The Job Engine

January 15, 2010

All of the angst around the “how” of funding early stage companies would be as meaningless as the philosophical debate that spawned the name of this blog, if it weren’t for one essential outcome: job creation. I was reminded of that perhaps obvious point yesterday when a friend handed me a copy of “It’s Not as Bad as You Think: Why Capitalism Trumps Fear and the Economy Will Thrive”, by economist Brian S. Wesbury. Wesbury is a supply-sider and takes the long macro-economic view, but after a quick skim I got to thinking about how to repower our job engine. The answer was easy — startups.

A short while back I was sent a slide produced for the Kauffman Foundation’s president and CEO, Karl Schramm, for his participation in the President’s Job Summit last December. A summary and PDF are posted on their site. The most impressive bit is reproduced below, and shows that for the past 30+ years, job creation from startups has been the driver of job creation in both up and down economies. In fact, 1984 was the last year job creation from non-startups was anywhere near that of startups. I’ve suspected that in my gut, but it’s great to see the data.

The most disturbing part of the slide, however, is the trend in the blue bars. Or, should I say, the absence of a trend. With all the fervor over the potential for new, low-cost startup business models, we aren’t seeing a lot of additional jobs being created annually from startups. I suspect the numbers don’t count a lot of entrepreneurs who don’t technically “employ” themselves (and may not even pay themselves…), but this seems like a real opportunity.

Core to the formula: get these folks some funding. Still looking for the big ideas that ratchet up the volume to 11.


Open, Sez Me

January 14, 2010

One of the most vocal critics of the pay-to-pitch angel model has been Jason Calacanis, internet entrepreneur and co-founder of the TechCrunch conferences.  Last fall he declared a “jihad” against all groups, events and programs that charged entrepreneurs, and ultimately launched his own angel event called the Open Angel Forum. Jason has a “Nation” of followers from his various media activities, and he stirred up a mighty rabble among the disaffected entrepreneurial crowd. The first Open Angel Forum event is set to launch tonight (1/14/10) in Los Angeles, and I wish them the best.

The format of the event is pretty common — a dinner followed by presentations — but has one key twist: sponsors will underwrite the cost of the event to the tune of $1500 apiece (max 5). While the investors are committing to cover the tab if enough sponsors don’t kick in, the goal is for the event to be free to both entrepreneurs and the money people. In return, the sponsors get… what? Logos everywhere, I assume.

Side note: as I reviewed all this again, I kept having flashes of another leader of a nation, swaggering and yelling, brandishing an automatic weapon, while surrounded by the logos of his corporate sponsors. Where was that?? Oh yeah…

 

Well, I’m sure it won’t be like that.

The two main criticisms I hear about dinner investor events are inclusiveness and focus. The first revolves around how the entrepreneurs participate in the overall event: are they peers, meeting and mingling with the investors; or are they the evening entertainment? No doubt the former is usually intended, but too often devolves into the latter. More than once I have seen these settings turn into circuses where the entrepreneurs take a beating, and no one likes being treated like the court jester. At one point there was a promise that the entrepreneurs presenting to the Open Angel Forum would get a free meal out of the gig, but that seems to be missing in the info online. No doubt they’ll have some little tables set up in a hallway next to the kitchen for the entrepreneurs, while the investors dine on…

…”steaks and fine wine!” Which brings up the second problem: focus. There’s nothing like pounding down some cow and chugging a few bottles of expensive Bordeaux to get ready to CHANGE THE WORLD. Or take a nap. Whatever. Neither of these issues can’t be overcome — they’re just issues to police.

For this first event, five presenters were chosen from fifty “qualified” applicants — an impressive weeding process. Fifteen über-investors will be in attendance this first time, and they’ll be assessing interest individually. As a result, there isn’t a sense of cooperation among the investors throughout the process.

Overall, my biggest concerns are scalability and sustainability. The goal is to use this event as a springboard for quarterly events in Los Angeles, and to replicate the event in additional geographies as a franchise of sorts. For this first time, the companies and investors were hand-picked by Jason as “chapter head,” and apparently that will be the approach going forward. (“Open”, it seems, has some obscure definitions…)  Granted, Jason has been transparent that he has a five-year goal to become “the most sought-after, and value-added, angel investor in the world,” and maybe building a network like this is a way to get there. However, I believe the series will quickly encounter pushback from their sponsors unless the format changes; and that may require new thinking about the financial model. Finally, the net new number of companies getting in front of investors is pretty small, so the overall impact on the investment ecosystem is nominal.

