Angel Financing

In a few months Lijit Networks will be two years old. We started the company in a fairly common way, finding employees that wanted that "ground zero" experience, having the seed of a good idea, and finding Angel Investors that would invest and keep the idea alive long enough to germinate. It wasn't easy but we got it done. A question I get a lot from new entrepreneurs is "how do you find Angel Investors?"

Many young startup entrepreneurs tend to look at Angel Investors as a group of people with more money than sense (which sometimes is true) but generally not. They give no thought to the motivations of their Angels, what their Angels should get from the relationship, or simply why the Angel should be interested in investing. Like anything, understanding your audience is half the battle. Don't trivialize your Angels Investment by rationalizing the money isn't important to them; I find that $25K is important to everyone.

I have been on both sides of the Angel Investment table. Lijit was Angel funded for the first year of its life. We raised approximately $900K from a combination of friends, family and seed professional investors. On the flip side I have made several Angel investments in other local companies – with varying success. Based on this sample set plus other random data I have collected along the way, I have established a basic way to look at Angel Financing.

Types of Angel Investors:

The Family Investor: The Family Investor is likely not really a classic Angel Investor at all but rather a supportive family member that "knows you". Their motivation is likely out of support (sometimes guilt), but their basic investment thesis is they trust you. For me these are the worst type of investor because you likely have intimate knowledge of their financial situation and whether or not they 'should' be investing. Likely, they have no inherent feel if your idea is good or not, but may have changed your diaper at one time or another and have overcome that experience to hand you a check for $25K or $50K. Personally, I like this category of investor the least because the investment is totally emotional and personal – and that sucks in business. But based on the financial situation of the individuals involved and the relationships this can work ok if everyone comes into the situation with their eyes open, but go out of your way to make sure.

The Relationship Investor: The Relationship Investor is probably one or more co-workers from a previous gig or business friends you have known for a while. They may or may not understand what your new company is doing but they have had a track record working with you. They want to be supportive, but are looking for a return. You won't lose them as friends if things go bad, but the investment for them is likely not 'trivial'. In my experience these are good Angels to have, again as long as their eyes are open going in. These people can also be wildly supportive of you in terms of finding employees and other resources.

The Idea Investor: The Idea Investor is probably very familiar with the space your company is targeting. These are in some ways the very best types of Angels because to some degree they validate your idea. There investment is based on the Idea and there is little emotion around the table (always good). If you can get them onboard they can open doors into partner relationships and just generally good advice. You will spend most of your time convincing the Idea Investor that you and team are the right people to attack this problem (as they likely don't have a strong relationship with you or the team). Often an influential Idea Investor makes a good early board member for the company.

The Once Removed Investor: The Once Removed Investor is likely connected through a personal or professional relationship with either the Relationship Investor or the Idea Investor. They likely don't know you, and they likely don't have a clue if your idea is good or bad but they have translated the trust in the investment to the person they know. This is a great way to get additional Angel Investors onboard, but without a solid Relationship Investor or Idea Investor it just isn't going to happen.

I personally have never seen an Angel Financing come together without some mix of the first three investor types plus a few Once Removed Investors. Be warned that the Once Removed category of investors will also supply the softest money in the upcoming financing. Simply put - as you verify amounts before close, the Once Removed guys are the ones that tend to "go away" or "get smaller" as the deal progresses. A friend of mine that has successfully financed several companies gave me the rule of thumb that most investors will end up being about half of what they initially committed to. This is definitely true of Once Removed Investors; I once had a $400K guy turn into $50K guy, and $50K was like pulling teeth.

Finally, there is a concept I refer to tongue-in-cheek as the Arc Angel. An Arc Angel is a Relationship Investor or Idea Investor that has a track record of success making other Angels (and perhaps non Angels) money. These people are valuable as they can be very influential attracting quality Once Removed Investors. If you can find this person and get them excited about your deal, do it.

The bottom line on Angels, spend your time looking for solid Relationship Investors or Idea Investors, they are the ones that will get you over the hump. Bring a few Family Investors along for the ride if they won't get sick on the Rollercoaster and hope that you can mix in a good set of Once Removed Investors.

