CHAPTER EIGHT

The Investment Process

From the time you first meet a prospective angel investor to the time you put that big check in your bank account, it seems like an endless series of interviews, requirements, hoops to jump through, discussions, and document reviews. The entire process can seem like a complete disruption to your business, dragging you away from the things you need to do to earn money. But remember, you are asking someone to trust and invest in you rather than in dozens, possibly hundreds of other opportunities.

It can’t be said too often: angel investing is not a philanthropic venture. Angels are in the business to make money. So consider how you would approach investing in a company if you had no prior relationship with the founder. Put yourself in the shoes of the investor. In fact, that kind of approach will bode well for you in all steps of the investment process. Understanding how your prospective investors think, including what motivates them, will make it much likelier that you will be able to engage and hold their interest. Part of the value provided by this book is understanding the mind and motivation of the typical angel investor.

The investment process includes numerous steps and varies from investor to investor. Although each potential investment takes its own course, if you are prepared for any possible request, you will make the process move smoothly and generally impress your prospective investor.

These are the steps the investment process generally follows:

• Get a referral to investor

• Make initial contact with prospective investor

• Send executive summary

• Make the follow-up call and set a first meeting date

• Do your presentation for potential investor

• Allow investor to review your business plan

• Draft term sheet

• Go through due diligence process

• Validate business and technology

• Agree on final term sheet—parallel with due diligence

• Prepare or approve final documents reflecting term sheet

• Close the deal

• Accept investment—often in traunches based on milestones

As discussed in Chapter Five, finding angel investors is not straightforward, but many avenues do exist. Persistence is important, as well as patience.

OPENING NEGOTIATIONS

For purposes of this discussion on the investment process, the referral process will occur through a professional adviser, but any of the other resources previously discussed can be substituted for the initial step.

Referral to Investor

Referrals through a resource trusted by an angel carry far greater weight than many other introductions. Angels rely on their lawyers, accountants, close friends, and business partners—people they are sure are looking out for their best interests. Making a good impression on a trusted referral source is also important because these professionals are not about to compromise their clients’ or friends’ trust by referring an unprepared, unworthy investment candidate. So consider even meetings with referral sources as networking events and put your best foot forward.

So you are fully prepared for the introduction (having followed all of the prior steps in the book), and have gained the confidence of your accountant—Ms. Archer, CPA—who just happens to have several clients who are angel investors. Please note that you did not pick Ms. Archer at random; you used networking and contacts to find an accountant who specifically works with angel investors. You should ask Ms. Archer for a referral and to provide you with an introduction to any angel she regards as an appropriate match for your business. These introductions often happen over e-mail, and are known specifically as “warm introductions” to prospective investors. Mr. Collins—one of the angel investors receiving these warm introductions from Ms. Archer—decides he is willing to speak with you. (Note: If Ms. Archer is very busy, then instead of asking her to give you a direct introduction, ask instead if you could use her name as a reference when you contact Mr. Collins and other potential investors. Also, ask for some background on each referral, including any communication preferences such as whether the investor prefers written rather than electronic mail and any other quirks.) The more you know about a prospective investor, the better communication you will craft, increasing your chances of making a good impression.

Initial Contact

Consider the first contact carefully, based on the information you received from Ms. Archer as well as any information you can obtain through your network contacts and the Internet about Mr. Collins. Do not use a standard introduction for all angels; customize each communication. Think about your audience and their background and possible interests. Also make sure you include some pithy comments about your company, including any recent accomplishments such as landing your first customer. Do not go on for pages about your product or services. Make the cover communication short and sweet. Attach your executive summary. End with a statement that you will follow up by calling in the next week, never less time.

Some thoughts at this step:

Ms. Archer does not want to waste her time or that of Mr. Collins. Time is always among the most precious commodities for a busy person. If Ms. Archer is reluctant to provide you with referrals, your company may not be ready for prime time with sophisticated angel investors. Alternatively, you may need help preparing your executive summary.

Many angel investors will rule out entrepreneurs on typographical errors or bad grammar. Proofread every communication. As trivial as this may seem, many investors believe typos and poorly written documents reflect a lack of attention to detail, lack of commitment to spend the time to do things right.

Follow-Up

As promised, make the follow-up call and set a first meeting date. Even if Mr. Collins does not respond to your e-mail, call to set up your first in-person meeting. While not receiving a response may seem like a bad sign, people do get busy, and you should go ahead and call. Also, some investors want to see if you will be persistent. To continue the example, say you contact Mr. Collins, who seems somewhat interested, and you set up an in-person meeting.

