Inflation isn't all bad news for angel investors and entrepreneurs.

Here’s why inflation can be both good and bad news for entrepreneurs and angel investors…

In an inflationary economy there are always winners and unfortunately losers, so what is the likely outlook for business angels and entrepreneurs should RPI and CPI continue climbing?

Let’s first look at the impact for business angels. Being individuals of high net worth they will have the opposite problem to your typical entrepreneur starting out. They will have a lot of money sitting there which needs to be put to work. Some will  choose to invest in start-up businesses sometimes for altruistic reasons but more often than not for profit.

Now this was all well and good when the times were good, but now the signs are that unless the Bank of England puts the brakes on through a base rate increase we will soon be in for a spell of runaway inflation, which hasn’t been seen since the bad old days of the 70s and 80s. Business angels will need to react to this gathering storm by being prepared for the worst.

The worst case scenario is that the value of cash will continue to erode as inflationary forces continue to push up the value of goods and services.

Now more than ever a well-balanced portfolio which includes investment in equities and even a proportion in gold is a good idea as a hedge against inflation, but just as importantly some of that cash should also continue to be placed in start-ups particularly those businesses with a high turnovers and low margins. History shows that some of the world’s most successful companies started up in recessions – take Microsoft for example.

This will explain the new investment boom in Internet start-ups. Everyday in the US and the UK we hear news of the latest £multi-million investment in this sector. There is even talk of a bubble, but this shows no sign of popping just yet.

But this is the good news for business angels. The bad news is, the businesses they invest in will also be caught up in the inflationary spiral when it comes to purchasing goods and services. As a business angel the money you invest in the company will also be eroding in terms of its capital every year in this inflationary cycle so you will need to carefully consider your funding structures rather than loading too much debt on your company to begin with.

Your mentoring skills will also be important in guiding companies through choppy waters as businesses are buffeted by rising costs. Bootstrapping is now even more important so choose those companies who demonstrate this capability within their business plans.

The problem with this inflationary cycle is that it has come hot on the heels of a major financial crisis. Entrepreneurs are already dealing with the aftermath of the downturn and the second dip into recession we have already experienced, while others are taking risks to take advantage of the next upswing. With banks twitchy many more entrepreneurs will be looking to business angels to help grow their businesses.

To keep those businesses angels interested, entrepreneurs will need to show commitment to keeping their costs down while showing a credible projections for growth in their business plans. Turnover will need to be faster and you will need to be acutely aware of cashflow, including those late payers to avoid your startup being crushed under a the burden of high prices.

So is there any good news for start-up entrepreneurs?

Well as we’ve already established now is as good a time as any to start a business, take the earlier example of Microsoft as your inspiration. Also while taking on debt should be avoided unless absolutely necessary now is probably a good time to consider a loan in the absence of other available options. Your loan will decline in value over time as inflation begins to eat away at it.

Both entrepreneur and business angel are in the same boat when it comes to inflation, but with a little caution there is no reason why inflation should keep either awake at night.

There are three questions that every business angel (or Venture Capitalist, for that matter) will ask, and hence, these are the three questions that every entrepreneur and investment proposal needs to answer.

That is, assuming the entreprenuer wants to get funding.

Question 1. What will you spend my money on?

Business Angels want to know why you need the money in the first place.

And, they expect a specific and clear answer such as

to further product development

and / or

to commercialise the product or service/ take the product to market

Be warned, spending on anything is a waste of money and shows that the entrepreneur and his or her team may be developing bad or expensive habits.

A rule of thumb is that no more than 10% of the money invested should be spent outside of these two key areas.

Peter Drucker said that ‘money should be spent on marketing (and sales) and R&D (or product development/ innovation), everything else is a waste’.

Hence, Business Angels should expect a clear answer to this question.

Question 2. Are you a pay packet in search of funding?

If the entrepreneur / shareholder is using the new funding to pay himself or herself a big salary then as an angel investor you should reject the project.

For a business angel or VC firm to have confidence in the project, they want to know that the interests of the shareholders are all aligned.

Therefore, the scenario in which some shareholders earn large salaries (or siphon off the cash before it gets to dividends or before it can be reinvested) and others do not, will lead to disputes and disagreements.