Size of Investment

Next, you have to consider the size of the investment. Money never goes as far as you think it will. My experience is you need to raise between $500K and a $1M to do almost anything. Using Angel Investors to achieve this goal you are likely looking at investments all over the board but usually in the $25K to $100K range. You may have a few smaller and a few larger but in my mind you have to target having no more than 10 to 15 total investors in an Angel round. It's just too hard to herd the cats when the group gets larger than this.

Pre-Money Valuation

A friend of mine with much more experience then myself told me, Angels should get a good deal. They are putting money in at a time when presumably no one else will and they are taking a huge risk. I can't tell you how many people have said, "Yeah, but its only $25K and they have lots of money". That's total bullshit; show me someone who lights $25K on fire for no reason.

Having been on both sides of these kinds of deals, I totally agree that Angel Investing is very high risk and the road ahead as an Angel is fraught with investment disaster. Lots of wonky things can happen to the Angels when VC's come into the company including investment preferences that take away the Angel Chocolaty goodness. I have also, unbelievably, had meetings with entrepreneurs where they are indignant I won't accept their pre-money valuation on their imaginary business. I always tell them the same thing, if my money is so unimportant, do it with yours. If you feel compelled to twist the valuation screws do it in the A round with the professional investors.

Investment Mechanism

There was a period of time where nearly every startup was doing convertible financings. This is where as an Angel you invest as if the investment is a debt type financing but can convert to an equity investment based on some outcome or the will of one party or the other. I tend to think these deals kind of suck. They are usually setup to attract money fast, and often in the case of the entrepreneur are empowering some kind of fantasy that the investment could be paid off based on success of the company and he won't need to give any equity away. As an investor that's the last thing I want because that just turns my investment into a very high risk bank account. The only time I saw this work well was a company that had plenty of investors around the table and incented them to invest early to get the company jump started faster. Early investors got some warrants to make it worth their while to have their money show up to the party sooner (and deal with the risk of being the first money in). Just skip this stuff, get all your Angels aligned, do one close, and make it a pure equity round. If you aren't ready to sell equity in your idea, finance it yourself.

Liquidity

With the exception of possible investors in the Family category, Angels are not in it to finance your dream indefinably. You would not think it to be the case, but I have had several conversations with people approaching me for Angel investments who simply could not articulate how I would ever get any money back. They were so focused on getting money from people they forgot 'they are an investment', and investments have terms. Almost without exception, I don't want to own your dream, I want to make money and have a little fun along the way. If you never sell the company, I never realize a gain.

Conclusion

There are probably 5 more posts I can do on this subject but my goal was simply to put together a primer on this subject. So many people approach me not understanding the dynamics of early stage financing. Brad Feld has written good stuff in this area on his blog as well as some quality stuff on AskTheVC. Use these resources to understand the numbers, but don't forget to understand the motivations.

Comments

[Will]

Todd,
This is an awesome post! Thanks for this. We have managed to get your first type of Angel to invest, now if we can get the rest we will be squared away. :-)

[Ben]

A great post. Thank you for this.

I do take issue with one of your last thoughts though: "If you never sell the company, I never realize a gain."

I'm always confused why so many people focus on the exit as the only path to return. A profitable company can be privately held and reward investors through dividends. Sure, this means more discipline in execution and monetization since you don't expect that billion-dollar buy-out, but dividends are an acceptable investment return mechanism for many investors.

[Larry Meyer]

Todd,
Great post! I am diving into the world of " I need investors". It appears to be a nerve racking endeavor, not for the weak. If you have further info in regards to "realistic equity" to investors that would be great. As a new owner to a virtual company, I have know idea what to expect.
L~

[Todd Vernon]

@Ben: thanks for the comments. You are correct that the outcome of the company can be a dividend to investors. I would say however that these kinds of businesses tend to be in the lifestyle category which is a different beast. You will get your money out in the form of an annuity but thats generally not a venture capital type profile. your comments are totally valid, just make sure that your Angels know this is your likely strategy or you can have misalignment between you and your investors.

[Don Jones]

Todd - nice post on the different types of angels.

