Blog

Recently I was talking with an entrepreneur that was looking to put together a seed round of angel investors. We talked about the normal strategies and halfway through the conversation I asked “What type of angel investor would be ideal?” Without missing a beat he said that he’d like a couple angel investors that have been CEOs of fast-growing companies. I probed deeper and he offered that he was confident he could raise the modest amount of money based on his network, but that he preferred to hold out for angel investors that had experience running companies and wanted to help mentor him.

Here are a few things to consider when it comes to angel investors:

• Do you just want money or do you want something more like a mentor relationship?
• What areas of expertise do you need the most help with (e.g. sales, marketing, product management, finance, etc.)?
• Do you have any geographic preference for where the money comes from?
• Do you want to plug into a certain circle or group (e.g. alumni from a company or industry)?

Not all angel investors are created equal. Some want to simply write a check and others want to write a check and roll their sleeves up and help out in a serious way. The world needs all kinds to operate but entrepreneurs would do well to think through what they want, and don’t want, in their angel investors.

What else? What are some other thoughts on angel investors and the idea that they aren’t all created equal?

I know angel investors that only like to do seed deals and I know angel investors that only like to co-invest in Series A deals. Now, writing a $250k check as part of a $5 million Series A might not seem very angel-like, but it happens more often than people realize, especially when it’s from a family office with a generic name (e.g. XYZ Capital). I’m finding more angel investors want to see traction and a higher score on the Investor Readiness Level such that the requirements are approaching that of a Series A round.

Here are a few thoughts on the tradeoffs for angel investors between seed deals and Series A deals:

• Seed deals come in at a lower valuation, so the same amount of money buys a larger percentage of the company
• Seed deal terms are often simpler, so there aren’t as many protections for the investors as with Series A deals (e.g. participating preferred, cumulative dividends, board seats, etc)
• Seed investments have a higher chance of becoming worthless (e.g. the startup goes out of business) compared to Series A rounds (even the startups that raise a Series A have a high chance of going out of business)
• Series A deals make it easier to deploy a more substantial amount of capital (e.g. if you have $2 million allocated to angel investing, it’s easier to write a few $250k checks than it is a bunch of $50k checks)

Another hybrid option is angel groups syndicating with a number of investors in lieu of a venture firm leading the deal, but that doesn’t happen as often (we’ll see more of it with AngelList). Regardless, I believe we’ll see the trend of more angel investors investing alongside institutional firms as part of later rounds instead of that same capital deployed in seed deals (we’ll still see plenty of seed deals).

What else? What are your thoughts on the tradeoffs for angel investors between seed deals and Series A deals?

One of the strange phenomenons I’ve seen, and have a hard time explaining, is that big wins often come in clumps. Big wins like closing new customers, securing new hires, and signing new partners. Things go quiet for a few weeks and then boom, five new customers sign on the exact same day. It’s the most dumbfounding thing.

Here are a few thoughts as to why wins come in clumps:

• Calendar timing and the associated sense of urgency spurs people to action (e.g. end of the month, end of the quarter, end of the fiscal year, etc.)
• Momentum comes in a variety of forms and can really help push things through (e.g. a new product release, pricing changes, messaging tweaks, etc.)
• People’s tone, mood, and morale really come through subconsciously and affect the negotiation (It sounds fuzzy but intangibles are more important than many people realize)

No matter how much effort and strategy is put into it, I still find that wins come in clumps. It’s a normal part of the startup world and the process of growing a company.

What else? What are some other thoughts as to why wins come in clumps?

Mid-way through the Pardot days one of our more serious competitors was Genius.com. Genius.com started out as a tool for sales reps to send emails where all the links were tracked such that sales people could understand what links prospects were clicking on and what web pages they were viewing. The novelty was that it didn’t require tracking code on the resulting website as all the rewritten links routed to a Genius.com proxy server that would serve up the appropriate page, and subsequent pages. Of course, this worked well for the first or second click but broke down quickly with dynamic websites and web applications. Regardless, sales reps love understanding what links are clicked in an email and what pages are visited on a website.

As an individual sales rep-oriented tool, Genius.com was able to sign up thousands of users and raise 10s of millions of dollars of venture capital. A couple years into the sales rep tool they realized that sales rep email link tracking was quickly becoming a mere feature within marketing automation systems. Genius.com did a pivot and built a full blown marketing automation tool while reducing the focus on the sales rep tool. Only, they could never get the product quite right and after a noisy start we stopped seeing them in the market. Finally, the company fizzled away to be picked up by a large software vendor.