Hence, it is fair and reasonable to expect that the entreprenuer’ pay-off will be in the sale of the business – a capital gain – not a big salary along the way.

Of course, entrepreneurs and their team need to eat during the business build and it is fair to pay some salary, but the rate needs to be set below market rate – by anything between 20 and 80%.

In general, a proposal that is still raising cash to develop the product might offer an entreprenur 20% of his or her market rate salary, whereas a developed product which is looking to commercialise and take the service to new markets (having already been proven) would look to pay upto 80% of fair market rate.

This discount to market rate salary should also apply to any commissions earned by the shareholder entreprenuers.

Question 3. When (and how) will I get my money back?

This is, of course, the most important question because investors want their money back.

Most entrepreneurs don’t realise that this is really important for the Business Angels and VCs and hence, don’t give sufficient thought to how or when this might occur.

Equally, as a Business Angel, you are wise to recognise that entrepreneurs are emotionally attached to their idea – as you’d expect and hence, they may be reluctant to sell the business or create lower quality but higher profit products and services.

A key part of your Business Angel due diligence will focus on whether or not you believe this team of entrepreneurs will be able to do the deal and sell the business when the opportunity arises.

As an investor, it is worth spelling out to entreprenurs and potential investees at the outset that you are just as emotionally attached to your money as they are to their idea or product/ service.

If the entrepreneur / investor relationship is going to work, then you both need to spell out this point early on and reach an agreement.

All 3 Questions Answered?

Okay, let’s say that this proposal and this team answer these three critical questions satisfactorarily.

Only then will the investor ask – do I have a reasonable chance to make a x3 (for low risk, highly developed business) or a x10 (for early stage or seed investment) return on my money within 3 years?

This question may become a reflective question as many entrepreneurs’ teams will lack the experience to accurately forecast the exit timing and method?

In which case, this will be the opportunity for the Business Angel to add value to the business proposal.

Without a credible exit plan, it may be difficult for the entrepreneurs to raise further funds. If you, the business angel, through experience and credibillity can help provide that clear plan, then you can negotiate a lower share price for the benefit of your experience and build an exit plan that you can believe in.

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Want to know if your business plan is suitable for funding? Easy, click here to take our free investment readiness survey and see if you can answer these key Business Angel questions….
http://goo.gl/2VJLX

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Dr Earl R. Smith II

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J. S. Gamble, Founder and CEO, Montis Group, LLC

In this series of articles, I describe several discussions that I had with investors in the Washington DC area. They range from angel investors to senior partners in well established funds. I have known most of them for many years. That allowed us to cut through the usual PR crap and get to the heart of the process of reviewing investment opportunities. When I told them that my objective was to provide a series of articles which would help companies seeking funding, each was very willing to help – it is, after all, in their interest to improve the process. I owe each of them a debt of thanks for agreeing to sit down and ‘open the kimono’ so to speak.

The first article in the series – Conversations with Investors – Chapter One – focused on Jim Hunt of The MITA Group. Jim is a fairly typical angel investor – a successful entrepreneur who has turned to investing on early-stage companies. My next interview was with a close associate of Jim’s whose background and experience makes for a different approach.

Vive la différence

Every investor is different – they have different backgrounds and approaches to the process. This is one of the greatest lessons that founders need to learn. Each investor has a common characteristic – they have money to invest. But their life and business experiences are always more important than their bank balance. In the first of this series, I emphasized the need to match the investment opportunity to the interests of the investor. Many meetings are wasted because founders did not take the time to match their opportunity to the investor’s interest. The lesson for this chapter is the need to match the presentation to the experience and tendencies of the investor – to realize that each investor is unique and will respond better if approached in terms they understand.

Visit with an experienced analyst

I have known JS for a number of years. He is Founder and CEO of Montis Group, which is focused on investing in and advising Early Stage Technology Companies. JS is an Advisory Partner of The MITA Group. In addition, he is a member of New Vantage Group, the Active Angel Investors of Vienna, Virginia, and a member of the Capital Access Network at the Dingman Center for Entrepreneurship at the University of Maryland. He is currently working with a dozen like-minded private investors to form a Group of Angel Investors focused on more active engagement with their portfolio companies.

