More myths about angel investors and venture capital firms

Myth - Entrepreneurs generally succeed in raising capital from angels who have no prior relationships with their companies based on the merits of their business plans. Mostly wrong. An angel investor invests primarily based on a prior relationship the angel investor has with the entrepreneur or with another angel who represents he or she will invest because of the merits of the deal and his or her established relationship with the company. The key for a company in raising capital from angel investors is to establish relationships with potential angel investors long before asking them to invest in your company. In other words, a precondition to starting a company which will need angel investment to get past the first year is to "prime the pump" so to speak in order to have a lead angel investor when the time comes to raise capital. Almost all entrepreneurial companies start with family and friends money, hoping to achieve a few milestones that will make the company attractive to angel investors for "just in time" capital from these investors. Inevitably, it takes much longer than contemplated to raise capital from angel investors and the company runs out of money. The reason for this is that entrepreneurs almost always underestimate how long it takes to raise capital from angel investors who are strangers. They wait too long to begin the process of establishing relationships with potential investors.

Myths about Angel and Venture Capital Investors

Most entrepreneurs have been exposed to myths about angel investors and venture capital investors. Let me dispell some of these myths:

• Myth - Venture capital investors invest in technology, not the people. Wrong. Venture capital investors invest in the management team far ahead of the technology that is the basis for the company. Their experience is that a highly qualified management team will engage the market, react and change the product or service the company offers as needed to succeed. Since most companies don't succeed with the first version of its product or service, a management team that can assess the market and make changes will more likely succeed.
• Myth - Angel investor groups act quickly when presented with an investment opportunity. Wrong. There is a trend toward angels forming groups to evaluate investment opportunities, select from the many opportunities they see, negotiate the terms of investment and make the investment. However, in most groups, this takes an inordinate length of time, especially if the angel group does not have a paid managing director to keep things moving. Most angel groups don't have a paid managing director. The reasons for the slow moving process is that the group often only meets once per month, a single naysayer in the group often causes the process to stop until others in the group override the negative opinion and the group has a preferred set of terms that may not be acceptable to advanced entrepreneurs, slowing the process down to get the group to accept other terms. It's not unusual for a company to make a presentation to an angel group one month, come back the next month to answer questions, begin negotiations lasting 30 days, then waiting another 30 days for the legal documentation to be completed before a closing occurs. Is it any wonder advanced entrepreneurs don't want to deal with angel investor groups? On the other hand, early stage entrepreneurs often have no choice but to raise capital from angel groups and don't realize how long the process will take.
• Myth - Venture capital investors want to control your company from the start. Wrong. Professional venture capital firms do not want to take control of companies when they make their first investment. First, they aren't staffed to exercise that degree of control over the companies. Second, if they have to have control in order to make the investment, they have concluded the management team is incapable of running the company which should lead to the decision not to invest. On the other hand, there are individuals and groups out there who hold themselves out as venture capitalists, but who will only invest if they obtain control. These individuals and groups are not true venture capitalists and advanced entrepreneurs should usually avoid them.
• Myth - Angel investors invest to make money. Usually wrong. Most angel investors are successful entrepreneurs who have cashed out. They invest to "be in the hunt" or to join with other angels who they want to be associated with or to have the opportunity to watch an entrepreneurial company go through the growing pains and, hopefully, succeed. Since, by definition, angel investors are wealthy, they don't have to make highly risky investments to increase their net worth. But, they HATE to lose money. Yet, angels will lose their entire investment in most of the investments they make in young companies. How do angel investors reconcile the risk-taking with hating to lose money? It's a mystery.
• Myth - Angel investors bring good advice to the table for the entrepreneur in addition to money. Usually wrong. The best thing an angel investor can bring to the table other than money is relationships, i.e relationships with potential investors, relationships with investment bankers, relationships with potentially large customers, relationships with law firms, accounting firms and banks, etc.

I've run out of time today. I'll continue this another day.

