It’s All In The Terms: What To Prioritize In Angel Term Sheets

Terms term terms! Angels, new and veteran alike, agonize over what terms are to ensure the proper incentives and to properly compensate for risk. Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article on this topic. Her full article (with her permission) appears further below.

 

An essential part of angel investing is setting and agreeing to the terms of the deal.  Many angels recognize the importance of deal terms, but often wonder which components of the term sheet to prioritize. I’ll reveal the answer, but first some background about term sheets.

A term sheet outlines everyone’s intent for a deal. It is typically provided by the angel with help from their attorney. For this article I worked with angel investor Katherine O’Neill and attorneys, Ben Straughan, Partner, and Jim Carroll, Counsel, for the Perkins Coie Emerging Companies & Venture Capital practice. They also shared their insights in a recent Angel Capital Association webinar, The Key Points of Term Sheets.

A well written term sheet is critical because it leads to a great contract and creates investor-entrepreneur alignment needed for a positive relationship because it delivers the returns everyone wants, assuming the company is successful. O’Neill, executive director of Jumpstart New Jersey Angel Network, underscores this point: “This is the time you have the greatest opportunity to really control the main factors that allow you to make a good exit.”

So what deal terms are most important to angel investors?  Tapping their years of experience, Carroll and Straughan suggest five critical terms for a series seed preferred investment (otherwise known as a priced angel round):

Pricing: This represents the value of the company and helps determine how much of the company you will own. It is important to get the valuation of the company right in the beginning, which can be an art with startups and early-stage companies with few assets and short track records to build on.

Participation Rights: These define an angel’s right to invest in future funding rounds, often providing the angel with a better chance of a good return. “Angels should focus on participation rights,” Straughan said. “It allows you to double down by continuing your right to invest in future rounds.”

Board and Information Rights: These rights outline whether you (or someone from the investing organization) will be on the board of directors or be an observer at company board meetings. They also determine the information you will receive from the company and how often you will receive it. For example by explicitly asking for quarterly financial statements and annual budgets, everyone can keep their eye on the ball on the status of the business while ensuring the company doesn’t have onerous requirements (because these are documents that a company needs to produce anyway).  Related to these, I like the idea of shareholders having the right to vote or at least have veto rights on key strategic issues such as selling or liquidating the company or developing entirely new lines of business.

Liquidation Preference: If the company is sold, these preferences define what preferred shareholders are paid e.g.  X times the original purchase price before any other assets are paid common stockholders. 1X liquidation is normal for angels.

Redemption Rights: These rights can help angels to achieve liquidity by selling their shares back to the company if management wants to continue running the company but investors want out.

Although these five components provide an excellent guideline for what to prioritize, term sheets can quickly get more complex, and most include many other terms which are also important.

Most experts recommend that angels start with a standard term sheet to help simplify the process and to reduce legal fees.  I’ve provided sample term sheet examples in this article and there are a wealth of other online resources.  These are a few of my favorites:

Angel Resource Institute – Their term sheet resource center includes both example documents and helpful insights. They also offer workshops on understanding term sheets.FundingPost Venture Capital Glossary – This is a glossary of financial terms for angels and entrepreneurs to understand.Hyde Park Angels – How to Read a Term Sheet (and several other great blog posts)Investor IQ – The Kauffman Foundation, ACA and ARI provide a wealth of video and materials on all facets of angel investing from experienced investorsSeraf Investor – Angel Fundamentals: Understanding Equity Deal Terms (Introduction), and many other great and important insights into being an angel investor

Term sheets are critical and that is exactly why they can sometimes be overwhelming. Beyond these resources I always recommend talking to other angels and learning about new approaches, trends and ideas at regional and national angel events. With resources like these there’s no reason to sweat the terms on your own.

Tips For Angels To Assess Startup Business Models

Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article with tips for analyzing startup business models. Her full article (with her permission) appears further below.

 

Can the company you are considering investing in scale and get to a good exit? How is it going to make money, really?  These are some of the most important questions every angel investor needs good answers for from the entrepreneur. Successfully evaluating a startup business model can make the difference between success and failure of your investment.

Business models can be stated simply – like “razor blades” (offering a high margin shaver at a good price in order to increase sales of razor blades) and “freemiums” (offering basic services for free and charging for premium services) – but they involve the detailed overall strategy of the company.  A business model is how the company defines the market and its products, along with how it gets and keeps customers, how they get to the market, and how its resources are set up, all while eventually making a profit.  Startup business models are even more complicated because most startups are essentially experimenting with their strategies and will evolve their model as they test it out.