JS has a more academic bent when it comes to analyzing investment opportunities. He earned an MBA in finance at Wharton and is very experienced at building and testing financial models. As a result, he is murder on unprofessionally drawn business models and financial projections.

Currently JS is invested in or actively engaged with several early stage Technology and Service Companies in the Mid-Atlantic Region. He served as Acting CEO of Smart Imaging Systems, Inc. and as an adviser to Agilyst, Inc., Semantic Labs and Wiser Together, Inc.

Prior to founding the Montis Group, JS was Senior Operating Executive in Broadband Cable and SVP of Wireless Operating Units with Comcast. He has more than 15 years of Full P&L (up to $1.2B in Annual Revenue) and CapEx responsibility. He had responsibility building teams focused on innovation, improving execution and launching new products and services to drive revenue growth.

Way back when, JS spent several years on the professional staff of McKinsey & Company, Inc. and Price Waterhouse where his clients were primarily telecommunications companies. He also served in various roles with GTE Mobilnet (Wireless Operations).

The Initial Screen

We met at Old Glory in Georgetown – a bourbon house that offers tables with a fine view of M Street. After chatting about deals that we were each involved in and people we knew, I turned to the interview. I told JS that I wanted to focus on how he decided whether or not to make an investment. My first questions was, “What percentage of the deals that come over the transom do you discard out of hand?”

He knew that I had already done an interview with Jim Hunt; so the first response was a question. “What did Jim say?” I grinned and said, “now, now – no cribbing. I’ll tell you afterward.” That was the first lesson from the interview. Angle investors in a given geographical region generally talk to each other frequently. They share information and track closely each other’s success and failures.

“Seventy-five percent of what I see is discarded out of hand,” offered JS. (Jim’s number was 70%). That means that, on average, three out of every four deals gets only a cursory consideration. His principal reasons for dismissing opportunities were 1) the business model does not hold up, 2) it’s not in my area, 3) the founders are looking for a passive investor and 4) I don’t know any of the principals or their advisers.

The first reason relates to how JS approaches the process of investing. Because of his background, he can take apart a business model and the attached projections quicker than most can review them. “I look at their model and projections. I take them apart and test them against what I know. If I find obvious mistakes, I walk away quickly.” His rule of thumb, “I cut the projected revenue in half and double the time it takes to reach it and then I look at the results. My experience is that that is probably closer to the way things will turn out – that is, if they are successful.” Other investors may get to the business model later in the process but JS goes there first. As a result, he may lose interest because your numbers don’t add up or make sense.

His second screen it very similar to one that Jim Hunt uses. Good investors know what they know about and are very disciplined about staying away from investing in what they don’t know. A particular type bothers JS. “I see these teams who have reinvented themselves to fit the latest, newest, hottest thing.” JS likes to see founders and management teams that are focused on what they know and have been successful with in the past. His investment is in the team’s ability to execute their business model – not in the business model. “Given a choice between a Superb Product/Model with Mediocre Execution and a Mediocre Product/Model with Superb Execution, I will take Superb Execution every time.” This is an important distinction which ran through all my interviews.

The third screen is particularly important to JS. He likes to invest in situations that call for an active participation by the investors. This is a variation of Jim Hunt’s third screen – ‘they don’t have any adult supervision’. JS prefers management teams that see a value in his or a co-investor’s participation beyond providing the funding. “I like situations that call for active participation.” To be sure, there are investors who like to take a more passive role. It is counterproductive to approach an ‘active participation’ investor with such a proposal.

The fourth screen is one that many angel investors have and founders need to pay attention to. Many of these angel investors will not look at deals that do not involve one or more of their significant contacts. It is important to remember that angel investing is a much more intimate process than venture funding. Relationships and endorsements generally play a big part of any angel investor’s decision to consider a deal.

The 25% Remaining

“So, JS, let’s focus on the roughly 25% that make it through your initial screening. What do you look for and what reasons cause you to discard them?”

“I look at the product or service that they plan to offer. My first question is does it work? You’d be surprised how many deals I see where the answer is negative or not yet. This investment round will get us there.” JS doesn’t like to invest in science projects and isn’t likely to fund product or service development. He expects the team to come with a fully developed value proposition. That’s the case with most angel investors I know. There are those who will fund development; but a team needs to know ahead of time if the investor they are approaching is likely to make such an investment.

