There is a tendency among entrepreneurs to chase money wherever they find it. The pressure to find the financial resources so necessary to build a business can be over-mastering. Most of the time the partnerships which form between founders and angel investors are productive but, in a few cases, I have seen it turn very destructive. Companies that should have realized success have been held back by investor partnerships that have severely limited their potential or, in some cases, doomed them to failure.

Look Beyond the Checkbook

It may be hard to be discriminating when you are in the heat of the ‘money hunt’ but the sins of omission you commit while chasing investors can return ten-fold to destroy any chance of success. The problem can become acute because of the incredible range of circumstances, experience and interests that angel investors bring to the table. Their having money to invest is not enough. You need to understand their basic motivations and what is driving them to act as an angel investor. You also need to understand that all investment money is not the same. Some money will help you succeed while other investments will be a poisoned pill that will reduce your chances of building the business you envision. Here are some ‘sacred cows’ that you need to slaughter:

• Angel investors are in it for a return on their investment: Well, how can you argue with that? You would assume that the primary driver is always a return on investment. But, as you will read further on, that is not always the case. I know angel investors who are simply bored and looking for something to do and others who are frustrated CEO-wannabees. For some investors, it is all about a return but for others the return is secondary. You need to sort these two groups out. Do not listen just to what they say; it is what they do that is important.
• They have money so they must be smart: This is another fallacy. Some of the dumbest and most self-destructive people I have ever met are wealthy. I have found only a weak correlation between wealth and intelligence and a slimmer one between wealth and wisdom. Many a destructive hubris has been built on a fat bank account. Investors have an important role in start-ups but pretense, omnipotence or omniscience can warp an investor’s understanding of that role. Smart investors play their part in a highly professional and constructive manner. Seek them out; they are most likely the winners you want to associate with.
• They have been successful in business so they will know how we can be: Past success is not always a good indicator of wisdom going forward. In fact, great success can be counter-productive when they decide to work with start-up companies. I know one investor who continually regales his CEOs with stories of how he ran his company. Of course, the company was running over one hundred million annually when these stories took place. The CEOs, wanting to emulate his success, take steps that are entirely premature. The result is wasted resources and a dysfunctional corporate culture. Past business success is not a good indicator of professional performance as an investor. Remember, you are seeking an investor, not a shadow CEO.
• They will become my close personal friends and advisers: Not a good idea; the correct focus of investors should produce a tension in the relationship with management. If you want a friend, buy a dog.

The Bad and the Very Ugly

The problem with writing about angel investors is that they come in an amazing variety. I have met lots of them and there is always something different about each. The ease of entry into the field may have something to do with it. The only real entry requirement is wealth beyond current needs. That’s all it takes to become an angel investor. There are no educational requirements, courses to take or certifications to merit. Only a bank account and a decision to ‘invest’ are required to hang out a shingle and open up for business. Watch out for the following:

