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In Angel Investing as Asset Allocation Strategy (1): Brad Feld on Home Runs, we reviewed why angel investing isn’t for the faint of hearts. The risks involved can be quite overwhelming.

For the ambitious bunch, though, it’s difficult to resist the attractive payoffs offered by angel investing. If we want to tap into the lucrative potentials and make sure our asses are covered, we need to understand the importance of personal asset allocation decisions and strategies.

This installment deals with the typical time required to exit an investment and the easiest way to determine how much to allocate to angel investments.

Liquidity Timeline

Angel investments are illiquid assets; you can’t just sell your positions like those in the public stock market. Angel investors primarily make money through liquidity events (e.g. M&A or IPO), which can take years to occur.

Lisa Lambert, Vice President at Intel Capital, said:

It just takes a long time to go from startup idea to a liquidity event. [...] During the boom days, it was like 2.6 years to get liquidity. And today, the latest average from NVCA, the National Venture Capital Association is 8.7 years.

Some suggest you should angel invest the money you don’t need for another 3 to 7 years or longer. But the safest bet is to invest the money you can afford to lose forever. That is, only play with the money you can lose without affecting your lifestyle.

Even if you have a sharp eye for picking promising entrepreneurs, there’s no guarantee as to when a liquidity event will occur, or if it’ll even occur. There are too many factors that’d affect the evolution and progression of a startup.

Joshua Schachter, an entrepreneur-turned angel investor, states, “I’ve been investing since 2006, in 38 deals so far, and I’ve seen exactly one exit so far.”

Thealzel Lee of VANTEC notes, “One angel investor lamented that some of his investments are in their second decade and he has no way of liquidating his initial investments.”

Having said that, there are great exits that have put a huge smile on angel investors’ face too. Otherwise, no one in their right mind would angel invest!

Mint, a consumer SaaS startup, had raised a total of US$32 million over 3 venture rounds before getting acquired by Intuit for a handsome US$170 million. At a mere age of 3 at the time of acquisition, Mint went on to become “The 2009 Poster Child of Early Exits” for angel investors.

Problem is, even the most sophisticated investor can’t say for sure how long it’ll take to get to an exit. Thus, having an asset allocation plan helps you stay on course and understand how much you’re putting at risks.

Asset Allocation Pie

David Hehman, former chair of North Bay Angels, says that the easiest way to determine how much you want to allocate to angel investments is to create a percentage of your total asset allocation:

If you have X dollars [in investable capital], you indicate that Y percentage will be for angel investing. Then, Stick to that!

To come up with the percentage, you might want to meet with your financial advisor, and discuss with him (and your spouse) how much you can you [sic] afford to lose. Angel investment money is often called mad money, as it is always high risk.

Let’s say John Doe Jr., Jane Doe, and John Doe Sr. each has $2,000,000 to invest.

John Doe Jr., who’s risk-adoring, allocates his capital this way:

Asset Class: % Allocation ($ Amount)

Public Equities: 20% ($400,000)
Bonds: 0% ($0)
Alternative Investments (Angel Investing): 80% ($1,600,000)

Jane Doe, who’s less risk-tolerant but not exactly conservative, allocates her capital this way:

Public Equities: 40% ($800,000)
Bonds: 20% ($400,000)
Alternative Investments (Angel Investing): 40% ($800,000)

John Doe Sr., who’s the most conservative among the 3, allocates his capital this way:

Public Equities: 0% ($0)
Bonds: 100% ($2,000,000)
Alternative Investments (Angel Investing): 0% ($0)

Your asset allocation pie will likely look different. How much you allocate to each asset class would depend on your risk tolerance.

But as you can see, asset allocation isn’t rocket science. You may come up with a percentage yourself to keep things simple, or discuss with your financial advisor if you have a more complex portfolio.

Having an asset allocation plan helps you understand how much money you’re allocating to high, modest, and low risk investments.

Coming Up

Later in the asset allocation series we’ll talk about follow-on reserves, ideal number of investments, investment timeframe, typical deal size, multi-stage investments, net worth implications, and successful exits/returns allocation.

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On the back of a successful 2009 conference that featured billionaire Sir Richard Branson and 43 other prominent speakers and business success stories, PerfectBusiness is orchestrating an even bigger event this year, The PerfectBusiness Summit 2010, to be held in Las Vegas at Palms Casino’s 2,500 seat concert theater on October 7 – 8.

