This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Photo: AGeekMom

The loan is “converted” as if investors had literally put money in that equity round. Because investors take an early risk to invest in an unproven company, they usually receive a discount when their notes convert.

“Sometimes the notes come with warrant coverage and/or other features that are designed to provide additional benefits to the early investors,” says Riaz Karamali, partner at Sheppard Mullin Richter & Hampton LLP. [7] We’ll cover investment terms in Part 5, Term Sheet Negotiations.

Defer Valuation

With convertible notes, investors are essentially lending money to the company until an event triggers a debt-to-equity conversion. Because they are loaning money rather than investing in equities, they don’t need to determine valuation, or price per share, of the company at the time of their investment. The valuation is deferred until the company raises an A round, in which VCs come in and establish a value for the company.

In other words, angels can use convertible notes to invest now, and let the VCs do all the valuation work when they come in later. The ability to defer valuation is arguably one of the main benefits of using convertible notes. Startups, by definition, have virtually little or no sale records and financial histories, which makes them nearly impossible to value.

From Creditor to Shareholder

If a company successfully raises an A round, the entire principal amount of the angels’ notes, plus any accrued and unpaid interest, will be converted, usually at a discount, into equity. Upon conversion, they will become a stockholder instead of a creditor and thus get to enjoy the potential capital gains of owning stocks.

Similarly, the company is a “debtor” who owes the angels money until the notes are repaid, plus interest, or until the notes are converted into stocks. Once the notes are converted, the company becomes the angels’ investee instead of a debtor.

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Image by: judepics

Now, let’s turn our heads to the fanta-bulous entrepreneurs and find out how they can benefit from royalty based financing. We’ll deal with its downsides later in the series.

This is Part 6 of an 8-part series on royalty or revenue-based investment (or “royalty based financing”). Please visit Part 1 for links to the entire series.

More Control. Entrepreneurs aren’t forced to sell. They can maintain control and ownership of the company. This allows them to spend more energy on executing their business plan rather than chasing the all-important exit, writes Gregory T. Huang of Xconomy.

Minimal Dilution. Warrants give investors the right to purchase a certain amount of the company’s equity at a stated price so ownership dilution is minimal. This may give management more incentives to build a durable company with solid, profitable revenue streams — the most important criterion to qualify for royalty based investment.

Deductible Expenses. Just like debt, Rockwater Capital points out that payments exceeding original principal are deductible expenses for the company.

Obtain Growth Capital. Not only can entrepreneurs obtain funds that they mightn’t be able to obtain otherwise, but they can do so without requiring personal guarantees from management or equity owners, says Jeff Joseph of VenturePopulist.

“[Royalty based financing] offers growth capital to companies that can’t participate in debt or equity [financing],” comments Jeff Schrock, a VC at Intel Capital.

Andrew Clapp of royalty based investment firm Arctaris Capital Partners points out that the model is “better suited for the company needing debt to replace the bank line it may have lost or had reduced during the recession.”

Flexible Repayment. Royalty based financing “is less onerous that debt because it is variable to revenues,” notes Joseph. Instead of paying a fixed amount on a strict schedule, companies have more flexibility in the amount they repay. The more sales they make, the more they repay, vice versa.

Valuation Avoidance. Because royalty based financing is a loan at its core, the company borrows money instead of sells equity. So there’s no need to put a price tag on the company, which eliminates the awkward and sensitive discussion on how much the company is worth.

Royalty Based Financing vs. Other Financing Methods

A table by royalty based investment firm RevenueLoan, comparing royalty based financing to other financing methods:

Next, we’ll study the drawbacks of the approach for both investors and entrepreneurs.

Previous articles in this series:

• Angel Investing: Exit Dependent Investment Models provides an overview of two exit-dependent investment models used by equity investors and addresses why some investors are testing a new investment vehicle that doesn’t depend on exits.
• Angel Investing: Royalty Based Investment Features “Built-In” Exits goes through the revenue-based model’s “build-in” exit feature and looks at an example of how the investment model works.
• Angel Investing: Components of Royalty Based Investment Model looks into the debt and equity components of the vehicle.
• Royalty Based Investment Works Best on These Companies outlines the repayment structures and some basic investment terms.
• Royalty Based Investment: What’s in It for Angel Investors breaks down why the approach may be beneficial to investors.

Image by: Juliana Coutinho

This is Part 5 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.

So what are the main features that turn some investors into a huge fan of the royalty based approach? Let’s take a look.

(Yes, we’ll go over the drawbacks later in the series.)