• The Shadow CEO: I have met investors who purposefully pick weak or inexperienced CEOs to work with. Their real agenda is to run your company from the back seat. These investors are very intrusive and will push you to make decisions and commit resources that will put your company at risk. They are mostly successful entrepreneurs who have built and sold a business. In the process, they have lost touch with the necessary energy levels and passion that is essential to building a start-up into a going business. Mostly they remember the later stages of their company and the extended staff they had. Then they turn the CEO into a kind of executive assistant and attempt to run the company by proxy. Most of the companies in the portfolio of this type of investor remain very small. They generally have very complex Excel spreadsheet projections and poor records in meeting them. Stay away from the Shadow CEO; they are very dangerous investors.
• The Crazy, Rich Uncle: This is probably the most dangerous type of angel investor because they are so easy on the management team. They are mostly retired and living comfortably. Their mission in life is to ‘give back to the younger generation’. A clear indication of this type is the total lack of performance metrics and a weak statement of expectations. They can be very seductive to entrepreneurs but there is a dark side. Without stiff set of performance metrics, the company can develop a culture of permissiveness. That will feel good until the money runs out. A key indicator of this type is the feeling that the amounts of money involved are, at least initially, not sufficient to cause them concern. The expenditure patterns are not carefully monitored and discussions do not turn serious until the money is spent and the wolves are at the door. As an entrepreneur, you need to seek out investors who will be hard on you; insisting on strict performance metrics and precise definitions of roles. Take the easy way out and you will be in for a ride to nowhere with a crazy, rich uncle. Sure you will enjoy the ride but, in the end, you will be let off the bus in the middle of nowhere with a tarnished reputation for failure.
• The Gaggle: Remember the old saying about a camel being a horse designed by a committee? These gaggles are fond of that kind of engagement. The investments that they make are very often selected in a very casual way and supervised fairly loosely. The problem comes as the group itself is very loosely organized. Different participants might have significantly different understandings of what it mean to be an investor and what that status entitles them to. This can range from complete indifference to total immersion in the management of the company. This situation can result in lots of pulling and pushing of the management team without an overarching strategic vision. Investments should be made based on clear and concise understandings codified in a detailed investment agreement.
• The Bottom Feeders: You will meet some investors who are really only interested in your intellectual property. They ‘drag the bottom’ of the entrepreneurial community looking for weak teams with good ideas. Mostly they insist that their funding be used to develop the technology rather than developing revenues. Once the money runs out, they regretfully inform management that they are closing the company down and taking the intellectual property as compensation for their investment.
• The Lead Broker: I have seen these lead brokers promote themselves into central roles in companies without putting much of any of their own money on the line. The net result is that the bulk of the investor group gets involved without much direct knowledge of the business or the management team. In one case, such a broker put together an investment in excess of one million dollars without making any investment of his own. He still managed a seat on the board and a dominate role in the management of the company. Be particularly careful of the broker who can invest but does not. This situation can turn nasty if expectations are not met. Finger pointing and recriminations can come to dominate the relationships among the investors. This could seriously damage chances of follow-on investments by the group.

The Good

Good angel investors always take a highly professional approach to the process and their portfolio companies. They generally focus in industries that they are familiar with. It is a good idea to avoid angel investors whose portfolio companies do not fit a close pattern. The best angel investors will often forgo the option of claiming a board seat and, instead, insist that an independent board member with professional experience be appointed. Beware of investors who seem to see investment in your company as an opportunity to enhance their reputation by sitting on yet another board. Here are some positive things to look for:

• Success Breeds Success: There are angel investors who have the knack to help their portfolio companies thrive; while others seem to doom them to failure or stagnation. I know of one angel who specializes in little deals and has a well developed ability to keep them that way. Other investors seem to have the opposite skill. Their companies grow and prosper. It is a good idea to do some diligence on the track record of the investor. Go with the successful ones even if the deal terms are less generous.
• The Investment Agreement: There ought to be a detailed investment agreement agreed to before any funds are transferred. This agreement should be very specific when it comes to the roles and responsibilities of each party. The best agreements provide for an earn-in by management based on performance. It also sets the ground rules for further investment. Good angel investors will require this as a matter of course. The worst ones will simply require a term sheet and then write a check. Remember that the absence of planning is the road to failure. Think of the investment agreement as a strategic plan for the relationship.
• Strategic Agreement on Roles and Responsibilities: Good angel investors will insist that the roles and responsibilities for each party be very well understood from the very beginning. These roles will be codified in the investment agreement and specify the actions that each party will be able to take under a range of possible outcomes. Although such an agreement can complicate initial negotiations, it will help greatly when performance does not meet expectations and realignment become necessary.
• Use of Proceeds: I have seen investors write rather large checks without insisting that there be an agreed upon use of proceeds. You can imagine what happened then. Entrepreneurs initially like the freedom to simply take the money and spend it as they see fit. But, more often than not, this leads to waste and spending on things that do not connect directly to the success of the company. One company, upon receiving funds in this way, spent a lot of the money on new laptops and cell phones with expensive service plans. They replaced very serviceable units. Another CEO kept paying his salary, even through results fell far below projections, and failed to pay suppliers. The result was a law suit that is almost certain to shut down the company. It is good business practice for the angel investors to insist on a detailed use of proceeds and for control over the spending of their money.
• Insistence on Performance Metrics: As a CEO you should be insisting on performance metrics for every member of your team. That is just good management. Your investors should take the same approach. It may seem initially easier to deal with angel investors who are very lax about this, but it is far from best practices. I am not just talking about Excel spreadsheet metrics. They have to be much more detailed than that. Good performance metrics detail the responsibilities of each member of the management team and the way their performance will be measured. Everybody from the CEO to the receptionist should have a job description with metrics attached. And the metrics should be sufficiently detailed to drive evaluations based on performance. Performance should be the driver in determining both compensation and earned-in interest in the company. Performance metrics are a sign of a professional and productive organization. Start-ups with that culture have a much higher chance of success.
• Focus on Governance Issues and Oversight: “Who’s minding the store?” If the answer to that question is “nobody but us entrepreneurs”, consider that a red flag. In the short-term, it may feel good to be free from oversight but, in the long-term, you are guaranteed to make more mistakes and waste more opportunities. The board of directors has a very important role to fill in any corporate structure and it is not just making sure that the investors get to a liquidity event as soon as possible. Good governance means overseeing the strategic planning process, dealing with issues of succession, audit and compensation, and providing for the protections and expansion of shareholder value. This fiduciary relationship with the shareholders is an important part of the corporate structure. Without it, management is under no effective supervision and the investment looks more like a roll of the dice than an investment.

