Saturday, December 1, 2007

Angel Deal Types

I’m involved with three different angel groups, and often guest at the meetings or screenings of two others. I see a lot of deals in the screening process for these groups. It seems these deals fall into four general categories:

1. Low Capital Requirement Deals. Deals that don’t need a traditional, venture capital-sized investment to get to cash-flow breakeven. These are capital-efficient deals that can get to revenue early, and boot-strap themselves through the growth stage. In today’s web x.0 world, I think these deals are more common than ever (as I have blogged previously). And I think they benefit from a particular kind of angel investor, i.e. one who has a more active hands-on approach and plans to mentor the deal and team more. These deals are unlikely to raise or even need follow-on VC investment and get a more experienced and connected board later. The mentors they pick up in the angel round may end up being the guys they use as advisors throughout the history of the company. These are not “fire-and-forget” angel deals. And they may make more sense as simple priced, preferred stock deals, rather than convertible debt deals that I have advocated in previous postings.

2. Seed Deals. Deals that need seed capital to address some early risk factors prior to seeking their first formal venture capital round. The idea is to reduce those risks so they can get a better valuation from their first VC round and experience less net dilution. Frequently, a valuation inflection point is only an angel round of seed investment away. It may be to build a proof-of-concept model, or launch a beta test, or stabilize and add to a thin development team. I think deals in this category are more common in areas like the Bay Area where there is abundant VC funding. And this is the kind of deal where I think a convertible debt deal with a discount or warrant, and an escalator for delay in conversion makes the most sense.

3. Failed To Raise VC Money Deals. Deals that have tried and failed to raise their first funding round from conventional VCs and are “moving down the food chain” to Angel Groups. These deals normally have very tenacious founding teams who aren’t taking no for an answer. Often they revise their pitch to reduce their capital needs so as to appear more angel-friendly. In some cases this may make sense. If they were naïve at first and underestimated the impact of their risk factors on the VCs, they may have come up dry. They may benefit from converting to category 2 Seed Deals described above. The logic is “Raise less money, address your weak points, and then go back to the VCs.” Unfortunately, I see a lot of deals in the angel world that aren’t like this. They are simply failed venture deals. Frequently, they are failed VC deals because of team problems, or IP issues. They still have high capital requirements and are inappropriate for angel investment. There is an irrational aspect to starting a company, and slightly irrational entrepreneurs can assume that a lot of turn-downs simply means the VCs don’t get it. And angels may not look as deeply or be as experienced investors. A good story may snag an angel where it wouldn’t convince a VC.

4. “Bridge” Deals. Deals where a company has already successfully raised a previous round or rounds of money, has burned through that money and the existing investors are now disenchanted and no longer interested in follow-on financing. The entrepreneurs are trying to repackage the deal, spin it a different way, “put lipstick on the pig” and sell it to the angels. The entrepreneurs in this case may be reasoning that angel groups are less likely to come at the deal with knives, i.e. to force a down round. Angels may be more gullible. The entrepreneurs may position this as an opportunistic chance for the angels to bridge the company to its next “inevitable” venture round. As I have said in a recent posting, this is very dangerous ground for angels to be investing in. Failed startups that are back looking for new money from angels in a distressed condition, will very likely “experience the knives” eventually. The capital capacity of angels is unlikely to be able to fix what ails that kind of company. Angels who play in this category had better be experienced bottom-feeders. This is a special and dangerous world.

No doubt there are other more specialized categories, and admittedly, some deals won’t fit neatly into one of the above categories, and may have aspects of more than one.

An important question for angels to address when seeing a new deal is which category does this deal fits into. In my humble opinion, angels and angel groups are best advised to invest in the first two categories, i.e. deals that are clearly within the capital reach of angel money (category 1), or deals where the angels are effectively becoming cofounders and helping position the company for its highly likely first institutional round under fair economic terms (category 2). I believe angels should avoid deals that have been extensively and unsuccessfully shopped to VCs (category 3), unless they can see a way to turn the deal into a category 2 deal. And I believe angels should avoid deals (category 4) where VC’s have already played and are now absent. “There be tygers…”

Entrepreneurs are just a bit irrational --- they have to be to start a company from scratch. I know. I’ve been there multiple times. They will say what they need to to get funded. They will alter their story to make it seem angel-friendly.

Angels and angel groups are usually seen as the farthest out-there on the money tree. They will tend to naturally see the earliest and rawest deals, or the most desperate deals. It is best for angels to first try to separate the deals they see into early vs desperate piles. Highly motivated entrepreneurs are great; desperate, back-against-the-wall entrepreneurs can be a lot of trouble. Then focus on whether you want to back a deal with a few other angels, or as a precursor to bigger investment by VCs.

My two cents…

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