1st Round

The founders hold a total of 700,000 shares of the company. You’re eager to play so you offer to buy, on the spot, 30% of the company for $300,000 (or 300,000 new shares at $1 per share).

A year later, the dot-com bubble bursts and the startup is no longer sexy. Luckily for you, it’s at least meeting milestones and generating a little revenue. But cash is tight and it needs to raise additional capital to survive – and it needs it fast. So you make a few calls to Ken, who later agrees to inject some cash into the startup, but at a price lower than what you’d originally paid.

2nd Round

Ken offers to invest $500,000 in exchange for 50% for the company. This works out to 1,000,000 new shares issued at $0.5 per share. Since the stock price has dropped from $1 in the 1st round to $0.5 in the 2nd round, your 300,000 shares now only worth $150,000 ($0.5/share x 300,000 shares) rather than $300,000.

This is called a “down round,” which results in a lower price per share and decreases the value of your holding. But neither you nor the startup has a choice – it’s either down round or down six feet under. Yea, you guys are feeling pretty down, too.

A syndicate of good guys

It’s not uncommon for a group of angel investors to form a syndicate, or for a single angel to join a syndicate, with the purpose of loaning a relatively large sum to a single startup company. (For those of you who are hooked on film noir, who own copies of Chicago Syndicate and The Big Heat, and who consequently believe that the word “syndicate” spells trouble – it’s time to move on.) In the world of finance, there is nothing underhanded or shady about syndicated investing.

It’s a simple concept: a syndicate is an alliance that brings together a large collection of angel investors to invest in a particular startup; they share the risk, and they’ll eventually share in returns from their investment. In most cases, one angel group will take the lead in deciding whether to form an investing syndicate; the group’s leadership will decide who they want to invite to join the syndicate and they’ll coordinate the syndicate’s activities.

None of us is as strong as all of us

Some angel investors say they no longer approach their investments from an individual perspective; instead, they make business deals in association with an angel organization of some sort. Their reasoning is pretty solid. The collective wisdom of the group is focused on screening every startup for potential. Each member of the group brings a distinct set of skills and experiences that will add to the overall strength of the group. And for new angels, working with an angel group is the perfect classroom to learn the ropes.

Angel groups can be formally organized (you call your lawyers and they draw up the paperwork to form an LLC or some other legal entity) or they can be a more informal, member-managed group (you’re probably still going to want to consult with legal counsel). And at some point, an angel group may make the decision to join with another group to take advantage of a particular investment opportunity.

Before you become a syndicated investor, you probably will want to work with a legal expert who specializes in financial services who can put together the details of the syndicate. Then, of course, you must make yourself entirely familiar with the terms of the agreement to ensure that your investment offers many of the same rights and privileges as an individual angel. Along the way, you may find value in the words of poet Alexander Pope, who tells us, “There is a certain majesty in simplicity . . .” (A brief interpretation for those lacking in poetic spirit: keep it simple.)

What exactly is a “seed” company? What about “seed” capital?

Startups, Philosophers and Seeds

Go figure – it took a 19th century poet and philosopher to capture the thought process of a 21st century angel investor making a financial commitment at the seed stage of a technology startup. Henry David Thoreau summed the situation up pretty well when he wrote, “Convince me that you have a seed there, and I am prepared to expect wonders.” Odds are, Thoreau had something very different in mind when he wrote (he was more into the simple things in life); still, his thoughts give us a jumping-off place for a discussion about startups and seeds.

From a little seed . . .

Thoreau’s words pretty well sum up the potential and promise of a startup company in its seed stage. The seed stage can be a perilous time for the entrepreneur, a period when the business may have little to show for itself. It’s no wonder, then, that a seed stage entrepreneur often finds it difficult to round up financing at this most critical point.

A thoughtful angel investor might want to make a mental note of Thoreau’s words because wonders do happen. A solid seed stage is essential to the enterprise’s successful future. An analogy that draws on the work of Mother Nature and Old MacDonald may help: in the earliest days of the life cycle of green, growing things – corn, for instance – small seeds fall (or are thrust) into the ground. Assuming Old MacDonald does his job well and creates the proper conditions for his seeds, they sprout and eventually develop into beautiful, tall stalks of corn.

Capital – seed for business

Seed capital is that money that entrepreneurs need to get their business idea into practice. To get started, the company’s founders will pump all their resources into the enterprise, then call on friends and family for additional support. Many successful startups wake up one day with the knowledge that outside financing is going to make the difference between growing the business or letting it wilt on the vine.