Keep This In Mind

An angel investment creates a relationship that will help determine how successful you are going to be. Your skill in crafting that relationship is a test of how dedicated you are to the success of your company and team. If you take the easy way out, your chances of success will drop significantly. If you opt for the limp relationship with an inattentive investor, your prospects will suffer. Angel investors, the good ones, bring much more than money to the table. The good ones have helped their companies succeed and will help you do the same.

© Dr. Earl R. Smith II

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Dr. Smith is Managing Partner of The Federal Circle. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

Where Business Angels Fear to Tread?

Investors in early stage and start-up businesses are known as angel investors. The tag ‘angel’ coming from their tendency to operate in the margins where venture capitalists, banks and other backers choose not to go.

They also help plug a major funding gap to get such ventures off the ground and they happen to be the kind of investors who are prepared to take a risk, rely on their instincts and invest large sums without too many hard questions asked.

At least this is the accepted view.

But we may well be seeing a new breed of business angel emerge, one that takes a more conservative approach in these risk averse times.

Times, as Bob Dylan once sang, are a-changing as we see a trend emerging both in the UK and the US for a more cautious approach to investing in embryonic stage businesses. With many investors’ fingers burnt by the financial crisis it is hardly surprising that the appetite for risk remains limited – which in turn is making it increasingly harder for start-up businesses to attract funding.

According to the latest NESTA report on business angel activity in the UK, 83 per cent of angel investments were made with co-investors and a significant proportion (28 per cent) were made within just 50 kilometres of home. Working close to home and in the company of fellow investors shows that most business angels need security like anyone else and are careful where they put their money. The figures debunk any myths suggesting otherwise.

This is further borne out by statistics released in the US where an article this month in BusinessWeek suggests angel investors are getting pickier based on their analysis of data supplied by Angelsoft, an internet based company supplying online tools to angel investors.

The study looks at the share of companies seeking angel funds passing through each stage of the ‘deal funnel’ between 2007-2009. Not surprisingly, given the economic climate in the past two years, a glance at the chart reveals a dramatic decline in the number of businesses getting even as far as the screening process between 2007 and 2009. The statistics make worrying reading for anyone hoping for an easy ride when they approach potential investors for their start-up if the pattern is repeated her in the UK. .

More worrying still, just 2.8% of businesses made it as far as the due diligence stage, a fall of more than 50% on 2007/08 figures. This would indicate that angel investors in the US have become, as the article suggests, more ‘picky’.

But is it simply a case of angel investors becoming more picky? The figures reveal that just under half of businesses make it through screening to the due diligence phase, which is a pattern that has been broadly repeated since 2007.

However even though there were around 50% less businesses making it through the deal funnel, when we reach the end of the funnel and to what those business are striving to achieve i.e. investment, the proportion of those businesses making it through the final stages, is shown to be higher in 2009 than in 2007 or 2008, with 2.8% making it to due diligence and 2.1% securing investment.

Herein lies the good news for those businesses who sought funding. The proportion of businesses receiving funding in 2009 compared to 2008 suggests that if a business made it to the due diligence stage, there was a significantly better chance of securing investment.