What the people in this room are doing is creating things which will make a difference to other people’s lives.

- Billionaire Sir Richard Branson at The Perfect Pitch 2009 conference

Watch The Perfect Pitch 2009 highlights.

The PerfectBusiness Summit 2010 is a 2-day event that showcases more than 60 powerful speakers, including world-class CEOs, founders, and business leaders, as well as celebrated investors who represent US$10 billion in investment capital.

This year, our own Joey Lo (Venture Hype) along with fantastic judges like

• John Babcock of Rustic Canyon Partners,
• C. Bryce Benjamin of Tech Coast Angels & Alta Ventures,
• Dan Bliss of PerfectBusiness,
• David Marshall of Santa Monica Capital Partners,
• John Nelson of California Capital Partners,
• Scott Sangster of Tech Coast Angels & OrganicStartup,
• Josh Stein of Draper Fisher Jurvetson & DFJ Global Network,
• Mark Suster of GRP Partners, and
• Andy Wilson of Momentum Venture Management

will once again evaluate pitch submissions received from all over the world. Promising entrepreneurs will win the opportunity to present at the PerfectBusiness Summit 2010.

If last year’s event is any indication, the judges will be up for a difficult task. The quality of talents and pitches PerfectBusiness received in 2009 were astonishing.

Are you an investor? Network in style with other investors and discover promising entrepreneurs at the PerfectBusiness Summit 2010. See a partial list of speakers and attendees and order your ticket here.

We say, give the judges an even harder time. Make them pull their hair out. Challenge them to seek out the bestest from the best.

You in? Enter the pitch competition in any of the 3 categories:

• Start Up businesses
• Established businesses
• Students (college/university)

The Top 3 submissions in each category will each win the following package:

• 2 VIP Tickets to the PerfectBusiness Summit 2010
• Airfare to Las Vegas and limousine to hotel
• 4 nights’ accommodation at the Palms Casino
• Opportunity to present LIVE to the PerfectBusines Summit 2010 audience

The winner in each category will receive:

• Perfect Pitch 2010 Award
• National media exposure
• Investor introductions
• Prize package from Deluxe Corp valued at more than US$2,000

PerfectBusiness encourages you to submit your pitch early to receive feedback or assistance. Last-minute pitches won’t receive this privilege. Sorry.

We were seeking funding that valued our company at US$10 Million dollars. We just received a commitment from an individual putting in another half a million dollars that is valuing our company at US$200 Million dollars. This increase is due solely to the amazing exposure we received and the people we met at The Perfect Pitch 2009.

- Dan Didrick
Winner of The Perfect Pitch 2009

Imagine being the winner of The Perfect Pitch 2010 and receive the funding you need to build your business empire. Don’t deny yourself the chance to experience that “pinch yourself moment”!

Learn more about the event and submit your pitch at the PerfectBusiness Summit 2010 website.

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Got ambitions for high-payoff potentials? Allocate a portion of your investable capital to angel investing, a form of alternative investments that offer high risk, high return opportunities.

William S. Podd, executive director of Landmark Angels, suggests, “Angel investing, with its historical high risk/high reward strategy, can provide an opportunity for significant returns for high net worth investors as part of an asset allocation strategy.”

Amazon, Facebook, Google, Mint, PayPal, and Yahoo are just some of the high-profile companies that have made their angel investors very happy.

High Risks/High Returns

A study by Scott Shane, author of “Fool’s Gold?: The Truth Behind Angel Investing in America,” reveals that accredited angel investors see a negative return in 40% of their angel investments, and 7% of investments account for 75% of all returns.

Roughly speaking, out of 10 angel investments, 3 to 4 will fail, 4 to 5 will be “walking dead” (survive but generate little or no return and not dead enough to be a write-off), 1 or 2 will be home runs that make up for the losses and generate a handsome return to angel investors.

Brad Feld, managing director of Foundry Group, explains the concept of home runs:

Understand the difference between 0x and 100x: I’ve had two of my angel investments return over 100x each.

Since I had a strategy of investing the same amount in each company, all I needed was one 100x to allow me to have 99 companies completely flame out and return 0 and I’d still break even.

With two investments at over 100x, I now have a built in gain of significantly over 3x across all of my investments since I’m [sic] made about 75 of them and I’m now deliciously “playing with house money” on all of the rest.