Some thoughts at this step:

Know the difference between being persistent and being annoying. Don’t obnoxiously pester or pursue Mr. Collins. If you do not get a call back after leaving two messages, leave him alone. You may want to follow up with Ms. Archer to find out if unrelated circumstances are causing Mr. Collins’s nonresponse.

Know a “no.” Say you contact Mr. Collins and have a phone conference with him. If Mr. Collins indicates that he is not investing at this time, that you are outside his area of investments, or you simply do not fit his investment profile, take those as a polite no. It’s OK to send an occasional update after this refusal, as most investors will accept occasional news of your company’s progress, and this gives you some continued connection with an investor who may be interested at a later stage. Mr. Collins may simply not have appreciated or understood your company the first time. Third-party validation, especially news of customers, patents, strategic partners, and the like, is far more effective than any statement you can make since you are supposed to be passionate about your company. Finally, turn a “no” into a networking opportunity. While you may not be a match for Mr. Collins, you may be a match for one of his contacts or associates.

Go to the investor. Make the meeting convenient for him. Work around Mr. Collins’s schedule. Bring your own equipment if you want to do a presentation (this does not include a screen since most offices have a white wall, and carrying a screen is a bit over the top.) If you meet in a restaurant or coffee shop, you can bring your laptop, but try to present off a paper copy of your presentation. If you have video clips or other technical aspects of your presentation that should be displayed on a computer, such as a Web page or calculation process, you should choose a private location to avoid making viewing difficult and ineffective. Bring a copy of your presentation, any product fact sheet, and a professional attitude. Also bring a copy of your business plan, which you can provide if the conversation seems to go well or if the investor asks for a copy.

Ask for a reasonable period of time, such as forty-five minutes. Let Mr. Collins decide if he wants a shorter or longer period at the time of scheduling the meeting or during the meeting.

Do not stack meetings. You never know if your prior meeting will start or end on time. Traffic can be a problem. Parking may be difficult to find. Even if you have a legitimate excuse, you run the risk of putting a blemish on your relationship before you start.

Presentation

For your first meeting with Mr. Collins, choose a quiet location that gives some privacy, preferably Mr. Collins’s office. Make sure the location is convenient for Mr. Collins. Arrive a few minutes early, especially if you need to set up equipment.

Now comes the hard part. How do you start your conversation? Some people prefer to get to know you better while others prefer that you launch directly into the presentation. You need to be attuned to Mr. Collins’s preference. To find out, have a couple of preset questions to ask Mr. Collins about his background or company. Note your surroundings if you’re in his office. These ice-breaking questions are quite important in discovering possible mutual interests and Mr. Collins’s personality. They also fill the time while you are setting up your equipment if unable to do so before the meeting. Remember, angel investing is always personal, so try to connect with your investor.

Make sure your formal presentation is no more than fifteen to twenty minutes. You may be in the meeting far longer because of questions, side conversations, and so on, but your presentation itself must not be overly long. Know the difference between enough information and too much information. An investor who is interested will make time to know more. Refer to Chapter Seven for more on presentation and pitch content.

Some thoughts at this step:

Practice your presentation on safe audiences repeatedly. That’s an absolute and uncompromising rule. Your idea or company is your baby, and parents always see their baby as the most beautiful, perfect bundle ever created. You need objective opinions from many sources about content, order of presentation, image, and other details.

Customize your presentation if possible. If you know Mr. Collins will be particularly interested in patent protection, spend an extra minute emphasizing your intellectual property protection. Also, you can have additional, more detailed slides at the ready for various subjects to drill down to if it turns out to be beneficial.

Don’t directly ask for money, but open the door for the money. Confusing? The following conversation illustrates the point:

“As you know, Mr. Collins, we are in the process of raising capital, and we are looking for $500,000 in this round. Your participation as one of our angel investors would be outstanding.”

“Well, initially, I am impressed by what you have shown me. Of course, I have many questions.”

“Absolutely. I’d like to answer all your questions through further discussions, and you’re welcome to a copy of the business plan now. May we schedule a follow-up meeting after you have a chance to review the business plan? I can also give you some preliminary contacts and references if you like.”

“That sounds like a good plan. Give me a couple of weeks. And a couple of references would be nice, even though you were recommended by Ms. Archer.”