Business Development Companies can fill the gap between angel funding and VC funding

A gap exists between angel funding and venture capital funding for qualified, second stage companies. Very few angel funded companies will ever obtain VC funding before being acquired. So, a second stage, angel funded company has no choice but to grow with internally generated capital after exhausting the angel funding. But, this results in a lower rate of growth than could otherwise be achieved if growth capital were available. Yes, a company at this stage will probably be able to obtain a line of credit from a bank secured by accounts receivable or an equipment line secured by equipment, but bank borrowing is insufficient to fund a high growth rate. Alternatively, companies in this stage may seek to be acquired earlier than they otherwise would if they had access to growth capital, partly at the insistence of the angel investors who want a liquidity event.

There is an opportunity for business development companies to fill this gap and achieve attractive gains for its investors while filling the need of second stage companies for growth capital. A business development company is a special animal under the securities and tax laws. Essentially, a business development company is a publicly held, closed-end mutual fund that must invest primarily in privately held companies. A BDC that makes equity investments is basically a publicly held venture capital firm. A BDC differs from a venture capital firm in that it has the ability to raise capital from time to time as it makes investments through public offerings. A typical venture capital fund has a finite life and once it is fully invested, it liquidates its investments and distributes the net proceeds to its investors. The principals who run the VC fund then form a new fund and start the process over.

Unlike a venture capital fund that is privately held (as almost all are), a BDC is transparent to its investors and the public due to being publicly held. While this can be a burden on the BDC, the transparency is what all investors want and deserve. The biggest problem a BDC has with transparency is how to value its investments in privately held companies. But, a VC firm has the same problem in reporting its status to its investors, but doesn't have the SEC looking over its shoulder.

There is only a handful of BDCs that make equity investments in second stage companies, but there are many BDCs that only make loans, usually secured loans, acting essentially as finance companies. Why don't more equity oriented BDCs get formed? Well, the dynamics of the market can make it unattractive for an investment banking firm to underwrite the initial public offering for a BDC and it is expensive to start a BDC. Let's start with the expense of starting a BDC.

A founding management team has to be formed to start and manage the BDC. This team must have sufficient capital to bear the substantial legal and accounting fees necessary to prepare, file and process the registration statement for the initial public offering and the other expenses associated with the offering. The team must find and convince an investment banker to manage and underwrite the IPO. This process can take as long as one year and the members of the team must have the resources to devote almost full time to this process for that period of time. The reward for the team is to have the opportunity to share in the gains made by the BDC in its investments, similar to the "carry" available to the management team of a VC firm.

If a team can obtain the resources to form a BDC, the challenge is to convince an investment banking firm that the price of the stock will increase over the IPO price and increase over time as the BDC makes investments. Historically, the price of the stock has declined after an IPO for closed-end mutual funds of this type because there is little after-market demand for the stock. No underwriter will knowingly underwrite an IPO if it believes this will happen. So, the challenge for the management team is make a convincing case that it has the opportunity to make very attractive investments and that the BDC can keep the interest of investors while it takes several years to invest the proceeds raised in the IPO.

I believe there is an opportunity for BDCs to form while the gap bewteen angel funding and VC funding exists. I also believe that potential investors in an IPO for a BDC can find this an attractive way to invest in growth companies where the capital invested by the BDC into second stage companies causes these companies to grow. Further, unlike an investment into a VC fund, an investor in a BDC has a highly liquid investment since there is a public market for the stock of the BDC.

A case can be made for a BDC to have a $30-40 million IPO. The BDC should be able to fully invest the proceeds in 3-4 years, then have a subsequent offering assuming its investment portfolio is showing an attractive increase in value.

A management team will probably need to have $1-1.5 million to start a BDC and, the underwriter will probably require the management team to obtain commitments from private investors to invest up to $6 million in the IPO before agreeing to manage and underwrite the IPO. Quite a challenge.

The "gap" between angel funding and venture capital

Does a gap really exist between angel funding and venture capital funding? Yes, but the gap also exists between venture capital funding and IPOs. The two gaps are related. When we had a market that accepted, even demanded, early stage IPOs, venture capital firms (VCs) were motivated to invest at the stage before the IPO. Otherwise, they missed the opportunity to invest because most VC funds are not permitted by their investors to invest in publicly held companies (the institutional investors who invest in VC funds can make those investments without the help of VCs).

