Unchained Entrepreneur – Business Advice

About a month ago, the venerable New York Times published a piece about The New Rules of Angel Investing. You can read the entire Times piece here
The New York Times references a Center for Venture Research study showing that total angel investments in the first half of 2009 were approximately 70% of the previous years total – and that the average deal size itself had also shrunk by about 30%.

With apologies to Kermit Pattison, the author of the Times article: No $#@&!

The U.S. lost in excess of $10 trillion of wealth in 2008 – about 1/3 of that from erosion of home equity and 2/3 from erosion of stock market values. In such circumstances, is it really very surprising that the amount of liquidity made available by angel investors declined dramatically?

Mr. Pattison goes on to suggest that companies can still obtain angel funding, but there are several key points to consider. Essentially, they boil down to:

1. Bootstrap your company as much as possible.
2. Have realistic valuation expectations.
3. Plan for future financings.
4. Practice pitching.
5. Know where to find ‘em.
6. Get coached.
I’m going to refrain from further snarky comments about the obviousness of these suggestions (and the fact that they are important all the time – not merely when angel investing has seen a 30% decrease). To be fair, Mr. Pattison and the New York Times are on the right track – the suggestions set forth have merit. Unfortunately, the article is a bit like cotton candy – sweet, light and fluffy but without much substance.

I’m going to address the six key suggestions made by Mr. Pattison and endeavor to extend the core of the piece with substantive ideas on how you can take action in seeking angel funding. Hopefully, I’ll succeed in offering you some practical strategies.

1. Bootstrapping. It’s easy to propound this tip to entrepreneurs. “Try and finance your own growth” doesn’t take much in the way of thought when offering advice. Obviously, the more you can do this, the better off you are in regards to financing and operating your business. The fact is, most entrepreneurs bootstrap, so this piece of advice is of little practical use. Instead, think about strategically bootstrapping with specific goals in mind – and measure the effects.
   
   Your primary focus, upon taking initial capital investment, is almost always to achieve regular positive operating cash flow. If you are looking to raise capital, it is imperative that you structure your business and operations with that goal in mind. Take a look at various bootstrapping tactics you might use (or are using) and relate them to your capital raising goal.
   
   An easy example is officer salaries. If you and other officers take reduced (or no) salaries and plan to do so until you reach breakeven, show this to prospective investors as a key part of your operating plan. If you’ve found cheaper labor, negotiated vendor discounts or acquired assets below their cost value, demonstrate how this factors into your ability to reach positive operating cash flow. Most of you are going to bootstrap in one fashion or another simply to keep your business growing – take pro-active steps to plan that bootstrapping and show a prospective investor how it will assist you in achieving positive cash flow.




2. Valuation. Yes, valuations have fallen – but so what? Valuation discussions are always difficult. The simple fact is investors and entrepreneurs are on absolute opposite sides of the table on this issue until the investment is consummated. One key point about valuation, implicit in the New York Times piece, is whether it’s a buyer’s or seller’s market. During the froth of the internet years (and to a lesser extent 2004-2007), valuations were so out of line because so many dollars were chasing quality (and not so quality) investments. That’s obviously no longer the case. As an entrepreneur, there are several key steps you should take regarding valuation before initiating a financing process:

Know your limit. What’s the minimum valuation you will take before the pain is too much? Before you sit with any prospective investor you need to know the valuation level that makes you get up and walk away from the table – often called the floor. Figure out what this is in advance (for some people, there is no number that’s too low – they will take the financing at any commercially reasonable terms). Also, give some thought to the dynamics of valuation and amount invested – your valuation limit will likely be different if I offer you a $5,000,000 financing vs. a $50,000 financing.

What’s the market? Once you’ve determined your floor, you can proceed with obtaining market information. Use your contacts and resources to get a sense for what metrics are used in financing businesses in your industry and at your stage of development. Gather intelligence regarding recent transactions in your space so you know what to expect. Take a look at various venture capital websites (and blogs) to find out as much information as you can about recent financings.

Be prepared. Once you’ve gathered enough information, prepare your own valuation presentation. If you don’t have a full financial projection model (including balance sheet and cash flows) STOP NOW. You will lose credibility (and likely any valuation negotiation) without full financial projections. Frankly, if you don’t have this you shouldn’t be out in the market seeking financing (if you need help with this, consider hiring consultants – your accountants, other advisors or even my company. Use your financial projection model, along with the industry information you’ve gathered to create several valuation calculations (comparable transactions, comparable companies, etc.). If you need further help with this, you can download my $49 How-To Guide to Valuation FREE.

Be aware, that if you present with this level of professionalism, the negotiation will likely shift focus to your financial modeling, rather than the metrics of the valuation itself. Be ready to present the reasons why you’re company is different (i.e., better) and deserves the highest range of possible valuation.

Avoid rigidity. Be aware that, as in any negotiation, price is not the only factor. There are a number of structures that you can use in taking an investment that allow for a great deal of flexibility. Instruments like convertible stock, convertible notes, warrants, options, earn-outs, clawbacks, etc. are part of a toolbox that can allow you and an investor to reach a meeting of the minds that may work for both of you, without compromising your valuation goals.

Control. One final point regarding valuation – distinguish between control and economic benefit. Your decisions regarding valuation should be made on an economic risk-reward basis. Will you be retaining what you believe is an appropriate amount of your company to insure economic upside (this is related to your initial determination of your valuation floor). Your control position in the company is a different matter. If control is important to you (and it is for more than 90% of entrepreneurs in early financing rounds) then any time a proposal involves the sale of more than 50% of the company, you need to seek additional clarification regarding intent. If the investor is comfortable with you remaining in control (in general terms) then you can use flexible structuring to create the proper economic upside for the investor while maintaining your control position.

This entry has grown a bit long, so I’ll address the last four points made in the New York Times article in my next post.

In the meantime what are your thoughts on the practical elements of bootstrapping and valuation?