This first meeting is far too early to make a formal request for an investment, but do not leave the meeting without having a concrete next step.

Promptly after the meeting, follow up with a thank-you note, preferably handwritten. Add two to three salient points—your prime messages—to your note, along with any information the investor requested during the meeting.

Opening Moves

For purposes of this example, assume everything progresses nicely with Mr. Collins. Expect this to be the exception, not the rule. As the old joke goes, you have to kiss a lot of frogs before you meet your prince, and the same is true of angel investors (or any other source of financing, for that matter). Not to say that most angel investors are frogs, but most angels are former entrepreneurs and it makes them hold you to a higher standard. If they feel they are not a good fit with your company, they are probably right. However, because of their experience, most angels are compassionate and knowledgeable businesspeople who have been in your shoes at one time, and any opportunity to meet with one is valuable as an opportunity to network.

So suppose Mr. Collins has had two weeks to review your business plan, and you call to set up the next meeting. Now you should invite him to visit your office. He most likely wants to see what your operations look like and get a feel for your company’s environment and culture. Make sure your employees are aware of Mr. Collins’s visit; you may even want to give them some information about Mr. Collins. The people you hire speak volumes about your business acumen and judgment. The caliber of senior management makes a statement about others’ views of your business. So hire capable, experienced people—people who are smarter than you in their respective fields.

Now is the time to request that Mr. Collins sign a non-disclosure (confidentiality) agreement. Many entrepreneurs ask for an NDA far too early in the process. Your initial presentation and business plan should not contain any proprietary or confidential information. Prospective investors see dozens and dozens of presentations each year and review numerous business plans. Remembering which information is confidential and which is public knowledge is almost impossible and investors are not going to take the risk of inadvertent disclosure. Some angels, who look at only a few deals a year, may be willing to sign an NDA earlier in the process, but you should not plan on this being the case. Venture capitalists routinely refuse to sign NDAs until they are into due diligence, and most angel investors will take the same position.

Some thoughts at this step:

In your correspondence with Mr. Collins setting up the office visit, make sure you mention the need to sign a non-disclosure agreement. Mr. Collins should know by now that your business has proprietary technology. Even so, take the time to explain that you would like to discuss the details of your technology, share specifics about your customer list, and really give Mr. Collins a chance to see and understand every aspect of your company. Having this discussion with Mr. Collins will let him know what information you consider confidential, and will also establish that you take your intellectual property rights seriously.

Find out what Mr. Collins is particularly interested in discussing. Ask him what questions he has so you can address these right away. Have technology or product demonstrations ready.

Clean up the offices. Have copies made of materials you plan to go over with Mr. Collins. Offer him something to drink or to eat depending on the timing of the meeting. If you have any product posters or trade booth materials, put them up in the office. Mr. Collins should not care if your offices are in an older building. In fact, he will probably prefer to see that you are frugal, using every penny for business growth rather than expensive office space. (One exception to the charms of frugality: if you’re expanding a service-based business that caters to upscale clients, you need to appeal to that audience.) But inexpensive is not the same as chaotic; Mr. Collins will observe and note if things seem disorganized or dysfunctional.

So Mr. Collins spends a couple hours in your offices. You conduct the product or technology demonstrations, allow Mr. Collins to talk with key management, and answer questions he may have about your business. Again, anywhere along this investment process, he may indicate he is not interested. Investors do not have to have a reason, so be careful how you ask what the basis is for not proceeding. It may be confusion about your technology, which you can correct, but it may also be personality incompatibility. As discussed before, know a “no.” If this happens, ask if you can send follow-up communications to keep him informed of your progress, and if he can be used as a reference.

Assume Mr. Collins is quite intrigued and wants to start due diligence. If you thought the prior process took time, wait until you get to the real details. So don’t rush in. To avoid headaches (and wasting Mr. Collins’s time), get a few essentials taken care of before you start due diligence.

Draft Term Sheet

First, if you have not already touched on it, talk about your desired investment vehicle. Talk about general terms. Do not go through the hours of due diligence just to find out you cannot agree on the basics.

Is this a debt or equity investment?

If debt, what time length? Convertible debt, with automatic conversion upon certain milestones or benchmarks, is generally the preferred debt investment vehicle. Also, unsecured debt is preferred to keep assets available for commercial bank debt financing through a line of credit. If he insists on security, Mr. Collins should be willing to subordinate his investment to such debt financing.