His second screen dealt with the path to revenue. “I am fairly impatient with a team that has generated no customers. The proposition ‘give us the money and we will generate revenue’ does not impress me much”, he offered. JS believes that good teams are compulsive implementers. “The good teams are always selling – always working to generate revenues. The less impressive teams are always tweaking and fine-tuning their technology and avoiding the process of generating revenue as long as possible.”

JS likes to drill down deeper into the business plan and value propositions which underlie it. He sometimes finds himself pushing teams to consider details that they may have ignored. But his motive is far broader than testing the business model. “I want to see how the team operates under pressure. I look for weak links – team members who are not up to playing their role. I drill down into the team, beginning with the CEO, and their capabilities as a team at the same time I am stress testing the business model and value proposition.” He is likely to request one-on-one meetings with individual team members in order to come to an assessment of how their personalities and roles mesh. Gaps in the team are particularly serious negatives to JS that need to be recognized and resolved. He sees such team capability gaps and the plans to resolve them as a reflection on the judgment of the founders.

In his view the quality of the team is central to the chances of success. He explained. “Most angel investors focus on the CEO – and the CEO is definitely important. However, I try to go beyond just the CEO to judge the larger Team skills, ID any gaps – for example. sales or business development – and try to judge how well the personalities/skills complement each other to make for a more effective Team. Some gaps are common and don’t necessarily bother me. Companies can outgrow a Team member’s capabilities; or, conversely, Cos. can grow into the skill ‘sweet spot’ of an experienced Team member. What can bother me is the CEO’s recognition/non-recognition of the gaps and their clear or non-existent plans to resolve the gaps.”

This approach allows JS to gather information on a critical area – is the team willing to listen to alternative assessment, do they stay obsessively with their initial perspective or do they grow their understanding with detailed discussions and new viewpoints?

The 5% of the 25%

“OK JS, let’s start with a hundred deals. You say that only twenty-five of them get any attention at all. What percentage of those get a detailed analysis and now many are you likely to seriously consider for investment.”

Every investor that I interviewed paused when asked this question. I suspect that was because the process has become so natural for them that they don’t keep track of such things. Their interest is to find investment opportunities that are sufficient to satisfy their need to invest funds. That is a key to understanding how and why investors go through the process – often a frustrating one that can go on for long periods without surfacing a good investment opportunity. They have decided to invest part of their wealth in early-stage companies. Most founders do not grasp this dynamic sufficiently.

“I may take a closer look at about 20% of the ones that pass my initial screening”, JS estimated. So, to run the numbers, out of every hundred deals that come to JS, he discards seventy-five out of hand. Of the remaining twenty-five, roughly five get a more extended consideration.

“And how do you go about making decisions about these few,” I asked. “I am working to satisfy my appetite for investment, balance my portfolio, manage the overall risk and make good investment decisions which will provide a hefty return,” he replied. This response is important and every founder should work to understand what it means. Investors are working to balance a complex set of criteria, needs and objectives. Their decision is unlikely to be limited to whether or not they should invest in your company. In other words, you may be turned down for reasons that do not directly relate to your company.

We had enjoyed a couple of very nice bourbons and I a good cigar. Time and other obligations were tapping us both on the shoulder. But I could not resist one additional question. “JS, I am getting the feeling that you see your role as extending substantially beyond that of an investor. Would it be fair to say that you see yourself more as a venture partner who happens to be providing funding?”

“I think that is more than fair. Sure I see the companies as investments. But I am a proactive investor and have confidence that I can bring much more than funding to the table. I am more likely to invest in a situation which calls for that involvement than in one which opposes it.”
© Dr. Earl R. Smith II

In an effort to boost Canada’s flagging business environment, the Prime Minister has unveiled an Investing in Business Innovation Program that will allow small start ups to apply for up to $1 million in repayable funding. This will only be available however if they have funding commitment from accredited business angels or registered venture capital investors.

Belfast-based SOPHIA Search Limited a technology company focused on enterprise search and unstructured content management has secured funding of £800k ($1.2M), the largest ever angel investment made in Northern Ireland. The funding will be used to assist the company with expansion into the USA. The company has appointed a safe pair of hands in Dr. Chris Horn who is regarded as one of the most successful technology entrepreneurs in Ireland and formerly of IONA Technologies PLC as chairman.

