Week 8: Harvesting

One of the deceptively hard things to do with an investment is knowing when to exit. Exit too late and you might just lose all your profits, if not also the principal. Exit too early and you might miss out on the profits to come.

Angel investors face this dilemma too. There are positive exits and negative exits; staggered exits and the cash-out-in-a-single-day exit. These are the forms an exit can take. But the exit strategy itself should be formulated in the initial stages of the relationship between investor and entrepreneur.

A wise thing to do might be for the investor and the entrepreneur to have a candid discussion in the initial conversations about funding. Do the investor and the entrepreneur have the same goals for the business?

The investor will be primarily concerned about returns. The entrepreneur may have other primary goals. It would avoid much tension down the road to get a sense of whether the goals of both parties are aligned here.

For example, if the investor wants the company to put out an IPO one day, but the entrepreneur would rather shutter the business than go public, that could turn into a problem. As stated in Amis & Stevenson, these potential conflicts can be discovered in the structural agreements that investors and entrepreneurs agree to for funding.

There is a direct relationship between exiting an investment and the structuring of the investment. If the goal of the angel investor is to effect an IPO, the structure of the deal should have enticements that lead the entrepreneur or CEO to that end. These enticements are financial in nature.

Interestingly, sometimes the investor and the entrepreneur are the same person.

When Elon Musk was fired as CEO from PayPal, the company had not yet gone public. Musk remained on the company board, and while retaining his stock he continued to exercise options to buy more PayPal shares.

By the time PayPal had its initial public offering in 2002, Musk was the largest shareholder with 11% of the company. When eBay bought PayPal later that year, Musk received $165 million for his shares.

Musk’s (lack of) an exit strategy proved to be quite lucrative in that case.

Week 7: Supporting

Along with financial support, counsel and connections are other major assets an angel investor can bring to the startup.

What often first attracts investors to the fledgling business is the achievement of an initial value event. The company has accomplished something that makes it look like it has real potential to grow and succeed.

Amis and Stevenson describe value events as key achievements the company must accomplish to succeed. We see evidence of value events everywhere. That framed dollar bill on the wall of your favorite restaurant is symbolic of a value event – the first sale.

Microsoft, for example, reached a value event when it first purchased the DOS operating system. It reached another value event when it struck a business agreement with IBM to ship DOS with its hardware, and then later on with the release of Windows 3.1, Windows 95, and so on.

Through money or advice, the angel investor should help the company reach more of these value events.

In the last few years I’ve noticed we see a lot of advisors or “angel investors” whose primary contribution isn’t so much financial or industry-related as political. Elizabeth Holmes, CEO and founder of the beleaguered company Theranos, hired heavyweights like Henry Kissenger and former secretary of state George Shultz to be on the board of the company. Sam Nunn, Bill Frist, James Mattis and Bill Perry were also present.

The strange thing is that Theranos’ business focus was…hematology – blood analysis, in other words.

Kissenger is one of the most well-connected people alive today. We remember him well from his negotiations with Russia, China, and the Vietnam War’s Paris Peace Agreements. I can understand the value of being well-connected, particularly in the regulation-heavy medical industry.

However, having Kissenger, Perry, Nunn and former secretary of state Shultz seems to be a curious case of overkill. It almost seems like the politico-cum-investor version of “lawyering up”.

More significantly, it also makes you wonder how much the company in question is focused on producing its revolutionary blood sampling equipment to market. These advisors don’t have a background in the technology at hand, and I can’t imagine Kissenger would join just any company board on a whim. What sort of time and resources did it take to get him involved with Theranos?

At its height in the private market, the company was valued at $9 billion. Holmes was the majority shareholder. Its headline product – the “Edison” – was a device that could analyze blood samples for disease with only a few drops of blood. Just imagine – today for an annual physical it isn’t uncommon for the nurse to extract two or three vials of blood for analysis. What if that could be brought down to just a finger prick? Every clinic in the country would be an interested customer.

In the rise of Theranos (and Elizabeth Holmes), the Edison was the driver of the company valuation.

Then things began to fall apart. When people wanted to see the new technology in action for themselves, the company demurred. Then, Theranos was discovered to be using traditional blood testing machines instead of Edison, due to the fact that Edison might provide inaccurate results. The SEC began an investigation into misleading investors, officials and regulators about their product’s capabilities. Federal prosecutors are also conducting a criminal investigation into Theranos.

In 2015, George Shultz’s grandson – who worked at Theranos – quit the company and became a whistleblower, reporting to the Wall Street Journal that the company was manipulating a key process that regulators used to measure lab test accuracy.

By 2016, valuation experts said that Theranos was more likely worth $800 million. According to Forbes, since the venture capitalists had negotiated ownership for preferred shares, they would be paid back before Holmes. This would mean Holmes’ shares would be worth essentially zero. Further, Holmes is reported to owe Theranos $25 million for stock options she once exercised.

