You’re Just Not Ready for Outside Funding (and Probably Never Will Be)

As a mentor I run into many young (and not-so-young) entrepreneurs who have apparently been conditioned by what Glen Hellman refers to as the Startup Industrial Complex to take the following steps in building their startup:

1.  Get an idea 
2. Network and tell everyone you meet about your great idea
3. Take the gobs of money that angels throw at you
4. Pay yourself a big salary get a cool office and buy lots of swag
5. Oh are there more steps?

Generally I find that most entrepreneurs I meet do a pretty decent job at steps 1 and 2 on their own.  When time for step 3 rolls around (from what I can tell somewhere between setting up an LLC and well before developing an MVP or any significant traction) the idea comes that they must now pitch angels and collect the cash.  Since I don’t hide the fact that I am a fairly active angel investor and member of Baltimore Angels, many times these entrepreneurs come to me for advice on funding.  Often they show me their ‘pitch’ which is so far off I can’t even figure out where to start in terms of advice.  It can be a really poor pitch but more importantly the company is just not remotely close to being fundable, and most likely they never will be.  That is not necessarily a bad thing.  The vast majority of new companies are just not realistic candidates for outside venture investment.  

It is a fact that not all new small companies are ‘Startups’.  As @FAKEGRIMLOCK commented on a recent Glen Hellman blog post “IF IDEA NOT INCLUDE "CAN SCALE TO HUGE MONEY WITH SMALL COST" IT JUST A BUSINESS. NOT STARTUP.” They are small businesses that can and should grow organically, funded through reinvestment of profits generated by steadily growing revenues.  This is the vast majority of small business and accounts for most of the job growth in the US.  Some of the startups I work with have sincerely and genuinely tried to follow the more ‘old fashioned’ approach of concentrating on building a small business and have asked me for (and taken my) advice.  But there always seems to be a feeling that maybe they should follow the ‘easy’ approach and just go and get angel funding.  I am often asked how they should go about this (and less often IF they should).  Some points I like to make to everyone I talk to about angel funding are:

1.       The majority of angel funded startups fail.   

2.       If you can build and grow your company without angel investment, do so.  You will be much happier in the long run.

3.       Don’t bother asking an angel for funds to develop your MVP.  I personally consider figuring out how to do that without angel or VC funding to be the first test that you encounter as an entrepreneur and the minimum entry fee for consideration of investment.

4.       The more and better quality traction you have before approaching investors, the better.

5.       Don’t approach an angel/VC unless your business is scalable and you have a business model in which the money you seek will accelerate growth dramatically. 

6.       Don’t pitch any investor without reviewing some of the many excellent examples of winning demo day pitches posted on the web.  As Paul Singh says, “Be the least shittiest pitch of all the shitty pitches”.  And remember, you are not just competing for investment dollars with the guy next door but companies all over the world.  There is no excuse for not doing your homework.

7.       Understand the economics of venture investing and how investors (must) think about this type of investment.  Paul Graham has some great posts on that topic here and here

I really want to be positive and supportive when working with young companies.  But I am really feeling now that the best way to help those seeking my opinions on angel funding is to be as honest as possible to the point of bluntness (crankyness?).  Most successful small businesses in the world are bootstrapped and seeking outside investment should not even be on the table.  Instead of following the ‘standard’ process, I think that a renewed focus on building the business and doing the required homework will better prepare companies for taking their best shot at long term success.

A Case for Convertible Note Valuation Caps

A couple of weeks ago I attended an excellent Angel Education session presented by Miles and Stockbridge at Betamore sponsored by the Baltimore Angels.  Being a relatively active angel investor but still having a lot to learn, I was quite interested in the topic of ‘Convertible Notes’. 

Convertible notes are now quite common in early seed-stage angel investing.  Use of convertible notes as a tool for seed-stage financing is fairly straightforward but there are some parameters that need to be negotiated as part of the terms, including the rate, discount, term, etc.

While in my experience it is pretty straightforward to set reasonable terms for a convertible note, one that usually seems to be the biggest sticking point is whether or not to have a valuation cap and if so, at what amount?  A valuation cap essentially insures that the conversion of the note to shares on a series A funding event will occur at no more than a previously agreed-upon maximum valuation.  This is probably the most polarizing of all terms between the investor and founders.  From the investor perspective, a valuation cap essentially sets a reasonable floor on the percentage of ownership for the note holders when they are converted.  From what I heard from some of the founders present it seemed like their feeling was that a valuation cap of any kind gave too much away to the investors.

At first glance the reaction of an impartial observer might be that a valuation cap seems to be not aligned with the interests of the founders, and in an extreme case I agree this would in fact be the case.  At a minimum it seems to go against one of the main advantages of a convertible note vs. equity financing, which is that a valuation is not required.  At the session the opinion seemed to be pervasive among the founders present that the 15-20% discount given to noteholders on conversion should be sufficient incentive to invest.

As an investor I look at this a bit differently.  In the extreme, I agree that a note with a too-low cap is not aligned with the interests of the founders, just as having a too-high cap (or no cap at all) is not aligned with the interest of the investors.  I propose that a reasonable cap is to the best interest of both parties.  Here’s why.

From the perspective of a reasonable investor, a cap that is significantly too low, while it gives the angels a larger percentage of equity on conversion, could actually be a disincentive to future investors to fund the A round that will trigger the conversion itself.  This acts against the interests of both seed-stage investors and founders.  On the other hand, a cap that is too high, or nonexistent, creates a situation whereby the interests of the founders and investors to do whatever they can to increase the value of the company prior to subsequent funding rounds are not aligned.  Why should I as an early investor work to help the founder to increase the value of the company prior to the conversion when it only means that I will end up with a smaller stake? 

Fundamentally, it needs to be understood by founders that a seed-stage investment by an angel in their startup is an extremely high risk proposition.  Many if not most of these investments fail and are essentially total losses to the investor.  While 15-20% discount looks like it should be enough of an incentive to the investor, in reality it does not adequately compensate for the many investments that fail.  There must be a mechanism for the investor to share fairly in higher returns for the few companies that succeed in the early stages and a reasonable valuation cap is that mechanism.  Part of any negotiation of seed-stage convertible note investment terms should include a reasonable valuation cap that will be low enough to incentivize the investors but also high enough that the founder will be quite happy to have their A round funding exceed that valuation.