Whoa. Slow down! Angel investing is risky — the exact reason why it garners such high potential rewards.

On average, 55% of startups fail within 5 years. Even accredited angels who invest with organized angel groups see a negative return in 40% of their investments, according to Scott Shane, author of “Fool’s Gold?: The Truth Behind Angel Investing in America.”

If angel investing is so risky, why on earth would anyone in their right mind do it?

Well, some angel investors aren’t strictly financially focused. Some might want to give back to the society; others might want to get involved with startups. After all, launching or help launching a startup can be one heck of a ride. These investors might loosen up the rules a little if they really dig the startup. But they aren’t philanthropists; they do expect to make some money.

Successful, financially focused investors often focus on the success rate rather than the failure rate. They see 45% of startups succeeding or still operating in 5 years, not the 55% of startups that fail. They know for fact that it’s the few homeruns among the 45% that would make up for the losses and generate a very handsome return.

What makes successful investors different from the average ones?

Successful investors understand risks, and they use risks to their advantage.

So let’s talk about risks. Let’s talk about how you may improve the odds of turning someone else’s idea into a huge profit.

Risks: Improving the Odds

What are the risks? There are plenty. But we’ll focus on 4 primary types:

• Financial
• Market
• People / Execution
• Product / Technology

Financial Risk

A company will die without sufficient funding. If it dies, you’ll lose most, if not all, of the money you invested. Wise angels would invest together as a group to pool capital and share financial risk. There’s safety in numbers.

More quality investors, more smart money, higher odds of company survival. Co-invest with seasoned investors or collaborate with other angel groups to mitigate financial risk.

“Last year, everyone was going around in a panic about financial risk and about the wherewithal of follow-on capital,” says James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Reserve money to participate in future funding rounds. The money you and your fellow angels reserved could be the key to turning the company around and bringing it from red to black. This, of course, assumes that the company in question still has potential and worth your follow-on investment.

Capital-efficient companies and industries are more suitable for angels since the amount required by these companies is within angel investors’ funding threshold.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” states Geshwiler.

Steer clear of capital intensive industries like cleantech and pharmaceuticals, especially if you’re a beginning or solo angel.

When evaluating an opportunity, some questions include:

• What’s the exit strategy? Does it look plausible?
• Is there a cushion in the budget?
• How long will this round of funding last?
• Will the startup able to hit milestones for the amount raised?
• Have follow-on rounds of financing planned?

Market Risk

Will people pay for this product? How will the market respond? Is the market big enough? Seasoned and successful angels look for big markets. If the market isn’t there then sayonara!

But the funding required to launch a successful tech startup is decreasing. Some investors point out that the market can be smaller if it can generate a desirable return on investment, which can vary from 5x to 30x.

Look at the market the startup competes in, not the general market. For example, the market for an online social gaming startup is people who like to play social games online, not the entire Internet population. The market size you look at must be relevant.

The startup should provide you with data that help you gauge market acceptance. Focus group research and potential customer surveys are good but real paying customers are even better.

To reduce market risk, you’ll also want to see the startup working closely with potential customers.

The startup should release fast and iterate often, as Paul Graham of Y Combinator would say. It should launch with a minimum viable product, which is “the minimum required to measure the response of early adopters,” according to Eric Ries, a frequent public speaker about the lean startup methodology. The startup should “use the insights gained by studying [the] customers to make improvements” and release a better version of the product. Repeat.

Maybe, the product has potential but the market doesn’t exist. It could be because it’s a tad too early for the market. In this case, the company might need to spend a large chunk of the funding on market education before it can gauge market acceptance.

This increases market risks and you’ll need to decide whether the potential return would outweigh the risk.

Some evaluation questions include:

• Does the market exist?
• Is the market crowded?
• Is there growth potential?
• Is the relevant market size big enough?
• Does the market need or want the product?

We’ll discuss People / Execution and Product / Technology risks in our next post.

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• So You Want to Start an Incubator?

Times have changed.

Now, not only are women running businesses, they are starting them. And they aren’t sticking with cosmetics or flowers or anything else traditionally “female.”

