Angel Funding Process – better than herding cats

Angel funding for growing companies is a mysterious process to most entrepreneurs.  Somewhere between hitting up your rich uncle and begging for a loan at the bank, a professional angel group can provide $250,000 to $1.5m in equity funds to accelerate growth and make it attractive to later stage investors.

Realistically, getting a group of angels behind you is a lot like herding cats.  Angel groups are voluntary, consensus-driven organizations, and decision-making is not the quickest.  Angels invest as individuals, not as a fund (like a VC).  On the other hand, you can get some very high-level people excited about your venture, and they will contribute not just cash, but advice, contacts and mentorship.  Angels want to be on the entrepreneur’s side.

Our executive team at the Pasadena Angels presented a detailed workshop a few days ago, and I thought I’d offer my explanation of the process.  Here’s how to avoid the herding cats scenario:

Steps in Angel Funding:

  1. Origination / Screening
  2. Evaluation / Due Diligence
  3. Risk Assessment / Valuation
  4. Structuring / Negotiation
  5. Documentation / Closing
  6. Representation / Tracking

I’ll deal with each of these briefly below and in later posts.

1. Origination / Screening
All angel groups have a funnel or pipeline of new projects.  Pasadena Angels are merit-based, in that all deals properly submitted to the website are considered by at least one Angel.  You don’t have to be a friend of an angel, but the more contacts you cultivate, the better.  We find deals when attending conferences, networking events and even from ideas germinated by our members.

Once a deal is submitted, it goes through a screening process.  An angel reads through the documents, determines if the deal fits within the angels’ “sweet spot”, and typically speaks with or meets the entrepreneur once or twice.  If the company is out of the area, or asking for more than $1.5m or thinks they’re already worth more than $5m, then they typically will be dinged right away…  Those that get through are asked to present to a larger screening committee.

2. Evaluation / Due Diligence
The few companies which get past the screening process (perhaps 2-3 per month), and which draw the interest of, say, 10 or more Angels, will begin a more formalized evaluation process.  This is a phase where prospective investors check out an entrepreneur’s references, verify that the books are in order, validate the product and commercial market, etc.  An angel group is typically a forum to learn about new deals and exchange information; the group itself does not invest.  So, it is up to each angel to do their individual due diligence to satisfy their personal criteria whether to invest or not.  Being in a group makes this process more efficient, both for the investors and the entrepreneur.

3. Risk Assessment / Valuation
Assuming the evaluation goes well, the angels and/or entrepreneur will draft a Term Sheet and determine a “pre-money” valuation of the company.  This is the value of the company before an investment is made.  Entrepreneurs come up with fancy justifications for why they’re worth $10m to $100m – while looking for a $500k investment.  It won’t work.  Ultimately, angels make a personal risk assessment of the opportunity and assign a valuation based on that.  It’s as much art as science.  What’s your company’s pre-money valuation?  That’s a book in itself; I’ll clarify later.

4. Structuring / Negotiation
A “term sheet” defines the structure of a deal, and this would include, among many other provisions, how much cash is invested, whether that is for preferred stock (equity) or a convertible note (debt), how dividends would accumulate and be paid out, expectations for the entrepreneur and management team, composition of the board of directors, etc.  Both investors and the entrepreneur will be represented by lawyers.  If you’re an entrepreneur, be sure you have a lawyer skilled and experienced in small-company angel financing, otherwise, they will inadvertently sabotage your deal.  An entrepreneur who lets the angels draft the term sheet (but of course negotiates the terms) will definitely get a deal done more quickly.  The key is to keep it simple.

5. Documentation / Closing
Once a term sheet has been agreed by both sides, the complete deal is presented to the whole angel membership.  At that point, it’s put up or shut up, and the angels begin writing checks.  Even more thorough documents are drafted (basically, advanced legalese of the term sheet).  If a minimum amount of funds are raised, then the deal can close.  At that moment, the company gets the money.  End of story, right?

6. Representation / Tracking
Through the years, angels have been burned by investing their good money in entrepreneurs who then proceeded to do whatever they wanted.  Nowadays, with more organized angel groups, angels expect seats on the board of directors (representation), demand to know what’s going on in the company and reserve the right to change course, if the entrepreneur heads in a bad direction.  To avoid that unfortunate scenario, angels track their investments and expect the company to provide ongoing reports.  This could be a monthly status, quarterly financials, conference call updates, etc.  From my own experience, this is a great discipline to have.  The more open an entrepreneur is, the greater cooperation they will receive from angels.

Many entrepreneurs hope for “dumb money” angels — someone who throws in their money and otherwise doesn’t bother the entrepreneur.  If you can find dumb money, go for it – but it really won’t grow your business.  It may even scare off later investors.  Angels want to be involved in a positive way.  They don’t want to meddle; they’d rather be advisors and mentors. 

Having angels in your company is like having the toughest professor at college:  the course was a b*tch, but afterwards, you realize you learned more than in any other course.  Ultimately, it will lead to higher rewards – both for the entrepreneur and the investors.

More resources for Entrepreneurs and prospective angels:
www.PasadenaAngels.com
www.TechCoastAngels.com
www.angelcapitaleducation.org

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3 Responses to Angel Funding Process – better than herding cats

  1. Housewife says:

    Supercool.

    Can I ask you to please blog about rememberthemilk.com.

    I want to try it but I’m waiting for the kbhayes stamp of approval.

  2. Ken Hayes says:

    This article was recently re-printed on http://www.SoCalTech.com under their new article section “The SoCalTech Startup Zone”: http://www.socaltech.com/articles/the_angel_funding_process/a-00008.html

  3. Jonathan says:

    Most entrepreneurs I know, myself included, are on a constant search for “smart money” — and constantly finding offers of “dumb money” instead.

    While it might be nice to be “left alone” for a bit, anyone serious about their growing their product wants the resources and experience of an angel/vc and their extended network. With smart money you get that guidance and connections from the outset for free. With dumb money you just get cash-for-equity to start building a prototype, and find yourself back to square one in a few months– having spent most of your financing learning from your own mistakes and buying into the right professional networks by overstaffing on the business site for even more chunks of equity.

    Perhaps this is emblematic of the differences between East Coast and West Coast markets, but out here (East Coast) dumb money is widely prevalent with smart money exceedingly scarce – both in quantity and in sources.

    Even worse, the NYC market tends to have what first appears to be smart money, but it has so many strings attached, its better labeled as “exceedingly dumb money”. Investor required kickbacks through contracts and patronage hires, etc reduce so many honest startup attempts into “ways to get a condo for your investors’ MBA friends”. Add to that a market where investors are so advertising and retail oriented, legitimate technologies often crumble under a mess of in-store and name-brand tie ins and marketing campaigns.

    God I miss the west ( Go Sagehens! ).

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