For a take on the process of working with angel groups, here's another resource:

http://www.venturedeal.com/Reports/AngelGroupFinancingGuide.pdf

Cheers

[Aaron Fyke]

Hi Ben, I'd like to echo Todd's comments above. An annuity stream of dividends can be a great payout for angels, but this pretty much precludes the business from being attractive to VCs. Because of the "closed fund" format of most VC funds (ie, the funds must be returned to the LPs within a set time period - usually 10 years), a long annuity stream can only be realized for the VC if they are able to sell it. As this is often impossible, a business with no exit path is a very different type of business than one that follows the traditional angel-VC-exit route.

Aaron Fyke
Starfish Ventures

[Chris]

Todd,

Great post. Any chance of you writing a post regarding the next round of raising capital? It would be really helpful.

Regards,

Chris

[Todd Vernon]

@Chris Since our Angel round of financing we have raised an additional 3.3M in Venture Funding. I may write something on that in the near future.

[John]

We are well into our second angel round and boy have you hit it on the head. I am now a professional cat herder. We could use a big dog instead!

[Ryan Bowse]

Great Post!

[Anthony Kuhn]

This is a great primer on angel investing with inside view information worth of a link today in my own post at the Innovators-Network blog. Thanks for sharing your hard-won knowledge, Todd and best wishes for continued success with Lijit.

[Dan Caruso]

Todd,

Thanks for this post. I will refer to this in my site and refer people to it often (as people often ping me for advice on angel investors)

Dan Caruso

[Chris Sheehan]

Todd,

As the co-manager of one of the largest angel groups in the country, I enjoyed reading about your thoughts and experiences in raising money from angel investors. Keep up the good work!

Chris

[Mark]

Todd,

Thanks for sharing.

Why angels and not seed-stage VCs? Was it equity? Terms?

[Knox Massey]

- Make sure all the angels are accredited.

Good luck!

[Todd Vernon]

@Knox We had one seed stage VC in our angel round and one individual that was a proxy for a VC that later came into our first venture round. I think seed investments from VC's are great, but my experience is they are hard to come by for first time entrepreneurs. After you have a success under your belt, much easier.

[Burke Franklin]

Outstanding explanation -- from a person who has been there and done that. May I have your permission to include your article on our website to supplement the education of our customers for BizPlanBuilder (www.jian.com), our very successful business planning software? Many are starting businesses and seek financing. Link, image, attribute back to you... of your choice of course. Thank you very much.

[Evan Bartlett]

Very insightful profile of angel investors. Its a different perspective from the standard x-entrepreneur vs. corporate angel that I hear so frequently, and I think your explanation does a better job of describing the variation in angel investors.

Another post that goes well with this is http://www.informationarbitrage.com/2008/04/super-angel-net.html?cid=111811854 and there's a discussion about Super Angels essentially being able to compete much more effectively against VCs in the seed space.

VC seed funding is definitely hard to find, and with effectively organized angels (maybe led by Arc Angels), you've got a better chance of finding money.

Evan

[Todd Vernon]

@Burke Franklin: Sure just point back to this post..

[Ray Weilage]

I have been on both sides of the table. I started buying property where I did all the work - found the property, developed the bank line of credit, developed the property and sold it. The investor received 50% for putting up his net worth as a guarantor and 10% cash up front. Later I started to purchase small banks. This took a lot of work and investors who had $100,000 to $200,000 to invest. Again, I did all the work for which I received 20% of the Bank Holding Company stock. The investors put up 100% of the book value of the Bank. Anything over book value was borrowed. The Investors received 80% of the stock.
The Article was excellent!

[Mike Michalowicz]

The biggest realization is that funding derived from VCs or Angels is simply an investment. Just like when the "common man" buying stock on the NYSE, the concern is the return. No one gives two hoots about the number of hours the President has to work, or what his grand ideas are - all we, as stock investors, care about is that the stock goes up and we make money.

We are all cut from the same cloth, VC or Angel or any one else - we invest to make money, not friends.

[Oliver Sweatman]

Thanks for the post. My experience with more experienced angels is that they often prefer to invest in convertible debt knowing that it is generally cheaper and faster for a start-up to paper & close, keeps them closer to the IP and affords them a little more leverage (perceived?) going into a subsequent dilutive financings. Such paper though, esp. it has too many bells and whistles, can muddy up follow-on equity rounds. My preference as an entrepreneur is to issue small rounds of common equity a reasonable valuations to Angel investors, but they won't always take it.