Welcome to the first lesson in Module Three of entrepreneurship, preparing for launch. Our topic for this entire module is fundraising. In this lesson, I'm going to discuss angel investors and venture capitalists, which are the largest sources of equity financing for start up businesses. The word cloud for this lesson is focused on angel and venture capital investors, including the types of returns that a business has to generate to attract their interest. Part of what I'll be covering is what to expect when you're dealing with angel investors and venture capital firms. This is where we left off at the end of Module Two. The first source of start up financing, of course, is the entrepreneurs own savings, money that you have available, that you can invest in your own company. It's probably the cheapest source of financing that you'll ever find for your company. More importantly, it sends an important signal to future investors that you're a big believer in what you're trying to accomplish in your business. If you haven't invested in your own company, it can be hard to convince others that they should take the risk. Entrepreneurs will often use the proceeds from a second mortgage or a home equity loan as startup capital. Others will use credit cards to pay their initial startup expenses. Before you borrow money personally to start your business. You should ask yourself if there will be a way for you to repay this money if the business can't. It's unfortunate when a failed startup company results in personal bankruptcy for the entrepreneur as well. The second source of financing is the entrepreneurs own network of family and friends. These are people that know you, they trust you, they believe in you and they want to support you in your business ventures, not necessarily because they're trying to make a lot of money on the investment. But because of the personal connection they have with you and their interest in seeing you succeed. Angel investors are the third source of financing and we'll be talking quite a bit about them in this lesson, we'll also be talking about venture capital firms. Crowdfunding platforms are a relatively new source of capital. We talked about them at the end of our previous module. And finally, there are strategic partners. These are usually larger corporations that have a strategic or a market related interest in what you're trying to achieve with your company. They want to be involved with it because it enhances what they're doing in their core business in some way. Let's jump right in and talk about angel investors. Who are angel investors? These are wealthy individuals and they're usually sophisticated investors. An accredited investor, according to the SEC, is an individual who has more than 200,000 dollars in annual income and a net worth of over $1 million, not including the value of his or her primary residence. So we're talking about truly high net worth individuals and not just the upper middle class. They're more likely to be successful entrepreneurs than doctors, professional athletes or celebrities. That's because as successful entrepreneurs, they have the expertise that's necessary to evaluate business plans and make responsible investment decisions for themselves. Wealthy individuals who don't have that kind of expertise would normally have to hire a financial advisor to help them make that kind of investment decision. And one of the ways that financial advisors keep their jobs is by discouraging their clients from investing in risky startups. And here's the most important difference between angel investors and venture capital firms. Angel investors are investing their own money. This means they can invest in whatever they want and they don't have to answer to anyone about it, except perhaps their spouse. If necessary they can be patient investors and wait quite a while to receive a return. That's why they're usually more willing to invest in start up companies than venture capital firms are. The best angel investors are willing and able to bring more than just their money to your business. They can share their expertise and contacts and will be willing to work with you to help the business grow. They might even be in a position to join your management team. So where can you find angel investors? You don't normally see classified ads in the newspaper saying I have lots of money to invest. Here's my personal email address. Please send me your business plan. Fortunately, many of the most active and experienced angel investors now participate in organized groups or networks. These groups can operate in different ways. Some angel groups are organized as loose knit networks through which members share deals with each other informally. Some are organized as formal groups that meet regularly and evaluate investment opportunities together. They may invite entrepreneurs to come to their meetings to present their companies. Some have a professional staff to select the entrepreneurs will give presentations and negotiate the terms of the investments. And some groups are even structured as funds through which the angel investors have pulled their capital to make investments together. Many angel groups are connected to universities, for example, Hyde Park Angels is an angel network that's been around for many years. There, loosely affiliated with the University of Chicago. Irish Angels is an active early stage investment group, affiliated with the University of Notre Dame. Some angel investors are involved in regionally or community focused networks. Here in Illinois you can find central Illinois angels, which