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Saturday, January 24, 2009

Angel Investing

I was recently involved in the second round of angel investing for Doyenz. Until I started doing it, I didn't know how the process worked, so I think it's interesting to talk about it.

The first part, obviously, is the selection of the firm to invest in. Unlike public companies where you're unlikely to get a chance to talk to the CEO or board of directors, an angel investor can expect to talk to the founders and probe them. During the first round last year, that was all we had. Many people have the image of Andy Bechtolsheim sitting on the front porch of his house writing out a check to Larry and Sergey after a demo, and in fact, if you have as much money as he does, and investing in the middle of the dot com bubble, that's probably the right thing to do. The truth is, though that the combination of a smart team with good business sense and ability to execute comes really rarely. Last year, Roberto and I went with a bunch of Googlers and ex-Googlers to Y-combinator HQ, and sat through about 5 or 6 startup presentations. It's worth your time to do so to get a feel for what the Silicon Valley startup vibe is (my opinion: it's surprisingly fashion driven, showing that even geeks like to look cool).

You have to evaluate the business plan with ruthlessness --- take into account how difficult the competition will be, what the technical risks are, and whether the venture is raising enough money to accomplish what they set out to do (most startups are under-capitalized, and that in itself is a big risk). As an individual investor, I hate investing in stocks, but as an angel, you get insight into the company you'll never have otherwise, and as a technical person you have an idea of how easy or hard it would be to build the product, as well as how easy or hard it is for the major competitors to replicate what your team is doing.

Now, you might think that typically an angel investor gets in and sets the valuation of the company and then invests at a given price. That can happen and does happen, especially if it's a large lump sum of money, but it risks a mis-price of the company. It takes a fit of optimism to fund a startup, so usually the risk is on the high side. Instead, what you typically do is get a promissory note with a principal, maturity, and interest rate built in. This note would then convert into stock at the first round of a large angel investing (where the valuation is set by the lead investor --- typically the largest investor) or a venture fund stepping in to fund the company. The conversion is at a discount to the lead investor (since angels came in earlier, they get a break), at the interest rate set in the note.

There's also typically a penalty valuation built in, so that if the company doesn't get a lead investor or a VC within the time period, you get the note converted at a penalty clause. This is not something I tend to pay a lot of attention to, because if the company runs out of money at that point your note is worthless anyway. On the other hand, if the company turns out to be wildly successful and profitable (and hence has no need for a VC round), you get a great reward for having the vision to invest in the business. The chances of that happening are low as well.

All through the process, the thing to remember is that ultimately, you have to be able to trust these guys you are giving money to. If they choose to spend it all on wine and plane tickets to Mexico, what are you really going to able to do to get the money back? Hence the typical emphasis on the team, what their track record is, and whether they are people of integrity. It helps if you know the team well from a previous life as well.

1 comment:

Suresh said...

Very informative. But I did not understand what you meant by

The conversion is at a discount to the lead investor (since angels came in earlier, they get a break), at the interest rate set in the note.

Could you please elaborate.