Welcome to today's lesson. In this lesson, we're going to talk about raising equity capital for your startup company and in particular, about different types of equity investors and how to approach them. My goal for this lesson is to provide you with insight into the venture capital process. Particularly, what angel investors and venture capitalists look for in startup investment opportunities. This is where we left off last time. The first source of startup financing, of course, is the entrepreneur's own savings. Money that you have available that you can invest in your own company. It's probably the cheapest source of financing that you'll ever find for your company and it's also an important signal to future investors that you're a big believer in what you're trying to accomplish in your business. If you haven't invested in your own company, it can be hard to convince others that they should take the risk. Entrepreneurs will often use the proceeds from a second mortgage or a home equity loan as startup capital. And others will use credit cards to pay their initial start-up expenses. Before you borrow money personally to start your business, you should ask yourself if there will be a way for you to repay this money if the business can't. It's unfortunate when a failed startup company results in a personal bankruptcy for the entrepreneur as well. The second source of financing is the entrepreneur's own network of family and friends. These are people that know you. They trust you, they believe in you, and they want to support you in your business ventures, not necessarily because they're trying to make a lot of money on the investment, but because of the personal connection they have with you and their interest in seeing you succeed. Angel investors are the third source of financing and we'll be talking quite a bit about them in this lesson. We'll also be talking about venture capital firms. Crowdfunding platforms are a relatively new source of capital. We talked about them in one of our previous modules. Finally, there are strategic partners and investors. These are usually larger corporations that have a strategic or a market-related interest in what you're trying to achieve with your company. They want to be involved with it because it enhances what they're doing in their core business in some way. So, let's jump right in and talk about angel investors. Who are angel investors? These are wealthy, sophisticated, "accredited investors." An accredited investor is a defined term. In order to be designated an accredited investor, an individual has to have more than $200,000 in annual income and they have to have a net worth of over $1 million, not including the value of their home. So, we're talking about high net worth individuals, not the upper-middle class. They're more likely to be successful entrepreneurs than doctors, professional athletes, and celebrities. That's because as successful entrepreneurs, they not only have an interest in helping other entrepreneurs be successful like they were, but they also have the experience and the expertise that's necessary to evaluate your business plan and make a responsible investment decision for themselves. Wealthy individuals who don't have that expertise would normally hire a financial advisor to help them make a decision like this and one of the ways that financial advisors keep their jobs is by discouraging their clients from investing in risky startups. The best angel investors are willing and able to bring more than just their money to your business. They can share their expertise, they can share their contacts, and they'll be willing to work with you to help the business grow. They might even be in a position to join your management team. So, where can you find angel investors? You don't normally see classified ads in the newspaper saying, "I have lots of money to invest. Here's my personal email address, please send me your business plan." Fortunately, many of the most active and experienced angel investors now participate in organized groups or networks. These groups can operate in different ways. Some angel groups are organized as loose-knit networks that shared deals with each other informally. Some are organized as formal groups that meet on a regular basis and evaluate investment opportunities together, they may invite entrepreneurs to come to their meetings to present their companies. Some have a professional staff to select the entrepreneurs who will give presentations and to negotiate the terms of the investments. Some groups are even structured as funds through which angel investors have pooled their capital to make investments together. Many angel groups are connected to universities. For example, Hyde Park Angels is an angel network that's been around for many years. They are loosely affiliated with the University of Chicago. Irish Angels is an active early-stage investment group affiliated with the University of Notre Dame. Some angel investors are involved in regionally or community focused networks. Here in Illinois, you can find UCAN in the Urbana-Champaign area and Central Illinois Angels which is based in Peoria. There are also online platforms like AngelList, on which you can create a profile and present your company to groups of investors. Don't be fooled by the term angel investor. These investors have a high risk tolerance and they expect to earn high returns on their investments. They're not trying to earn their wings. They're called angels because they're willing to make early-stage investments to help you succeed when others won't. The Kauffmann Foundation in Kansas City conducted an extensive survey of angel investors a couple of years ago in order to identify the characteristics of typical angel investors and what makes them successful. They found that the typical angel investor in the United States is 57 years old with a masters degree and extensive experience both as an entrepreneur and as an investor in entrepreneurial companies. Angels typically invest 10% of their wealth in startup company investments. Those investments are spread out across several companies. 