SOPHIA has developed advanced search technology which helps businesses to internally search for quality information much more quickly and accurately. There are many applications for the technology with significant global markets. Initial products have been released that assist in researching information, cross-referencing and reducing the duplication of data. Funding recieved by the company included a significant contribution from a newly formed Belfast based Angel syndicate – ‘Volcano’. SOPHIA Search’s clients include IBM and Accelrys.

The significant contribution the OION Network made to the growth of early stage businesses was also recognised with the award of Business Angel Network of the Year by the British Business Angels Association – seeing off competition from rivals including Angels Den, Envestors LLP, Central England Business Angels, Octopus Investor Group and South E

OION’s investor members invested nearly £1 million in 16 companies during the past financial year. This direct investment enabled the firms to leverage an additional £5 million of funding from other sources.

Angelic Agreement? But will it stay heavenly?

More than half of business angel investments fail, but why? How much of this can be put down to the innate vulnerability of start-up businesses?

Surely having an enthusiastic angel investor on board, eager to provide a timely injection of funding to ensure success should mean failure rates i.e. those leaving the business angel out of pocket come exit time should statistically be on the better side of half.

Yet this clearly isn’t the case. In an ideal world entrepreneurs and the angel investors are made for each other, a real match made in heaven as the title to this blog suggests. Put simply most start-ups require money and if it seems like a good idea, most angel investors on the lookout for new opportunities  are eager to supply it – and make a decent return in five years or perhaps less. Perfect, the entrepreneur gets his money, establishes a viable business and the angel investor rides off into the sunset profit in hand ready to fund the next venture.

But life isn’t that simple. Good relationships are crucial to the stability and success of a business. Relationships need not necessarily be cordial at all times, debate and alternative viewpoints are healthy and can be productive , but like all relationships in life, certain elements must be in place to ensure relationships don’t unravel and become destructive.

While some angel investors will be looking more at business structures and the ideas and innovations those businesses are bringing to their market, it would be wrong to ignore the importance of the individuals who run businesses – the management team and the person(s) leading them.

The most successful investors should put fairly large sums into two or three businesses they know something about and whose management is trustworthy, at least this is what the most astute investors like Keynes and more recently Warren Buffet would tell you.

Finding out if the managers of the business you invest in are trustworthy isn’t easy. First you must establish a relationship. We often speak of relationships as having the right chemistry and it is crucial for the angel investor to feel that chemistry when he meets the entrepreneur he’s willing to invest in for the next four, five or maybe more years.

This is no easy task. Not all angel investors are entrepreneurs and many entrepreneurs don’t have the right instincts or ideas to make their business a success even with the help of investment as the statistics show. There can often be gaps in age and experience between business angel and entrepreneur. Take for example an ambitious 18-year-old fresh out of college, full of ideas and exuberance, the business angel who invests in the business may have a wealth of experience to offer, but will he/she be able to pass that knowhow, as well as money, on to ensure a successful future? There may well be gaps in age and understanding as well as experience.

If both angel investor and entrepreneur lack experience of starting up and developing a business, the relationship might turn into a voyage of discovery for both which may then flounder on rough seas. No matter how much money is invested, at least one party should know how to make the best use of it and both investor and entrepreneur must be able to work together and have their interests in alignment to achieve success and a positive return on investment.

Increasingly these days, angel investors are opting to join business angel networks and groups to spread risk rather than be faced with the possibility of choosing the wrong business to invest in. While this approach may have its advantages it will naturally create a distance between them and the entrepreneur. The cash may well pour into the business, but can the entrepreneur be trusted? This is a major question to consider, and also is the entrepreneur self-disciplined to spend the money wisely?

Investing too much money too soon can be toxic for a start-up particularly when an entrepreneur may lack focus or is prone to taking risks with your money.This brings us back to relationships, put simply, the business angel’s role is to invest not only money but also add value. For the relationship to work, therefore, the entrepreneur must be flexible, be willing to be mentored, work as part of a team and frugal with the money at his/her disposal.

Keeping these tips in mind should ensure that at least (market forces permitting) it will be the business that fails rather than the business relationship.