If this is an equity investment, does Mr. Collins want common or preferred stock? As discussed, most sophisticated angels require preferred stock. Make sure you have a general idea of Mr. Collins’s essential terms.

Mr. Collins should already know what amount you are looking to raise. Understand his possible investment range limits.

Understand Mr. Collins’s post-investment expectations. Do not accept an angel’s money if you know you just want a passive investor, but the angel wants to be directly involved. Mr. Collins may require active involvement in the company such as a board position, a primary advisory role, or actual position in the company. Know these requirements up front. Fundamental incompatibilities and differences in expectations spell trouble, headache, and possible disaster.

Have a preliminary discussion of valuation. If respective valuations are logarithmically different, there is slim likelihood of finding a satisfactory middle ground. Before you have even these preliminary discussions, seek out a third-party, unbiased opinion on valuing your company. Be ready for numbers lower than you expect. Investors will not pay more than what they independently determine a company is worth. While valuation discussions are often emotional, and while the company is your passion, which is a trait investors look for, investors also expect you to be realistic. So do not take statements about your company’s weaknesses and lack of progress personally.

Have your due diligence materials ready. Pulling together all your corporate documents, contracts, marketing materials, lead sheets, customer lists, references, and so on can take weeks, so have them prepared beforehand. Again, Mr. Collins will be evaluating you on responsiveness. You want to keep his enthusiasm and interest on the front burner, so try to stay two steps ahead of him.

After these discussions, create a rough term sheet to memorialize these very broad, general terms. Don’t expect Mr. Collins to sign anything, but rather send him an e-mail message or paper note addressing other matters related to due diligence, such as timing of meetings, document production, and the like, and mention in the correspondence your understanding of the general terms under which he may invest. No more than a paragraph or a half dozen bullets should be necessary at this point.

Work with your advisers to assist you with this process. This is an area where advisers can play a key role in making the process less of a headache, mediating between you and the investor to make sure both sides have the same understanding of the terms and requirements.

You should have already completed the steps outlined in Chapter Five on preparing for your angel investor. While some investors will not care if you have all corporate matters covered, why take the chance? You will eventually need corporate documents such as option plans and disclosure agreements, so do not risk losing an investment opportunity for lack of preparation.

Valuation

Negotiating valuation can be quite emotional for some entrepreneurs. Ego, greed, arrogance, and ignorance have probably killed more deals than any other factor. This is one of the reasons for early valuation discussions. Price per share is not everything, and receiving a high valuation is not always the best deal. Consider the entire value proposition of each angel investor. Do they bring value-adds such as market contacts, high visibility, and access to follow-on funding? These attributes can increase your valuation immediately after the investment, offsetting a small compromise in valuation on your part.

Chapter Two provides information on typical seed/start-up valuations for venture capital deals. Since at this time no one has published data on angel round valuations, you can only extrapolate from VC values to angel investing at a similar stage. There are many industry-recognized methods of valuing a company, particularly ongoing companies with existing revenue. These methods include book value (a liquidation-oriented valuation), market value (doing comparables), income value (using discounted cash flow), and, more often, a weighted average of the various methods.

For a pre-revenue company—meaning most seed/start-up companies—a multiple on expected return on investment in a certain time period is probably the most common. What pre-revenue valuation often comes down to is what the currently accepted market value is—in other words, what will the market bear?

A number of factors can impact valuation, all of which are covered in due diligence and carry various weights of importance, differing by the angel investor, region, market, and industry. These factors can include, among many others, the quality of the management team, the size of the market, the industry focus, the company’s stage of development, its competitive advantages and their strength, and its current and long-term funding needs.

Finally, angel investors all have a number of biases that go into their valuation calculations, either consciously or not. Be aware of concerns like these, and be prepared with answers:

• Is management capable and focused?

• What are the chances product development will go as planned?

• How much can you anticipate competitive behavior?

• Has pricing been accurately forecast?

THE DUE DILIGENCE PROCESS

Nelson Gray, experienced angel investor, catches the essence of the time-consuming, detail-oriented due diligence process in three simple questions:

• So what?

• Who cares?

• Why you?

Of course, the devil is in the details, and details are the core of due diligence. But these three questions do provide the big picture on what your angel investor is trying to bring out in due diligence.