Before you proceed, we humbly suggest that you read these articles to put things into context:

• Angel Investing: Exit Dependent Investment Models provides an overview of 2 exit-dependent investment models used by equity investors and addresses why some investors are testing a new investment vehicle that doesn’t depend on exits.
• Angel Investing: Royalty Based Investment Features “Built-In” Exits goes through its “build-in” exit feature and looks at an example of how royalty based investment (or “royalty based financing”) works.
• Angel Investing: Components of Royalty Based Investment Model looks into the debt and equity components of the vehicle.
• Royalty Based Investment Works Best on These Companies outlines the repayment structures and some basic investment terms.

Royalty Based Investment: Benefits for Investors

Big Market. The kind of companies that fit this model are those “that have annual revenues of a few million dollars but have modest annual growth rates — 20 percent, say — that won’t attract VCs, who are searching for 10x home-run returns,” explained Andy Sack of RevenueLoan.

“We’re going after a segment that is today underserved by traditional equity like VCs and banks,” Sack said. “It’s a huge market.”

Built-In Exit. Rather than relying on an exit (M&A or IPO), royalty-based investment features a “built-in exit strategy,” according to Rockwater Capital.

“Royalty payments are typically made monthly, and begin shortly following the infusion of capital,” explains Rockwater Capital. “Companies pay as they go, paying more as they grow” until you’ve achieved a fixed multiple return on your investment.

“Instead of waiting five or 10 years for a startup to go public or get acquired, an investor can start seeing returns almost immediately,” says Gregory T. Huang of Xconomy.

Huang goes on to quote Arthur Fox, the god father of royalty based investment and the founder of Royalty Capital Management:

“When you invest in a company, buying stock and equity, you have no way of getting out unless they become significantly large enough to have a liquidity event.”

With the new approach, he says, “every month you get a check, and it doesn’t matter if they ever have an IPO, or get bought out.”

Early Evaluation. Huang continues with Fox’s biggest win and notes how this approach can get your foot in the door of promising companies:

His biggest win was Andover Advanced Technologies, a multimedia software startup that had no revenues when he originally invested $100,000 in 1993.

After two years, Fox had gotten back $125,000 in his cut of the revenues, and he invested in a second round with an angel investor, in which he took some equity.

The company (renamed Andover.net) went on to ride the dot-com wave with a successful IPO in 1999, and was acquired for $1 billion by VA Linux Systems in 2000. Fox’s stock ended up being worth $15 million.

It’s an example, he says, of how “royalty investment lets you get your foot in the door, evaluate how the company is really doing, how management is doing, and you may have the opportunity to participate in a follow-up round with much more knowledge.”

Note: Though the royalty based approach got Fox in the door, it’s the traditional equity investment that gave him the significant upside. And let’s not forget that this happened during the dot-com wave.

As discussed in Angel Investing: Components of Royalty Based Investment Model, companies that sign up for royalty based financing are typically, though not always, those that don’t want to sell or give up ownership, or that aren’t IPO candidates.

If you want a home run or the potential for significant upside, you still need a conventional equity deal. The chance that these companies will exit via M&A or IPO is statistically less likely, says GigaOm columnist Brian McConnell.

More Stable Steam of Payments. Royalties are based on a percentage of the company’s gross revenue, not net profits. You’ll receive payments even if the company’s not profitable.

Higher Priority. Royalty based financing is a loan in its core. Because note/debt holders have a higher pecking order than shareholders in the event of default, you’ll be paid in full first before equity holders see a penny. Which means you’ll have a better chance getting all or some of your money back when the company liquidates its assets.

Upside Potentials. Through warrants, you can participate in the company’s upside if it does end up getting acquired or going public.

Warrants give you the right to purchase a small amount of the company’s equity at a stated price. The upside potential is much smaller than is the case with traditional equity based investment.

Valuation Avoidance. Similar to convertible debt, you’re loaning money to the company instead of buying its equity. This avoids the awkward discussion over valuation – a term that investors and entrepreneurs often have a hard time coming to an agreement on.

Next, we’ll examine the benefits of royalty based financing for entrepreneurs.

Missed it? Here’s a summary of the controversy, dubbed “AngelGate,” that’s created quite a stir in the startup and venture community.

Mission AngelGate: Bin 38 Secret Meeting

9.21.2010

It all started when Arrington barged into a “secret meeting” that took place at Bin 38, a posh restaurant and bar in San Francisco. According to Arrington, about a dozen investors gathered around a table in a private back room, “Godfather style.” Those in attendance are powerful players who’ve been responsible for almost all early-stage startup deals in Silicon Valley.