Many entrepreneurs and investors use the Business Model Canvas by Alexander Osterwalder to develop and evaluate business models.  Brigitte Baumann, founder and CEO of international angel group Go Beyond Investing and 2014 European Business Angel of the Year, takes more of an economic approach.  I’ve been working with Baumann to develop a set of free resources for new angels to get started successfully and connected with her recently on how angels evaluate business models.

When Baumann reviews a business model her first step is to sort the business plan information into four economic-focused building blocks:

Unit economics: the hard data that include the selling price of the product or service and the costs involved.Customer economics: customer acquisition, retention and support).Market economics: what it will take for the entrepreneur to actually create the market buzz or demand needed to acquire customers who will use the units.Business economics: the development and overhead; this includes anything from additional offices that might open to support for handling finances, etc.

Thinking about a business model through these four lenses helps to get to an understanding about how much money an entrepreneur needs in order to become self-sustaining. It also makes the financial goals for each round of funding more obvious.

Knowing how entrepreneurs think about the business model is very important. To quote Baumann, “The entrepreneurial team should all ‘live’ the model. They touch it every single day in every action that they do.”

Naturally getting to those important answers requires analyzing the business model from two crucial perspectives: scalability and the break-even point.

Scalability – is a key indicator in whether or not a company will go public or be acquired and investors will get returns on their investments. It is about a company’s ability to multiply revenue with minimal incremental cost, creating a profitable and valuable business.  Baumann suggests that when angels meet an entrepreneur, we need to understand whether he or she is planning for 3x, 10x or 100x growth from where they are currently.

Knowing which level helps investors understand the amount of money the entrepreneur needs to raise and in how many rounds.  A company that is planning for a 100x growth is likely further along in their development and has the chance of a great exit for all involved.

The Break Even Point – Beyond scalability it is important to understand the company’s break-even point, when it becomes self-sustainable and doesn’t require more outside capital.  Baumann has a chart to determine break-even, incorporating fixed and variable costs, as well as the incremental costs that come with increased scalability in a new video.

To understand scalability and break-even points in due diligence, angels need to understand the economics of the company’s revenue growth plan and when they are a “real business.”  Questions to investigate how revenues will grow and all of the involved costs.  Make sure entrepreneurs are realistic about how much money they will need to get to break-even by asking them where the current round of funding will take them, how many rounds of funding they think they will need, what resources they need to get to each level of scalability and what milestones they accomplish in each round.

Many scalable business models involve big margins between true product costs and selling prices and/or pricing mark-ups.  But angels need to make sure the entrepreneurs have thought through all of the relevant costs, including the costs of customer acquisition, retention and support over the lifetime of the customer relationship.

Other critical things to check into during due diligence are the market economics, particularly whether they are using the true accessible market and whether their potential share of the market is possible.  These days, it is easier and easier to get data on the company’s existing competitors to get data to compare to.

The bottom line is it is key that entrepreneurs and investors understand the business model before reviewing the financials. Entrepreneurs need to know the drivers that capture market share, outmaneuver the competition and make the business succeed. And investors need to know how to get that information out of the business model or help entrepreneurs build a business model that provides those answers. Without this knowledge it’s difficult to properly evaluate a startup and to make a wise investment decision.

Scorecard Helps Angels Value Early-Stage Companies

Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote this article on a growing techqniue used by angels to evaluate companies. Her full article (with her permission) appears below:

 

Scorecards are ubiquitous in baseball, helping coaches, players and fans understand the factors that led to a victory or defeat.  It turns out that scorecards come in pretty handy for startup business investing, too.

This past October, I enjoyed watching my hometown Kansas City Royals become the World Champions of baseball. Their scorecard was easy to understand, what with runs, hits, and great pitching stats.  Those stats were the factors that led to their World Series win.

Angel investors are using a similar concept for determining the value of the startups that approach them for financing.  They look at the factors that make a new business more or less valuable in a valuation scorecard.  The factors are just different, like industry sector, market size and quality of the management team.

Before we jump into the details of the scorecard, it’s important to understand first why company valuation is so important to angels and entrepreneurs.  The bottom-line is that it is part of the critical calculation of determining how much of the company the investor owns for their investment.  Marcia Dawood, an experienced investor and board member of the Angel Capital Association, walked new investors through the important calculations in a recent webinar.

