EIGHT KEY STEPS IN STARTING UP WITH AN ANGEL INVESTOR

EIGHT KEY STEPS IN STARTING UP WITH AN ANGEL INVESTOR EDWARD E. SHARKEY 4641 MONTGOMERY AVENUE SUITE 500 BETHESDA, MD 20814 (301) 657-8184 ESHARKEY@SHARKEYLAW.COM WWW.SHARKEYLAW.COM

CONTENTS Introduction... 3 Who are these angels?... 4 Principal benefits of angel financing... 5 Principal cons of angel financing... 6 8 key considerations... 7 (1) Clarifying a Vision the Business Plan... 7 (2) The Investor Plan... 8 (3) Assembling an Advisory Board... 9 (4) Looking for Angels... 9 (5) Approaching a Potential Angel Investor... 10 (6) Angel Expectations... 10 (7) Making an Angel Contract... 11 (8) Maintaining an Angel Relationship... 11 Conclusion... 13 2

INTRODUCTION Pete Donahue had the innovative idea, he had the business know-how, and he had the management team that could pull it off. What he did not have was the capital to get him to the starting line. Michelle Sampson had worked as a personal chef for more than twenty years and knew it was time to turn her restaurant plans into a reality. She found the perfect location and her niche in organic cooking, but she lacked the financing to back her venture. Pete and Michelle are like the thousands of entrepreneurs who want to launch start-up enterprises but know that commercial banks generally do not lend funds to ventures with little or no assets, customer base, or track record. Compounding the dilemma, venture capitalists generally work with business concepts that are already up and running with the prospect of million dollar revenues. So what is a possible option for motivated entrepreneurs like Pete and Michelle? Angel investors are a resource that can provide seed funding for start-up business ventures. They commonly prefer to take an equity position in the start-up, either directly through the issuance of shares or indirectly through other instruments that can be converted into shares. Many are motivated by the energy of young emerging companies and are willing to take risks that venture capitalists tend to refuse. 3

WHO ARE THESE ANGELS? Typically, an angel is a high net worth individual who provides capital for the start-up or expansion of a business. Angel investors come in all forms but are usually independently wealthy individuals who make private investments in early-stage ventures. Many are successful entrepreneurs or former executives who want to help other entrepreneurs get their businesses off the ground. Angels generally provide the first round of financing for start-up companies before the business is established enough to attract venture capital funding. Angels are looking for a higher return than they would normally receive from more traditional investments. Although data suggests that there are wide ranges of initial investment amounts, most angels keep their investments under $100,000 in order to spread their risk across several companies. Angel investors often act in formal groups to complete larger deals. Estimates regarding the number of active angel investor groups in the Unites States tend to be quite anecdotal and often vary tremendously based on the lack of SEC registration requirements. Data suggest that there are close to 200 active angel groups and well over 250,000 individual angel investors. Angels fill the gap between financing from friends and family and venture capitalists who generally invest in much larger businesses. Consequently, they remain a viable and necessary source of capital for many start-up companies. As well as providing the needed initial financing, angel investors can also operate as mentors, supply business expertise, and serve as a conduit for additional business contacts, all of which are beneficial to a new venture. 4

PRINCIPAL BENEFITS OF ANGEL FINANCING Angels often provide seed capital when other options are not available. If there is little or no history of profitability, it can be difficult for an entrepreneur to attract institutional investors. Angels generally invest on the strength of a new idea backed by the enthusiasm and experience of the entrepreneur. This provides new companies with resources to hire key employees and to develop a business model to the point where they can eventually seek larger scale, second-round financing through venture capital. The process of negotiating and documenting the terms of financing is generally not as burdensome as other types of financing. It often takes less time to meet with an angel investor and to receive funding. Due diligence is not usually as onerous, and angel investors generally expect a lower rate of return than venture capitalists. This can expedite initial transactions between the parties. It is also generally easier to manage an angel relationship than relationships with institutional investors. Angels tend to focus on early-stage investments, and they are more willing to accept the inherent risks, such as higher failure rates and uncertain capital returns, which regularly accompany these types of investments. In addition, many angel investors have extensive entrepreneurial backgrounds and sophisticated business expertise. This frequently enables them to offer assistance to the entrepreneur on a wide array of topics. This is particularly useful for a start-up that has an innovative product or service but an unclear view as to its implementation. 5