Ning was co-founded by a woman. So was Flickr, which was bought by Yahoo in 2005 for US$30 million.

Research Findings

Research from venture capital firm Illuminate Ventures presents a compelling case for funding female entrepreneurs. Some of the notable findings are:

• Efficiency, efficiency, efficiency:  The high-tech companies women build are more capital-efficient than the norm. The average venture-backed company run by a woman had achieved comparable early-year revenues, using an average of one-third less committed capital.
• Fewer Failures: Despite often being capital-constrained, women-owned businesses are more likely to survive the transition from raw start-up to established company than the average.
• Growing Influence in Tech:  Women-owned or led firms are the fastest growing sector of new venture creation in the U.S., growing at five times the rate of all new firms between 1997 and 2006 – now representing nearly 50% of all privately held businesses.
• Diversity Improves Performance: Organizations that are the most inclusive of women in top management achieve 35% higher ROE and 34% better total return to shareholders versus their peers – and research shows gender diversity to be particularly valuable where innovation is key.

Looks like, giving women a shot isn’t that bad of an idea. In fact, far from it. It can bring about social progress. And it can restart our economy in the process. Sounds like, it’s worth a bet.

Yet, the Center for Venture Research has found that, in the first half of 2009, 22% of businesses looking for angel investors were owned by women. But only 6% of them were able to establish a relationship with an angel investor.

What’s Missing

Thanks to Facebook, Twitter, and a bounty of blogs, wikis, and everything else that comes with Web 2.0, people are organizing and connecting in ways unknown 5 years ago. Women in the technology sector are on the forefront of these advances.

Women in Technology International (WITI) is a trade association that connects and supports female technology professionals. WITI’s membership numbers 140,000, half of whom either own or hold an executive role in a technology company, according to the association’s 2010 demographics.

This spring, Women Who Tech will hold its Third Annual Telesummit for Women in Technology. These virtual symposiums broadcast panel discussions via podcasts, which makes them free resources that are available on demand.

Earlier in February, Women 2.0 held its 2-day “Will it Launch?” workshop in San Francisco to help women polish their startup ideas.

Apparently, the business resources are in place. What’s missing is your investment to transform business plans into businesses.

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This is the second in a two-part series.

In Part 1, we took a look at how ABC’s reality show “Shark Tank” gets some key angel investment concepts wrong. In the second and final installment, we’ll offer five things the show gets right.

A Japanese import, “Shark Tank” has helped thrust angel investing and entrepreneurial spirit into the spotlight. The show throws hungry small business owners before a panel of self-made millionaires.

Entrepreneurs pitch their investment proposals and look for a specific dollar amount from the sharks. In return, the investors seek a percentage of ownership stake. The real-time negotiations play out in an ultra-public setting that, at times, makes for combustible debate — passionate entrepreneurs who’ve poured their lives into a startup rarely take defeat well.

Some of the show is closer to make-believe than anything resembling “reality” television. Valuations, time frames and negotiations are all warped or misconstrued for the benefit of the neat TV package.

But “Shark Tank” doesn’t get it all wrong. In fact, here are five things the show gets right about angel investing:

1. Points for Presentation

The Sharks don’t shy away from ripping an entrepreneur for a lackluster investment proposal. While some of the bluster is no doubt for the TV audience, there’s definitely a pragmatic foundation there. It’s seemingly common sense but needs to be reiterated: Presentation matters. One that’s cobbled together or that reflects a certain degree of seriousness, professionalism or general knowledge isn’t likely to inspire confidence or investment.

2. Smart Money

Entrepreneurs should seek smart money. The investor should hopefully be able to add value more than just the dollar investment. Small business leaders solely in search of dollars are almost always doing themselves a significant disservice. Some of the smart entrepreneurs target particular Sharks because of their past experience with similar ventures. Likewise, the Sharks often pursue a venture where they feel they can add significant value or will pass on deals where they have little to offer.