By the time you get to due diligence, investors have already decided they are more likely than not to invest. They are looking for potentially serious problems with your business—deal killers. Be completely transparent and willing to answer questions honestly. Provide any information or documentation a prospective investor requests. Angel investors realize your company is not complete; you’re not expected to have all key hires, an established market, and a long list of customers. They understand you have steps and milestones ahead of you with numerous potential pitfalls and setbacks. Angel investors want you to recognize your current limitations and needs, and your potential future obstacles. Don’t make your prospective investor ask questions or dig for answers. Be forthright because experienced investors have a sixth sense about matters, and when they find inconsistencies and loose ends, their radar goes off and tells them that you are not giving them the full story. As in most cases, the cover-up is a far greater sin than the actual problem itself.

No two angels will conduct exactly the same level or intensity of due diligence, so prepare for the most diligent angel investor. You will probably receive many document requests and questions specific to your industry, market, and company. Have your documents in order and preferably in notebooks with tabs and tables of contents. Appendix 6 is a lengthy document checklist that you can use as you create your due diligence notebooks, and Appendix 7 is a list of possible due diligence questions. Having all your documents in order will impress your prospective investor and further solidify the relationship.

Making your investors wait while you compile documents, making them have to ask repeatedly for documents, or providing them with incomplete or disorganized documents will either kill the deal outright or raise serious concerns in your prospective investor’s mind. These are matters you should have taken care of without investor demand; if you cannot adequately prepare for someone as important as an investor, what will you do with customers, suppliers, or strategic partners? So get your act together and present yourself as a capable, experienced, prepared entrepreneur.

Reviewing documents and asking endless questions is just part of due diligence. Many angel investors will conduct a number of other activities to assess your company. Most angels will want to visit your company office. As noted, potential investors are interested in experiencing team interaction. They also like to talk to your other employees to get a sense of their commitment to the company and develop a firm grasp of the company’s goals and strategies.

Be open about interactions between your angel investor and your employees. In the example used in this chapter, you should have other members of your management team participate in presentations to Mr. Collins. Show Mr. Collins around the office, no matter how small it is, because you are proud of what you have already created. Give your team some background on Mr. Collins and ask them to spend time with Mr. Collins if he so desires.

Investors will often conduct due diligence on your team as well as on you, to see what attributes you all have as a group. You are the inspiration, the fearless leader, the inventor, but a company is not one person. One deal killer for angels is a founder who feels able to do it all; no one is that talented nor has forty hours a day to handle every task necessary to grow a successful company. These are the main characteristics Mr. Collins will be looking for in your team:

• High-quality, experienced people covering key functional areas with complementary skills.

• A full-time commitment to the company either now or at the time of funding.

• Team compatibility and fit, often resulting from team members’ past experience in working together.

• Agreed-to and respected systems, controls, and reporting structure.

• A stake in the outcome through ownership.

• Interests aligned with those of investors to build a great company that is highly profitable with a strong potential exit strategy.

• Coachable, willing to listen and hear input, and then integrate that information into their work.

• Passion.

Mr. Collins will ask for references, possibly from a number of different sources including other investors, customers, suppliers, bankers, previous employers, and even competitors. Do not be obstructive about references. Unwillingness to allow a potential investor to speak freely with references is a big red flag, indicating that you are trying to hide something or being less than honest. You should also know that most angel investors take what your direct references say with a grain of salt, because they expect you to give the names of people you trust who will sing your praises. So angels typically ask your references for further references and they often make their own calls to others they know who will have information about you. If you believe Mr. Collins could compromise a particular relationship by calling someone, talk with him about it. He may be willing to limit questions or let you participate in the call. You may even be able to satisfy his needs with another reference or source of information.

Remember that angels invest locally for the most part and so live in the city where you’re starting your business, or a neighboring city. Because many are successful entrepreneurs, they are connected with the same service providers, suppliers, and so on that you expect to use. For them, the “six degrees of separation” that allegedly connect everyone on earth to everyone else are in practice about two degrees—they’ll know how to find out whatever they need to know about you and your team. Many angels consider references one of the most important aspects of due diligence. Investors look for third-party validation of you and your company. They know you will wax eloquent about your company, so don’t be offended by their need to independently validate everything you say.

Some angels will run a background check on you and your team, so don’t be surprised if they ask for your driver’s license number. Investors are looking for criminal records, particularly related to business-related felonies. They may also check Federal databases and consult the SEC and NASDAQ for possible securities violations.