Dawood explains there are two types of valuation – ”pre-money” is the company’s value before an investment and “post-money” is after the investment.  And an investor’s percent of ownership equals the size of the investment divided by the post-money valuation.  We use both to determine percentage of ownership.

For example, if a company has a pre-money valuation of $2 million and raises $500,000, then the post-money valuation is $2.5 million.  The investors own 20 percent of the company (by dividing the $500,000 by $2.5 million).

Sometimes entrepreneurs back into a valuation when they know how much they want to raise and how much of their company they are willing to give up.  Investors can do this too.  Dawood says, “Think about Shark Tank.  Mr. Wonderful says ‘I’ll give you $200,000 for a 10 percent stake in your company.’  Divide the $200,000 by .10 and you get a $2 million post-money valuation and after subtracting the $200,000 investment, you get a $1.8 million pre-money valuation.”

The numbers in the calculation can have a huge impact on your success in an investment, so it is important to be comfortable with the final pre-money valuation and the elements that get you to that number.  You don’t want to buy company stock for too high of a price.  So how do you do that?

Keeping Score

There are several ways to value startups, but the most popular method used by angels to determine a pre-money valuation is the Scorecard MethodBill Payne, a long-time angel who also led the webinar, uses a real estate analogy to explain the method:  it appraises startups using comps.

The Scorecard Method is used for comparing target companies to similar startups, such as business sector, stage of development and geographic location.  You compare your target company to the norm for several factors and then adjust the median by your appraisal of the target.  These days it is easier to find data on investments and valuations of entrepreneurial firms on the Internet.

The main parameters, or criteria, of the Scorecard Method, in order of importance, along with their respective weights, are: entrepreneur, team, board (30%), size of opportunity (25%), product/technology (15%), sales/marketing (10%), need for more financing (5%) and other (5%). You can change the percentages according to your own preferences about what is important to a startup’s potential.  Put them into a column.

Next , approximate how the company you’re trying to determine a valuation for stacks up in each of those parameters against similar startups. If you think the management of the target startup is 20 percent stronger than the other similar companies, for example, then use the number 120 percent in the comparison column for the parameter. Do the same for the other criteria. When you are finished, multiply the two numbers in the row and post that number in an adjusted weighting column.

Tally the numbers in the adjusted weighting column and multiply that sum by the pre-money valuation for similar startups.  You end up with a chart with a final valuation scorecard like this:

 

This should be fairly accurate as long as you have a good starting value and use a similar stage of development, a comparable business sector and a like location.

Obviously, you want to keep in mind that if the seed stage valuation is too low, entrepreneurs are going to eventually be diluted after multiple rounds. As a result, their interest in driving the company is going to be diminished. If the seed stage valuation is too high, the entrepreneurs and the investors have undervalued the financial contribution.

Other Options

The Scorecard Method, along with the Venture Capital Method and the Dave Berkus Method, are only three of the many methods used by angels in appraising a pre money valuation of a startup company. It is best to use multiple methods, then make a decision from there as to what you think is appropriate for your company and the company you are investing in.

Besides these methods, the Angel Resource Institute offers other ways to learn valuation.  There are also some ACA webinars which are chock-full of good information.

Payne recommends that angels try multiple valuation methods for each investment opportunity.  Essentially, establishing benchmarks helps make something that is very subjective more objective.

Angels who get a 10X plus exit return have hit one out of the park.  Hitting it out of the park goes a long way toward establishing a winning portfolio. And, with a quality business model, good management and a scorecard, it is a whole lot easier to tell if you are winning, in finance – or in the World Series.

Interested in angel investing? Consider applying to join the River Valley Investors.

How Angels Can Enjoy The Best Returns — Financial And Otherwise

Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article making the case for wealthy to consider becoming angel investors. Her full article (with her permission) appears below:

 

With angel investing being so risky, eventually most smart angels wonder – is there a way to increase my odds for good returns?  And how else do I make investing a good experience for me?

Here’s the good news.  Studies show that angel investors can make good returns, on par or better than VC or other types of private equity, when they follow some good investment practices.  The studies put proof behind what was previously just common sense. On top of that, many angels are having a blast investing in startup companies and are happy to share their secrets for fun.

