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gambling obsession: the exhilaration experienced just before the check is
written. This is another compulsion not to be underestimated.
Another motivation involves the sheer joy of high-risk investments.
Possibly adding to a fledgling company™s success has returns well beyond
ROI. Investors participate in the joy of giving by working closely with entre-
preneurs who appreciate their accomplishments, experience, knowledge, and
the added value they bring to the dynamic early-stage, creative environment
venture. Being part of a start-up, giving birth to a venture, being instrumental
in transforming a dream into reality are not experiences to be undervalued.
As Osnabrugge and Robinson state, playing a role in the entrepreneurial
process is an “influential motivation.” Doing something the investor has al-
ready accomplished, and something he or she wishes to do again, can be
pleasurable, creating in the investor a sense of satisfaction beyond the money
returns involved. For successful entrepreneurs who have the potential to be
angels, being shunted aside is a much less desirable alternative in life.
Last, but important, however, is the motivating power of ROI. One in-
vestor offers in Exhibit 6.7 the rules of thumb in alerting entrepreneurs to
the levels generally regarded by investors as acceptable rates on return by
venture stage. At the seed/start-up stage, for example, an investor is looking
for a compounded, annualized rate of return of 60 to 100 percent, while at
the bridge-to-cash-out stage, the expected rate of return is measured at only
20 percent.
Compare these “rules of thumb” return expectation levels with actual
returns of one professional venture fund over 10 years: total loss, 11.5 per-
cent; partial loss, 23 percent; break even, 30 percent; two to five times in-

EXHIBIT 6.7 Stages of Venture Capital

Rule-of-Thumb Required Return
Description Internal Rate of Return*
Stage of Development Anticipated Rates of Return
Seed/start-up 60%“100%
Development + mgt. team 50%“60%
Revenues/expansion 40%“50%
Profitable/cash-poor 30%“40%
Rapid growth 25%“35%
Bridge to cash out 20%+

*Before applying subjective factors.

vestment returned, 19.8 percent; five to ten times investment returned, 8.9
percent; ten times or more investment returned, 6.8 percent. These returns
are cash on cash plus capital gains. It™s fun to make money!
Given the level of returns, and potential for loss, it is easy to understand
how prospective investors may not share the entrepreneur™s level of optimism
for the venture™s success. Successful, sophisticated venture investors are
risk-averse, quick to discount projections in reviewing proposals. Also, as we
have suggested, investors also find that management teams of early-stage en-
terprises rarely forecast cash requirements accurately. Investors realize that
unforeseen follow-on financing is lurking about.
The motivation to take charge of the stock selection process has to do
with a trend in the brokerage industry to avoid or circumvent retail brokers
and personally assume a more active role by using the information available
through various resources, for example, the Internet, trade papers, and mag-
azines. The idea is to take more control in managing one™s portfolio. This
type of investing allows for ways to diversify based on past experience, a way
to control the placement of a percentage of one™s portfolio, or a way to steer
a portfolio percentage into other equity areas, perhaps increasing the rate of
return. People today are taking on the responsibility of managing their re-
tirement, of choosing mutual funds and other asset classes for their various
retirement accounts. The desire for increased control, using technology and
available information, fuels this type of investing, which gets the investor
more deeply involved in the selection process and more directly involved in
the deal.


Since the founding of ICR in 1989, one of the authors has interacted with
more than 4,000 entrepreneurs. A review of the results of the fund-raising ef-
What Do Private Investors Look for in a Deal?