Market and Technology Validation

Just as with other steps to independently validate your assertions, Mr. Collins will likely conduct his own market and technology analysis and validation. Discussions with references can provide some of this information. Be willing to provide market analyst reports on your product and your market—both must be validated. If you have patents or patent applications, provide copies and also a list of any prior art you may have cited in the application. The same is true for trademarks and copyrights. If you have not filed for intellectual property protection and plan to keep your inventions and ideas as trade secrets, make sure you can explain how you will keep this information confidential and unavailable to competitors. Also, practice what you preach; if you plan on keeping trade secrets or filing patents, make sure all third parties sign NDAs. Few things will make an investor lose confidence in a company faster than failure to protect valuable intellectual property.

In conducting his market and technology analysis to validate your claims, Mr. Collins will look at several sources, particularly third-party market analyst reports, recent IPOs in related industries, and the reports filed by public companies in the industry, as well as public and private databases, reports, and publications. Mr. Collins will run comparable financial models. He will also talk with friends and business acquaintances who are well-versed in your field, along with the extensive reference checking already being conducted with vendors, suppliers, customers, previous investors, employees, and anyone else he believes likely to provide useful insight.

The market and technology analysis and validation will also include Mr. Collins’s independent assessment of your competition. He will make his own decision on what constitutes a competitor and will probably talk to some of them. Be sure to have a complete and accurate section on competition in your business plan. Missing a key element of a competitor’s product will be seen as sloppy research or a lack of understanding of your market—or, worse still, as an attempt to hide something. You must have well-considered reasons for your position against each competitor.

Intellectual Property—Ownership and Protection

If intellectual property is key to your company’s success and you plan to file for patent, trademark, or copyright protection upon securing your funding, make sure you have taken all appropriate steps to prevent the loss of intellectual property rights prior to filing. Chapter Six contains a primer on intellectual property and protection. Make sure you take all necessary steps—maintaining confidentiality, filing provisional applications, proper recordation, limiting commercialization, and so on—outlined in Chapter Six to ensure protection.

Employee proprietary information and inventions agreements are a must even if you plan to patent, trademark, or copyright all protectable intellectual property. These agreements are essential no matter what intellectual property strategy you plan to follow. Confidential and proprietary information goes far beyond inventions and trademarks: to customer lists, business strategies, contractual arrangements, and the like. Employees must observe and respect these valuable assets. These agreements should have all of the following characteristics:

• They must be signed upon employment to show adequate consideration, that is, employment.

• Their wording must sensitize employees to the importance of maintaining the confidentiality of company information.

• They must provide employees with a clear understanding of the breadth and depth of your company’s proprietary and confidential information.

• They should describe the full extent of activities considered to be work done on behalf of the company or during work hours, that is, activities whose results are owned by the company. The agreement also recognizes independent activities outside the scope of employment and company.

• They should clearly articulate company ownership of inventions, ideas, and proprietary or confidential information.

• They should state the continued obligation to the company for maintaining confidentiality.

• They should recognize possible reciprocal care of third-party confidential information.

Clear and unfettered ownership of intellectual property is essential to your business. The earlier discussion has assumed that key (and even collateral) intellectual property was developed by the founder and within the company, giving clear ownership to your company. Often, internal development is not the case; instead, technology has been licensed from a university, corporation, research institute, or individual. These license agreements must be clear, clean, complete, and uncompromising.

Note: Even development made within your company can be challenged in the absence of prior agreements regarding ownership. Therefore, an employee proprietary information and inventions agreement must be signed upon employment. Additionally, as founder, you should assign all your intellectual property rights to your company. The value of such an asset can often operate as the consideration for your founder’s stock issuance. A red flag for investors is an arrangement in which the founder only licenses technology to the company rather than assigning ownership. Investors want the entire bundle of rights for any intellectual property owned by the company.

Financial Analysis

Chapter Four provides a comprehensive discussion of what financial documents you need and what goes into building these documents. These documents need to be completed before you begin due diligence, as your angel may ask to review your financial documents before anything else. Mr. Collins does not want to waste his time looking at your legal structure, contracts, and business procedures if you have not thought through the financial aspects of building your company. Therefore, have all documents and backup information well organized and ready for review. Know the contents backwards and forwards so you can answer any question about any number or assumption. Be ready to explain why you decided on certain assumptions and not others. Prepare to have your financials compared and contrasted with those of other start-ups in your field.