Adolf Hitler Finds Out Bin 38 AngelGate

Click here to view the embedded video.

“The Hitler video was genius.” — Dave McClure

When the uninvited blogger crashed their party they seemed nervous. Arrington was later tipped off by anonymous sources that these super angles have met on more than 1 occasion to discuss things like how to reduce deal valuations, and prevent new angel investors from grabbing market share and pushing valuations higher.

Dave McClure: Whining and Dining

9.22.2010

Dave McClure, one of the super angels in attendance, fired back with his usual colorful language and called these claims of collusion a conspiracy theory, saying that the meetings were just networking events for relationship building, shaking hands, and swapping notes.

Ron Conway: Private Email Leaked to TechCrunch

9.23.2010

Meanwhile, the most influential Silicon Valley super angel Ron Conway, who didn’t attend the meeting, sent a confidential email, which soon leaked to TechCrunch, to all those in attendance at the infamous Bin 38 dining event. He condemned their alleged collusion and insinuated that the members were unethical and despicable.

Conway’s motive was unclear. Some believe the legendary investor is genuine given his platinum reputation. Others think it’s a CYA (“Cover Your Ass”) email to distance himself from the allegations since his own firm’s David Lee has “uncomfortably” attended the meetings.

Dave McClure’s Private Tweet Accidentally Made Public. Oops!

9.23.2010

McClure accidentally tweeted his thoughts about the email.

TechCrunch reports:

McClure sent out a tweet earlier that was clearly meant to be a direct message. It read, “Ron is throwing us under a bus. and it’s chickenshit that he writes that after David Lee comes to both meetings.” He quickly deleted the tweet, but not before plenty of people saw it, responded to it, retweeted it, and it was syndicated elsewhere

This is sad. McClure actually liked Conway just fine before the AngelGate incident/misunderstanding. Here’s his retweet of our coverage on Conway’s character:

Wish we could pick sides – we can’t.

Conway and McClure Met Face to Face at TechCrunch Disrupt

9.27.2010

At TechCrunch Disrupt McClure and Conway sat next to each other and were expected by many to produce a heated debated. But Arrington promised not to turn the conference into an AngelGate platform. The 2 super angels also said the blogs and leaked emails have already covered what they wanted to say on the topic and they had nothing else to add.

But they weren’t done talking about it, according to MG Siegler of TechCrunch. There was noticeable tension between McClure and Conway at multiple times during the panel. You can find Siegler’s live notes from the panel at The Panel That Was Definitely, Maybe Not About AngelGate.

AngelGate Plausible? Price Fixing Needs Market Power

Let’s get back to price-fixing.

Chris Yeh, a “minor” angel, thinks that the claim is laughable. Dean Takahashi of VentureBeat reports Yeh’s reasoning and adds a few comments of his own:

[For] price fixing to work, you must have control of a market, just as OPEC controls oil production. [Chris] Yeh noted that the 10 or so super angels might have each had $50 million funds. That amounts to about half a percent of the $20 billion in angel investing that happens in the U.S. These super angels don’t have the market power to enforce a price-fixing scheme.

Add to this the fact that rising valuations of startups are good for angels. If valuations are rising, that means the market is heating up. Startups may command more money when they raise it. But they will also sell for more money. So why would the super angels try to fight market forces? That’s what makes the scheme so implausible. Arrington compared the meeting to a scene from the Godfather. But this is really more like the kind of scheme you would expect from Dr. Evil, the incompetent bad guy in the Austin Powers movies.

It reminds me of mobster movies such as Good Fellas, where even the mafia has trouble keeping a lid on the biggest secrets because there are always stool pigeons and undercover agents and braggarts who want to talk about their evil deeds. The lesson for those who want to commit clueless conspiracies is that there is always the danger that someone is going to leak the evil scheme to the world.

AngelGate or Not, No One Knows

Except those in attendance, no one knows whether the super angels have really been acting devilishly. But even the illusion of impropriety is enough to create quite a stir, especially considering how vocal the super angel community has been in its criticism of some VCs for their greed, arrogance, and lack of morals and ethics.

When angels band together for strength in numbers to support entrepreneurs, everyone considers it super. But if they gather in private as an organized crime syndicate engaged in activities that involve illegal price-fixing monopolies then they’ve definitely fallen from grace.

Who Wins?

Not angels; not entrepreneurs.

Bin 38, definitely. Crazy amount of free publicity. Yum.

Image by: Seth1492

There are two models in the field of technology transfer, says one veteran angel investor.