Let’s start with the largest study and what we can learn from it to enhance financial returns.  Rob Wiltbank, CEO of software company Galois and professor at Willamette University, collected data on exits – good and bad – from hundreds of angels in the Returns to Angel Investors in Groups.  The study found that the overall return for the 1,100 plus exits in the dataset was 2.6 times the invested money in 3.5 years, or about 27% gross Internal Rate of Return.

More important than the average return for this “portfolio” of 1,100 exits, was the very wide and unbalanced distribution of the exits, with 52% of the exits losing some or all of the investment and 7% providing nearly all of the return.  This means the average in the study didn’t describe the performance for most of the angels who participated.  But there are some good takeaways that can lead to better returns:

Look for the home run opportunities. As Wiltbank says, “The returns are massively skewed. Ten percent of all of deals produce 90% of the returns.” Really sophisticated angels have paid attention to this. A few top angels have told me they started out looking for singles and doubles, thinking they could make most of their returns in those deals. Now they have changed their game – it’s all about hitting home runs.Diversify your investments. Not only does a small percentage of deals deliver the biggest returns, but there a 50-50 chance that each individual investment will be a failure or a success, so you need to make many investments to find the one that will be a home run.Take your time and be patient but persistent. The 52% of the exits that lost money did so in an average of three years, while the big returns took an average of six years. As you wait for the bigger returns, learn from your experience by watching others and enjoy the process and the angels and entrepreneurs you meet. (More on this later.)Do due diligence. Just looking at amount of time in due diligence, angels who did more than the median amount of diligence on a deal (20 hours) did significantly better than those below the median. The overall multiple difference was almost six times – 5.9X compare to 1.1X! This is mostly about reducing failures. Said another way, 65% of the below-median due diligence angels lost money, compared to 45% for the above-median group. Now, there’s a reason to roll up your sleeves to check the companies out!Invest in what you know. Putting your specific industry expertise into your investing is common sense. The study showed that when the investor had expertise in the company’s industry, the exit was three time higher than for others (3.7X compared to 1.3X, both in around four years). Use your entrepreneurial experience too. Wiltbank says that “angel investors are well suited to early-stage investing because many have been entrepreneurs themselves.”Stay connected to the entrepreneur after you invest. Investors who met with company leaders often to mentor, coach, or offer strategic consulting and that monitored the company’s progress saw an overall multiple of 3.7X in four years. Conversely, those who took a more passive approach reported an average lower multiple of 1.3X in 3.6 years.

Angel investing is about financial returns, but it is so much more than that.  As top angel David S. Rose wrote in his recent book, “…investing in startups has so many other dimensions that, for quite a few angels, the external rewards may be even more important than then financial ones.”  He sees a number of non-cash benefits that come with your “angel wings,” from “entrepreneurship without responsibility” to giving back and developing life-long friendships.

My organization, the Angel Capital Association, gives an annual award to one person who makes a big difference to angel investing and one of my fondest memories is watching the first winner receive his award in 2005.  Bob Goff, leader of the Sierra Angels in Nevada, won not only for his active investing and support for the entrepreneurial community, but for his total embodiment of angel investing as “doing good, having fun, and making money – not necessarily in that order”.

That phrase has stuck with me and so many other angels I know.  Many angels enjoy spending time with other smart investors, meeting remarkable entrepreneurs and learning about interesting and innovative ideas.  Beyond the personal experience, it’s wonderful to know as an angel that you’re helping build the economy, creating jobs and life-changing innovations, and giving promising new businesses a chance.

And I can’t leave Rose’s “entrepreneurship without responsibility” without another comment.  One of my favorite angels has said how much he loved starting his very successful company and selling it for a great return, but not so much the part in the middle (running and growing the company).  As angel investors, we know the responsibility for the company’s success is with the CEO and we can enjoy being involved with the company without taking the responsibility “in the middle” of getting to a great exit.

Angel investing offers many returns.  What could be better than doing good and having fun while employing good investment practices that make money at the same time?

The Case For Being An Angel Investor

Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article making the case for wealthy to consider becoming angel investors. Her full article (with her permission) appears below:

 

The other day I was listening to an entrepreneur pitch his company to a group of potential investors and it hit me how great it is to be an angel investor. I’m admittedly biased, but I think being an angel investor is one of the best things high net worth investors can do.  Supporting great entrepreneurs is a real kick – and it can bring significant financial returns.