Investors want to see things like these:

• Financial projections that include a diversified customer base with multiple products off a broad-platform technology

• Markets being entered in a thoughtful, calculated manner, with strong support for your choice of the first market

• A well-mapped-out process for introduction of products

• Enough flexibility in your numbers and your mind to adjust your projections should an unanticipated market show strong interest

In other words, you need a well-developed view of the future, and you need to demonstrate the ability to recognize the signs for needing to rethink your projections if necessary.

Board of Directors and Board of Advisers

Mr. Collins wants to see that you are thinking outside your insular team. He also wants to know that you recognize the contributions experts can make in forming and growing your company. Equally important are outside board members to provide validation. If one or more noted leaders in your industry are willing to attach their names to your business and give of their time to help you grow the company (generally in return for stock or stock options), you have elevated your status in the eyes of an investor. Just as important as having outside directors and advisers is having them add value rather than just contribute names and résumés to your documentation.

Due Diligence Red Flags

Every angel has a mental list of factors that raise serious questions about the merits of a potential deal. These factors differ with each angel investor since they are all unique individuals, but the following list does give an idea of potential red flags that can turn into deal killers:

• No investment by founders: Investors read this as, “I do not really believe in my idea.”

• Numerous small investors, especially friends and family: Professional investors recognize the need for pre-seed funding and know that friends and family are among the few potential sources. However, having dozens of very small investors, particularly ones who are unsophisticated, spells a potential headache and distraction for the entrepreneur.

• One-trick ponies: If your company has only one product or a single-application technology, the available markets are very limited and the investor is essentially betting on acceptance in a single market.

• Claims of “no competition”: Every company has competition. Saying you have no competition will cause angels to run, not just walk away.

• Any portion of funds being used to cash out earlier investors or pay liabilities: Angels want every penny of their investment used to grow the company.

• Lack of participation by earlier investors (if relevant): If none of your prior investors step up to reinvest, it shows a possible lack of confidence in your company.

• Prior financings have greater protection and more favorable terms: “The last gold rules.” In other words, the most recent money in the door will expect the most favorable terms—and will not enter without them.

• A history of failure by the management team: Though experience often comes in the form of a failure, investors are not interested in supporting someone who does not learn from past mistakes.

• Family business: Most angels refuse to invest in family businesses because nepotism and family drama can create unfavorable dynamics and cause the retention of marginal performers, which prevents real growth.

• Multiple licenses required for practicing technology: Licensing involves many different possible scenarios, from a concern that the field is already flooded to the chances of being sued for patent infringement, making the value of your technology or product questionable. It can also result in low realizable margins due to the license fees’ impact on the cost of goods.

• Heavy debt: If a young company is already carrying a disproportionate amount of debt, investors will interpret this as poor financial management skills, overspending, poor business judgment, or some other unfavorable sign about the company’s worth.

• Hockey-stick growth projections: It is just not realistic to project a sudden, explosive rise in value. That kind of success would require every assumption to be 110 percent true, the market to react perfectly, no technical glitches to occur, and almost limitless funding to be at hand. You need exceptional proof for exceptional projections.

• Key assumptions missing in financials: Not having considered many of the basics in developing financial documents can mean many things—starting with inexperience, poor business judgment, and a failure to retain skilled advisers. In general, incomplete financials will cause angels to seriously question your abilities and their interest in your company.

• No board of advisers or board of directors, or only internal parties on either board: If you don’t have boards with external participation, it suggests that you do not seek advice beyond your team, creating a question of your coachability. Remember, external board members and advisers validate your ideas.

• An entrepreneur who wants total control: In a start-up, the entrepreneur typically does everything from five-year strategy to answering customer support calls. One of the reasons for raising investment funds is to hire smart people to take over various responsibilities; people who have years of experience in their area of expertise. An entrepreneur who wants to be the ultimate Renaissance businessperson will ultimately fail to meet investors’ expectations, either keeping a small and interesting (but exit-proof) company or burning out and leaving the company and investors high and dry.

• Unrealistic valuation: If you are asking for a $20 million valuation on a seed/start-up and your prospective angel is coming in thinking around $2 million, you are unlikely to have a meeting of the minds. No matter how much you love your idea, it is still only worth what the market will pay for it.