3. Smart People

Ideas without great management are not worth much. Talent is key and so is the ability to execute. Having IP may be the only other thing that helps make an idea valuable, but the IP is partly a result of execution and management. The Sharks are often wary of companies that lack a strong, visionary leadership who can generate results with the funding dollars. The general investor should be, too.

4. Valuations Vacillate

Valuations fluctuate wildly and there is no standard method. This can be seen in the wild fluctuations proposed between the sharks and the entrepreneurs. Entrepreneurs looking for a plug-and-play formula for valuations need to prepare for uncertainty.

5. The Elevator Pitch

There’s a duality inherent in “Shark Tank” when it comes to the pitch itself. In the real world, the thought of investors making a decision after reading a plan and listening to a few minutes of presentation is hard to fathom. At the same time, the show offers entrepreneurs solid examples of why cultivating a sharp “elevator pitch” is extremely important. It also illustrates how key it is for entrepreneurs to craft a compelling story for their vision.

Interested in submitting an article to Venture Hype? Just follow these guidelines to get your article featured.

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This is the first in a two-part series.

ABC’s reality show “Shark Tank” has helped bring the concept of angel investment to the mainstream. Millions of Americans who had never even heard the term now tune in each week to watch hard-working entrepreneurs pitch their investment proposals to self-made millionaires.

In the show, entrepreneurs are forced to sell their ideas and themselves before an imposing panel of investors. These small business practitioners must ask for a specific amount of money from the investors, who in turn seek a percentage of ownership stake.

Entrepreneurs typically unleash a torrent of impassioned pleas, tears and promises of future profits. The sharks, meanwhile, poke, prod and push to find holes or weaknesses in business plans and revenue models, all the while jockeying for position on the really standout pitches.

In essence, it’s reality television at its tension-building best. Too bad it’s giving viewers a warped view of what angel investment is really about.

Here are five ways that “Shark Tank” gets it wrong, along with the bad lessons it’s teaching entrepreneurs and angel investors.

1. Pre- and post-money valuations

In one episode, an entrepreneur says he is seeking $250,000 and will give up 1/3 of his company. The investor then questions the entrepreneur, asking how he can justify a valuation of $750,000 when they don’t have much in sales.

Here’s the problem: The shark isn’t correct in his valuation. The entrepreneur is not valuing the company at $750,000. He is valuing it at $500,000. This is the pre-money valuation or the valuation before the investment. Once the investment is made, the company would be valued at $750,000 — with $250,000 of that coming from the investor. And that $250,000 would get 1/3 of the post-money valuation. So the entrepreneur should not be forced to justify how the company is worth $750,000.

Instead, he should need to justify a $500,000 current (or pre-money) valuation.

2. Wacky company values

In the same episode, the investor claims valuations are based on a multiple of revenue or profits. However, this is not accurate in a startup or early-stage company.

Valuation amounts are generally placed on other things such as management, market potential, intellectual property and a few other key essentials. Sales can help justify a higher valuation, but they are generally given very little weight for startups and early-stage companies.

3. Unrealistic time frames

On “Shark Tank,” investors and entrepreneurs shake hands and seem to agree on a deal very quickly. But deals of any real merit are very rarely done without a significant amount of due diligence to help verify claims, checking out the entrepreneur and other things common in any due diligence process.

The idea of a quick shake and a sudden influx of capital runs counter to the measured and deliberate nature of angel investing. Angels didn’t make money by blindly rushing into business deals while relying on gut instinct alone.

4. One-track negotiations

When entrepreneurs and sharks are negotiating a deal, the focus is entirely on the valuation of the company and the investment amount. While these are clearly important to both stakeholders, the terms of investment deals in the real world of angel investing include a wide array of other cornerstones. We’re talking about things like stock options, liquidation preferences and so much more.

5. Adversarial relationship

For the most part, “Shark Tank” makes it seems like angels and entrepreneurs are pitted against each other. But it’s really not a zero sum game. Both sides are fighting earnestly for the same thing — to build a successful company with terms that provide mutual benefit and long-term growth.

Stay tuned for Part 2 of the series.

Interested in submitting an article to Venture Hype? Just follow these guidelines to get your article featured.