Final verdict: while there may be some initial flaws in the business model, and a fair amount of unrepentant self-interest, the core principles are solid and let’s hope it benefits some new companies.

[Update 1/15/2010: The inaugural event being called a grand success. Entrepreneurs happy, investors happy, a new Colorado chapter announced, and apparently minimal machine-gun fire. Congrats to all – keep it going!]


Quitcherbitchin Ferchrissakes

January 12, 2010

A colleague active in the angel community dropped me a nice note encouraging me to keep writing here, but asking if I’d gotten negative about angel investing. He pointed out that angel activity was higher than ever, in spite of the challenges organizing all the parties involved. If that was the impression, I apologize: was just my cynical humor coming out. As I noted in my first post, I’m a big believer in the need for angels and a variety of means for gaining access to early-stage capital. I just believe that the current environment is in need of some shaking up.

The main reasons for starting this blog were to underscore the issues angel organizations face, and to start highlighting some new ideas. I felt the first part was necessary because the arguments around what to do differently often ignore the realities of the constraints. For instance, I was whining kvetching explaining to another colleague about the challenges operating an angel group sustainably. He’s an outspoken critic of angel groups charging entrepreneurs, and his advice boiled down to “raise your revenues, lower your expenses, but DO NOT CHARGE ENTREPRENEURS”. Okay… [Dude… Am I wrong? Am I wrong?]

Suffice it to say, I hope the previous posts illustrate that the problem is somewhat more complex in execution. However, I’m happy to say that innovation is alive and well in the angel community, and a number of people are applying brainpower to create new funding paths.  For the next few posts, I’ll look at some of the emerging models.

 


So what about those pay-to-pitch dbags?

January 6, 2010

I’m itching to start digging into the fun stuff, and the topic of the hour is whether companies should EVER pay to pitch their deals to investors. I’ll forego the opportunity to win the TechCrunch “Defender of the Free World of Entrepreneurship” award and say the answer is yes.  Sometimes.

In my first post, I stated two of my core principles in the angel space were caveat emptor and TANSTAAFL: “let the buyer beware”, and “there ain’t no such thing as a free lunch”. Maybe it’s because I’ve been in businesses at many different stages, and maybe because I expect some basic decision-making capability from entrepreneurs, but it seems to me companies can usually sort out the cost/benefit for themselves.  There’s also a natural selection process going on: whether an angel group charges fees – and how much – determines a lot about the types of companies that choose to pitch, and in turn about the types of investments that the group tends toward. A few illustrations:

If you’re a bootstrapped startup with two young, first-time founders living and working together in a garage, and think you’re ready to raise some capital for your new online Twaddle service idea, should you pay several thousand dollars to pitch to a big angel network? Probably not: there are undoubtedly other ways you could put the money to better use (e.g., buy more Ramen noodles), and you’re better off at that stage with just one or two investors who can help groom and connect you.

Should you pay a hundred bucks to pitch at an investor event put on by the local entrepreneur networking group, that includes business coaching and presentation advice? It’s probably worth it – you can use the help – the first time or two. After that you’re likely getting seesawed on the coaching, and you can let someone else help pay for the event. If you want to attend and think it might have value, by all means pay your dues and go and network like crazy. Maybe you’ll meet that one investor you need, or someone that knows him/her. How about paying for a booth or a demo station? Here I’d give the same advice I give to companies marketing at trade shows: if you aren’t a known player and aren’t speaking, your odds of getting the right traffic can be pretty horrible, so watch your expenses.

How about if you’re a little further along: mature founder team; product in beta; got some revenue coming in, but burning through founder capital fast and need to get an infusion. Here I’d expect the founders to troll their personal networks first, but if that isn’t successful it probably makes sense to try a number of sources quickly, and some of those will cost you. Just manage expenses to your expectations.

Finally, what if you’re squarely in the “gap”: solid revenues and nearing breakeven; good growth, but for a variety of reasons not interesting to the venture community at this point. You need to raise $1.5M for a major expansion, and know that your boutique investment banker friend will take on the project, but it will end up costing $50K after retainer and success fees. In this case, paying $5K to pitch to a large network makes sense – if the probability of getting funded is 10% or higher. But be prepared – you don’t want to waste this chance. 

These are the decisions I’ve made myself as an entrepreneur, or helped other entrepreneurs through over the past five years as an investor and angel group manager. Most of the time entrepreneurs “get it”, and decide the right path for their situation. If they don’t take advice and/or make bad financial decisions… well, not everyone is cut out to be an entrepreneur.