Financial Returns: Angel Investments vs. Other Asset Classes

Few years ago, the Ewing Marion Kauffman Foundation and the Angel Capital Education Foundation conducted the largest study on the financial returns of angel investors in North America and released a report in 2007, showing that angel investors participating in organized angel groups achieved an average 27% internal rate of return (IRR) on their angel investments.

Overall, this set of angel investors affiliated with angel groups experienced exits that generated 2.6 times their invested capital in 3.5 years from investment to exit. This return compares favorably to that of other private equity investments, including those of early-stage venture capital. Seven percent of exits generated returns above 10 times their initial investment.

New Series: Asset Allocation Strategies for Angel Investors

You see, angel investing is a high-risk, high-payoff activity. To help investors tap into the potential lucrative returns without risking more than what they can stomach, we’ve prepared a new series on asset allocation strategies, which studies what veteran angel investors recommend in respect to personal asset allocation and effective portfolio building.

Don’t want to miss any articles in this series? Sign up for our weekly newsletter now!

* Venture Hype will never sell or share your email address. And you can unsubscribe anytime.

You’re destined to start your journey on angel investing!

Think about it. You invest your own money and report to no one but yourself.

Cut a check if you like; close the checkbook if you don’t.

You always have the final say ‘cos Golden Rule says that “he who has the gold makes the rules.”

But with tons of other asset classes to choose from, what’s in it for you to angel invest?

Receive Firsthand Info

Unlike other forms of investments (e.g. investing in a fund or in the public market), direct angel investments give you the discretion to positively influence the outcome of your portfolio companies. You can leverage your network and expertise to help the startups. Simple as that.

Mike Volker, a Vancouver-based veteran angel investor, told The Globe and Mail:

“With larger companies you’re removed from the action, and you’re getting second-hand information, reading analysts’ reports and opinion letters,” he says. “Working with startups I’m basically an insider, although you can’t trade on that.”

And it sure as hell beats the odds of hitting the jackpot!

Make Money

Few years ago, the Ewing Marion Kauffman Foundation and the Angel Capital Education Foundation conducted the largest study on the financial returns of angel investors in North America and released a report in 2007, showing that angel investors participating in organized angel groups achieved an average 27% internal rate of return (IRR) on their angel investments.

Overall, this set of angel investors affiliated with angel groups experienced exits that generated 2.6 times their invested capital in 3.5 years from investment to exit. This return compares favorably to that of other private equity investments, including those of early-stage venture capital. Seven percent of exits generated returns above 10 times their initial investment.

But making money is just one aspect. There are much more to being an angel investor. Read on.

Get Involved With Dynamic Startups

Angel investing is exciting. Its high risk/high reward nature charges up certain macho type. If you’re like most angel investors, chances are that you’re or were an entrepreneur yourself. In this case, you can re-live the startup adventure without doing the hard work, as Dharmesh Shah, founder of HubSpot, puts it.

In this regard, we couldn’t have said it better than Will Herman, TechStars mentor and Boston angel investor:

I invest because I have a blast doing it. It’s about 75% of the fun of running the company yourself with only 5% of the stress.

Give Back

Or maybe, you’re truly enthusiastic about sharing your startup experience and/or giving back to the startup community.

Jason Calacanis, founder of Open Angel Forum, said:

When I was coming up as an entrepreneur I had to fight for everything I got and there was no clear roadmap of how to be successful. I’ve been more successful than I probably deserve, so I’ve been spending 10% of my time trying to give back to “the game.”

That’s why I started the TechCrunch50 conference with Mike [Arrington], that’s why I angel invest and it’s why I started This Week in Startups. I like to share what I, and others, have learned. I think entrepreneurship is a beautiful thing.

You bet entrepreneurship is a beautiful thing. It creates heaps of jobs and stimulates our beloved economy.

Get Good Will

And you get good rep. It’s the side-effect of helping the community. Shan avouches, “One of the side benefits of being an angel investor is that it builds credibility and good will within the local community.”

Learn New Things

Just because you’ve got some nice coins in your pocket doesn’t mean that you’re a Know-It-All, although some suck-ups might have you believe otherwise.

When you got skin in the game you’d suddenly pay much more attention to the invested domain. No matter how big an expert you already are in a given space, you’d pick up something new when your antennas are focusing on the beam.

“I learned as much from going into angel investing as I got out of my Sloan MBA,” Shan states.