Innovations from research labs are either transferred to established corporations or startup ventures. The goal is to transform innovative technologies into marketable products and applications to promote economic growth and/or create money-making opportunities.

About 80 percent of lab technologies are suitable for established companies and 20 percent for startups, the angel continues.

University Technology Transfer: Traditional Model

In the past, university technology transfer managers predominantly used traditional licensing model as a technology transfer mechanism to generate revenues. Exclusive, rather than non-exclusive licenses, with upfront initiation fees, milestone payments and running royalties were pretty much the only way things were done, Garold Breit, executive director at the University of Manitoba Technology Transfer Office tells Venture Hype.

Universities were reluctant to license their technologies to cash-strapped startups because most can’t cough up the cash required by the traditional licensing model. In occasions where lab technologies were licensed to startups, equity was accepted only as a last resort method of payment.

Startups as Effective University Technology Transfer Vehicles

Garold Breit of UMTTO

Today, forward-thinking technology transfer managers recognize that startups are a powerful launching vehicle for new discoveries. And they realize the force young companies can bring to fortify local economic development initiatives, says Breit.

It’s startup firms, rather than their bigger corporate counterparts, that are the most effective when it comes to translating university inventions into commercial products or processes.

A licensed startup would focus entirely on commercializing the technology. A mainstream company, however, would be distracted by other undertakings. Commercializing technologies that are licensed to established corporations is “fragile at best due to competing projects, possible loss of the champion, change of management, change of company direction, etc.” Caltech opines opines on its website.

Enterprising University Technology Transfer Managers Do Creative Deals

Enterprising technology transfer managers who favor startups aren’t afraid of experimenting different structures to achieve flexibility. They’re receptive in granting co-exclusive and limited-time exclusive licenses. And they’re much more open to taking equity deals and reducing or waiving royalty rates.

Caltech comments: “This is very important to VCs or angels because high royalty rates together with the perennial problem of royalty stacking results in a lower valuation for a company at the time when an acquisition or IPO is being considered.”

According to “Equity and the Technology Transfer Strategies of American Research Universities,” [PDF] accepting equity in place of hard cash helps relieve a startup’s cash flow burden and benefits the licensing university by making the university a part owner of the startup.

Among other benefits, it reduces the time required to generate revenue compared to a traditional license, and aligns the interests of the university and the firm (towards the common goal of commercializing the technology).

These managers aren’t just accepting plain-vanilla equity. They’re making deals with creative configurations of equity, royalties, royalty holidays, and success fees (either in cash or equity), shares Breit.

For example, to prevent dilution, university technology transfer managers are structuring deals in which the university’s final equity stake may increase or decrease, depending on the company’s financial realities; commercialization efforts; technology development progress; and the technology’s attribution to the company’s success and ability to raise risk capital, according to Breit.

But if you think the technology being transferred is the key to successful commercialization, think again.

Next, we’ll reveal what really make or break a commercialization effort; why it’s difficult to commercialize public sector technologies; and the requirements for successful commercialization.

* Special thanks to Didier Leconte of MSBiV for recommending Garold.

Alliott Cole

It’s no secret that investors fight head over heels for sizzling deals and promising entrepreneurs to increase odds of success and potential returns. But when demand for quality deals exceeds supply, you better come up with exclusive, creative, or effective ways to lure the Steve Jobses of tomorrow.

How to compete for hot deals? Are startup competitions a source of quality deal flow? What are the key terms to negotiate?

From deal sourcing and picking winners to negotiating terms, Alliott Cole of Octopus Ventures shares his perspectives with Venture Hype.

Alliott Cole and Octopus Ventures

Alliott Cole is an associate director at Octopus Ventures (@OctopusVentures) and a director at the British Business Angel Association (BBAA). He’s a broad member of several startups and he devotes his time advising and discovering promising entrepreneurs at the University of Oxford society Oxford Entrepreneurs.

Octopus Ventures is an award-winning early-stage investing firm in the United Kingdom. Its model is unique in that it prefers to back exceptional entrepreneurial teams rather than specific sectors, and co-invests with a private investor group, Octopus Venture Partners, in every investment. The group of private investors is made up of 110 scientists, entrepreneurs, businessmen, and leaders of commerce who can add value to the companies they back.

* Edited interview

Sourcing Deals

VH: How does Octopus Ventures source quality deals?

AC: Most entrepreneurs — around 4,000 companies each year — come to Octopus Ventures directly or are referred to us via the Octopus Venture Partners group. We also receive many introductions via corporate financiers and other venture capital houses.

