Words Heard / Our Take   Title:   Angels & VCs - Bridging The Gap   What:   CAVCC Professional Development Series In Collaboration with The Toronto Venture Group   Where:   National Seminar   Event Held On:   February 21, 2006   Who:   Ten contributors including entrepreneurs, angel investors and venture capitalists were grouped into four panels: 1)How Do Angels and VC's Evaluate Deals; 2)Due Diligence Approaches; 3)Deal Terms at Each Financing Stage; and 4)WorkBrain - A Case Study. Most panelists had played more than one role and Bryan Kerdman and Peter Suma had played all three.   Quote To Note:   "There is no analytical methodology for assigning a value to a pre-revenue startup company. Nonetheless, angel investors (venture capitalists) and entrepreneurs negotiate the value of such ventures every day." "Myth: any good business can be VC funded."   What Was Said:   Net returns measured as IRR, showed that US seed/early stage funds obtained 45.8% over a decade with negative returns in years 3 and 5. Holding for two decades more than halved their realized IRR. Early stage investment pays, in the USA. The annual amounts invested by US angels and VC's in seed deals were about the same, $22B, angels invested in 16 times as many deals, 48,000 versus 2,876. From the entrepreneur's perspective while a third, 841, were early stage, less that one in twenty, 171 were seed for a total of 1012 VC deals. The equivalent Canadian total was 312. Despite the activity the reality is that there is only a partial alignment of incentives and knowledge exists amongst entrepreneurs, angels and venture capitalists. They have in common that all want wealth generation. VC's invest on a portfolio model for home runs - returns > 50%. VC's expect 2 deals to yield 10:1 plus, 5 to yield 2:1 to 5:1, and 3 to lose all capital. This works because VC's see the whole market. They make their returns on the outliers. And VC's must realize these returns in cash within the time frame demanded by their investors, less than a decade. In contrast, entrepreneurs are not diversified and need not seek only home run returns. Like entrepreneurs, angels need not only seek home run returns. They are somewhat more diversified than entrepreneurs but less so than VC's and have less market vision. By way of contrast with the VC's and entrepreneurs, angel investors and the structures they use are evolving. Formal groups now exist across Canada and the USA and some syndicate. For better or worse in the process they appear to be becoming more like VC funds. One panelist, whose firm specialized in financing software firms, stressed the real differences between the objects of due diligence in seed and series A VC deals. The Workbrain case demonstrated that the structural misalignment of interests and gaps, can be overcome. If the entrepreneur understands that IRR and exit drives VC's, the angel investors know and deal with this reality, and thus do not overpay at their round, then, no gap exists. Everyone's expectations are aligned. In the WorkBrain case everyone shared and accepted a common knowledge base including the exit strategy. The outcome stars were aligned: all parties had the same dominant incentive, wealth creation with exits for investors by an IPO and the founder remaining as CEO throughout.   Our Take:   The ugly reality is that for most businesses the gap between angels and VC's is only one of several. By design the session excluded a fourth player, governments and thus gaps between them and the session's threesome. Think of the potential for gaps as a pyramid with government at the apex and the base having entrepreneurs, angels and VC's. The time and effort spent by CAVCC and The National Angel Organization provides ample testimony to the importance of policies supportive to entrepreneurs, angels and VC's and the corollary absence of barriers erected as byproducts of governments' pursuit of other objectives. Despite the Workbrain case and leaving government aside, four "gaps" exist between: (1) entrepreneurs and founders masquerading as entrepreneurs; (2) entrepreneurs and VC's; (3) entrepreneurs and angels; (4) VC's and angels. The myth that any good business can be VC financed underpins the primary gap between VC's and the vast majority of entrepreneurs. Use rate of growth in sales as proxy for the set of firms potentially able to pay investors a competitive return on their money. Only the 3% of businesses grow at 20% pa or faster have the prospect of jumping this hurdle and most of them will not. All other entrepreneurs, plus many of those who could potentially jump the hurdle - a good business and a good investment - waste half a year, or more, looking for money in all the wrong places. Customers are the most realistic key to cash for most. A secondary gap exists when entrepreneurs with VC eligible opportunities take the