Meet Great People

What’s more? Not only will you meet passionate entrepreneurs but you’ll also connect with other investors who’ve also invested in the deal. Their expertise and networks are something you might be able to tap into in the near future.

Big things happen when great people get together. This kind of instant connections isn’t something you can develop at run-of-the-mill networking events.

Herman admits that meeting people is one of his motives to becoming an angel investor: “I get to meet smart, energetic people with great visions and boundless energy. ”

Shan also makes no bones about how being an angel investor has put him in touch with brilliant people who he wouldn’t have gotten to know otherwise: “Angel investing has been very helpful getting me into the right groups of people, and that has helped me in my third startup [HubSpot].”

Stay In the Loop

Like many angel investors, Del.icio.us founder Joshua Schachter believes angel investing “pays vast dividends outside of dollars.” Schachter says that angel investing allows him to stay close to interesting projects and avoid getting bored. He adds, “I know about a lot of what’s going on in the Valley right now, for example.”

Now What?

Excited about the prospects and possibilities of what angel investing can bring? Sign up for our newsletter to receive tips, news, and insights (from the experts) on how to become a better angel investor now.

Alliott Cole

It’s no secret that investors fight head over heels for sizzling deals and promising entrepreneurs to increase odds of success and potential returns. But when demand for quality deals exceeds supply, you better come up with exclusive, creative, or effective ways to lure the Steve Jobses of tomorrow.

How to compete for hot deals? Are startup competitions a source of quality deal flow? What are the key terms to negotiate?

From deal sourcing and picking winners to negotiating terms, Alliott Cole of Octopus Ventures shares his perspectives with Venture Hype.

Alliott Cole and Octopus Ventures

Alliott Cole (@alliott) is an associate director at Octopus Ventures (@OctopusVentures) and a director at the British Business Angel Association (BBAA). He’s a broad member of several startups and he devotes his time advising and discovering promising entrepreneurs at the University of Oxford society Oxford Entrepreneurs.

Octopus Ventures is an award-winning early-stage investing firm in the United Kingdom. Its model is unique in that it prefers to back exceptional entrepreneurial teams rather than specific sectors, and co-invests with a private investor group, Octopus Venture Partners, in every investment. The group of private investors is made up of 110 scientists, entrepreneurs, businessmen, and leaders of commerce who can add value to the companies they back.

* Edited interview

Sourcing Deals

VH: How does Octopus Ventures source quality deals?

AC: Most entrepreneurs — around 4,000 companies each year — come to Octopus Ventures directly or are referred to us via the Octopus Venture Partners group. We also receive many introductions via corporate financiers and other venture capital houses.

In addition, I’ve been running monthly “Open Office” sessions in Oxford for undergraduate entrepreneurs and MBA students in the last 2 years. Similar sessions are also held periodically at our London office.

We also actively reach out to entrepreneurs through panels, conferences, and networking events.

VH: Competition is fierce for hot deals. How should investors position themselves as the most suitable/preferred investors for such deals?

AC: Not an easy question to answer!

At Octopus Ventures we look to build enduring relationships with entrepreneurs and to continually help their businesses in as many ways possible.

In competitive situations, we always ask the entrepreneur to do his or her own due diligence on Octopus. We encourage them to speak to the businesses we’ve partnered with in the past. We hope this will give a candid and accurate picture of Octopus and our modus operandi.

As to how should other investors position themselves as the most suitable investor for a deal, I think it comes down to building a strong, equal, and open relationship with the entrepreneur; communicating clearly at every stage of the negotiation; and demonstrating a proven ability to add value to growing businesses.

VH: You also judge startup competitions like the Innovate!100 competition held in March. What do you think of this type of deal flow?

AC: I love meeting entrepreneurs. Their enthusiasm and conviction is inspiring and infectious. If you add in the pressure and expectation of a pitching competition, you often witness something very special.

I’m always impressed by entrepreneurs who can thrive in this environment, articulating their proposition concisely and with force. I think these events provide a great source of deal flow for investors. I try to attend them as often as possible.

Picking Winners

VH: What do you look for in the businesses you invest in?

AC: For the most part, Octopus invests in companies that have revenues but may not be beyond breakeven.

We believe that the team is the single most important factor. We look for effective, inspiring individuals who can infect those around them with excitement and passion of their proposition.

Second to this, we look for companies that can scale quickly into big businesses addressing large markets.

Finally, these companies must resonate with the Octopus Venture Partners group.

