Tuesday, February 27, 2007

Where angels fear to tread

If you're reading my blog post by post, I will sound like a broken record about this, but bear with me please.

I'd complained about the general lack of deal flow and VC issues here, here and here. A recent post on Venturewoods had comments leading into the angel investment space. Angel investors, for the uninitiated, are those that give money to entrepreneurs when have diddly squat to demo. When people want money to build something that they can make very big, they will need to turn to angel investors.

Why? Because the typical amounts such ideas need are between 10 and 50 lakhs. Why that much? Two founders, salaries for a year @25K per month, let's say they need equipment, outsourced graphics design and programming perhaps, colocated or dedicated web space, collateral, etc. And perhaps a small team of people towards the end of the year to be able to generate the traction needed for a VC funding round. Okay maybe this is too big an amount, but everyone is not debt free and rent free.

You might think: Ok, why not go to a VC directly? VCs have $20-100 million dollar funds. They don't want to invest pocket change in you right now - after all, what you have is a dream and everyone has a dream, including Martin Luther King. For unlike him, everyone's dream cannot become reality. So they tell you to do something, hustle around, get some "traction" and come back.

Plus, if they gave you your 50 lakhs ($100K) they will need to fund some 200 companies like you in order to cover their fund of 20 million. Now if these 200 companies gave progress reports just ONCE a quarter, the VC will have to meet 3 companies a day just to cover them all in a quarter, and heaven forbid someone wants time in between. Typically VCs do 10-20 investments.

You might say: Uhm, why not find a VC that has only 5 million? I will now ask you to sit back and think about how VCs get paid. They get a "management fee" which is a percentage of the fund value, and they get a profit fee. Profits are five years away at least, so how does the VC pay their bills? Yes, management fees. Say that's 5% (I am picking a figure from the air). For a $20 million fund, fees are $1 million which pays for the lexus, the chalet and the trips to investor meetings in Honolulu. (To any VCs that are reading: I'm kidding! The Lexus is already paid for)

Now think about a piddly $5 million fund. The fees there are $250K which covers less than Bipasha Basu's clothing, speaking in the VC world. (Not that Bipasha Basu is in the VC world, though if that happened we would have a lot less bickering) That kind of VC would have to travel economy class, which means 'regular' VCs will have the room cleaned with water from the Ganga after they visit.

So VCs won't want to hear about your 10-50 lakh thingie. Now what do you do? Let's say your project manager, a smart guy with lots of contacts and good industry knowledge, professes interest in providing you the money - but he won't join you. Just be on the board, help with some initial setting up and refining, and provide the money you need to get traction, so you can go to the VC.

In return, you give him equity - say 25% of your company. He is now your angel investor.

If, after a year, you go to a VC who values your company at 18 crores ($5 million) and now is happy to invest another 9 crores. What happens to your angel investor?

In the US, many investors will pay the angel the valued amount of his stake (full or partial) and take over his stock. Your angel investor is happy to get this kind of a return and doesn't have to wait 5 more years - that was his risk taking capacity.

This kind of partial or complete cash-out happens at many levels in the US - from first round to second, and even founder partial-cash-outs . This is what I call deal-flow.

Deal-flow is non-existent in India and the reasoning for this, judging from the comments in the venturewoods post, is because VCs are not happy to see other investors exit. Why aren't they staying, they say, and is there something they don't like about this company that we are overlooking?

Plus, of course, financially it means someone is exiting when you are entering. The greater fool theory means that I will buy at a high price and find a bigger fool who I will sell to at an even higher price. VCs do not want to be the greater fool. The fact that they are buying from someone else makes them feel they could be one.

But that theory holds very little water. In mature markets like stock exchanges and such, there are people who buy high and sell higher all the time. Even traders buy high priced goods and add their margin when selling to others - and you have been a greater fool at some point in your life. Ever drunk Barista coffee? You're a greater fool. Ever eaten at a five star? You're a greater fool. Ever bought a cinema ticket in "black"? There you go. Ok these are consumption themes, but I don't know what business you are in - even so, do you take a salary from your company? You are a greater fool - it is far more worthwhile to take the same money in a consulting role. Being a greater fool suddenly is not as bad as you think.