The rewards are many, assuming you can check yes to these basic caveats: Legally, you must have the wealth or income to be an accredited investor. Personally, you must be willing to lose your investment money, should have a portfolio strategy, and use good investment practices.  This high risk, high reward kind of investing isn’t for everyone, but for every article I read encouraging people not to get into angel investing, I see more reasons to do it.

First, consider the potential financial returns.  A study found that the overall return on 1,100 plus angel exits was 2.6 times the money in 3.5 years, or about 27% gross Internal Rate of Return.  Not bad compared to other types of equity investments. Even so, it’s important to look into the details.  More than 52% of those exits lost some or all of the investment and 7% provided nearly all of the returns.  This means that angels need to start with a strategy to make multiple investments to minimize risk and increase the chance of good returns. Angels should also educate themselves on good angel investing processes via eventsreading and networking with experienced angels.

Angel investing can also help diversify your overall investment portfolio.  Ryan Feit, CEO of SeedInvest, put it this way: “Allocating 5% of your overall portfolio into angel investments can increase returns while lowering volatility.  This is because early-stage, private companies generally have a low correlation with traditional asset classes, such as stocks and bonds.  A recent SharesPost whitepaper concluded that allocating 5% to private growth companies could increase the returns of a traditional portfolio by 12%.”

While returns are the measuring stick for any kind of investment, investing in early-stage companies provides a whole set of additional, hard to find, personal rewards:

Meet interesting people with fascinating ideas – Top entrepreneurs are the best communicators I’ve ever seen, getting across their technology or medical innovations in ways nearly anyone can understand while also explaining their business models very well. You can feel their tremendous passion and see how fast the wheels in their brains are going.  Through angel investing I have also had the pleasure of meeting other investors. Often we have highly different backgrounds, yet we share a common core that builds great bonds, leading to long-lasting, true friendships. And let’s not forget the great food and beverages we enjoy as we analyze and debate our next investment.

Support what you care about – Since angels decide which companies they want to invest in, they can put their own money in the kinds of businesses that are the most important to them. This might be industry sectors you have experience in, or entrepreneurs who are alumni of your university, or supporting a demographic you care about such as women entrepreneurs.

Know you’re doing good – As Feit says, “Unlike any other type of investment, startup investing provides the opportunity to invest in innovation and to feel real ownership in the companies that you invest in. Every year, angel investments create thousands of revolutionary and life-changing technologies.” I’ve met so many angels who are also proud that the companies they invest in create new jobs.

“Entrepreneurship without the responsibility” – Super Angel David S. Rose coined this phrase in his 2014 book“Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups.” Entrepreneurship is exciting.  As I wrote a few years ago, one of my favorite angels has said how much he loved starting his very successful company and selling it for a great return, but he didn’t really enjoy the part in the middle—running and growing the company.  As angel investors, we know that the responsibility for a company’s success lies with the CEO and we can enjoy being involved with the company without having the responsibility of leading “in the middle” to get to a great exit.

Learn new skills – Angel investing offers something new for everyone. Learning new things like deal terms, the most effective way to mentor entrepreneurs, or how to be a good board director can be lots of fun. Sometimes gaining these skills can also lead investors on new life paths. For instance, one reason angel investing is attractive to women is because it’s a fast track to learning about being on boards of directors, getting board experience, and then leveraging this to become better candidates to serve on corporate boards.

Apply current skills in new ways – Angel Barbara Clarke is an example of how an investor’s background can contribute to the angel process. As she told me recently, “Everyone on a due diligence team has their own unique expertise and experience. For example, angels with journalist backgrounds are good at research and interviewing. My background is management consulting, and I’ve found that I am comfortable with competitor and market analysis, even in industries and fields I am unfamiliar with.”

When you add the financial benefits with the personal perks, how can’t you make a case for angel investing? My advice? Continue to learn as much as you can about angel investing before diving in, but know up front that it is one of the best things you can ever do.

8 Steps to Becoming an Angel Investor

The Angel Capital Association put our a great starter guide for people who are Angel Curious (my term, not theirs :)).

The Short version:

  1. Make sure you meet accredited investor standards

  2. Understand the risks of investing in startups

  3. Educate yourself

  4. Ask experienced angels for advice

  5. Join an angel group or angel platform (like the River Valley Investors)

  6. Develop an initial investing strategy

  7. Actively participate in Q&As

  8. When ready, write that first check

Get the full details from the original article here.