is based in Peoria. There are also online platforms like angel list on which you can create a profile and present your company to groups of investors. Don't be fooled by the term angel investor. These investors have a high tolerance for risk and they expect to earn high returns on their investments. They're not trying to earn their wings. They're called angels because they're willing to make early stage investments to help you succeed when others won't. A recent survey, sponsored by the Angel Capital Association found that the typical angel investor in the United States is 58 years old with a master's degree and extensive experience, both as an entrepreneur and as an investor in entrepreneurial companies. Nearly 80% of the angel investors, they identified were male and nearly 90% were White. The median age at which the angel investors in the survey made their first investment was 48. This suggests that although there are more younger investors getting into angel investing. Most angel investors are people who've been around the block and know a thing or two, both about entrepreneurship and about investing. How do angel investors invest? The most experienced and successful angels take a portfolio approach rather than having too much capital tied up in just one or two deals. Angels typically invest 10-12% of their wealth in angel investments. The rest is invested it more traditionally. They typically invest in a portfolio of 10 to 12 investments and their median check size is $25,000. Although many angel investors continue to use their personal networks to find good deals, nearly 90% of them are active in one or more angel investor groups or networks. And when they make their investments, the majority of angel investors expect to take on some board level or advisory role with the company. How successful are they? A 2016 survey by the Angel Resource Institute, updated in 2017, found that on average, angel investors realized a return of 2.3 times the amount they invested on angel deals with an average holding period for their investments of 4.8 years. That translates to a 19.3% gross IRR across their portfolio. That sounds pretty good, but it's actually just slightly better than the 18.4 % annual total return for the S&P 500 over the past five years. Still, it's important to recognize that these are high risk investments. The angel investors in the survey lost part or all of their money on 30% of their investments. But the returns are more concentrated than that last number would reflect. Just 10% of the investments in the Angel Investors portfolios, ended up being responsible for between 85% and 90% of their total returns from all Angel deals. And that's why the best Angel Investors take that portfolio approach. They invest smaller amounts in multiple companies rather than larger amounts in just one or two, so that they can have a more diversified portfolio and increase their odds of success. Remember that Angel Investors like to invest in new ventures for the same reasons why anyone might want to get involved with startups. The first reason is to make more money than they can by investing in some other asset. The second reason is to back a venture that has the potential to make the world a better place in some way. And the third reason is that they enjoy working with startup entrepreneurs. When you're approaching Angel Investors, remember to communicate with them about how you can do all three of these things. As I mentioned earlier, many Angel investors participate in organized Angel investor groups or networks. Approaching groups like these, whether they're connected to a university alumni network, a regional economic or business development program or something else is the most direct way to get your plan in front of qualified Angel investors. You can also find individual investors by networking with Angel investors that you already know and through entrepreneurs that have been funded by them. A good strong referral can be really important, and you can register your start up on an online syndication platform like Angel list. A good referral and if possible, a commitment from a lead investor will help you open doors. So when you're ready to approach, try to find Angel investors who are willing to invest in companies like yours, companies in your industry and at your stage of development. If your business is a startup, don't bother approaching investors that don't like to invest in startups, do your research ahead of time. I'm constantly amazed by entrepreneurs who blindly email their executive summaries or power point decks to random investors that they found on some mailing lists that they purchased. You should expect to spend a significant amount of time with investors if they're interested in your company. They'll want to get to know you, your co founders, your technology and your market really well. They're going to be spending time with you both before and after they invest. You'll be building a long term relationship with these investors and that relationship has to work. Ideally, your Angel investors will provide more than just cash. They can advise you on your financing plan and they can make introductions for you, both for financing and for growing the company. As I mentioned before, Angel investors will want to back you if they think they'll enjoy working with you. But if you don't make any money, it's not going to be much fun for either of you. Unlike angels, Venture Capital Firms are professionally managed investment partnerships. And they're usually investing institutional capital, it's not their own money. They have