In addition, I’ve been running monthly “Open Office” sessions in Oxford for undergraduate entrepreneurs and MBA students in the last 2 years. Similar sessions are also held periodically at our London office.

We also actively reach out to entrepreneurs through panels, conferences, and networking events.

VH: Competition is fierce for hot deals. How should investors position themselves as the most suitable/preferred investors for such deals?

AC: Not an easy question to answer!

At Octopus Ventures we look to build enduring relationships with entrepreneurs and to continually help their businesses in as many ways possible.

In competitive situations, we always ask the entrepreneur to do his or her own due diligence on Octopus. We encourage them to speak to the businesses we’ve partnered with in the past. We hope this will give a candid and accurate picture of Octopus and our modus operandi.

As to how should other investors position themselves as the most suitable investor for a deal, I think it comes down to building a strong, equal, and open relationship with the entrepreneur; communicating clearly at every stage of the negotiation; and demonstrating a proven ability to add value to growing businesses.

VH: You also judge startup competitions like the Innovate!100 competition held in March. What do you think of this type of deal flow?

AC: I love meeting entrepreneurs. Their enthusiasm and conviction is inspiring and infectious. If you add in the pressure and expectation of a pitching competition, you often witness something very special.

I’m always impressed by entrepreneurs who can thrive in this environment, articulating their proposition concisely and with force. I think these events provide a great source of deal flow for investors. I try to attend them as often as possible.

Picking Winners

VH: What do you look for in the businesses you invest in?

AC: For the most part, Octopus invests in companies that have revenues but may not be beyond breakeven.

We believe that the team is the single most important factor. We look for effective, inspiring individuals who can infect those around them with excitement and passion of their proposition.

Second to this, we look for companies that can scale quickly into big businesses addressing large markets.

Finally, these companies must resonate with the Octopus Venture Partners group.

To this end, the business must be simple to understand, has a product or service of value, with a clear route to market and a defined customer.

Negotiating Terms

VH: How does the negotiation process work?

AC: Octopus Ventures looks to build strong partnerships with entrepreneurs from the outset and the negotiation process is a critical element of this.

We provide detailed and lengthy heads of terms so that the entrepreneur can negotiate all of the critical terms of an investment at the same time — before committing his or her business.

Someone once described this process as moving in ever decreasing circles until both parties come together at an agreed focal point. We like to do this face to face and in an open and frank manner.

If the process becomes too difficult, we’ll agree to disagree and step away from the negotiation. It’s not in the interest of the entrepreneur or Octopus to force a partnership if either party isn’t directly aligned with the other.

VH: From an investor’s perspective, what are the key terms to negotiate? Why?

AC: The valuation of the business and structure of the investment are key terms.

It’s critical for all stakeholders in a business to negotiate terms that aren’t only fair and workable for the present but also for the future.

Early-stage companies often require several rounds of finance. Entrepreneurs and investors should be careful not to agree to terms that might make the business unattractive for follow-on investment (e.g. unrealistic first round valuations; complex distribution rights; ratchets and/or anti-dilution provisions) or misalign stakeholders when there are key strategic decisions to be agreed (e.g. on an exit).

It’s also important to strike the right balance on governance and ensure that nothing will prohibit efficient decision-making and action.

VH: Entrepreneurs and investors often disagree on valuation. How do you go about negotiating a realistic valuation with these entrepreneurs?

AC: Investment structures like ratchets and distribution preferences can be used to bridge these gaps, but they run the risk of misaligning the stakeholders in the business. And such structures may lead to bigger problems at a later stage.

With this in mind, a frank and fair agreement is always preferable but there’s no quick and easy route to arrive at this outcome.

This is the second in a two-part series.

In Part 1, we took a look at how ABC’s reality show “Shark Tank” gets some key angel investment concepts wrong. In the second and final installment, we’ll offer five things the show gets right.

A Japanese import, “Shark Tank” has helped thrust angel investing and entrepreneurial spirit into the spotlight. The show throws hungry small business owners before a panel of self-made millionaires.

Entrepreneurs pitch their investment proposals and look for a specific dollar amount from the sharks. In return, the investors seek a percentage of ownership stake. The real-time negotiations play out in an ultra-public setting that, at times, makes for combustible debate — passionate entrepreneurs who’ve poured their lives into a startup rarely take defeat well.

Some of the show is closer to make-believe than anything resembling “reality” television. Valuations, time frames and negotiations are all warped or misconstrued for the benefit of the neat TV package.