money but don't appreciate or perhaps accept the consequences, that the VC's drive to exit quickly to obtain their target returns - ten times in five years - will dominate the future agenda. The gap is not secondary to those involved: it will dominate their lives for a half a decade or more. Not mentioned was the corollary, existence of a tertiary gap, entrepreneurs whose opportunities meet VC criteria but choose not to seek or accept it. When angels behave as members of a VC farm team league, "micro VC's", the gap between angels and entrepreneurs is identical in structure to that between entrepreneurs and VC's. The result is the un-choreographed and un-choreographable danse macabre called, valuation. As with VC's and entrepreneurs a second gap exists between angels and entrepreneurs. Measured by the number of investments made by angels, it is the primary gap not the secondary. Some 15,000 of a total of every 16,000 angel investments are exposed to this gap. That it exists and persists is curious. Angels' motivations for investing are more akin to the entrepreneurs than a VC's, a combination of passion for the product and the potential for a high return. Time frames are also better aligned. Yet, these facts are almost never carried through to a logical conclusion and incorporated into a financing strategy designed for these two parties. Unlike VC's, an angel investor's time frame is not constrained by obligations to investors. Thus they do not need, as do VC's, a one time exit event to obtain a competitive rate of return. Angels are principals and thus not bound by obligations to others. Angels are akin to suppliers of capital to VC's who seek to meet ongoing obligations to pensioners. The angel-entrepreneur gap arises from two sources: mistaking a founder for an entrepreneur, and use of a financing strategy that fails to meet the investment needs of angels and the reality of the entrepreneur's business opportunity. The first gap, which also occurs between VC's and founders, arises when angels fail to accurately distinguish those in whom they invest who are dedicated to the product and/or solving the customers pain from those who also seek to create wealth by solving customers pain. This is a particular issue at the very earliest stages as shown by the difference in the due diligence requirements at the seed and A round. For many angels and angel groups an income stream is at least as valuable as a capital gains event. Neither debt nor shares fit the reality of early investments in a private company being built for growth and long term operation. Here wealth creation arises from a disciplined focus on long term growth of positive cash flows from sales. Put another way efficient use of capital should be the key to the entrepreneurs' financial reward. Debt is an obvious but wrong answer: a significant risk of loss of capital is present and the timing of revenues is highly uncertain. Common shares in private firms are also the wrong answer. In reality they offer investors a competitive return if and when a big bang exit event occurs. This is precisely what a private company being built for a long term hold should not and cannot offer. This gap is a factor for the 15 of 16 angel investments should they use debt or equity. For the handful of good business that can profitably use outside capital, the investors' returns should be targeted to a competitive return, IRR's in the 45% plus range, tied to growth in sales via royalties and that of entrepreneurs to wealth creation arising from growing profitable cash flows driven by excellence in management of sales and costs. Logic suggests that angels have far more investment opportunities available to them from use of royalties for returns. Entrepreneurs would thus have increased access to capital, particularly if angels support their "equity" investment with aggressive working capital support designed for early-stage, rapid-growth companies. To return to the thrust of this thought provoking session, gap bridging would really occur were: (1) VC's to collaborate with entrepreneurs and angels by advising good businesses that are also good investments to seek funds from angels who get returns from royalties; (2) angels to focus on IRR and not being a farm team for VC's; and (3) entrepreneurs not captured by the myth that you are nobody if you do not have venture capital and accept the reality that any business is nobody with out cash flow from sales. Proof of the pudding is that the company winning the 2006 award as the best early stage firm in Ottawa, Lumenara, has not sought angel or VC financing. Their financing was indeed sales driven.   708-350 Sparks Street, Ottawa, ON K1R 7S8, t: (613) 563 4588, f: (613) 563 4689, ourtake@acornpartners.com, www.acornpartners.com If you wish to unsubscribe, reply to this email with "unsubscribe" in the subject.