to report on what they do to their investors, which means they have to take a different approach to investing. They've promised that they'll invest in specific kinds of businesses. They can't just take a flyer because they think you're deal is interesting. Usually, the managers of a Venture Capital Firm are compensated with a management fee based on the size of the fund that they're managing and a share of its eventual profits. They can have a wide range of investment strategies. Some funds are industry focused while others are focused on companies at a specific stage of development or located in a specific geographic area. Just as you do with Angel investors, you need to understand whether they're willing to consider investing in a company like yours before you go to the trouble of approaching them. Fortunately, this is not difficult to do. Most Venture Capital Firms have websites where they describe their investment strategies and the kind of investments they'll consider. Most of them list their portfolio companies or at least the ones they're proud of. You can see whether they're likely to be interested in a business like yours and you might even be able to find an entrepreneur who can make an introduction for you. Early stage Venture Capital Firms are looking for very high rates of return, often, even higher than Angel investors are shooting for. They invest in multiple companies but at the earliest stages, they expected only one or two out of every ten investments they make will really pay off. Those one or two companies will ultimately determine whether their funds are successful or not. So let's take a closer look at this. This chart represents a typical early stage Venture Capital Fund portfolio. Out of every ten investments that a Venture Capital Firm makes, there are likely to be several that turn out to be strikeouts. These are companies that fail and the Venture Capital Firm loses most, if not all of the money that is invested. There will also be several that wind up as singles. These are businesses that go sideways but when they're eventually sold or liquidated, the Venture Capital Firm manages to get its money back. Perhaps a bit more and perhaps a bit less. Then there are going to be a few doubles where the company does reasonably well and the Venture Capital Firm makes a decent profit, maybe two or three times the amount they invested in the business. Hopefully there will also be a home run or two. These are the most successful investments in the portfolio. The Venture Capital Firm will get a return of ten times its investment or more. On the right side of the chart you can see what that means for the fund's overall returns. When you put all the singles, doubles and strikeouts together, the fund will probably just break even on those investments. All of the real net profits for the fund will probably come from the home runs. This is why Venture Capital Firms won't invest in a startup company unless they're convinced that it truly has the potential to be a home run. I've heard home run potential being described as having the ability to return the entire value of the fund. If your company doesn't have that kind of home run potential, if you're going after a niche market, for example. You probably won't be able to raise money from an early stage Venture Capital Firm, even if your business is less risky than most. The first piece of advice about approaching Venture Capital Firms that I can give you is that you should not bother making cold calls. These are almost always a waste of time. I remember visiting a Venture Capital Firms office once back in the days when business plans were printed on paper and seeing a stack of business plans on the corner of the desk. I asked what that was and was told that they were plans that had come in unsolicited through the mail. They were waiting for an intern to read through them and let one of the managers know if any of them were interesting. You don't want your business plan to end up in a pile like that. That's why you should always try to use a referral when you're reaching out to a Venture Capital Firm, the stronger the better. The best referral is one from a successful entrepreneur. If an entrepreneur who's made money for a Venture Capital Firm recommends that they meet with a new startup, they'll take that meeting. What's that, you say you don't know any successful entrepreneurs? If that's the case, you're probably not ready to raise money, you need to spend more time networking first. Network in your industry, your local community, your colleges alumni directory and so on. One good way to get an entrepreneur to help you raise money is to ask him or her to be an advisor. If not from an entrepreneur, make sure that your referral is from somebody that the Venture Capitalist knows and respects. This could be an attorney, an accountant, a consultant, a customer and etc. As with Angels, do your homework so you're not wasting their time or yours. Study their websites and study the companies that they've invested in. Most Venture Capitals will tell you that they see hundreds, if not thousands of opportunities every year. You have to stand out from that crowd to get attention, this means that you need to have a great executive summary and a terrific investor presentation. As the saying goes, when you need advice, ask for money and when you need money, ask for advice. Try to meet potential investors and develop a relationship before you have to ask them for money One way to do this is to ask for advice, then tell them when you expect to be ready to seek investment and what you intend