The small percentage of businesses that made it through screening and the presentation phase also stood a greater chance of making it to the end of the deal funnel. This may suggest that angel investors are indeed becoming more choosy, but it could well be more a case of less money in the angel investor’s pot making it tougher to get past this initial screening process.

We know that more than half of investments fail; therefore it doesn’t take a great leap of the imagination to conclude that angel investors are willing to take fewer risks than they once were. This will be bad news for many start-ups and there will be many innovative businesses that fail to get a vital injection of capital. The number of businesses that have slipped through the net since 2007 is anyone’s guess.

It isn’t all bad news, according to the figures in the US business angels are choosing to invest in a greater proportion of those businesses that make it through screening. But we may be seeing that even business angels have their limits.

Start-ups just aren’t feeling the love from banks right now

It may have been Valentines Day yesterday, but with banks’ reluctance to lend to businesses, they could push more start-ups into the arms of angel investors.

With UK banks still showing a reluctance to lend to businesses, companies could well be forced to look towards alternative sources to fund their ventures. The recession may be over, but with UK GDP figures just crawling over the line into positive territory, how are the banks doing? Those vital foundations of a functioning economy and an equally vital source of lending for start-up enterprises.

Banks may well have received an eye watering £850 billion of taxpayers’ money to keep them afloat but a glance through last week’s House of Commons Committee report, ‘Maintaining financial stability across the United Kingdom’s banking system’ the crisis of confidence that has haunted banks since 2007 appears to have a sting in the tail for businesses in the UK seeking funding.

Despite recent declarations that they are ‘open for business’ banks are still struggling to help those innovative start-up companies the country needs to help UK plc climb out of recession are still being starved of investment. Lending to business, as the report suggests, is ‘falling short of legally-binding commitments entered into by two of the banks that received the most support: the Royal Bank of Scotland (RBS) and Lloyds Banking Group’

The reasons for the banks’ inability to meet their lending commitments are unclear but when it comes to small or medium sized business, lending in a downturn is perceived as even more risky than usual. This creates a paradox where businesses are starved of the vital capital they need to grow which in turn can lead to the failure of those businesses vital to a flourishing economy.

This can only be bad news in the long term for banks looking to bolster their balance sheets. So where can businesses turn to for help? The obvious answer is angel investors.

What has become an age of austerity for the banks could be a golden age for angel investors, those wealthy individuals willing to take a calculated gamble on start-up companies. But it isn’t just start-up capital angel investors will need to provide if banks continue to refuse or give unfavourable terms to businesses hoping to borrow.

According to an article in this week’s Scotsman, angel investors in Scotland are increasingly acting as bankers to fledgling companies, providing £1 million in overdrafts or loans in the past twelve months. Angel investors are also being asked to act as debt providers in the absence of loan and overdraft facilities offered to businesses by banks.

It isn’t just in Scotland that banks are perceived as the villains for taking taxpayers’ money and showing reluctance to lend to businesses. Ask any business owner or entrepreneur in the UK and you are likely to hear that trust in banks is at a low-point.

This could well be good news for business angels, if not for entrepreneurs struggling to launch their businesses. As we have established angel investors are becoming more picky with the businesses they invest in, therefore for all but the most promising businesses, there will be no easy alternative and the door will remain firmly shut when it comes to accessing vital capital.

But what this means for business angels, who unlike banks require an equity stake in the businesses in return for investment, is they can now afford to be even more choosy when faced with more choice. Due to the perception that banks are the villains when it comes to lending, those businesses with the most potential will be more likely to take the angel investment route rather than approach the banks.

And for those entrepreneurs who do make it through the deal funnel, they can gain access to valuable advice and coaching from those who have been there before, rather than just cash from the bank.

There is a caveat. How many of these extra businesses seeking capital from business angels will be viable? According to the banks, one reason they haven’t been able to reach their lending target is the higher proportion of those companies needing credit not having viable business models.

This leads us to two conclusions. Business angels will need to be more wary when it comes to assessing the viability of companies. Banks meanwhile will need to be careful that their reluctance to lend now creates an irreversible trend of the best businesses turning to business angels for their start-up capital now and in the future.

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.