But “Shark Tank” doesn’t get it all wrong. In fact, here are five things the show gets right about angel investing:

1. Points for Presentation

The Sharks don’t shy away from ripping an entrepreneur for a lackluster investment proposal. While some of the bluster is no doubt for the TV audience, there’s definitely a pragmatic foundation there. It’s seemingly common sense but needs to be reiterated: Presentation matters. One that’s cobbled together or that reflects a certain degree of seriousness, professionalism or general knowledge isn’t likely to inspire confidence or investment.

2. Smart Money

Entrepreneurs should seek smart money. The investor should hopefully be able to add value more than just the dollar investment. Small business leaders solely in search of dollars are almost always doing themselves a significant disservice. Some of the smart entrepreneurs target particular Sharks because of their past experience with similar ventures. Likewise, the Sharks often pursue a venture where they feel they can add significant value or will pass on deals where they have little to offer.

3. Smart People

Ideas without great management are not worth much. Talent is key and so is the ability to execute. Having IP may be the only other thing that helps make an idea valuable, but the IP is partly a result of execution and management. The Sharks are often wary of companies that lack a strong, visionary leadership who can generate results with the funding dollars. The general investor should be, too.

4. Valuations Vacillate

Valuations fluctuate wildly and there is no standard method. This can be seen in the wild fluctuations proposed between the sharks and the entrepreneurs. Entrepreneurs looking for a plug-and-play formula for valuations need to prepare for uncertainty.

5. The Elevator Pitch

There’s a duality inherent in “Shark Tank” when it comes to the pitch itself. In the real world, the thought of investors making a decision after reading a plan and listening to a few minutes of presentation is hard to fathom. At the same time, the show offers entrepreneurs solid examples of why cultivating a sharp “elevator pitch” is extremely important. It also illustrates how key it is for entrepreneurs to craft a compelling story for their vision.

Interested in submitting an article to Venture Hype? Just follow these guidelines to get your article featured.

This is the first in a two-part series.

ABC’s reality show “Shark Tank” has helped bring the concept of angel investment to the mainstream. Millions of Americans who had never even heard the term now tune in each week to watch hard-working entrepreneurs pitch their investment proposals to self-made millionaires.

In the show, entrepreneurs are forced to sell their ideas and themselves before an imposing panel of investors. These small business practitioners must ask for a specific amount of money from the investors, who in turn seek a percentage of ownership stake.

Entrepreneurs typically unleash a torrent of impassioned pleas, tears and promises of future profits. The sharks, meanwhile, poke, prod and push to find holes or weaknesses in business plans and revenue models, all the while jockeying for position on the really standout pitches.

In essence, it’s reality television at its tension-building best. Too bad it’s giving viewers a warped view of what angel investment is really about.

Here are five ways that “Shark Tank” gets it wrong, along with the bad lessons it’s teaching entrepreneurs and angel investors.

1. Pre- and post-money valuations

In one episode, an entrepreneur says he is seeking $250,000 and will give up 1/3 of his company. The investor then questions the entrepreneur, asking how he can justify a valuation of $750,000 when they don’t have much in sales.

Here’s the problem: The shark isn’t correct in his valuation. The entrepreneur is not valuing the company at $750,000. He is valuing it at $500,000. This is the pre-money valuation or the valuation before the investment. Once the investment is made, the company would be valued at $750,000 — with $250,000 of that coming from the investor. And that $250,000 would get 1/3 of the post-money valuation. So the entrepreneur should not be forced to justify how the company is worth $750,000.

Instead, he should need to justify a $500,000 current (or pre-money) valuation.

2. Wacky company values

In the same episode, the investor claims valuations are based on a multiple of revenue or profits. However, this is not accurate in a startup or early-stage company.

Valuation amounts are generally placed on other things such as management, market potential, intellectual property and a few other key essentials. Sales can help justify a higher valuation, but they are generally given very little weight for startups and early-stage companies.

3. Unrealistic time frames

On “Shark Tank,” investors and entrepreneurs shake hands and seem to agree on a deal very quickly. But deals of any real merit are very rarely done without a significant amount of due diligence to help verify claims, checking out the entrepreneur and other things common in any due diligence process.

The idea of a quick shake and a sudden influx of capital runs counter to the measured and deliberate nature of angel investing. Angels didn’t make money by blindly rushing into business deals while relying on gut instinct alone.

4. One-track negotiations

When entrepreneurs and sharks are negotiating a deal, the focus is entirely on the valuation of the company and the investment amount. While these are clearly important to both stakeholders, the terms of investment deals in the real world of angel investing include a wide array of other cornerstones. We’re talking about things like stock options, liquidation preferences and so much more.