forts of these past clients and contacts suggests that the most accurate pre-
dictor of an entrepreneur™s success at raising capital is having successfully
raised capital in the past. Based on an informal review of 4,000 records, 65
percent of those entrepreneurs who went on to successfully raise capital in
their current rounds had raised capital previously from family, friends, co-
founders, and angels and/or professional venture capitalists. If you are
among the 35 percent who have not yet raised capital from family and
friends, who have not been subjected to thorough due diligence, or perhaps
who have raised capital but did so before the dot-com bubble burst, stock
market meltdown, and recession, just what do these findings mean to you?
We contend that by understanding what goes into the investor™s decision
making, entrepreneurs will be better able to position their ventures, docu-
mentation, offerings, and fund-raising presentations, and so increase the
probability of a successful financing outcome. How investors have decided
to allocate their financial resources will influence whether a private deal will
be appropriate for their serious consideration.
An investor™s allocation decision is, of course, intrinsically tied to port-
folio management. The private investor is not investing an entire life™s
savings in a single venture. We have never met a sophisticated investor who
had not developed an investment plan. Such planning encompasses such el-
ements as (1) defining the industries, markets, and technologies they under-
stand; (2) specifying a geographic region of interest; (3) forming an informal
network of co-investors; (4) establishing a target compound rate of return
(or multiple); (5) clarifying procedures for protecting themselves from loss,
for example, hedging strategies; and (6) knowing preferred liquidity (exit)
Based on research of ICR™s investor database, early-stage or high-net-
worth high-risk investors also invest in a range of assets, including corporate
stock, real estate, cash (e.g., CD and money market accounts), noncorporate
business assets, bonds, notes and mortgages, life insurance, and other assets.
So while it is true that angels are interested in investing in liquid and rela-
tively liquid assets, they are also interested in investing in private equity,
which boasts a range of alternative asset classes, including seed, R&D,
start-up, first-stage, expansion stage, mezzanine, bridge, acquisition/merg-
ers, turnaround, special investment situations, and distressed securities (e.g.,
junk bonds).
Strong evidence suggests that these investors place a small percentage of
their money in higher-risk deals”about three to five percent of their equity
portfolio. High-caliber money managers confess that they always leave some
money for the client to manage, money for clients to invest on their own. It
is this “crazy” money that represents their discretionary resource for invest-
ments in higher-risk deals. So it is the individual™s allocation decision that in-
fluences where private equity investment ends up.

As we have stated, angels do possess an investment strategy and”con-
trary to the erroneous belief of many entrepreneurs”this type of investment
is not a crapshoot. The key to understanding angel investment strategy can
be found within the concept of allocation decision. Asset allocation, which
determines how your portfolio is divided among stocks, bonds, and cash
equivalents, each of which differ according to the risks involved and the re-
wards they offer, is a critical component of angel investment strategy. If the
concept of financial planning is essentially analogous to a road map, then
asset allocation is the road itself. Angel investors are typically diversifying
their equity portfolio by placing a small percentage of the money allocated
for equity investments directly into private deals. Based on our research, this
ranges from three to five percent.
Alternative investments, which generally have a low correlation to per-
formance of the public stock markets, are extremely useful for high-net-
worth investors seeking diversification, performance enhancement, portfolio
predictability, and risk reduction. What many entrepreneurs fail to appreci-
ate is that by following the extensive angel investment process model that we
have identified and relate in Part 4”the process used by sophisticated an-
gels”many investors are able to manage risk of investment into early-stage
companies. Although 33 percent of the time these investors report loss of
capital, 66 percent of the time they are getting some or all of their investment
back, or earning returns from savings and CD account levels through highly
significant multiples of ROI.
To better demonstrate this point, consider the array of hedging strategies
that investors use to help manage risk in private deals. Angels hedge their
risk using a number of unique risk-management strategies, including co-in-
vestment strategies or sharing the risk with other investors even when the in-
vestor has the financial ability to fund considerable portions of the
investment transaction alone. Hedging strategy also can include the devel-
opment of a diversified portfolio allocation strategy, whether it™s along geo-
graphic lines or industry lines, stage of development, or some other criteria
inherent in the private equity portfolio to create diversification. In addition,
investors manage their investment size and use milestones and phased in-
vestment to ensure that the company is meeting its milestones before putting
in the investor™s full financial capability. The angel investor becomes further
actively involved in the venture. He does this in a constructive way by adding
value and defining a role in which he can make a contribution, one that al-
lows him to remain in close touch with the venture in a constructive capacity,
allowing him or her to monitor the venture to identify any potential prob-
lems before they begin to drive the company. Angels are adept at developing
deal structures, that is, terms and conditions that help to moderate some of
the risk; for example, obtaining a liquidation preference, or insuring through
What Do Private Investors Look for in a Deal?