To this end, the business must be simple to understand, has a product or service of value, with a clear route to market and a defined customer.

Negotiating Terms

VH: How does the negotiation process work?

AC: Octopus Ventures looks to build strong partnerships with entrepreneurs from the outset and the negotiation process is a critical element of this.

We provide detailed and lengthy heads of terms so that the entrepreneur can negotiate all of the critical terms of an investment at the same time — before committing his or her business.

Someone once described this process as moving in ever decreasing circles until both parties come together at an agreed focal point. We like to do this face to face and in an open and frank manner.

If the process becomes too difficult, we’ll agree to disagree and step away from the negotiation. It’s not in the interest of the entrepreneur or Octopus to force a partnership if either party isn’t directly aligned with the other.

VH: From an investor’s perspective, what are the key terms to negotiate? Why?

AC: The valuation of the business and structure of the investment are key terms.

It’s critical for all stakeholders in a business to negotiate terms that aren’t only fair and workable for the present but also for the future.

Early-stage companies often require several rounds of finance. Entrepreneurs and investors should be careful not to agree to terms that might make the business unattractive for follow-on investment (e.g. unrealistic first round valuations; complex distribution rights; ratchets and/or anti-dilution provisions) or misalign stakeholders when there are key strategic decisions to be agreed (e.g. on an exit).

It’s also important to strike the right balance on governance and ensure that nothing will prohibit efficient decision-making and action.

VH: Entrepreneurs and investors often disagree on valuation. How do you go about negotiating a realistic valuation with these entrepreneurs?

AC: Investment structures like ratchets and distribution preferences can be used to bridge these gaps, but they run the risk of misaligning the stakeholders in the business. And such structures may lead to bigger problems at a later stage.

With this in mind, a frank and fair agreement is always preferable but there’s no quick and easy route to arrive at this outcome.

According to exit strategist Basil Peters, selecting a great M&A advisor is crucial to the M&A process because advisors who can sell “ice to Eskimos” can increase the sale price 50% to 100%, which means investors and founders will make more money if the company is successfully sold.

Here, Maalouf picks up where we left off in Part 1 and talk about the roles lawyers play in the M&A process; why M&A deals fall apart and how to prevent it; how to select M&A advisors; and the purpose of Special Purpose Acquisition Corporations (SPAC).

* Edited interview

VH: From starting dialogue to closing, how long does it take to complete the M&A transaction?

JM: A typical M&A transaction can take anywhere from 2 to 5 months or longer. But it can vary widely depending on a number of different factors, such as

• the complexity of the deal;
• the amount of due diligence required; and
• how far apart the parties are with regard to price and other deal terms.

VH: Where do M&A lawyers come in? In what ways can attorneys help AppleSoft?

JM: Lawyers come in at the beginning of the M&A process to help AppleSoft move forward efficiently and maximize gains from the sale.

They can

• offer insight into selecting the right investment bank;
• help negotiate and structure the deal in the most profitable manner possible;
• help prevent unforeseen pitfalls, which can ruin an otherwise profitable M&A deal;
• draft all necessary agreements and documentation to protect AppleSoft’s rights and ensure it’ll receive all of the considerations agreed to; and
• advise on minimizing tax liability from the sale.

VH: Why do M&A deals fall apart? How to prevent it?

John J. Maalouf

JM: The due diligence phase is where a lot of M&A deals fall apart. If AppleSoft hasn’t involved an experienced finance lawyer in the drafting of Information Memorandum (IM) and Executive Summary (ES), then the documents may contain innocent misstatements and/or omissions, which can come back and haunt AppleSoft in the due diligence review process.

During due diligence review, if the acquirer discovers information that’s inconsistent with that in the IM and ES, even if the inconsistencies are seemingly minor, the acquirer will likely view these as “red flags” and walk away.

VH: Any advice for AppleSoft as to how to choose M&A advisors?

JM: The United States Lawyer Rankings puts out an annual list of Top 10 Finance lawyers in the US. Any of whom will be able to provide AppleSoft with excellent legal and business advice.

If AppleSoft has a value of less than US$50 million, then it may want to choose one of the smaller firms on the list to make sure it’ll receive the senior level attention it deserves.

Experienced finance lawyers have relationships with all of the major investment banks, as well as most of the smaller ones. They can help AppleSoft decide which investment bank is right for the company.

VH: Anything else you’d like to add?