Quite often, an angel investor provides funds at that crucial point in the venture. The startup requires sustenance – in this case, capital – to support product development and market research. As an angel investor and part owner (you receive a piece of the business in return for your financial investment), you may be able to touch a prototype or see a demonstration, but oftentimes there is no mass production of products or services to sell at this point.

Angel investing at the seed stage is not a matter of blind faith: when you do your investment homework thoroughly, you are more likely to be able to sort the strong seeds from the duds.

I am interested in becoming a full-time investor and am learning the ropes. What are the differences between an angel investor and a venture capitalist? It seems like they are doing the same thing, more or less …

As you learn more about private investing, you will come across a couple of terms, angel investor and venture capitalist, that seem the same, but somehow different. Don’t let the language confuse you.

Angels are Like Venture Capitalists Because . . .

• Opportunities exist in a variety of markets around the globe for both angel investors and venture capitalists. Just a short while ago, green technology was the ‘hot field of investment’ and environmentally conscious startups created plenty of chances for angels and venture capitalists to “go green” with their investments.
• Angel investor or venture capitalist, you should expect when you invest in a startup company that you’ll be part of the program for a while, typically 3 to 7 years. Naturally, you want to stay on top of your investment, attend meetings, ask questions; at the same time, have patience and give the enterprise time to mature and grow. Rome wasn’t built in a week or a month, yet most people agree that the result was worth the wait.
• Critical evaluation of the startup is a necessary first step for any investor, angel or venture capitalist. It may seem more like homework than high finance, but successful investors insist that you must size up a number of factors, including the business environment, the players, and the nature of the deal. Console yourself with the knowledge that yesterday’s nerds drive slick cars and vacation on Bimini today.
• No one can predict the future. Angel investors and venture capitalists all experience setbacks – in other words, the thing never gets off the ground and the investor loses money. Knowledgeable angels recommend spreading your investments around several startups; one spectacular success can offset other, less spectacular, projects.

Angel Investors are Different

• Venture capitalists most often are associated with a professional investment firm. An angel investor usually acts solo. Does this mean you’re not a professional investor or that you’re hung out on a limb, all by yourself? Absolutely not – you can launch your own LLC, join an angel group, or syndicate with other angels to fund a promising startup company. In fact, angels in the know say it’s best to pool your resources and experience with other experienced investors.
• You, the angel investor, will use cash from your own pocket, or bank account, to fund your deals. When it comes to your investment business, you are the boss. Venture capitalist firms usually solicit working capital from insurance companies, pension funds and other large investors. The venture capital firm is the general partner, the investors are limited partners.
• Angel investors are often more willing to fund innovative startups in the very earliest stages of development and with no track record. Venture capitalists are not so easy-going; they want a bit more history behind their prospects. That isn’t to say that angel investors are “financiers gone wild”; it simply suggests that you’re willing to look at proposals that might not even get in the door at a venture capital firm.
• Venture capital firms are highly organized enterprises that put together deals in excess of $4 million. With the exception of organized angel groups, you and your fellow angel investors are usually informally coordinated, and your investment in a single deal will be smaller, ranging from US$10,000 to US$200,000 per individual angel. According to a survey of Angel Capital Association members, the average pooled investment in 2008 was US$281,000.

Who’s Running This Show?

In a word, everything. This article in no way suggests that the above-referenced start-up is not a worthy investment opportunity. The thing is, you have no way of knowing at this point. The founder does invite interested angels to get in touch for more information. So pretend that you have done just that; what is the first thing you say to her? How about, “Let’s hear your pitch.” Then drill down to learn about her management team and their ability to launch successfully.

The management team is one of the most, if not the most, important components of any business: they’re the folks who should have the experience and know-how to keep the enterprise afloat. Who are the team members? What is each individual’s industry background?

101 Questions

When you‘ve dug into each executive’s background, you should be convinced that this group of individuals will be able to work together to make the business a success. Learn about them with these questions in mind:

• Does at least one person among the leadership group have demonstrated experience in the industry? Are they qualified?
• Does the team include the right mix of knowledge and skills to manage the company successfully? Are they capable?
• Do team members share a vision for the future of the business? Are they playing from the same page?

These entrepreneurial wizards are asking you to invest in their business; you are entitled to ask questions of them to reassure yourself that they know what they’re doing. Talk with members of the management team; ask them all of your hard questions and get more details about them and the business.

Always remember, this is your money we’re talking about, and you want to invest it wisely. Take a close look at these people. Confirm their competence and integrity. If they can’t give you acceptable answers, or if they choose not to reply, think twice about letting them use your angel wings.