PRINCIPAL CONS OF ANGEL FINANCING Finding the right angel can be laborious and time-consuming. The diversity of angels, with varying degrees of expertise and business strategies, can sometimes complicate the identification and selection process. While many angels are extremely sophisticated, others may lack the knowledge and proficiency in investing that an entrepreneur is seeking. The entrepreneur should always research the background of any potential angel investor. The offer of capital alone should not be sufficient. The most significant con to angel financing is that the entrepreneur will be required to relinquish some ownership of the business. Angels typically look to share in the upside potential of the businesses in which they invest. The angel may ask for equity shares giving them preferential rights over common stock holders or other securities that give them a degree of preferential leverage. An entrepreneur needs to fully consider the implications of the equity structure that is agreed upon and should be confident that the business can meet the payment obligations, transaction costs, and other definitive benchmarks. Finally, the entrepreneur may need to accept a loss of a certain degree of control over the business. This may be difficult for entrepreneurs, particularly if there is a personal history of exclusive management and control. An entrepreneur may want to find other means of financing outside of an angel relationship if absolute control over the business entity is the only option. 6

8 KEY CONSIDERATIONS Set forth below are eight key considerations for angel financing process: (1) CLARIFYING A VISION THE BUSINESS PLAN The business plan is an essential first step. No serious angel will consider the opportunity without a comprehensive plan. There are multiple necessary components of the business plan: The business plan should begin with an executive summary. The executive summary provides a succinct synopsis of the business plan. It highlights the key points and should communicate to the prospective investor the size and scope of the market opportunity, the venture s business and profitability model, and how the skills of the company s management team make it uniquely qualified to execute the plan. It should tell a compelling story and be easy to read. Next, the business plan should set forth a market analysis by defining the competitive landscape of the business. An analysis of the market demonstrates that the entrepreneur has done his homework. This section should evaluate the playing field in which the company will be competing by identifying direct and indirect competitors. It should provide well structured answers to key market research questions. The section must show the demand for the product or service, the proposed market, the trends within the industry, the size of the target market segment(s), and the profit potential. The entrepreneur should demonstrate that the business is offering a product or service in a market where others have missed the opportunity. It should also include a description of the pricing plan, as well as the willingness of the target customers to pay for the product or service. The business plan should discuss the organizational set-up by setting forth the structure of the venture. This section should identify the name and intended location of the new business. The legal structure of the business should also be described, whether it be a partnership, corporation, or limited liability company. It should include a description of the management team and highlight their capabilities and team strategies. It is often a good idea to include resumes and biographies of the entrepreneur s key players. The business plan should provide an operational map. This should set forth a timeline for events by stating operational milestones and expected dates of completion. This section gives the entrepreneur an ideal chance to demonstrate adeptness at problem solving by discussing potential risks, applicable solutions, and a feasible exit strategy. Investors know that market fluctuations will occur, and they want to be sure that the entrepreneur is prepared to deal with those changes. Projections, management personnel, market demands, and other industry issues will inevitably adjust. The entrepreneur must be aware that original expectations may transform during the process of building a business. The final step is setting forth the financing plan. Angel investors need to have a clear idea of the financial assistance an entrepreneur is seeking for an effective start-up of the company. This section should include operating costs, financial projections, capital structure, and investment criteria. It needs to clearly delineate the amount of capital that the 7