5. Adversarial relationship

For the most part, “Shark Tank” makes it seems like angels and entrepreneurs are pitted against each other. But it’s really not a zero sum game. Both sides are fighting earnestly for the same thing — to build a successful company with terms that provide mutual benefit and long-term growth.

Stay tuned for Part 2 of the series.

Interested in submitting an article to Venture Hype? Just follow these guidelines to get your article featured.

The reader writes -

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

We’ve covered dilution in an up round in Part 1 and examined dilution in a down round in Part 2. Here, we’ll go over some of measures you can take to lessen the impact and/or likelihood of getting burned by dilution. If this topic is new to you, you may want to read the basics in Part 1 and Part 2 before proceeding.

Note: Not all of the measures below can be taken simultaneously. Sometimes it’s either A or B, but not both. Talk with a lawyer who’s very experienced with startups and angel financing to gain a better understanding of the terms and deal structures.

Aligned Interest. Align your interests and objectives with the founders’. Paul Graham of Y Combinator writes:

Dilution is normal. What saves you from being mistreated in future rounds, usually, is that you’re in the same boat as the founders. They can’t dilute you without diluting themselves just as much. And they won’t dilute themselves unless they end up net ahead.

One way to do this is to offer entrepreneur-friendly terms, such as opting for common shares instead of preferred shares. The tradeoff is that common shares offer you very little protection.

Another way is to agree on an exit strategy early on. Basil Peters — an angel investor, prolific speaker, and author of Early Exits: Exit Strategies for Entrepreneurs and Angel Investors (But Maybe Not Venture Capitalists) — believes that “angels, and entrepreneurs, would have fewer dilution surprises if companies had good alignment on an exit strategy before the first investment went in.”

Angel-Only. Focus on angel-only deals to prevent follow-on financing from VCs (which can be very dilutive), notes Peters. The companies should require only US$0.5 million to US$3 million to prove its business model.

Early Exit. Big corps like Google are increasingly buying pre-revenue ventures as their growth strategy, says Peters. Help the company exit early (e.g. look for an attractive acquirer before it becomes sustainable or profitable) once it’s proven its business model. Exiting early allows you to cash out and helps avoid raising dilutive rounds.

Anti-Dilution Provision. Include anti-dilution provision in the term sheet, which allows you to re-price your stock if subsequent funding rounds are down rounds. In general, this comes in 2 forms, full ratchet and weighted average ratchet. More on anti-dilution protection in a future post.

Even if you’re protected by this provision, later investors can force you to waive or remove it. It’s really a matter of bargaining power. If the company needs the cash to survive, but potential investors refuse to invest if you don’t waive your right, then the company could die.

Board. “Negotiate for permanent board status or at least observer status,” advises Jeffrey Leavitt, partner of DLA Piper. This way, you can “learn of pending company activity that could affect [your] interests.”

But don’t take this as you-should-stick-your-nose-into-every-little-detail. Y Combinator, for example, interferes as little as possible. The seed firm realizes that independence is one of the reasons startups succeed. “Investors who try to control the companies they fund often end up destroying them.”

Though we should mention, the amount Y Combinator invests is relatively small — usually around US$11,000 + US$3,000 per founder. Which means US$17,000 for 2 founders, US$20,000 for 3, and etc.

Capital Efficient. Invest in companies that don’t need a lot of capital to reach breakeven or profitability. These companies have better odds to become self-sustainable; they’re less likely to be desperate for cash or funding from outside investors.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” stated James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Deal Structure. Avoid unnecessary dilution by acquiring preferred shares or convertible debt, which converts to shares at a later date when the venture is properly valued by professional investors, Leavitt further suggests.

Follow-On. Reserve funds for follow-on investment. John Huston of Ohio Tech Angels Fund said, “The angels’ best protection against a ‘down round’ is to have adequate dry powder to preclude the need to seek new outside investors.”

Milestones. Before you invest, make sure the company has set, and will likely hit, milestones that will increase its valuation before raising the next round. Increasing valuation in the next round means there’ll be no down round. As mentioned in Part 2, down round can be very dilutive and can decrease the value of your holdings significantly.

One angel says, “[Significant milestones include] licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc.”

Valuation. Value the company reasonably from the start. New angels frequently pay too much at the early stage, placing too high a value on the startup. Over valuation is more prone to down round if the company needs to raise more money from outside investors in order to get the business going. Again, down rounds can significantly dilute the value and size of your holdings.