10, for a typical angel investor in the study. He or she had also had at least 2 exits in the past several years. So, how successful are angel investors? The Kauffmann study found that on the average, the angels that they surveyed had achieved a return of 2.6 times of their invested capital over 3 and a half years. That's a pretty attractive rate of return. It translates into a 27% IRR. Still, it's important to recognize that these are high-risk investments. Less than half of the companies that they invested in return the full amount that the angels had invested. Only a third generated the returns that the investors had expected going in and just 6% of the deals resulted in returns of more than 10 times the original investment. What this means, is that only 15% of all the companies that these angel investors financed, were responsible for all of the actual profits in their portfolios. This is why the best angel investors take a portfolio approach. They're going to invest in multiple companies, not just one or two, so they can have a more diversified portfolio and better odds of success. So, when you're ready to approach angel investors, it's important for you to recognize that an angel will want to back you for the same reasons why anyone might want to get involved with a startup company. The first reason is that you've convinced them that they can make more money by investing in your company than they can by investing in some other asset or some other start-up. The second reason is that you've demonstrated that by investing in your startup, they'll be helping you make the world a better place in some way. And the third reason is that they think that they'll enjoy working with you. If you can make the case successfully on all three of these, you should be successful in finding angel investors. So, when you're ready to make the approach, make sure that you're reaching out to Angel investors, who are willing to invest in companies like yours, companies in your industry, and your stage of development. If your business is a startup, don't bother approaching investors that don't like to invest in startups. Do your research ahead of time. I'm constantly amazed by entrepreneurs who blindly email their executive summaries or PowerPoint decks to random investors that they find on some mailing list that they purchased. You should expect to spend a significant amount of time with investors if they're interested in your company. They'll want to get to know you, your co-founders, your technology, and your market really well. They're going to be spending time with you both before and after they invest. You'll be building a long-term relationship with these investors, and that relationship has to work. The best way to approach an Angel investor, or an Angel network, is with a referral. Do this by networking with other angels, entrepreneurs that they financed, or through syndicates. Ideally, your Angel investors will provide more than just cash. They can advise you on your financing plan and they can make introductions for you, both for additional financing and for growing the company. As I mentioned before, angel investors will want to back you if they think they'll enjoy working with you. But if you don't make money for them, it's not going to be fun for either of you. Let's switch tracks here and talk about venture capital firms. Unlike angels, venture capital firms are professionally managed investment partnerships. They're usually investing institutional capital. It's not their own money that they'll be risking. They have to report on what they do to their investors. Which means that they have to take a different approach to investing. They've promised their investors that they'll make specific types of investments. They can't just take a flyer because they think your deal is interesting. Usually, the managers of a venture capital firm are compensated with a management fee based on the size of the fund that they're managing and a share of its eventual profits. They can have a wide range of investment strategies. Some funds are industry-focused, while others are focused on companies with specific stages of development or located in a specific geographic area. Just as you do with angel investors, you need to understand whether they're willing to consider investing in a company like yours before you go to the trouble of approaching them. Fortunately, this is not difficult to do. Most venture capital firms have websites where they describe their investment strategies and the kind of investments that they'll consider. Most of them list their portfolio companies or at least the ones that have been successful. You can see whether they're likely to be interested in a business like yours, and you might even be able to find an entrepreneur who's willing to make an introduction for you. Early-stage venture capital firms are looking for very high rates of return on their investment, often even higher than angel investors are shooting for. Like sophisticated angels, they're going to take a portfolio approach. They understand that only 1 or 2 out of every 10 investments that they make will ultimately determine whether their funds are successful or not. Let's take a closer look at this because it's important for entrepreneurs to understand. This chart represents a typical early-stage venture capital fund portfolio. Out of every 10 investments that a venture capital firm makes, there are likely to be several that turn out to be strikeouts. These are companies that fail, and the venture capital firm loses the money it's invested. There will also be several that wind up as singles. The businesses go sideways, and when they're sold or liquidated, the venture capital firm manages to get its money back. Perhaps a bit more and perhaps a bit less. Then they're going to be a few doubles. Where the company does reasonably well, and the venture capital firm makes a decent profit, maybe 2 or 3 times the amount that they invested. Hopefully, there will also be a home run or two, these are the most successful investments in the portfolio. The venture capital firm will get a return of 10 times its investment or more. On the right side of the chart, you can see what that means for the fund's overall returns. When you put all the singles, doubles, and strikeouts together, the fund will probably just break-even on that portion of the portfolio. All of the real net profits for the fund will probably come from the home runs. This is why venture capital firms aren't going to invest in a startup company unless they had been able to convince themselves that it truly has the potential to be a home run. If your company doesn't have homerun potential, if you're going after a niche market, for example, you probably won't be able to raise money from an early-stage venture capital firm, even if your business is less risky than most. So, now we're ready to make our approach. The first piece of advice that I can give you is that you should not bother making cold calls. They're almost always a waste of time. I remember visiting a venture capital firm's office once, back in the days when business plans were printed on paper, and seeing a stack of plans on the corner of the desk. I asked what that was and was told that they were plans that had come in through the mail, and they were waiting for an intern to read through them and let one of the managers know if any of them were at all interesting. You don't want your opportunity to end up in a pile like that. You should always try to use a referral when you're reaching out to a venture capital firm. The stronger