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Dixon has founded 2 successful Internet companies in New York over the last 4 years. Dissatisfied with the venture capital market, however, he has now teamed up with friends and fellow angel investors, Eric Paley and David Frankel, to create Founder Collective, which aims to fund startup tech firms.

Tech Startups Are Underfunded

Dixon says that he wants to do what he wished was available when he started out as an entrepreneur. The tech segment, he believes, is highly under-funded, an oversight that Dixon hopes to correct. Unlike firms filled with VCs with zero real-life operational experience, this new venture among capitalists is run by people who have themselves been entrepreneurs and know exactly what is needed by startups.

The problem, as Founder Collective sees it, is that there has been a trend towards bigger and bigger funds over the past decade. This has consequently led to multimillion dollar funds that need to make huge investments. This, in turn, means that VCs can focus only on the more well-established companies.

Founder Collective Focuses on Seed

What Dixon and his friends decided to do, as a result, was to raise a small fund of US$40 million that would focus on technology startups. Based in Cambridge, Founder Collective has 2 full-time managing directors — Paley and Frankel. Dixon and his other partners, Mark Gerson, Zach Klein, Bill Trenchard and Micah Rosenbloom, will continue as the CEOs of their own firms and come in as sponsors on specific deals.

Founder Collective aims to specifically focus on seed-stage funding. This means that rigorous checks on the entrepreneur will be crucial, although Dixon acknowledges that one really cannot predict the future after all.

What holds all the partners together is their common interest in companies at the early stages. The phase of team building, product development, and financing can be the most exciting time in the life of a company. Oh well, some people bungee jump…whatever gets the adrenalin going.

“We get to work with energetic, passionate, thoughtful young entrepreneurs, who just need a little guidance,” Dixon says. “We all enjoy the process of building companies ourselves — or helping other people to do it.”

Founder Collective has so far made 9 investments between US$50,000 and US$700,000, including New York-based Hot Potato and art gallery and website 20×200.

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These are some of the questions Thealzel Lee will answer in this interview.

Lee is the senior partner of Rocket Builders, a management consulting firm that sponsors Vancouver Angel Technology Network (VANTEC) and Vancouver Enterprise Forum. The firm also actively supports the annual Canadian Financing Forum.

Previously, Lee was an advisor at Science Council of Canada and a management development consultant at United Nations Development Programme (UNDP). She’s also worked on the technology portfolio at CIBC Investment Banking Division.

* Edited interview

VH: You took over the VANTEC’s Life Sciences portfolio in 2006. How did you first get involved with life sciences and subsequently with the angel network? What’s your story?

TL: I was originally in pursuit of an academic career in life sciences – having received an undergraduate in microbiology and seeking a doctorate in biochemistry and immunology – but was seduced by the business world so I obtained an MBA from the Richard Ivey School of Business at the University of Western Ontario instead.

It’s been a great ride since, with stints in public policy, biotech companies, and third world development. I later became an entrepreneur and an investor in real estate.

I began to delve into the world of angel investing almost a decade ago, first as an advisor to local startups, then as a senior partner with the Vancouver-based management consulting firm Rocket Builders, and recently as an angel investor with “skin” in the game.

Together with VANTEC-founder Mike Volker, I manage the monthly angel investor meetings and the pre-screening sessions with entrepreneurs.

VH: What are the unique characteristics of life sciences companies? For example, how are they different from technology ventures? What advice would you give to investors interested in backing life sciences companies?

TL: Life sciences encompasses many different types of products and services in the bio/health sectors – such as biopharmaceuticals, medical devices, bioinformatics, health IT – and bioenergy and other bioproducts in the environment, agriculture, marine and other resource sectors.

These companies operate in heavily regulated environments; and hence, investors in life science companies face longer timelines to exit than investors in not so regulated sectors such as social media and Internet companies.

The metrics for success are also different for life sciences. There’s a strong emphasis on proof-of-concept, which highlights the significance of the science behind the products and services.

The success of the life science company is tied to the achievement of the next regulatory hurdle, which is akin to receiving customer orders in businesses that don’t face the same types of regulatory controls.

