Angel Group Financing Guide

Friday, September 26, 2008

Don Jones, Always On, http://www.VentureDeal.com

The idea for this series came out of a series of blog posts at VentureDeal, and it aims to shed light on the world of angel groups. In doing so, perhaps more entrepreneurs will be encouraged to seriously consider angel groups as a viable funding source and stepping stone to business success.

This work represents my own views on standard practices among the more established angel groups. For any particular group, there may be significant variation from what I describe. That is to be expected, as this relatively new form of organized investing grows and adapts to the business environment around it.

To entrepreneurs seeking funding for their startup company, angel investment groups are shrouded in mystery. It needn't be so. While angel groups tend to be private organizations operating in many cases by word of mouth, they actively seek high quality investment opportunities and strive to work effectively with both experienced and promising entrepreneurs.

An angel group is a loose organization of SEC accredited investors who come together to invest individually or as a group in promising business opportunities. This series will focus on the modern version of the angel group, more specifically groups that invest principally in technology-oriented startup companies. In addition, I hope to provide entrepreneurs with insight in dealing with angel groups and the process by which they source, evaluate and interact with investment opportunities.

The earliest technology-focused angel groups were initially formed in the mid 1980s. One objective of these groups was to invest venture capital in promising technologies and entrepreneurs that were coming out of existing, large technology companies, notably the semiconductor and software companies among others. These large entities were the backbone of the nascent technology industry at the time.

Early angel groups formed from a small core of successful technology entrepreneurs, adding members based on word of mouth. Over time, a simple framework emerged: The members would share duties of sourcing and evaluating new companies. They would meet once per month, usually over dinner, to have the potential investee companies formally present their opportunity for funding. Members who decided to invest would do so from their own account. Later, some groups would develop a separate fund, financed by institutions to co-invest alongside members when additional funds were needed.

Not long after, other successful business people located in various technology-oriented regions of the country began to adopt various forms of the same idea, so that today there are numerous variations on the original theme.

Today, angel groups operate with numerous structures: some groups have created a fund for individual members to invest in and have decision-making authority over. Others form a separate corporate entity for each investment. Other groups invest on an individual member basis. Some angel groups have separate funds, while other groups do not see the need to raise and operate a fund.

There are also angel group networks, which are umbrella organizations that help underserved regions easily create and develop angel groups using a template. The umbrella organization assists the local angel groups to perform the necessary administrative work, thus freeing them to focus on sourcing and evaluation of potential investees.

On a national level, the Angel Capital Association (ACA) was formed in 2004. The stated purpose of the ACA is to "increase the success of member angel groups," by sharing best practices, educating members via its affiliate Angel Capital Education Foundation (ACEF), promoting regional collaboration among member groups and encouraging individual angel investors to join angel groups. As of publication date, the ACA listed 126 angel groups as member organizations. The ACA is led by a Board of Directors composed of prominent angel group leaders and has several sub-committees responsible for recommendations on various aspects of its operations.

Are Angel Groups Right For You?
The first question to ask yourself as an entrepreneur is whether angel groups are right for you and your company. To gain insight into that question, you should understand where angel groups fit into the "funding chain."

The funding chain can be roughly summarized as follows, with exceptions based on differing circumstances:

1. Self funding: An entrepreneur provides his or her own funds to begin
development of the company's technology. Common funding amounts
range up to $100,000.

2. Friends and family; individual angels: Usually tapped for larger funding
amounts to further develop the product or service to demonstration
or alpha stage. Common funding amounts range up to $500,000.

3. Angel groups: A higher funding threshold for creating a beta version of
the company technology for pilot test purposes or initial marketing.
Common funding amounts range from $250,000 to $1 million.

4. Institutional venture capital firms: Commonly used for final product/service
development as well as sales and marketing expansion once the technology
has been validated on a smaller scale. Provides follow-on financing
through exit via M&A transaction or IPO. Common funding amounts
exceed $1 million.

Another metric for determining whether an angel group is right for you and your company are the types of investments the group typically makes. Most angel groups invest via preferred company stock, which places an agreed-upon valuation on your company as of the transaction date and in which you trade an ownership stake in your company in return for the investment. Other groups prefer to invest via promissory notes, often called convertible bridge notes, which typically convert at some discount to the next equity round. Additionally, promissory note transactions tend to be simpler and faster, with less documentation and lower legal fees.

The central question for the entrepreneur on this issue is whether you wish to give up equity in your company, or sign on a promissory note in return for the investment. On the angel group side, many groups prefer not to use the bridge note vehicle, due to a lack of alignment of interests that may occur.

This lack of alignment can happen because the investor in a bridge note is helped if the note converts to equity at a lower valuation in the subsequent equity round, whereas the entrepreneur wants the highest possible valuation. Also, with a bridge note, the investor has no shareholder voting rights in the company, which typically come with an equity stake.

A third element for reviewing potential angel groups is qualitative. Does the group have members that are knowledgeable and familiar with your industry? If so, the group may be able to enhance your future prospects by introducing you to resources and other investors, providing valuable guidance and adding value in other, non-financial ways. By learning about the industries and other companies that an angel group has invested in, you may be able to determine if that group is potentially a good fit for your business.

Another aspect in dealing with angel groups is their particular process for reviewing investment opportunities. The group should be open about their process—what it entails and how long it typically lasts. If they aren't forthcoming, you would be well advised to proceed with caution.

Most angel groups do not require a fee for evaluating your opportunity. However, some do in order to defray their administrative expenses. Many groups do have significant administrative costs and are not money-making concerns at the administrative level, so in some cases a nominal fee may be justified. This is for you to judge whether you find it acceptable to pay a fee.

Many groups provide online forms for submitting your company information. Follow these procedures as closely as possible. Angel groups typically review large quantities of business opportunities and "following the rules" will only help your chances. Groups want to be able to easily compare opportunities, so it is important to provide your company information in their format. Standing out from the crowd at this stage would not be helpful to you, as it would likely be perceived by the angel group as "can't follow simple instructions." If you want to create the impression that you are easy to work with and establish a relationship with, this is your first test. As you proceed further down the funding process, some groups even provide consulting to help improve presentation skills and materials.

As for the amount of time it should take to obtain funding, a good estimate for the situation of a motivated angel group, an investee company that has clean due diligence and both parties share reasonable deal term expectations, is about 90 days from initial process to the check in the bank. It can be shorter in duration in some situations, such as a convertible bridge note with an experienced entrepreneur, or longer if due diligence is difficult, lengthy or deal negotiation (and re-negotiation) causes delays.

Don Jones is a member of a prominent angel group based in Silicon Valley, a veteran of three startups, and the founder and CEO of his fourth company: VentureDeal, a venture capital database serving the emerging technology industry.

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