
Less well understood is the role assessed risk plays in rejecting a deal,
and that investors evaluate risk along a number of different dimensions. One
is the team risk and whether the management team will stick together.

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