their negotiation of the investment arrangement a multiple on investment be-
fore proceeds from the company sale or asset sale or other liquidity event
would provide an ROI to earlier-round investors.
Furthermore, angels are careful to not invest in deals without complete
and competent business plans that include explanations of business strategy,
a clear revenue model, adequate financials, and clear valuation assumptions.
Typically, angel investors will have advisers to handle aspects of the invest-
ment due diligence process, and sometimes investors will get involved in
angel investment groups, formal and informal, to take advantage of the con-
cept that “two heads are better than one,” meaning that they will share some
of the monetary risk, due diligence exercise, and deal finding with other re-
spected investors. And last, angels will sometimes wait for established lead
investors to negotiate the terms of a transaction before considering adding
the company to their private portfolio”an approach used not only by pas-
sive investors. One need only ask entrepreneurs who have heard from in-
vestors that they must “find someone else to be a lead investor; then come
back and I™ll look at the deal.”
It is also important to remember that alternative investments do not
track the public market and so can still provide returns regardless of devel-
opments within the public market. Individuals have made investments into
companies in specific industries that are not doing well in the public stock
markets, yet at the micro, or private level, these companies will still be per-
forming profitably and will potentially provide returns to the angel.
Exhibit 6.8 shows the specific elements that influence the decision to in-
vest in a particular venture.
First, the investment in a particular company must match the investment
strategy of the individual investor. If the investor desires income, he or she
will invest in a subordinated note providing interest or perhaps in preferred
stock providing a dividend. If the capital strategy is to generate capital ap-
preciation and capital gains, the investment will be in a common or preferred
equity deal, requiring the investor to hold that position for a period of five to
eight years, hoping that the stock will increase in value.

EXHIBIT 6.8 The Allocation Decision

• Match investment strategy
• Stage of life
• Risk posture
• Part of business cycle of interest (experience)
• Relative attractiveness of participatory investing
• Net worth, income, liquid financial assets on hand

Another factor in the allocation decision reflects the investor™s stage of
life. Investors in their early thirties are concerned about buying a house, sav-
ing for a child™s education, buying a boat, taking a grand vacation, or per-
haps buying jewelry or art. These investors, in other words, are less likely to
have the discretionary income necessary to make these kinds of investments.
However, by the time these investors have reached their late forties to late
fifties, the kids are out of school, the house is paid off, and more discre-
tionary income or net worth is available. So more discretionary income or
net worth becomes available at a time when their income has increased or
has reached its peak. Thus, the stage of life of investors has a significant im-
pact on the allocation decision. Remember, too, that based on one™s age, dif-
ferent hold times for investments are palatable.
Additional impact arises from the investor™s proclivity for risk. One who
can stomach the ambiguity associated with the earlier-stage deals will likely
sport an aggressive risk posture, a willingness to invest in an early-stage deal,
preseed, seed, or start-up. One who cannot stomach the ambiguity and
risk”despite having the money”probably will gravitate to later-stage pri-
vate equity transactions, such as a leverage buyout of an existing company,
one that has a financial history, or to a mezzanine financing with a higher
level of confidence in payoff in 18 to 24 months.
Another aspect of the allocation decision of private investments is the in-
vestor™s experience in various stages of the investment cycle. An investor is
like a physician: The doctor who feels engaged in the early stages of life is
likely to go into pediatrics, while another physician might opt for taking care
of the elderly. In the same way, a private investor may like to associate with
early-stage companies, reflecting his or her earlier successful experience, per-
haps as president of an early-stage company.
Investors tend to let their background experience guide them in assess-
ing risk. They are inclined to compare their experience in various stages of
the company life cycle with potential venture investments, and gravitate
to ventures at stages of development they are familiar with. We know other
investors who have had great success in turning around old, staid, bureau-
cratic enterprises. So if we take an early-stage deal to someone who has been
president of a large corporation, he or she may not understand or may feel
uncomfortable. There simply may be no grasp of the interpersonal relation-
ships, or the political and emotional dynamics, of such an enterprise. Two
things have to fit: the stage of the company in the business cycle that the par-
ticular investment represents and the experience of the individual investor.
Next in the allocation decision is the relative attractiveness of the partic-
ipatory investment. As we have indicated, value-added investing means more
than supplying capital, particularly for an individual participatory invest-
ment that is a time-intensive activity. One of the reasons venture capitalists
What Do Private Investors Look for in a Deal?

have moved out of such investments is not only that venture capital funds
have become much larger, but that those individuals managing the funds do
not have the time to sit on five or ten boards. The private investor is looking
for that participatory role most likely to furnish the necessary level of in-
volvement. So the relative attractiveness of this type of time commitment”a
value-added commitment beyond the element of money”is a prominent
component of the allocation decision.
Last, but centrally important to the allocation decision, are the levels of
the investor™s net worth, income, and liquid financial assets”the tendons of
the entire investment process.


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