the better. The best referral is one from a successful entrepreneur. If an entrepreneur who's made money for a venture capital firm, tells the managers in that firm that they should look at a new startup company, you know that the venture capital firm will want to take that meeting. What's that? You say you don't know any successful entrepreneurs? If that's the case, you're probably not ready to raise money. You need to spend more time networking first. Network in your industry, your local community, your college's alumni directory, and so on. One good way to get an entrepreneur to help you raise money is to ask him or her to be an adviser. As the saying goes, "When you need advice ask for money, when you need money ask for advice." If not from an entrepreneur, make sure that your referral is from somebody else that the venture capitalist knows and respects. This could be an attorney, an accountant, a consultant, a customer, etc. As with angels, do your homework so you're not wasting their time or yours. Study their websites. Study the companies that they've invested in. Most venture capitalists will tell you that they see hundreds if not thousands of opportunities every year. You have to stand out from that crowd in order to get attention. This means that you need to have a great executive summary and a terrific investor presentation. Entrepreneurs often ask me about things like non-disclosure agreements, term sheets, and in particular, valuation. Here's what I tell them, don't lead with a non-disclosure agreement or a confidentiality agreement. If you haven't figured out a way to explain how exciting your opportunity is without disclosing highly sensitive and confidential information, you're not ready to raise money. Venture capital firms have lots of companies that they can invest in. If you tell a venture capitalist that he/she has to sign a confidentiality agreement before you'll provide any information, they'll probably say: "Thanks, but no thanks" and they'll ask you to move along. It may very well make sense for you to have them sign a confidentiality agreement later on when they're definitely interested in investing. Until you get to that point, keep your proprietary details to yourself, and just share information that you feel comfortable sharing. Don't offer your own terms or propose your own valuation. Most venture capital firms expect that they're going to be the ones that make the actual investment offer. They're going to prepare and issue a term sheet to you. If you start out by telling them what valuation you'll accept, you run the risk of either turning them off because they think your valuation is way too high or leaving money on the table by offering a deal that's worse for you than it needed to be. Finally, make sure that you have enough cash on hand to get through the fundraising process. Raising money can take quite a while, and the last thing that you want is to be so desperate for cash toward the end of that process that you lose all your negotiating leverage. Let's talk about that process. If a venture capitalist is interested in your opportunity, you're going to get a meeting. If you make a good impression, they're going to spend time getting to know you and your business. This is when they'll start digging in with you to understand your management team, your target market, your go-to-market strategy, your financial projections, your technology road map, and so on. This is the start of what's known as due diligence. When they've decided that they want to invest in your business, the venture capitalist is going to offer up a non-binding term sheet. That will be a 2 to 10-page document that details the amount that they're proposing to invest, their proposed valuation for the company, and the other key terms of the investment. You may go back and forth on this with them. But if you're able to come to agreement on terms, they'll start doing additional due diligence. This is going to involve looking at your company's organizational documents, your legal contracts, your intellectual property rights, your historical financial statements, your customer contracts, and your employment agreements. If you don't have your house in order, it will be hard for you to close the deal. This will be followed by the final negotiation over the legal documents for the investment itself. If the due diligence went poorly, the terms could change, and not in your favor. The entire process from start to finish can easily take 90 to 120 days. That's why it's important for you to make sure that you have enough cash runway to get through that period of time. Getting the first ''yes'' from an investor is always the hardest. There's no substitute for competition. It's always best to be talking to more than one investor if you can. If you're relying on a single investor to come forward with money, and you have no options, you won't have much leverage in your negotiations. Know who the decision-makers are at the venture capital firm. Make sure that you have their attention and not just that of junior people within the firm. Remember that no one is better at selling your opportunity than you are. Don't rely on an analyst to sell your opportunity to a decision-maker in that firm. Be as transparent as possible during the fundraising process. Bringing on an equity investor is often described as a marriage. In any marriage, there has to be trust and confidence. If the investor comes to believe that you're being anything less than honest with them, the discussions will be over. No news is not good news. Don't assume that just because you haven't heard the word "no" yet, the investor is actively moving toward a yes. Stay in touch. Push the process forward as diplomatically as you can. A fast "no" can be better for you than a slow "maybe" that never gets to "yes." It gives you the opportunity to learn from your experience and move on to other and hopefully more productive options. Have experienced legal counsel on your side. Someone that's been through the venture capital process before. Your investor probably does lots of deals. You're at a disadvantage if you have no experience in this area. The last piece of advice I'll give you is to keep your eyes on the prize. Venture capital transactions are complex with many terms, many conditions, and many contingencies. All of these are subject to some degree of negotiations. In order to get to "yes," you need to understand and focus on what's truly important. We'll talk more about this in another lesson. If you're interested in learning more about the venture capital process, here's a book I highly recommend by Brad Feld and Jason Pendleton. Here also is a glossary of important venture capital terms and an article on negotiating with venture capitalists from the Harvard Business Review. You can find the links in the resource guide for this lesson.