Of course the other big issue is of valuation. Startups are founded by people who may not have too much of an idea about finance. When I started Agni, we brought in two other people who frankly provided very little to the company (though one did give us some office space to start, and later charged us the rent) - but we gave them stake at the same proportion as our money bought. Yes, really. This was 1998, and I was an uninitiated fool.

VC's will generally identify that the founders have been screwed in an angel round, and therefore readjust the capital to distribute the real value. The being-screwed part is obviously subjective, for angels will argue that they paid money where nothing was visible, so their investment would cover the risk. But then the VCs have the money, and the golden rule of finance is: Who has the gold makes the rules.

Thus VC investment generally means that angel stake gets substantially corroded, and therefore it may be in her best interest to sell the stake during the VC round - there is no management input by definition, and there is no control, and this in a private illiquid company; all reasons to sell out. Of course, all of this may be overshadowed by the phenomenal growth potential, and most angels would stay invested. Yet, some may decide they would like to exit, and providing them that exit path is best for all in question - the VC, the founder and of course, the angel herself.

The one way to avoid this is to find angel investors willing to stay very long term. Not that tough, even project managers will have that tenacity. And the second way is to use bridge loans.

At seed time, valuations are murky, so there's no end to valuation arguments. Therefore seed investors can provide capital as a loan, convertible to equity at two points - a) if the company is acquired and b) if there is VC investment. In either case, the conversion will happen at a discount to the valuation offered; say 30% or such. Such loans will be given at about 5% above the market rates, and the accrued interest is not paid out, instead it adds on to the loan amount for a later conversion. This is called a bridge loan (or at least, that's what I call it)

This is great stuff - in fact if you are starting a company, and investing your own money, go down this route. Reason it's great is - if you buy shares early, then you end up valuing the company way too low, which obviously affects other investors later. Secondly, you keep the cash as a loan so if the company goes down you will have first claim on any assets. Convertible debt as a bridge loan is what even big companies do now, through convertible debentures, FCCBs and such. In fact, if VCs were not afraid of losing control, they would also use convertible debt as an option.

Angels can therefore provide money as a bridge loan instead. This kind of thing is just starting to happen, and it may now be the evolution of the angel process. Yet, angels will want to see the possibility of earlier exits if the angel space is to really evolve.

And why should the angel space evolve? Because when you start, you don't need $2-3 million. With tech becoming cheaper and cheaper, why would you take that much money when you can do with far lesser? But VCs won't give you lesser, and angels aren't even in there because the model doesn't permit exits easily. Perhaps we should change the model.

As for founders - I would say put your money as a bridge loan, and take stock options for your hard work. So part of your stake will come as conversion of your upfront money and another part as options vested over time. That arrangement comforts a later VC also about valuation.

Thoughts?

5 comments:

Anonymous said...

Hi Deepak,
First of all congrats on becoming a father!! and welcome back to the blogspace to enlighten us with your knowledge and experience.
What you have mentioned is absolutely true and has happened with one of my friends.He tried hard but couldn't get somebody to fund 20-30 lakhs.On top of that he has started into retail food business for which its even more difficult to find somebody to invest.Finally ,his project manager has become his angel investor and now they are pushing hard to scale up and finally find some VC.

Thanks,
Anshul

Mohit said...

Hi Deepak,

Nice post. I would like to discuss more about Angel funding as I have some specific questions. Can you email me @ mohitis@gmail.com ? It would be really nice of you to clarify some of my doubts since we are looking for angel investment right now.

Siva said...

Hey Deepak,
I saw your comments on the venturewoods on mobile transactions. Do you know anyone who is working on this in India

Siva

santosh said...

Here is an appropriate tail to this article.

santosh said...

The article I am linking to is called Making your debt attractive to investors.