Exit opportunities for investors in life science companies often occur when these companies reach a tolerable investment risk and valuation commensurate with their regulatory achievements – and often before revenues are generated.

My advice to investors interested in backing life science companies is to be

• confident in the management team’s ability to execute,
• very comfortable with the science underlying the business, and
• very, very patient for the exit opportunity to occur.

VH: A reader asked:

“Would you advise folks against becoming part-time angels, i.e. maintain a day job and be an angel investor during evenings/weekends? Has this worked for anyone in the past?”

What would you say to this reader?

TL: It depends. Different individuals have different personal reasons to become an angel investor, and these reasons affect the way they participate in the angel investment community.

So, if someone wants to be an angel investor part-time, that’s fine. What’s more important is that everyone understands and accepts the roles and commitment levels of everyone involved in the venture.

If the motives of the angel investor and the entrepreneur aren’t aligned, the relationship – and the venture – will sour very quickly.

VH: Brad Feld of Foundry Group recently wrote a post in an attempt to “define the parameters that qualifies someone to call themselves an angel investor.”

Opinions vary. Some believe the term “angel investor” should be strictly defined. That is, one shouldn’t call himself an angel unless he’s invested a certain dollar amount in a certain number of companies per year for a number of consecutive years.

Others disagree. One argued that some angel investors simply invest quietly in companies they like, however often they like. Not meeting the so-called minimum threshold doesn’t diminish the fact that they are angel investors.

What’s your opinion on this? How would you define an angel investor?

TL: The key is that an angel investor invests his/her own money (unlike VCs and other institutional funds) and isn’t part of the entrepreneur’s “friends and family” source of funding.

It’s not the size or the check that matters either. In my own experience with the local angels, I’ve frequently found that angels who are most capable of writing big checks don’t, and a surprising number of lower net-worth investors do. Go figure!

VH: Agreed. Another thing: Some people invest in their own company and call themselves an angel. No, investing in your own venture doesn’t make you an angel investor. So don’t call yourself that if you don’t want to become a joke.

Link:

• Angel Networker

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• The Markets Take a Beating But Come Clean
• How to Value a Startup Part 2: Start With What You Have

The reader writes -

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

We’ve covered dilution in an up round in Part 1 and examined dilution in a down round in Part 2. Here, we’ll go over some of measures you can take to lessen the impact and/or likelihood of getting burned by dilution. If this topic is new to you, you may want to read the basics in Part 1 and Part 2 before proceeding.

Note: Not all of the measures below can be taken simultaneously. Sometimes it’s either A or B, but not both. Talk with a lawyer who’s very experienced with startups and angel financing to gain a better understanding of the terms and deal structures.

Aligned Interest. Align your interests and objectives with the founders’. Paul Graham of Y Combinator writes:

Dilution is normal. What saves you from being mistreated in future rounds, usually, is that you’re in the same boat as the founders. They can’t dilute you without diluting themselves just as much. And they won’t dilute themselves unless they end up net ahead.

One way to do this is to offer entrepreneur-friendly terms, such as opting for common shares instead of preferred shares. The tradeoff is that common shares offer you very little protection.

Another way is to agree on an exit strategy early on. Basil Peters — an angel investor, prolific speaker, and author of “Early Exits” — believes that “angels, and entrepreneurs, would have fewer dilution surprises if companies had good alignment on an exit strategy before the first investment went in.”

Angel-Only. Focus on angel-only deals to prevent follow-on financing from VCs (which can be very dilutive), notes Peters. The companies should require only US$0.5 million to US$3 million to prove its business model.

Early Exit. Big corps like Google are increasingly buying pre-revenue ventures as their growth strategy, says Peters. Help the company exit early (e.g. look for an attractive acquirer before it becomes sustainable or profitable) once it’s proven its business model. Exiting early allows you to cash out and helps avoid raising dilutive rounds.

Anti-Dilution Provision. Include anti-dilution provision in the term sheet, which allows you to re-price your stock if subsequent funding rounds are down rounds. In general, this comes in 2 forms, full ratchet and weighted average ratchet. More on anti-dilution protection in a future post.

