(This article was originally published in Mass High Tech on September 29, 1999)
A wealthy individual who invests his own money in early-stage companies is known as an “angel.” Some angels approach investing like bankers, carefully structuring their investments to minimize risk and maximize both return from and control over their portfolio companies. Others are more like the entrepreneurs they back, making simple investments and leaving control of the company with management.
Let’s compare two $250,000 investments. Both portfolio companies are Internet start-ups. We’ll call them ”MoreMoney.com” and “CategoryKiller.com” (both fictitious names).
The MoreMoney.com investment looks like a standard venture capital deal, with 97 pages of legal documentation. The angels can control the company with veto power over the annual budget, capital expenditures and additional stock sales. For legal protection, angels have a liquidation preference, anti-dilution protection, pre-emptive rights, super-majority voting provisions and disproportionately large representation on the board of directors.
CategoryKiller.com’s angels are all ex-entrepreneurs, and are very pragmatic in approach. They complained that the legal documents (8 pages) were too long. Other than a right to participate in future stock sales, these angels wanted no special rights or controls.
Reduce Cost and Complexity: One of the beauties of a start-up is that management stretches each nickel to buy a quarter’s worth of progress. Founders frequently work 16 hours a day, seven days a week, to build their companies on a shoe-string. Any precious dollars unnecessarily spent in transaction costs (primarily legal, accounting and brokers’ fees) are wasted. For its complicated deal, MoreMoney.com paid $35,000 in legal fees. CategoryKiller.com paid only $4,000. By throwing away $31,000 of a $250,000 investment (more than 12% of the deal!) the MoreMoney.com angels have made their founders’ fund-raising efforts that much less effective. Smart investors want to put every nickel to work.
To be sure, some paperwork is appropriate. Both sides need to understand the essentials of the deal, and a written record is important because memories fade and players change. Creating formal, legal agreements serves both these purposes. But the amount of paper should scale with the deal. A $250,000 angel deal should not require the same legal documentation as a $20,000,000 venture capital investment.
A complex deal also takes more time to negotiate. During the negotiation period, a significant amount of management attention and emotional energy is devoted to fund-raising, and can’t be applied to the core business. It took two months to close MoreMoney.com. CategoryKiller.com closed in substantially less time. In the race to build a company, a simple financing saves management time and attention, increasing the odds of getting through the market window before it closes.
Trust in Management: One striking difference between these deals is the degree of control investors have over management. The MoreMoney.com investors have approval rights over the budget, capital expenditures and stock sales; if they don’t like the way the company is being run, they can cut off management’s ability to spend. In contrast, the CategoryKiller.com investors have given the purse strings over to management.
Investors in new start-ups are bettors at a horse race – they shouldn’t try to be the jockeys. In very early stage companies, management’s vision and energy ARE the company. No investor should invest in a start-up unless he believes in management’s abilities. By hamstringing management’s ability to make decisions, the investor will undercut management’s confidence and effectiveness. Certainly, management should be given some structure and held accountable. Board meetings should be held frequently, with management explaining the latest numbers, performance shortfalls and strategic developments. But entrepreneurs will rarely be successful if the drive, creativity and willingness to take risks that attracted investment in the first place is so hobbled that it cannot function.
“Downside” Protection: Other than a right to participate in new sales of stock, most mechanisms intended to protect investors’ down-side will be ineffective in very small companies. Why? Because if a start-up isn’t successful, there won’t be anything left to pay investors. Most unsuccessful start-ups simply pay off as many non-investor creditors as possible and close their doors. To be sure, there are situations where protective mechanisms are useful. But the cost of putting these mechanisms in place, in terms of dollars, time and complexity, has to be weighed against the possible benefits. In a small deal, they are rarely cost-efficient.
More realistically, investors should mentally write off all money given to a portfolio company. If the company is not successful, the investment will most likely be lost no matter how much downside protection is built into the deal. If management is dishonest or acting in bad faith, little will be recovered for the investor. Only if the company is successful will investors see their cash again.
An investor’s real leverage is the company’s need for more money. Most start-ups need multiple rounds of financing. If management is not performing, the second round of financing will be difficult to get. If the company looks like a winner, it will be turning money away.
The way an angel invests can increase the chance his investment, and the company, will succeed. Put as many investment dollars as possible into the company. Give management a chance to prove itself, without unnecessary restrictions that will only hamper performance. Don’t waste resources now in a vain effort to salvage something should the company fail.
The mantra “Faster! Cheaper! Better!” is well understood by successful entrepreneurs. Savvy investors, and their professional advisers, know it applies to them as well.