Due Diligence for an Angel Investment

When raising money from angel investors, they often require a fair amount of due diligence to ensure the startup is what the entrepreneurs say it is and that it has proper record keeping. If the startup raises money from Institutional investors, like venture capitalists, the amount of due diligence increases substantially. Here are a few commonly requested items as part of due diligence from angel investors:

  • Operating agreement
  • Founder legal agreements like non-compete, non-solicitation, etc.
  • Cap table with any equity grants, stock sales, etc.
  • Customer contracts
  • Employee IP assignments
  • Financial forecasts
  • Financial statements
  • Recent bank statements

Entrepreneurs would do well to keep their legal and financial affairs in order generally, but especially so when close to the term sheet phase of the fundraising process.

What else? What are some more thoughts on due diligence when raising money from angel investors?

Atlanta Startup Village #47

Tonight is Atlanta Startup Village #47 at the Atlanta Tech Village.

Follow the conversation on Twitter (https://twitter.com/atlsv) and Instagram (https://www.instagram.com/atlstartupvillage/).

Here are the startups presenting:

  • SkilRoute: Online learning reinvented.
  • Reech.io: The Instagram analytics you’ve been waiting for!
  • Netify: Prototype development and business strategy consulting
  • inSITE: Fundamentally changing the way organizations share information
  • Shotzy: Pro Photographers On-Demand

Admission is free and all are welcome. Come join us.

4 Year Projections With 100x Growth and 50% Profit Margins

When meeting with entrepreneurs they often have a slide that shows their amazing projected growth. Most of the time it shows projected revenue amount for the current year (e.g. $200,000) and then goes out four years with a projected revenue amount in the 4th year that’s 100x this year (e.g. $20,000,000). Now, that might be doable, and entrepreneurs are an optimistic bunch, but they always have a corresponding profits bar to go along with the revenue bar and it typically shows losses in the first year (from the funding cash they’ll burn) and then massive profits in year four (e.g. $10,000,000 in profits on $20,000,000 in revenue).

What’s always missing: massive losses and the funding rounds necessary to hit those growth numbers.

Starting a startup is cheap. Scaling a startup is expensive. Entrepreneurs would do well to provide projections that show they’ve thought through the costs of scaling their business.

What else? What are some more thoughts on startup projections not recognizing the costs to scale?

Video of the Week – Shawn Achor: The happy secret to better work

With the annual TED Conference this coming week, let’s look at one my favorite TED Talks – Shawn Achor: The happy secret to better work. Enjoy!

From the talk, here’s the happiness advantage:
Better securing jobs
Better keeping jobs
Superior productivity
More resilient
Less burnout
Less turnover
Greater sales

From YouTube: We believe that we should work to be happy, but could that be backwards? In this fast-moving and entertaining talk from TEDxBloomington, psychologist Shawn Achor argues that actually happiness inspires productivity.

The Rule of 3 and 10 – Everything Breaks When Tripling in Company Size

Mid-way through the book Tools of Titans: The Tactics, Routines, and Habits of Billionaires, Icons, and World-Class Performers, the author Tim Ferriss interviews Phil Libin, the founder of Evernote. Phil shares a lesson he learned from Hiroshi Mikitani, the founder of Rakuten, the largest online marketplace in Japan, on “the rule of 3 and 10” where everything breaks when tripling in company size.

From the book:

He was the first employee at Rakuten, now they’ve got 10,000 or more. He said when you’re just one person, everything kind of works. You sort of figure it out. And then, at some point, you have three people, and now, things are kind of different. Making decisions and everything with three people is different. But you adjust to that. Then, you’re fine for a while. You get to 10 people, and everything kind of breaks again. You figure that out, and then you get to 30 people and everything is different, and then 100 and then 300 and then 1,000.

The idea is that things break in the company at these multiples of 3 and powers of 10. Startups figure it out when smaller but then struggle as they grow without realizing they hit the next 3 and 10 milestone and haven’t adjusted.

Entrepreneurs should think about the rule of 3 and 10 and be cognizant of what needs to be reinvented as the startup grows.

What else? What are some more thoughts on the idea that things break at company sizes that are multiples of 3 and powers of 10?

When the Startup is No Longer Owned by the Founders

After yesterday’s post on Raising Money as Forcing Function to Drive Towards an Exit, an entrepreneur brought up another point to me: raising money also starts the track towards the founders no longer owning the majority of the business, and, often, losing control. Many entrepreneurs start companies to be their own boss as they have a high internal locus of control. Only, after two, sometimes even one, round(s) of financing, the founders no longer have control.

Here’s how the math might look:

  • Start – Founders own 90% with a 10% employee option pool
  • Series Seed – Sell 15% of the company and add another 10% to the option pool for 25% dilution taking the 90% for the founders down to 67.5%
  • Series A – Sell 25% of the company and add another 10% to the option pool for 35% dilution taking the 67.5% for the founders down to 43.9%

So, in a “normal” scenario, after the second round of funding, the entrepreneurs no longer own the majority of the business. But, now the startup has the desired capital to execute against the plan and hopefully build a large, successful business.

Entrepreneurs need to understand the trade-offs and determine how far they can go on their own vs going faster with outside capital. The long-time question investors like to offer up to entrepreneurs: would you rather own a slice of a big watermelon or the entirety of a small grape.

What else? What are some more thoughts on the founders reaching the stage where they no longer own the business?

Raising Money as Forcing Function to Drive Towards an Exit

Recently I was talking to an entrepreneur that was working on raising money for his startup. After asking the normal questions including “why do you want to raise money”, he volunteered something I don’t hear too often: I want to raise money to bring on a partner that will position the business for an exit in a few years. The idea is that raising money will act as a forcing function to drive towards an exit.

Here are a few questions to think through:

  • Why not sell now? What additional value will be gained raising money?
  • What specifically is desired in a capital partner?
  • What’s the ideal timeline? What milestones need to be hit?
  • Are there any market dynamics at work that might improve or decline over the next few years?
  • How many more rounds of capital, and dilution, will be required to achieve the desired exit?

Planning for an exit in a timeframe is never really doable unless the business is profitable with enough scale to know that there’s an exit based on an EBITDA multiple to a private equity firm or other financial buyer. Most startups want a buyer that pays up based on growth potential, and those are nearly impossible to plan for confidently. Raising money does create more pressure to eventually find an exit, but isn’t a guarantee.

What else? What are some more thoughts on raising money as a forcing function to drive towards an exit?