Even if you’re protected by this provision, later investors can force you to waive or remove it. It’s really a matter of bargaining power. If the company needs the cash to survive, but potential investors refuse to invest if you don’t waive your right, then the company could die.

Board. “Negotiate for permanent board status or at least observer status,” advises Jeffrey Leavitt, partner of DLA Piper. This way, you can “learn of pending company activity that could affect [your] interests.”

But don’t take this as you-should-stick-your-nose-into-every-little-detail. Y Combinator, for example, interferes as little as possible. The seed firm realizes that independence is one of the reasons startups succeed. “Investors who try to control the companies they fund often end up destroying them.”

Though we should mention, the amount Y Combinator invests is relatively small — usually around US$11,000 + US$3,000 per founder. Which means US$17,000 for 2 founders, US$20,000 for 3, and etc.

Capital Efficient. Invest in companies that don’t need a lot of capital to reach breakeven or profitability. These companies have better odds to become self-sustainable; they’re less likely to be desperate for cash or funding from outside investors.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” stated James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Deal Structure. Avoid unnecessary dilution by acquiring preferred shares or convertible debt, which converts to shares at a later date when the venture is properly valued by professional investors, Leavitt further suggests.

A note on convertible debt: Investors like Basil Peters and Bill Payne have pointed out the overuse of convertible notes and how they’re unfair to angel investors. This topic deserves an entirely different post. We’ll look into this later.

Follow-On. Reserve funds for follow-on investment. John Huston of Ohio Tech Angels Fund said, “The angels’ best protection against a ‘down round’ is to have adequate dry powder to preclude the need to seek new outside investors.”

Milestones. Before you invest, make sure the company has set, and will likely hit, milestones that will increase its valuation before raising the next round. Increasing valuation in the next round means there’ll be no down round. As mentioned in Part 2, down round can be very dilutive and can decrease the value of your holdings significantly.

Significant milestones include “licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc.,” notes Payne.

Valuation. Value the company reasonably from the start. New angels frequently pay too much at the early stage, placing too high a value on the startup. Over valuation is more prone to down round if the company needs to raise more money from outside investors in order to get the business going. Again, down rounds can significantly dilute the value and size of your holdings.

Final Words

Dilution is inevitable in both good times and bad. When it comes down to it, you ought to be confident that the company’s valuation will exceed the impact of dilution before opening your checkbook; otherwise you may want to pass on the opportunity and look for one that has such potential.

You Might Also Like:

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• Angel Investing: Dilution in an Up Round (Part 1)
• VCs Finding Seed Financing More Attractive
• Angel Investing: Dilution in a Down Round (Part 2)
• Building and Backing Startups in a Recession

Here’s the question:

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

Dilution can be scarier than your in-laws. When the company is low on cash and has to raise money in a “down round,” outside investors get to purchase new shares at a price lower than what you’d initially paid. That is, they can buy more with less.

Let’s say the economy takes a nose dive after your investment. (No, we’re not saying you jinxed the company. Sh*t happens.) The company still has great potential but it’s hungry for cash. Existing investors can’t provide the funding it needs so it issues new shares at a price of $0.5 per share in order to attract outside investors.

Using our example in Part 1:

1st Round

• You invested $0.2m in exchange for 25% of the company
• This means the company is implicitly valued at $0.8m ($0.2m / 0.25 = $0.8m), post money
• Price per share = $1
• No. of shares you own: 200,000
• Total no. of shares outstanding: 800,000

2nd Round

• Each share is priced at $0.5
• This is called a down round since the valuation, or price per share, is lower than the previous round
• Venture raises $5m by issuing 10,000,000 new shares
• Total no. of shares outstanding: 800,000 + 10,000,000 = 10,800,000
• The no. of shares you own remains 200,000
• Pre-money valuation = $0.4m (800,000 shares from the 1st round x $0.5 per share)
• Post-money valuation = Pre-money + Investment = $0.4m + $5m = $5.4m
• Value of your investment: 200,000 shares x $0.5 per share = $0.1m
• Your percentage ownership: $0.1m / $5.4m = 1.85%

Do you see what just happened? In a down round, both the size and the value of your holdings are in the race to become The Biggest Loser, shedding pounds off left and right. Your percentage ownership has shrunk from 25% in the 1st round to 1.85% in the 2nd round. Not only that, the total value of your holdings has also dropped from $0.2m to $0.1m. Yikes.