Now, we do not have a market that supports early stage IPOs largely because there are no securities analysts who will follow small, publicly held companies. Why? Because the securities analysts can't get compensated for promoting these companies within their own organizations. So, VCs aren't very interested in making investments at the early stage of a company's life. In addition, the VCs have so much money to invest that they can't make small investments of, say, $1-3 million because the small investments won't make a difference to a portfolio of $200-500 million. Further, for a $200 million fund, a 10 to 1 gain on a $2 million investment (yielding a $10-20 million gain) produces the same fee to the managing partners as a 2-3 to 1 gain on a $10 million investment. It is a lot easier to invest in companies that make a 2-3 to 1 gain over several years than it is to invest in companies that will make a 10 to 1 gain.

With the non-existence of an early stage IPO market and the growth in the size of the VC funds, a layer of capital is missing for attractive, early stage companies that have made it through the startup stage and are poised to grow if capital were available (second stage companies). What is a company in this stage to do? Can this company obtain bank financing to grow? Yes, but only to marginally grow the accounts receivable or inventory, not to fund more product development or marketing campaigns.

Why doesn't our market system take care of gap between angel funding and VC funding? Primarily because of the unintended consequences of added regulation pertaining to broker dealers and the effects of Sarbanes Oxley (making it very expensive to be a publicly held company). Still, our market should find a way to invest in companies at this stage.

Maybe, investors will wake up and realize that investing in the stock market is only a "market play" and does not result in high growth potential companies receiving capital. Shouldn't investors want to invest directly into companies with high growth potential so that the capital invested causes the high growth? But, the securities laws, mostly written in the 1930's, make it difficult to spread risk among many investors in non-public companies. Instead, the securities laws force the risk of investment in privately held companies to be concentrated among a few investors. This is upside down.

One answer to this is to invest in business development companies, a special animal under the securities and tax laws. A BDC is basically a closed end mutual fund that can raise capital from investors in the same way that a closed end mutual fund raises capital. A BDC is required to invest in non-public companies, usually early stage companies. A BDC is essentially a publicly held VC firm, but with the transparency of a mutual fund. There are a handful of BDCs that invest in early stage companies and quite a few that are essentially finance companies making secured loans to companies who can't borrow from commercial banks. BDCs that focus on making equity investments in early stage companies could fill the gap between angel funding and VC funding. But, it is hard to launch a BDC. I'll write more about why it is hard to get a BDC launched in another blog.

Why do young businesses have to go through hoops to succeed?

In order to succeed, a young business (from startup to high growth mode) must go through many hoops. Why? Should our government (federal, state or local) eliminate some of these hoops? My view is - No. A market driven economy has an "invisible hand" that allocates success among the many young businesses at each stage of their existence. As with any scarce resource, success is hard to come by. Can government pick winners and losers? Hardly.

The "invisible hand" customizes the hoops that each young business has to go through. If the business makes it through these hoops, then more hoops are presented. It's the way our market driven economy disciplines businesses. Each set of hoops is different, but most of the types of hoops can be predicted such as finding a product or service for which demand exists (not just a perceived need), finding a good (although not perfect) mix of people to run the business, obtaining capital (directly or indirectly), staying focused (but on the right things), etc. When a business makes it through the hoops, it deserves to grow and, possibly, thrive. If it doesn't make it through the hoops, it deserves to fail or become part of the living dead.

So, one of the jobs of an entrepreneur is to know the hoops that he or she will have to go through and, then, to acquire the skills and resources to go through the hoops. But, entrepreneurs "don't know what they don't know." So, how can they possibly anticipate the hoops let alone be able to get through the hoops?

Frankly, most entrepreneurs who make it through a set of hoops are lucky. But most of them don't make it through the hoops because they are blindsided by the hoops and, when a hoop that wasn't anticipated is presented, it's too late to change direction or gather more resources to avoid the hoop or overcome the hoop. This is why smart investors want to invest in serial entrepreneurs - they have been through the process and are smart enough to know most of the hoops or to get "just in time" advice,to tackle or avoid a major hoop.

The hoops are the best filters our system has to pick the winners and losers. Government should stay out of the way and not try to eliminate the hoops. Our economic system is much better at determining the necessary hoops than bureaucrats who are just like entrepreneurs. They usually "don't know what they don't know."

The best way entrepreneurs can find out what they don't know is to ask others who have been there. Yet, one of the weaknesses of most entrepreneurs is an unwillingness to seek advice (or listen to advice). The hoops will take care of entrepreneurs who fail to seek advice.