JM: We’ve seen a significant increase in M&A activity lately, due in large to the use of Special Purpose Acquisition Corporations (SPAC) to fund acquisitions.

A SPAC is a newly formed company organized for the sole purpose of going public and using the proceeds of the offering to acquire an existing business.

In general, a SPAC will raise between US$50 million and US$500 million in equity in order to fund an acquisition. Key features of SPACs:

• Have a limited life span of 24 months (with a 12-month extension). During which, the SPAC must identify 1 or more companies and conclude the acquisition(s).
• All acquisitions are subject to approval by the public shareholders of the SPAC.
• Pending an acquisition, a minimum of 99% of the IPO proceeds must be held in a trust account with a major money center bank.

SPACs have increased in popularity lately, as both the NYSE and NASDAQ have amended their rules to allow this type of offering.

Image: futileboy

According to GigaOm’s Om Malik, angel investors are thinking twice about funding pure-play startups – single-platform focused companies whose profits often bypass investors and developers and go home with platform owners.

When hot startups enter the market, entrepreneurs go crazy trying to discover new ways to capitalize on their success.

Think Twitter. Think Facebook.

Malik offers his perspectives on platform owners and pure-play/single-platform companies:

Historically, developers have had much less control over their destiny than platform owners. Take Facebook. It has played the developer community like a fiddle with its recent actions (and ad-hoc changes). And platform owners always play favorites. Intel had Dell, eBay picked PayPal, Facebook chose Zynga.

Similarly, some of Twitter’s recent actions, such as imposing limits on companies building ad-related businesses on Twitter, have thrown developers into a tizzy, Malik writes.

Chris Dixon, founder of VC fund Founder Collective, suggested angels and VCs are pulling back on outlays within the Twitter ecosystem.

“Expect investment in ecosystem to drop significantly,” he recently tweeted. Later Dixon added: “A bunch of investors told me recently there is no way they’d invest in Twitter ecosystem now.”

Angels No Longer Playing Ball With Pure-Plays

A raft of other angels was willing to anonymously add their opinions to Malik’s draught. They did mention their interest in Twitter-related startups but they also tabled the main reasons why many investors aren’t playing ball with pure-plays right now.

To start with, angels have staged their exodus from pure-play Twitter startups due to proof that the micro-blogging company still lacks the business ecosystem to support returns to venture investors.

One investor put it concisely: “Twitter is more of a broad distribution platform for customer acquisition than an investment platform.”

Another believed the economic interests of Twitter and their hard-working, but often forgotten, developers need to be aligned before its ecosystem will pose a good investment option.

To do that, Twitter needs to first become profitable. “One needs to wait until Twitter becomes profitable before investing in its ecosystem, since that’s the point at which the company will likely embrace it,” shared the investor.

All in all, the article serves as a good reminder to investors: Remain vigilant when filtering single-platform companies. Like celebrity VC Fred Wilson said: “You can’t simply develop [or invest in] stop-gap products for the company’s service, because Twitter will end up filling those holes.”

Image: dan paluska

Sophisticated investors always think about exits before they invest. “Does the company have the potential to go public or become an attractive acquisition target?” If not, they’d take their money elsewhere.

Going public or IPO means the company raises money by offering stocks to the general public – you know, those stocks that anyone can buy at the public stock exchange. This allows private shareholders (e.g. founders and angel investors) to eventually cash out by selling their shares in the public market, explains Bill Payne, a veteran angel investor.

Mergers and acquisitions or M&A, on the other hand, means the company

• is sold to or merged with a larger private company in exchange for cash or for private, illiquid shares of the acquirer company; or
• is sold to or merged with a public company in exchange for cash or for publicly tradable shares of the acquirer.

In angel investing, IPOs are far and few between. A vast majority of angel investors exit their early-seed investments via M&As.

Ron Conway, the most influential angel investor in Silicon Valley, said he won’t invest if he can’t think of 5 potential acquirers for a company within 10 seconds.

Conway is of course legendary. But you get the idea: Think about exits before you invest. That’s how you make money.

M&As? “That’s Hot”

According to exit strategist Basil Peters, an increasing number of young tech startups (2 to 3 years old) are getting snapped up by big companies to increase competitive edge. Most of the M&A deals are done in the US$15 to US$40 million range, and the sweet spot is about US$30 million. Once the selling price exceeds that sweet spot, it’d become more difficult for the corporation’s M&A department to get approval for the acquisition.