Is there anything you can do to prevent dilution? Martin Zwilling of Arizona Angels Venture Group says no:

Nobody can prevent dilution, if the company gets into trouble and needs more money than planned. The alternative is to watch the company die. Would you rather have a larger percent of nothing, or a smaller percent of something?

Though you can’t prevent dilution if the company needs more money than planned, you can take measures to prevent it, or at least minimize its impact, before it occurs. We’ll look at exactly that in Part 3.

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• What the @#$ Is a “Down Round”?

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

We’ll divide the answer into 3 parts: Part 1 looks at dilution in an up round; Part 2 examines dilution in a down round; and Part 3 goes over some of the measures that you can take to minimize the impact and likelihood of dilution. We’ll start with the fundamentals, so those who just came across this topic would have a chance to understand what dilution is about.

By definition, dilution — or a reduction in your percentage ownership – occurs when your portfolio company issues new shares. When new shares are issued, “the new investor takes a chunk of the company away from you and all other existing shareholders, just as you took a chunk of the company away from the founders [and other shareholders who invested before you, if any],” Paul Graham of Y Combinator explains.

Let’s paint a scenario based on your numbers:

1st Round

• You invested $0.2m in exchange for 25% of the company
• This means the company is implicitly valued at $0.8m ($0.2m / 0.25 = $0.8m), post money
• Price per share = $1
• No. of shares you own: 200,000
• Total no. of shares outstanding: 800,000

2nd Round

• Venture raises $5m by issuing 5,000,000 new shares
• Total no. of shares outstanding: 800,000 + 5,000,000 = 5,800,000
• Each share is priced at $1
• This is called a flat round since the price per share is the same as the previous round
• Pre-money valuation = $0.8m (800,000 shares x $1 per share, or previous round’s post-money valuation since it’s a flat round)
• Post-money valuation = Pre-money + Investment = $0.8m + $5m = $5.8m
• If you don’t participate in this round, you get diluted; your 25% ownership will shrink to 3.45% ($0.2m / $5.8m)
  • In this case, no. of shares you own remains 200,000, with a total of 5,800,000 shares outstanding
• If you want to keep your 25% ownership you’ll have to inject another $1.25m ($5.8m x 25% – $0.2m) in this round, and your total investment in the company comes to $1.45m
  • In this case, no. of shares you own increases to 1,450,000, with a total of 5,800,000 shares outstanding

When the company goes on to raise more money and issues new shares, you’ll need to pump more money into the company again if you want to maintain your percentage interests.

Eventually, you’ll have no choice but to stop following, either because you have no more money to participate or because you no longer want to commit more funds into the company.

So, you get diluted.

Up Round

Dilution isn’t sexy but it isn’t indisputably distressing either. If your portfolio company is doing great and the valuation of which is increasing, “in theory, each further round of investment leaves you with a smaller share of an even more valuable company,” says Graham. In this case, dilution isn’t something you should worry about.

“In fact [dilution is] often a byproduct of success (because nothing sucks up capital like a high growth rate),” comments Basil Peters, a veteran angel investor and an angel investment fund manager.

He continues:

For me, the real question is whether the dilution is accretive to the share value. In other words, I am happy to suffer a 10% dilution if I believe that dilution will add capital to provide an overall 20% increase in share value.

Going back to our example, let’s say you didn’t participate in the 2nd round and your percentage interests dropped from 25% to 3.45%. Lucky for you, the company is gaining traction and is savored and bought by a bigger company for $30m. Now your 3.45%, or $0.2m investment, has become $1.035m ($30m x 3.45%).