Advanced entrepreneurship and an MBA

I teach Entrepreneurship and Entrepreneurial Finance as an adjunct instructor in the Rollins College MBA program. As a lawyer for 34 years working with entrepreneurial companies, primarily high tech companies, I've been part of the growing pains that these companies go through. I also have an MBA and worked as the CFO for a startup company that went public (before I decided to go to law school).

Having an MBA is incredibly useful when your company has the resources to do things that MBAs are skilled at doing. That is, researching the market, developing a strategy, finding and arranging for the infusion of new capital, managing the supply chain, developing sales channels, etc. all require a minimum amount of resources just to consider these matters. Startups are always severly resource limited and have to be very clever at using other people's money to get to a sustaining level of business.

I've seen only a handful of startups where one of the founders had an MBA. But, the skills taught in an MBA program were not really applicable to the startup. Not until the company reached a level of revenues of $5-10 million did the company have the resources to even consider doing the things a person with an MBA could suggest.

So, my observation is that a person with an MBA usually has a greater impact on an entrepreneruial company at the stage where the company has reached a level where it can obtain resources such as investor capital or bank borrowings to use to grow the business. Companies at this level have the potential of making a much greater impact on the local community than startups because they can grow rapidly with the use of resources that are not generally available to startups.

Advanced entrepreneurs must be global entrepreneurs

Most entrepreneurial businesses that are technology based must have a management team that is comfortable with doing business globally. The Orlando Sentinel newspaper reported today that a company located in Central Florida had raised $15 million in venture capital financing from foreign sources. This same company has its manufacturing operations in South Korea, its R&D operations in Finland and its headquarters in Central Florida. The largest market for its products will be in the United States.

This company is a great example of how advanced entrepreneurial companies will operate in the future:
- It is taking advantage of the critical mass of engineers in South Korea for its particular product in order to make the product in South Korea.
- Its product will be a component of cell phones. Where better to have R&D than in the country where Nokia is headquartered?
- Its largest market will be in the United States. So, locate the headquarters where your largest market is.
- It obtained its early stage funding from foreign investors. This company undoubtedly found that venture capital in the United States has shifted its focus to later stage deals to reduce risk, yet also reduce potential gains. On the other hand, non-U.S. institutional investors have a greater appetite for investment in earlier stage companies than U.S. institutional investors because they typically have a longer term view and believe in achieving investment gains based on the increased value of companies they invest in rather than on gains based on financial engineering (i.e derivatives or roll-up acquisitions).

In order to execute this kind of strategy, the entrepreneurial company must have a management team that is capable of operating in the global environment. A critical component of being able to operate in this environment is the ability to collaborate using the collaboration tools that are now available using the Internet. These tools will get better and become even more important to entrepreneurial companies in the future. Further, entrepreneurial companies will be able to implement these collaboration tools must faster and more effectively than large companies.

But, where and how will CEOs, CFOs, CMOs and CTOs learn how to operate in the global entrepreneurial environment? MBA programs will have to evolve to provide the critical thinking skills necessary for managers to understand the strategic advantages of starting and managing entrepreneurial companies that are global enterprises.

Advanced entrepreneurship

Entrepreneurship covers a broad spectrum of business activity. Most entrepreneurship programs focus on startup businesses. Yet, the greatest impact that training in entrepreneruship can have is on businesses that are well beyond the startup stage. This is especially true for entrepreneurship programs that are part of MBA programs.

So, why don't MBA programs focus on "advanced" entrepreneurial businesses where having an MBA can truly make a difference to those businesses? Think about it. The characteristics of a successful startup entrepreneur are very different than the subjects covered in the MBA program. My observation is that most people who get an MBA don't have the characteristics to be a successful startup entrepreneur. However, they do have the characteristics to develop an entrepreneurial business once it is of a size that it has the resources to employ an MBA and the resources to implement changes in the organization and strategy recommended by the MBA.

Most entrepreneurial businesses don't have a member of senior management who has an MBA until it decides to engage a COO, CFO or CMO with an MBA. Shouldn't the MBA entrepreneurship programs provide thought provoking courses that prepare the MBA for these positions?