Editor’s Note: New angel investors often place significant focus on a startup’s business plan. This is justifiable — you want to learn all you can before making your first investment and want to make sure the startup knows where it’s headed. This post is intended to help new angels who want to look for some of the most basic elements of a functional startup. But keep in mind that everything in the plan is subject to change. From the business models and company processes to the competitive landscape, nothing will remain static forever. Once you gain more confidence and experience in the angel business, you may want to focus instead on the way the entrepreneur presents her business ideas. That is, the way she pitches you. Just replace “business plan” with “pitch” in this post and you’ll get a general idea of what to look for in a pitch. More on that later.

It’s tough to know where to put money these days. Interest rates are low, the markets are all over the place, and the price of gold is through the roof. It could be that you’ll find some of your best opportunities as an angel investor supporting a start-up company. If that’s the path you’re taking, you will naturally spend time reviewing business plans to identify an appropriate candidate. Take your time, and ask the right questions. The business description should answer a couple of big ones.

To What End?

The first questions you might want to ask of your prospective are “What?” and “Why?” That is, what is the purpose of this enterprise, what does it do, and why is it destined to be a winner? The business plan should make very clear the concept behind this start-up. It should identify the firm’s competitive market or industry and it should describe that industry’s playing field and the firm’s position on the field. Most important, it should explain why this particular firm will succeed in its market.

An anecdote from US history may help to illustrate. Once upon a time, in the 19th century, an enterprising gentleman built and buried a large statue of a man, and when it was “discovered,” he convinced locals they were looking at the remains of a giant. People lined up to pay for the privilege of looking on this marvel, the so-called Cardiff Giant. After attempting unsuccessfully to acquire the statue for his own use, promoter P.T. Barnum built a statue of his own, proclaimed it to be the one true giant, and won an even larger following.

A Grand Design

Mr. Barnum may or may not have produced a formal document that detailed his “giant” project, but there can be little doubt he had a plan, one that included a very clear concept and purpose. He knew his industry – entertainment – quite well, and he knew that the Cardiff Giant had already proved to be entertaining. He also understood his challenge: to make his second giant even more attractive to thrill-seekers than the original. A person might suppose that New York State wasn’t big enough for two phony giants, that Barnum and his statue would fail to find a niche. Not so. He played to his strengths and carved out a niche using creativity and ingenuity.

The point is this: your start-up client should tell you up front in his business plan where his company is situated in the world of business and how he plans to compete successfully with the other guys. He should tell you exactly what the company is and how it is special in its industry. In short, when you have finished reading your start-up’s business description, you should have a sharp picture of the idea behind the business, the product or service it proposes to market, and its competitive advantage. The second giant should make perfect sense as a business proposition.

Angel Who? Invest Where?

It works something like this: you attend an industry event (or maybe a cocktail party) where you encounter a brilliant and enthusiastic entrepreneur in the process of launching a new venture. It’s clear to you that the business is on track to succeed if the owner can scrape together enough capital to get the thing off the ground. The two of you might be made for each other. She’s looking for investors, and you’re looking for an investment opportunity.

Before you slam the door on this one, give it a bit more thought. It’s true, you want in, but you’re scared – you’re fairly certain you’ve never done this sort of thing before. It’s pretty simple, really. As an angel investor, that is, an individual with capital (money in hand), you agree to lend financial backing to a promising start-up business, preferably one in a high-growth industry with tremendous upward momentum. The angel (in this case, you) invests personal funds and gets a stake in the new company in return (usually bonds that must be repaid at a specified date in the future or ownership in the form of stock shares).

Angel Research

Naturally, you’ll do your homework before making the decision to become an angel investor. You want to be as certain as humanly possible that you’re putting your money in an enterprise that will make more money for you, so don’t strap on those angel wings until you have thoroughly reviewed the company’s potential for growth. Learn all you can about the skill and experience of the management team. Ask about everything, and don’t be shy about it; and when you have picked over every detail of the start-up’s files, learn more from outside sources.

As an angel investor, you have some flexibility to name additional terms for investing in start-up enterprises. At the very least, demand regular communication and updates on the status of business, and make sure you define “regular.” Maybe you want a seat on the board. You may be an angel, but that doesn’t mean you can’t negotiate terms.

If this is sounding good, but you’re pretty certain your modest nest egg won’t be attractive to a start-up business, consider forming an angel investor pool. That’s right, invite your friends and acquaintances to join you.