With a record-breaking, all-time quarterly high of 111 startup M&A deals completed in the first quarter of 2010, M&A is the new black in the startup investment community. We did hear Paris Hilton say “That’s Hot.”

To learn more about the sell-side M&A process, we once again caught up with John J. Maalouf of Maalouf Ashford & Talbot to talk about small M&A transactions; specifically, M&A deals that are under US$50 million.

John J. Maalouf and Maalouf Ashford & Talbot

John J. Maalouf, known as the “Idea’s Man,” is a globally recognized attorney who’s been ranked by the United States Lawyer Rankings as one of the “Nation’s Top 10 International Trade & Finance Lawyers” 5 years in a row from 2006 to 2010.

Maalouf Ashford & Talbot regularly advises clients in the areas of M&As, IPOs, venture capital, private placements, and private equity investments, among others. They’ve recently opened their sixth office in Riyadh, Saudi Arabia. The firm also has offices in Boston, Hong Kong, London, New York City, and Shanghai.

* Edited interview

VH: What’s the typical sell-side M&A process? Let’s say the name of the selling company is called AppleSoft, whose valuation is under US$50 million.

JM:

1. Select M&A Advisors

AppleSoft needs to select experienced M&A advisors, such as an investment bank and a law firm. If AppleSoft selects a law firm first, the firm can help the company choose the right investment bank.

AppleSoft should look for advisors who specialize or have the expertise in representing companies of similar size. Otherwise, small transactions like this will be passed on to junior associates and won’t receive the senior level attention that it deserves.

2. Collect Documentation and Prepare Marketing Materials

This step involves

• collecting documentation, which will be required during the due diligence phase; and
• preparing marketing materials, which generally include an Information Memorandum as well as an Executive Summary.

3. Shop for Potential Buyers

Next, the investment bank will look for and contact potential buyers. These generally include: (i) direct competitors; (ii) companies that are in the same industry as AppleSoft but operate in a different geographic region; (iii) companies that are in a related industry and where potential synergies exist; and (iv) firms that exist mainly to buy companies, help them to grow, and then exit.

As an example to (i), one of our clients, which we’ve represented since the company was a startup 3 years ago, has just acquired a major competitor and is now worth over US$200 million.

Potential buyers are then vetted based on their interest level and financial ability. Shortlisted potential acquirers then submit a non-binding Letter of Intent, which spells out the proposed deal in broad terms.

AppleSoft compares the various offers and selects a single potential buyer.

4. Start Due Diligence

Enters due diligence, which is a lengthy and sometimes arduous process. It’s during this phase that many deals fall apart. Particular attention must be given to ensure that all documentation is in order and is in conformity with the information provided in the Information Memorandum.

5. Draft Contracts

The drafting phase is where actual contracts are negotiated and written. No 2 deals are exactly the same. It’s essential that the contracts are drafted by an experienced finance lawyer. Otherwise, AppleSoft may end up with significantly less than what they’ve bargained for.

6. Close the Deal

Once the contracts have been properly drafted, all that remains is the actual closing where the documents are signed and the consideration (either cash or stock) is delivered to AppleSoft.

Coming Up

Stay tuned next week as Maalouf talks about the roles lawyers play in the M&A process; how to prevent deals from falling apart; the purpose of Special Purpose Acquisition Corporations (SPAC); and more.

SoftTech VC’s founder and managing partner Jeff Clavier knows how to pick a winner.

New angels may ask: How does this super angel weed out the roses from the thorns amongst all ‘em seemingly promising web companies?

To Clavier, startup executives who can’t prove their healthy team dynamics probably won’t make the cut.

In a candid interview with VentureBeat at the recent CEO Accelerator Summit, Clavier shared all about his preference for startups with strong team dynamics.

Like most investors, Clavier said he prefers a team of 2 or 3, and he likes to observe the dynamics of the team, whether the team is a “good mix” and how well team members “gel”.

“Many times, when one digs deep, one sees that the better members of the team often have silenced doubts or reservations about the less/least capable one.”

And in his years of experience Clavier has learned not to invest in a team that shows the slightest possibility of a dysfunction or mismatch.

Clavier said, aside from having team members with silenced reservations who put the proverbial spanner in the company works, teams who

• have chosen the wrong cofounder;
• have skimped on legal advice or picked a bad lawyer; and/or
• haven’t sorted out things like equity division or member responsibilities at pitch point

are also to be avoided.