A few lessons learned:

• Even with $40+ million in venture capital it doesn’t mean that the company will build a successful product in a competitive market
• It’s tough to have minor success with an initial product, raise huge amounts of money, and then pivot in a new direction (going from software for sales teams to software for marketing teams)
• Heroic efforts and tapping out personal networks can get enough sales to look like there’s something substantial when there really isn’t (Genius.com was known for working its team extremely hard and delivering amazing results until people quickly started burning out)

Two days ago it was announced that RapGenius had acquired the domain name Genius.com and rebranded itself Genius. The Genius.com we battled many years ago is truly no more.

What else? What are some other thoughts on a once high-flying competitor quietly going away?

After reading about yesterday’s Salesforce.com proposed acquisition of RelateIQ, and the speculation that the purchase price was in the range of 100x run-rate, it reminded me a piece of advice I received when we were considering selling Pardot:

If you executed perfectly for the next two years, how much would the business be worth under normal market conditions? If you don’t want to sell, but would sell for an aggressive price, make it for what you think the business will be worth in two years.

At Pardot, we had about $10 million in trailing months revenue at time of acquisition. Based on our growth rate, not taking in outside capital, and our guess as to market conditions, we felt we could be at roughly $25 million in trailing twelve months revenue in two years. A normal Software-as-a-Service company, depending on a number of factors, is often worth 3-6x revenue. So, take $25 million in trailing twelve months revenue in 24 months and a 4x revenue multiple and you get $100 million. When the negotiated offer finally got to that price range we knew it was time to sell.

What else? What are your thoughts on the two year rule when it comes to considering acquisition offers?

Back in the summer of 2009 we were out trying to raise venture capital for Pardot (we didn’t end up raising any money). During the fundraising process we pitched over 30 different VCs including several famous ones. At one point we were out on Sand Hill Road meeting with a well-known venture capitalist and yesterday’s topic of liquidity preferences came up.

Mid-way through the conversation he stopped us and said, “You know guys, it’s a liquidity preference and not a liquidation preference. I have another entrepreneur in our portfolio who constantly refers to it as a liquidation preference. Liquidations are bad. Liquidations are when the company goes out of business and all the assets are sold. Liquidity preferences come into play when the company is bought, and it’s usually in a positive context.”

From that day forward, whenever someone mentions a liquidity preference, I always think of the VC and his comments that a liquidity preference is not a liquidation preference.

What else? Have you heard someone confuse the term liquidity with liquidation?

Recently an entrepreneur asked me what the current market was for liquidity preferences and dividends for institutional investors funding startups in the region. As a background, liquidity preferences are a provision investors often ask for as part of a preferred security that guarantees them some amount of money before other shareholders receive any money in the event of a sale.

Within the concept of liquidity preferences there are non-participating preferred and participating preferred. Non-participating preferred means that the investor gets some amount of money back first (usually the amount invested) and if the amount of the sale is large enough, then everyone participates based on their percent ownership. So, if an investor invests $1 million and has a 1x non-participating preferred equity and owns 25%, if the company sells for at least $4 million, then everyone gets paid based on the percent of the company they own. If the company sells for less than $4 million, the investor gets their $1 million back first and the remaining amount of money is split amongst the other shareholders based on the percent they own.

Participating preferred is where the investor gets some amount of return on their investment (usually the amount invested) and gets the percent ownership of the remaining amount of the proceeds regardless of the amount of money. These types of investments effectively reduce the valuation of the company by the amount of the participating preferred investment. So, if a company raises $1 million with a 1x participating preferred investment at a $3 million pre-money valuation, the valuation is effectively $2 million pre-money due to the participating preferred equity. If the company sells for $4 million, and the investor owns 25%, the investor gets $1 million plus 25% of the remaining $3 million, which equals $750,000, for a total of $1,750,000. You can see that 25% ownership of a $4 million exit doesn’t normally equal $1,750,000 unless they have this type of provision.

Dividends are typically in the form of cumulative and non-cumulative with the difference being if the dividends compound every year or stays fixed based on the original investment. With a $1 million investment and non-cumulative dividends of 8%, the effective amount owed for the dividends goes to $80,000 per year. With a $1 million investment and cumulative dividends of 8%, the effective amount owed goes to $80,000 in year one, $86,400 in year two, $89,000 in year three, etc.

The current market for the region is a 1x participating-preferred liquidity preference with an 8% cumulative dividend. On a simple level this means investors are offering valuations higher than might be expected for entrepreneurs with a tradeoff of serious downside protection in the event the investment doesn’t do well. Again, this is more for institutional investors and not as typical with angel investors and seed rounds.

What else? What are some other thoughts on the current market for liquidity preferences and dividends?