All of the above is based on one premise: that the entrepreneur has good information about the potential outcomes at every stage in order to make good decisions. If a group or event manager can’t tell you what types of company are getting funded, how often and for how much, you should walk. And don’t go by long term averages (mean, median…): find out what has been happening in the past six months. Angel investor velocity changes over time, and in a down economy, velocity can trend to zero.

For angel group managers, there are two additional things I will add: give startups a break, and provide good feedback. Even though I ran a group that operated on a pay-to-present model, if we had exciting startups come through that were operating on a shoestring (think Twaddle in the garage), they got “scholarships” and a free ride. It’s just the right thing to do for them at that stage. Similarly, I always made sure applicants and presenters got good feedback: brief written comments with an offer to review in person in detail (no need to spend lots of time crafting pearls to cast… well, you get the idea). This practice was born out a personal bad experience: paying $500 to apply to an angel group that should have been a good fit for our offering, only to get a rejection with no reason. After harassing them, I got a mindless response of “come back when you have more traction”. Thanks for playing.


The Three… Two… One-Legged Stool

January 6, 2010

The previous few posts established the environment in which organized angel activities operate: a need for revenue to support increasingly professional operations and hired management, combined with limited means of assessing fees to participants in any transaction. The result today is that angel groups and events predominantly function on the basis of flat fees collected from investors, entrepreneurs, or sponsors. Charging each of these audiences has issues.

Investors are usually seen as the best source of fees to run angel activities: after all, they are the ones with the money and stand to make the most from the deal, right? Well… if you put yourself in their shoes, it’s not so simple: there is a limit to how much anyone will pay for what effectively boils down to a club membership or trade show attendance. For angel groups, I have heard investor memberships across the country ranging from $1000 to $5000 annually. Any less, and there isn’t enough income to support a manager; any more, and the investor expects the manager to provide a lot more service: such as screening deals independently, conducting due diligence, and negotiating terms. Those activities, of course, are viewed by the SEC as streng verboten, so most groups keep the amounts in line with value delivered. The same is true for events: investors are willing to pay a few hundred to a few thousand dollars, depending on the lavishness of the venue, headline acts, and extra-curricular activities.

Sponsors can be either public or private, though service providers like law and accounting firms, investment banks, valuation companies and the like are the most common targets. They make the big bucks, so they must have a lot of money to spread around, right? Well… as anyone who produces events can tell you, there are two problems with this assumption: there isn’t as much sponsorship money as there used to be, and sponsors have an annoying habit of expecting value for their contributions. Over time, sponsors start filling more of the seats in the audience, appearing in signage on every visible surface, and showing up on the agenda for “brief” welcomes, thank-yous, and overviews.

Finally, we come to the touchiest constituency: the companies seeking financing. There is enough debate in this topic for a separate – and upcoming – post, but suffice it to say this revenue channel has challenges. Whether couched as application fees, presentation fees, coaching fees, boot camps, or any combination, most entrepreneurs view these costs skeptically – often for good reason. Still, these fees persist, and aren’t necessarily indicative of some deep-seated class warfare against struggling entrepreneurs.

So, for better or worse, the organized angel sector today depends on these three revenue sources. Take away any one, and it becomes a balancing act to keep a group going. And more than likely, at some point you’ll lean back and land on your ass, wondering what the heck happened.


Who’s not writin’? John the Regulator

January 2, 2010

The Securities Acts of ’33 and ’34 established some interesting dynamics in the financing of private equity investments. At one end of the spectrum, we have funds (venture capital, buyout, distressed asset, mezzanine, and many variants). These are usually established as limited partnerships; restricted to at least accredited investors (individuals and/or institutions); and operate on a combination of management fees and carried interest. To date, funds have to date been mostly unregulated: the assumption being that if appropriate disclosures are made to a limited class of investors at inception, investors and fund management agree on terms, and the fund managers don’t run off to Brazil with the investor’s money, then everybody’s done their bit.

At the other end of the spectrum are transaction agents: variously called brokers, dealers, merchant and investment banks. These entities don’t typically manage money; instead they bring together investors and opportunities for a fee. Fee structures range from fixed amounts for capital formation advisory services and retainers, to a percentage of the capital raised. These organizations are very highly regulated: requiring testing and certification of the professionals; registration of the firms with an industry self-regulatory organization such as FINRA; indemnification and capitalization minimums; audits and other compliance measures. Not surprisingly, engaging an investment bank to raise startup capital can be prohibitively expensive. 