entrepreneur requires and how this investment will be returned. The financing plan should also address profitability and subsequent offerings. Any pertinent financial worksheets should be provided in this section such as: annual income projections, a break-even worksheet, projected cash flow statements, and a balance sheet. A sample outline for a potential business plan should read as follows: I. Executive Summary a. size and scope of market opportunity b. profitability of venture c. brief high-light of management team/expertise II. III. IV. Market Analysis a. competitors and industry trends b. product demand and customer base c. pricing Organizational Set-Up a. name and location b. legal structure c. in-depth management team description Operational Map a. operation/production timeline b. risks/exit strategy c. projections V. Financing Plan a. operating costs/capital requirements b. debt repayment c. profitability and offerings (2) THE INVESTOR PLAN The entrepreneur should next devise an investor plan. Without a viable investor plan, an angel will be unable to gauge the practicality of the potential investment. An investor plan is not the same as a business plan. It is a short summary of the investment opportunity set forth in a one-page outline or term sheet. The most important component of the investor plan is valuation. Valuation is defined by a company s ability to generate cash flow in the future. It is more of an art than a science, particularly early in the life of a business, so valuation is often subject to great latitude and negotiation. This is particularly applicable to businesses that have yet to create any revenue or profits to speak of. The entrepreneur must recognize that the key to valuation is focusing on the future. Here s the trick, though. The entrepreneur should always attempt to work on valuation with potential investors. The risk of getting it wrong, valuing the company too high or too low by proceeding unilaterally is too significant to overlook. A valuation that is too low 8

could be costly for the company. A valuation that is too high can end potential investors interest on the spot. Rather than leading with a proposed valuation, the entrepreneur should collect information relevant to valuation and present that in a constructive manner. The entrepreneur should begin the valuation process by finding out how much similar companies in the same niche and geographic area are worth. Information regarding sales of businesses in the entrepreneur s industry are readily available on business web sites. Accountants and lawyers can also provide advice about market rates for comparable companies. They can further assist with the countless valuation methods used, ranging from multiplier methods to discounted cash flow methods to virtual CEO methods. There are pros and cons to all of these, and an advisory board, as discussed below, can assist the entrepreneur in determining which valuation method would be most applicable to the needs of the venture. (3) ASSEMBLING AN ADVISORY BOARD Ideally, an entrepreneur will assemble an advisory team that includes an attorney and a certified public accountant knowledgeable in securities. This team will be able to assist the entrepreneur in developing a professional business plan. They will also be able to provide critical information about applicable federal securities laws and can help an entrepreneur understand prohibitions on solicitations. By obtaining this information before a mistake is made, an entrepreneur will minimize potential harm to the business and potential investors. Mentors can also be a valuable resource and an integral part of an advisory board. When choosing a mentor, entrepreneurs should look for individuals that can fill a knowledge gap. If the management team is weak, the entrepreneur should seek a mentor that has prior business or managerial experience. Entrepreneurs can find mentors locally through their own personal and business contacts. There are also a multitude of formal mentor groups, readily accessible on the internet, who offer professional mentoring in the areas of valuation, appraisals, and financial consulting. The entrepreneur should assemble the advisory team at an early stage in the venture. Many start-up entrepreneurs are unfamiliar with the intricacies associated with contract negotiations, securities laws, accounting, and taxation. A competent advisory board will help to navigate these procedural obstacles by ensuring that they are addressed efficiently and effectively. (4) LOOKING FOR ANGELS Although privacy is important for many angel investors, most angels like to be actively involved with the companies they support. The relationship between company and investor is usually close. When seeking a private investor, the entrepreneur should seek an investment partner with whom he or she can comfortably work and communicate. Mere financing alone, without a significant level of compatibility, will increase the likelihood of future disruptions to the business. The entrepreneur should always begin the search for an angel investor locally. Angels tend to invest in start-up businesses that are within close proximity to them. Geographic 9