FINAL TERM SHEET AND RESULTING DOCUMENTS

As mentioned earlier, you should already have discussed high-level terms with your angel investor before entering due diligence to avoid wasting their time or yours. To continue with Mr. Collins, assume that he is quite impressed, has not found any red flags, and is ready to move to finalizing the terms of his investment. Chapter Three provides a thorough discussion of alternative forms of investment and term sheet content. The final terms should be a win-win. If either party feels resentful about the compromises made in the terms of the investment, it can sour the whole future relationship. Be up-front about your desires and especially about wanting a mutually positive outcome. Also think about these questions:

Who is driving the investment terms? Angels generally expect you to draft the term sheet and have your legal counsel create the underlying documents. Therefore, you will bear most legal costs. Venture capitalists almost exclusively require that the company cover their legal costs as well, but angels typically foot their own legal bills.

How many angel investors do you want? Mr. Collins may be quite interested in providing all the funding you need for this round, but are you really interested in just one angel investor? One of the many advantages of angel groups is the access to many angels and the likelihood of multiple investors from the same groups or a couple of different groups.

What are your long-term funding needs and how does this affect decisions on early investors? As discussed elsewhere, if your pro-formas call for subsequent funding rounds, particularly venture-capital-level funding, keep the terms relatively simple and straightforward with your early angel rounds. Sophisticated angels will understand your need for creating incentives rather than disincentives for follow-on funding. At the same time, you need to understand that angels are entitled to protect themselves—they are taking a great risk on you.

In negotiating the deal, know your strengths and weaknesses. Understand long-term ownership dilution for you and your angel investor. Understand your investors’ needs. You may even wish to conduct an “angel investor interview” with each of them to make sure you understand their needs and desires. Ask questions like these:

• What is the single most important factor in your determination of investment? Why?

• What are your expectations for return?

• What level of dilution are you willing to tolerate?

Understand each of your angel investors as an individual and let them get to know you, because angel investing is a personal decision.

After all the negotiations, you finally have your term sheet. Your lawyer will then generate the multiple documents related to these terms. If you are doing a convertible debenture (note) the documents may be relatively simple. If you are doing a preferred stock round, the number of documents will depend on the complexity of terms. Make sure your lawyer is experienced in early-stage funding and able to guide you through the document creation process.

Shareholder and Buy-Out Agreements

Some investors will ask for a shareholder agreement that governs the disposition of shares by the founders and other major shareholders. Most often, angels do not want shares to go to the spouse or significant other. Rather they want the company to have the obligation to repurchase the shares, and then (or simultaneously) they want the right to purchase the shares on a pro rata (equal) basis with other investors. Control of ownership is important in any company, and this is particularly true for professional private equity investors.

Buy-out agreements create an obligation by the company to purchase back investor shares at a designated time or upon demand after a certain period. If some uncertainty surrounds your ability to execute on an exit strategy, contractually mandating a return on investment may induce your prospective angel to invest. Buy-out agreements are particularly useful for companies that forecast high margins and strong cash flow but have limited ability to realize the traditional exit strategies, an acquisition or IPO. The parties agree to the multiple on investment or the formula to be used for calculating the investor’s payout. As previously discussed, limited liability companies (LLCs) can work well to attract angel investors if your business model does not project large market share but does show a handsome profit potential. One aspect of an LLC that you may not desire is that investors become members (like shareholders) in the LLC, and unless you have a buyout agreement or provision, they are members forever. Therefore, a buyout agreement can work well as a stand-alone agreement or in conjunction with an LLC structure.

Deal Closing

At last! Finally receiving your investor’s check can seem almost anticlimactic after making it through this entire process. Make sure not to rush the close. After having gone through this entire process, one key lesson should be to plan ahead so you do not run out of money before investors are ready to invest. You do not want to be desperate, so estimate the amount of money you need to get through six months. Finally, go ahead and celebrate.

SUMMARY THOUGHTS

If you have learned anything from all this discussion, it should at least include these maxims:

• Be prepared; stay two steps ahead of your prospective investors.

• Act professional; be professional.

• Recognize that investors enter due diligence with the thought of doing a deal and are looking for deal killers.

• Make sure you have a rough term sheet done before entering due diligence to avoid wasting your time and that of the investors.

• Discuss mutual expectations sooner rather than later. Don’t think you can make an ill-fitted relationship work.

• Be open and honest at all times. Do not hide bad news; better you say something than the angel find out through other means.

• Angels don’t expect a fully staffed company, but you should know what else you need to cover.

• Have the best advisory board you can assemble. Remember, angels put more stock in third-party opinions of your company than in your own self-praise. You are supposed to be enthusiastic and totally committed—that’s passion, and essential, but it means angels will take what you say with a substantial grain of salt.