Somewhere in the wilderness between these two are “finders”: consultants, advisors, networkers and others who bring together investors and entrepreneurs for something in return. The securities industry has a less flattering name for these folks: “unregistered broker/dealers”, implying a level of sophistication that is usually absent. Instead, finders are often primarily engaged in some other business, but on occasion take remuneration for connection-making. Sometimes that remuneration is cash, sometimes equity. Irrespective, the law (sorta) says that if you want to be compensated for raising money for someone else, you have to be a registered broker or dealer. If found guilty of impropriety, the finder is not only subject to individual penalties (fines and presumably incarceration), but the transactions they have been involved with are forever tainted, and can trigger exercise of investor rights all the way through to an IPO. 

I’m fine with establishing a level playing field for private equity fundraising, but the current situation falls way short. The reason is simple: finders aren’t strictly policed, and as anyone who has been around private equity for a while can tell you, the rules aren’t very clear. Granted, the SEC is pretty busy with nuisances like Madoff, Stanford and Rajaratnam, but the lack of clarity in legislation means very uneven enforcement, often based on the priorities of regional SEC investigators. Finders who fall potentially under this restriction, then, never know if they have ridden into Dodge City, or Tombstone

So why should angels care? Theoretically, organized angel groups fall under this classification if they collect fees from any of the parties directly involved in the transactions: i.e., the investors and the companies. Practically, this has been enforced only in the case of success-based fees, no matter which party bears the cost (investor or entrepreneur), and regardless of whether the fee is flat or a percentage of the raise. This leaves the professionally managed angel group with limited options for revenue (hence, sustainability), and takes away the potential to align the interests of parties to the transaction from the outset. I’ll look at the implications in the next post.


The Snipe Hunt

December 30, 2009

Growing up in California, I spent a lot of time in the High Sierra at a family cabin. One of the popular games the parents organized was “hunting snipes”: taking the kids out after dark armed with paper bags and flashlights, stomping around in the woods shouting “Here snipe!” while shining the lights into the bags hoping to catch one of the elusive bird/mammal/reptiles when it ran toward the light. At some point in affair, the kids would notice the parents were all gone, as were the flashlights. Alone in the dark, lost in the woods. Panic and crying. Huge laughs from behind the trees!

Trying to connect the right investors to the right deals feels a lot like that. If you are an investor, you’d probably like to collaborate with other investors with complementary skills and interests, and it’s hard enough to find a few of those.  Then you have to find deals that fit your profile, and do it as efficiently as possible.  Somewhere out there, just beyond the light, is an entrepreneur with exactly the kind of deal you are looking for, if only they’d make themselves known. 

For some investors and entrepreneurs, this is no big deal. If you’re well-established in the community, visible and accessible, and have a track record on the appropriate side of the transaction, you’re going to get deals done.  You’ll have great access and say or hear “no” a lot. But for the new investor or first-time entrepreneur, it’s a tougher hunt.  Perhaps somewhat obviously, this is why organized angel activities survive and evolve: to minimize the friction in the opportunity discovery process. All the rest is really secondary and more sociological than functional.

The most fundamental human organizing principle is a group. Big and small, formal and informal, groups help us navigate life… even when we’re reluctant members.  Not surprisingly, organized groups persist as the most common way for angels to engage entrepreneurs. These might be informally managed by a few members, or a large organization formally run by paid professionals, but the principles are pretty much the same: find deals; vet and screen them; discuss, vote, dig deeper.  Having groups focused on specific market sectors allows them to be smaller; larger groups allow for more pooling of skills and broader industry reach.

Events are another popular means of getting the party started.  Whether monthly dinners, quarterly breakfasts, or annual blowouts, events get entrepreneurs in front of more investors (hopefully), but there typicallyisn’t a structured follow-up process, so the entrepreneur is often left working with a bunch of individuals, individually.

Investor directories and match-making sites are becoming more popular, and provide a great way for investors to search out deals that fit their profile without enduring a lot of social activities.

Finally, angel funds are a small but very interesting means of pooling investor resources and using the skills in the network.  There is a fair amount of management complexity to be discussed, but this may provide the best means of getting more potential investors into the mix. I’m going to consider incubators with a co-investment strategy a special case of funds.

With these options, it’s no surprise that investors and entrepreneurs have trouble figuring out where to invest their time.  But there’s another wrinkle: almost all of these activities costs money, and figuring out who pays for them is the source of a lot of angst.  Before I dig more into that, let’s look at the unnamed participant in the whole ecosystem: the regulatory environment.  Queue spooky music…