Only when the company is sold for, or exit at a value, less than $5.8m (post-money valuation of 2nd round) will you lose money. That is, of course, the simplest case with no other debts and fees involved.

Another way to look at it is this: Say, you paid $1 per share for 200,000 shares. The company’s doing great; it decides to raise money to fuel growth by issuing new shares. New investors are willing to pay $2 per share. Your percentage ownership gets diluted because of the issuance of new shares, but the value of your shares has increased from $1 to $2 a pop. The total value of your holdings has jumped from $0.2m to $0.4m (or $200,000 to $400,000 if you like zeros).

As you can see, dilution isn’t always a bad event. You can get diluted even if your shares and total investment increase in value. As Stephanie Hanbury-Brown of Golden Seeds puts it, “Ultimately investors care more about whether the value of the stock has changed more than whether or not their percent ownership has changed.”

Next, we’ll look at dilution in a down round.

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• Angel Investing: Dilution in a Down Round (Part 2)
• Rob Delman of Golden Seeds: Due Diligence Tips for Angels

Delman was the president of Delco International Ltd., a US$76 million manufacturing and distribution company of tableware products for the food service and transportation industries. In 2000, Delman sold the company to Oneida Ltd., the world’s largest producer of tableware products. Since then, he’s become an active angel investor investing in high-potential companies.

So far, Delman has held equity positions in 11 companies and has had 1 positive exit. The rest of his portfolio companies have survived the tumult of 2009 and are still in business today. Delman expects some positive exits within 2 years.

VH: One of the ways to learn the ropes of angel investing is to co-invest with seasoned investors. What etiquette should new investors adhere to in a syndicated deal, in order to avoid doing things that might annoy experienced investors?

RD: A seasoned and professional angel investor is always happy to help a new angel. Other than common sense and professional courtesy, there are no specific etiquette rules that we require. It’s our job to make sure they understand the opportunity and the technical issues of the term sheet. Most of all, we need to constantly remind them that there’s no such thing as a “dumb” question.

VH: Your colleagues and friends at Golden Seeds have given you props on the way you conduct due diligence. When you take lead on DD:

a. What data do you analyze immediately? Why?

RD: The benefit of working on a due diligence committee is that you have people with different areas of expertise.

Some of the first items the team looks at are:

• the funding requirements
• valuation
• historical sales
• forward looking projections
• gross margins

Of course, hard data is only a small part of what we look at. The management team, product phase (alpha, beta, etc.), market size, revenue stream model are all just as important.

b. There are varies ways to do credit and background checks on entrepreneurs. How do you go about conducting these checks?

RD: There are various services that you can employ on the Internet but we always ask the entrepreneur if they’ve ever been convicted of a felony or declared personal bankruptcy.

We also do reference checks with past employers.

It should also be noted that during the due diligence process, we spend a lot of time with the entrepreneurs so you definitely develop a gut feeling about their integrity.

c. How much time should be spent on due diligence for a typical deal?

RD: Of course that all depends on how detailed you want to get, but 4-8 weeks is usually the norm.

Remember that due diligence should include:

• financial modeling
• exit opportunity analysis
• research of the industry
• validation of market size
• competitive analysis
• site visits, and etc.

After all of that is completed, we generate a comprehensive deal memo to be circulated among our members.

d. Any organizational tips that would help speed up the due diligence process while making sure all bases are covered?

RD: You should definitely have a checklist of generic due diligence items to send to the entrepreneur.

Establish a timeline at the beginning of the process and deadlines for submission of specific items.

Try to highlight all your deal-breaker points early on.

e. What due diligence advice would you give to individual investors who are just starting out?

RD: There’s no question that being part of an organized angel group helps in the process. You learn all the right questions to ask and things to look for when evaluating a deal. It’s tremendously difficult to do a good job on your own unless you’ve been doing it for a very long time.

VH: The Golden Rule of Angel Investing from the Golden Dude is …

RD: Have fun and listen to your gut.

Link:

• Golden Seeds
  

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• Angel Investing: Dilution in an Up Round (Part 1)
• RRE Ventures: Robinson’s Take on Valley Startups and Business Plans