proximity will also facilitate meetings, which tends to make for a more constructive start-up process. Chambers of commerce and local business organizations are good places to make contacts that can lead to an angel connection. The entrepreneur should also speak with friends and business associates who may be in a position to provide information or references to angel investors. Referrals from successful people in an entrepreneur s given industry can also be conduits to potential investors. Local capital brokers and business advisors are frequently familiar with the identities of angel investors and can provide leads. Internet searches can also provide leads to angels, but the entrepreneur should limit the search to his own geographic area. Networking firms found on the internet generally provide angel contact details for a subscription fee and will also include the entrepreneur s contact information in their data base. (5) APPROACHING A POTENTIAL ANGEL INVESTOR The angel s first impression of the entrepreneur is critical. Angels tend to appreciate brevity, particularly during initial introductions. The entrepreneur should be able to summarize the investment opportunity succinctly. If the angel is interested in the business idea as presented, the entrepreneur can expand the explanation and provide supplemental detail. The entrepreneur should prepare a pitch that can be delivered in different circumstances: during a phone call, over a casual lunch, or standing in a conference room in front of a group. The pitch should focus on how the start-up intends to meet a demonstrated need in the market. The entrepreneur should be equipped to adapt to the angel s personality and needs in order to create a comfort level for open discussion. It is also vital to be able to articulate workable solutions to potential problems that a start-up company may face by reviewing those issues prior to the first meeting with a new angel. This will ensure a level of preparedness to address problematic issues that might arise in the future. (6) ANGEL EXPECTATIONS Angels expect to make money on their investments. A desired return of five to ten times their initial investment within a five year time frame is common. Thereafter, the level of expected returns may vary significantly depending upon the exit strategy of the angel. Angels also like to see the entrepreneur investing his or her own capital in the startup. This shows faith in the business idea. Angels want to see a defined product with a large market potential. Good ideas alone are not sufficient. The entrepreneur will need to describe a focused launch strategy that will catapult the business idea past where others have failed. Evidence of an already-tested positive market response to a new product or service will further illustrate that the start-up has gained some of the foundational requirements of a successful new business. 10

These investors expect particulars about the management team and their experience. Many desire advisory or board membership roles within the business to ensure a degree of control over their investment. As the relationship proceeds, angels usually will require accurate projections, accounting, and analysis of the given market. Being informed of the expected returns and the accompanying level of profitability will reassure the angel that he or she has made a prudent investment. (7) MAKING AN ANGEL CONTRACT Angel terms can be structured in a variety of ways but generally fall into one of three categories: funding with a promissory note, a cumulative convertible preferred stock position, or the creation of a common voting equity right. Funding with a promissory note generally includes deferment of payments for a set period of time and a conversion option whereby the debt can be converted into equity. This option frequently involves sales targets or other related benchmarks during the first few years of business operations. Other angels are interested in taking a cumulative convertible preferred stock position. This scenario allows the start-up to defer fixed cash dividends for a set time period. Investors seeking a more active role may ask for common equity. This enables the angel to take a place on the board of directors and allows for much more active participation in company management. An arrangement such as this works well for angel investors who are keenly interested in hands-on involvement in the business. During contract negotiations, an entrepreneur must decide what percentage of equity he or she is willing to part with and how that will affect the venture in the future. (8) MAINTAINING AN ANGEL RELATIONSHIP Angels tend to invest in people more than in ideas. Maintaining a positive working relationship with an angel investor will strengthen the business and its growth potential. The following tips will help preserve the relationship: Reporting: The entrepreneur should regularly communicate the progress of the business to the angel through a predetermined mode of communication. Whether it is weekly, monthly, or quarterly reports, there should be consistent transmission of information between the parties. These date sensitive reports will enable the angel to keep abreast of the investment. Obligations: The entrepreneur has an obligation to meet the goals and expectations of the angel who has provided the equity capital. It is important that the parties have a mutual understanding of these goals and how they will be achieved. The entrepreneur should allow for open discussion and critique from investors. 11

Objectives: The entrepreneur should set reasonable objectives for the venture. Waiting to disclose foreseeable or actual problems will only cause friction that could ultimately result in a loss of trust. Advice: The entrepreneur should seek advice from the angel investor if the investor has experience and/or expertise in the industry. This shows respect for the investor s skills and promotes camaraderie. 12

CONCLUSION Angels are a diverse group, with a wide range of personalities, investment strategies, and financial aspirations. The choice of the right financial investor is an important component in the creation of a successful business venture. With a focused business plan, a well-prepared investor presentation, and a competent advisory board, the entrepreneur should attract suitable angel investors, thereby placing the business on a successful capital growth track into the future. 13