to accomplish in the meantime. Entrepreneurs often ask me about things like non disclosure agreements, term sheets and in particular valuation. These can be sensitive issues. So here's my advice. Don't lead with a non disclosure agreement or a confidentiality agreement. Most venture capital firms won't take a meeting with you if you do. If you haven't figured out a way to explain how exciting your opportunity is without disclosing highly sensitive and confidential information, you're not ready to raise money. Venture capital firms have lots of other companies that they could invest in. If you say they need to sign a confidentiality agreement before you provide any information, they'll say thanks but no thanks. It may make sense for you to ask them to sign a confidentiality agreement later on, when they're definitely interested in investing and they're asking you for proprietary details. Until you get to that point, keep them to yourself and just share information that you feel comfortable sharing. Don't offer your own terms or propose your own valuation. Most venture capital firms expect that they'll be the ones that make the actual investment offer, that's their business after all. If you propose evaluation for your company at the start of the conversation, chances are that you'll either turn them off because they think your valuation is way too high. Or you leave money on the table because they'll never propose evaluation that's higher than the one that you've already said you'd accept. And this is important, make sure that you have enough cash on hand to get through the fundraising process. Raising money can take months. And if you're close to running out of cash before the deal is done, you'll lose all of your negotiating leverage. Let's talk about the process. If a venture capitalist is interested in your opportunity, you should be able to get a meeting. If you make a good impression, they're going to spend time getting to know you and your business. This is when they'll start digging in to understand your management team, your target market, your go to market strategy, your financial projections, your technology roadmap and so on. This is the start of what's known as due diligence. If everything comes back positive and they've decided that they really do want to invest in your business, the venture capitalist will draft a non binding term sheet. That will be a 2 to 10 page document that details the amount they intend to invest, their proposed valuation for the company, and most if not all of the other key terms of the investment. You may go back and forth on the term sheet with them but if you're able to come to an agreement, they'll start doing additional due diligence. This is going to involve looking at your company's organizational documents, your legal contracts, your intellectual property rights, your historical financial statements, your customer contacts, and your employment agreements. If you don't have your house in order, it could be hard for you to close the deal. This will be followed by the final negotiation over the legal documents for the investment itself. If the due diligence went poorly, the terms could change and not in your favor. The entire process from start to finish can easily take 90 to 120 days. That's why it's important for you to make sure that you have enough cash runway to get through that time period. Getting the first yes from an investor is always the hardest. There's no substitute for competition. It's always best to be talking to more than one investor if you can. If you're relying on a single investor and you have no options, you won't have much negotiating power. Know who the decision makers are at the venture capital firm. Make sure that you have their attention and not just that of the junior people there. Remember that no one is better at selling your deal than you are. Don't rely on an analyst to resell your opportunity to a decision maker in the firm. And be as transparent as possible during the fundraising process. Bringing on an equity investor is often described as a marriage. In any marriage, there has to be trust and confidence. If the investor decides that you're not being honest, the discussions will be over. No news is not good news. Don't assume that just because you haven't heard the word no yet, the investor is actually moving toward a yes. Stay in touch, push the process forward as diplomatically as you can. A fast no can be better for you than a slow maybe that never gets too yes. It gives you the opportunity to learn from your experience and move on to other and hopefully more productive options. You should have experienced legal counsel on your side, someone that's been through the venture capital process before. You're at a disadvantage if you try to go it alone. The last piece of advice I'll give you is to keep your eyes on the prize. Venture capital transactions are complex with many terms, many conditions, and many contingencies. All of these are subject to some degree of negotiation. In order to get to yes, you need to understand and focus on what's truly important. We'll talk more about this in another lesson. If you're interested in learning more about the venture capital process, here's a book I highly recommend by Brad Feld and Jason Mendelson. Also, here's a glossary of important venture capital terms and an article on negotiating with venture capitalists from the Harvard Business Review. All of these will be helpful to you in learning the language of the venture capital and angel investment process. You can find the links in the resource guide for this lesson.