Final Words

Dilution is inevitable in both good times and bad. When it comes down to it, you ought to be confident that the company’s valuation will exceed the impact of dilution before opening your checkbook; otherwise you may want to pass on the opportunity and look for one that has such potential.

Whether you visit news sites or flip open the newspaper, you’ll see that Chinese entrepreneurs and the state of economy in China are garnering some serious ink. To learn more about China’s angel investing scene and general investing practices, Venture Hype got in touch with Shanghai-based investor Bruno Bensaid.

Bensaid is the founder of MobileMonday Shanghai, a mobile industry-related community; managing director of Shanghaivest, a boutique financial advisory firm; and accredited investor with AAMA Angels Shanghai group, an institutionalized angel group in China. Prior to Shanghaivest, Bensaid served as vice president of business development at Ventech China, a French venture capital firm with operations in China.

* Edited interview

VH: What’s the angel investing scene like in Shanghai?

BB: Angel scene in Shanghai and China is still in its infancy. Very unstructured in general, with a lot of talking but very few actions and investments. The real action usually comes through wealthy angels, typically those who’ve exited a company and who are pulling in a few other rich angels, usually of similar profile.

Since AAMA Angel was created in 2007, we’ve seen the establishment of a few other angel groups. As of today, none of them has established a track record or put in place a proper investment process, e.g. selection, presentations, due diligence, investment, post-investment follow-up, and divestment. I think AAMA is the first non-profit organization that has proper investment process in place. This is a reassuring factor for entrepreneurs who come to us expecting to be treated properly and fairly throughout the process.

VH: In regards to your current investments, what made you decide to choose these from among the myriad of potential investments you hear about?

BB: All of my investments are made in the internet and telecom space. What caught my attention is always the team, then the project itself. If I believe the team can pull it through, I begin to study the fundamentals of the business. I do a lot of research on the market before I decide on any investments.

Also, I immediately rule out companies that

1. haven’t done proper research on their own market
2. underestimate the quality of the competition due to lack of research
3. are completely delusional on their sales forecast

We all know that forecasting is rarely accurate, but when you see numbers that are 10 to 100x off common estimates, it’s a deal breaker for me.

VH: What are the qualities you look for in a startup founder? How do you nurture these qualities and bring out the best in them?

BB: Complete dedication to the project is most important. I usually don’t like founders who run several companies at the same time or dilute their efforts on too many business models and hope one will stick.

I much prefer entrepreneurs who slightly hedge their risk but focus on their core business and don’t stop until they understand the model perfectly and have made necessary improvements.

My role is to tell the exec team what I believe they should do to make the company more cash efficient and more attractive to other investors. I don’t want to be the only investor in the company!

VH: How do you value a startup?

BB: Look at valuation 101 from b-school books and you’ll see that there are many ways. But beyond technicality, we look at the team, the market potential, the stage of the company, and what they’ll achieve in the coming 3, 6, 12, or 24 months. These are what matter most. After that, I also benchmark with other recent fundraisings and try to establish some similarities.

VH: What terms do you insist on in the term sheet? Why?

BB: To dilute the risk, I often look at investment based on milestones. It’s a commitment from both sides to achieve success. Some entrepreneurs may see this as unfair, but when you start investing more than US$50,000 then you want to see some serious results before you continue. Otherwise, anti-dilution terms are also quite useful but it’s usually harder to obtain when you only put a small ticket.

VH: When you think of your investments that weren’t successful, what would you do differently if you had the chance to redo them?

BB: The most common mistake is to become too “close and personal” with a startup. That happens a lot when you’ve befriended the startup founders. I’d strongly advise to treat them with equal, but not more, respect as other startups. That would avoid any conflict of interest or being too soft on due diligence.

VH: What advice would you give to new angels?

BB: Choose your industry focus and make sure it’s consistent and relevant to what you’re already doing. I see a lot of angels coming from traditional backgrounds looking at deals in the tech side, internet or mobile. Nothing wrong with that, but unfortunately they don’t bring much value to the table other than money. Entrepreneurs need cash as well as someone to tell them when they’re wrong or help them stay ahead of the competition.

On the flip side, I also see a lot of would-be angels who can’t disburse any money in the end but want to receive shares in exchange for their knowledge and network. However valuable that is, this is usually not acceptable for a young venture. Startups need cash, then value. No cash, they die.

Just for fun

VH: iPhone or Blackberry?

BB: Nokia E90 Communicator. Get a life, it’s the best professional tool ever. I use iPhone to test new apps and check out what some prospective companies I’m looking at are producing. I’m not a fan of BlackBerry, not yet, except the push mail technology.