Show the Pink Slip

Clavier has honed his ability to pick out a team that works cooperatively and efficiently so well that he can usually smell a rat before the pitch session is through.

But if by some chance he has already invested in the company before noticing team troubles, he pointed out that it is the role of the investor to do the necessary firing “as humanely as possible”.

“The investor has to effect change somehow,” Clavier said.

“The first step is to have a ‘gentle discussion’ — which is actually a warning.”

Reality Bites

Clavier also gives founders who demand luxurious startup salaries a wide berth – taking their unrealistic demands as a sign that they’re not committed enough to the startup.

“People always want to make similar sums to what they made at their previous jobs. Founders need to know that you won’t get rich on salary. That’s why they’re in a start up. It’s a choice they made,” he said.

And on the flipside, Clavier said savvy startups will likely research and even make contact with an investor’s past company failures as part of their own due diligence into the best angel choice for their project, telling Marshall, “to do due diligence on a VC or angel, founders should research/call one of its portfolio companies that flopped in the past”.

Something to keep in mind – angels used to doing all of the watching over should always remember that they may also be judged from afar by the next big thing.

Joshua Schachter / Image by Joi

We recently dived into Joshua Schachter’s “Ask Me Anything” at HackerNews to learn more about the founder of Delicious and the way he invests as an angel investor. He calls himself a “junior” angel who’s trying to figure out if he wants to become a professional investor someday, but the way he thinks and vets deals are very similar to those of sophisticated investors. You can too, if you hang out with the right people and educate yourself on angel investing!

Schachter has invested in “34’ish” startups to date, including mouth-watering deals like Foursquare, Square, and Bump Technologies – deals that definitely not your average “junior” angel can get into.

Find out what motivates Schachter to invest, how he got access to proprietary deal flows, and how he “filters the crap” in Del.icio.us Founder Joshua Schachter: Not Your Average “Junior” Angel Investor.

Here, let’s check out the kind of deals he’s into and his opinions on small angel round.

Deals He Likes

The team, product and market are all important to Schachter. Specifically, he’s interested in new things in interesting spaces that have a comfortable competitiveness climate, as well as those that have the potential to exit in 5 to 10 years via acquisition or IPO.

He looks for strong people

• with firm belief, but not inflexibility;
• who have the “ability to roll with the punches”; and
• who’ve succeeded in tough environments.

He adds that the “evidence of having built something is better” than having a fancy business degree.

Opinions on Small Round

When asked about raising US$200,000 from angels, Schachter notes that pre-revenue companies raising less than US$500,000 “are making a huge mistake.”

“The point of raising funds is to hire people who can accelerate the growth of the business.” He explains: Startups “should spend most of it on people and the rest on other constraining resources.” US$200,000 gets the company “a person or two, which doesn’t do very much.”

So the founders find themselves “raising again pretty much immediately.” The fundraising process is a colossal waste of time. Entrepreneurs going this route are “not making good trade-offs.”

“In my experience, most of these companies fail,” shares Schachter.

If a small US$200,000 round is enough, “it smells like a lifestyle business.”

Some may disagree with Schachter but it’s definitely food for thought. One thing is sure – savvy investors don’t invest in lifestyle businesses.

However, companies raising from Y Combinator, which usually invests US$11,000 + US$3,000 per founder, are an exception. Schachter argues:

If YC were just investing the dollars, it’d be a terrible deal. But it’s doing a great deal more.

Deal Structure

Like all seasoned investors, Schachter favors priced rounds over convertible debt: “I’m investing now, let me price it now.”

He then shares his observations on the use of convertible debt:

I’ve noticed that both very hot and very cold deals are debt. Hot because they can demand it, and cold because they can’t scrape a real round together.

Fun Stuff

What are you wearing?

I am wearing a red “foo camp” tee shirt from 2007, jeans possibly from j-crew, and white gym socks I bought at Wal-Mart.

A year or two ago I threw out all my mismatched pairs of socks and bought all identical white socks. Now I do not have to match and fold the socks when washing them. I just pile them into the drawer.

Was the recent stock market plummet your fault? Did you sabotage the investment banking industry on your way out?

You can’t prove anything. I have an alibi.

Do you talk to yourself often?

Yes, I do talk to myself.

What do you do at Google?

Press buttons, mostly.