Holmes herself was barred from owning or operating a diagnostic lab for two years by the Centers of Medicaid and Medicaid Services. When Amis and Stevenson warn about messy failure in their book, this is what it looks like.

Theranos is a strange case. It makes you wonder where in the process fantasy outpaced reality. The value proposition of Edison is an enticing one – a better blood analysis using less blood. But by all appearances it seems that Theranos became a sort of runaway hype train, fueled by impossible promises and well-connected insiders.

When angel investors offer support, it is important for the entrepreneur to weigh how those contributions will help the company reach value events to sustain it over the long haul.

In the case of Theranos, we can see that not all value events provide equal value. The value events Theranos did achieve – massive valuations, widespread buzz, and access to the halls of power – did not help reach the one value event that mattered: making its miracle product a reality.

Week 6: Negotiating

One of the best things I ever read about negotiation was an article from Edmunds.com called Confessions of a Car Salesman. Between that article and Amis & Stevenson’s look at the tactics of angel investors, we get an interesting glimpse at negotiation itself.

Like many things in life, negotiation brings ethics to the fore, along with the negotiator’s animating motivations. Empathy and mutually-shared goals are possibilities, as are misdirection and manipulation.

While negotiation doesn’t lend itself well to universal statements, let’s look at a few of the tactics that can be used for good effect or bad.

Use of a Catspaw

Haggling over financial details can engender a lot of ill will – something you want to minimize when entering an investing relationship. In Amis & Stevenson, a portion of the book outlines the benefits of letting someone else do the negotiating. One way to do this is to hire a lawyer and let the ill will of negotiation fall on their shoulders.

We see this in the Edmunds article about car salesmen as well. After a successful conversation out in the parking lot, a salesman will sit a customer down in the box (his cubicle) and together start going through the paperwork to discover the price of the car.

Often the customer won’t agree with this or that number in the equation. So the salesman has the option of calling his manager, assume (or feign) the role of advocate for the customer, and displace the confrontation of that haggling onto an absent sales manager. This allows the manager to be “the bad guy” while the salesman himself builds further rapport with the customer.

It is important to remember that when someone is acting as your advocate in a situation they stand to gain financially, their true loyalties can be revealed by determining the outcome in which that advocate will gain the most. Just something to keep in mind.

Creating a Sense of Urgency

We’ve all been to a car dealership, inquired about a car and then heard the statement, “You better move fast – someone came by this morning asking about this car!” The gesture can be transparent and hackneyed, but it also triggers an instinct in our brains: the fear of losing out.

Investors can do this as well. Entrepreneurs may have their own ideas about valuation, but this belief can be short-circuited by putting a deadline on an offer of financial support. This can be good and bad.

On the one hand, a deadline forces the issue, allowing both the entrepreneur and the investor to move on in case the deal doesn’t work out. It frees up valuable time to pursue other opportunities. But it could also rush the process, leading either party into a bad deal that further reflection might help them avoid.

The only counter to a sense of urgency is the sense that you have enough time. Do you?

Make Your Money in Other Parts of the Negotiation

Some investors say that they usually cede to an entrepreneur’s initial request for funding and wait for the next round before imposing demands. Maybe it’s kind of like a drug dealer: sure, the first one is free, but the next one you have to pay for. What this highlights though is that entrepreneurs should consider other dimensions aside from just the amount of money they are receiving.

If you take a deal only to set yourself up for a complete burn job six months from now, are you really coming out ahead?

Let’s say you want to trade in your old car for a new one, and you’re willing to pay X amount of dollars on a monthly payment. You’re fine with financing through the dealership. People do this all the time and often are content with the results.

But in a transaction of this complexity, there are many variables to keep track of and negotiate over. For example, maybe you can buy the new car for your target price, but perhaps you get a low-ball number on the trade-in value and accept, thinking only of the victory gained from the new car’s price.

The more numerous the variables, the easier it is for something to slip past. In an ideal world you might keep each of these transactions – selling your old car, buying a new car, financing – separate from each another. You break up the transaction into smaller, easier-to-understand pieces.

Granted, not everyone likes this approach. And in investing, there is the added dimension that you may not have a lot of investors waiting in the wings to spend money on you.

Cues and Non-Verbal Communication

Everyone has heard the saying that 75% or so of all human communication is non-verbal. This is no less true at the negotiating table.

The first thing to make sure you do is simply to show up to the negotiation on time. Don’t be late. That might sound basic, but would you rather be twenty minutes early or two minutes late? Which do you think strengthens your stance? I thought so.

Another thing is to be aware of cues. One of the most humorous parts of the Edmunds article is the “up to…?” cue. A customer will come in and say he’s willing to put down $4000 on a car. The salesman will then simply respond “up to…?” And the customer will take the cue and say something like “$4500”.

That’s a $500 bump, surrendered effortlessly.

There are many lessons to be learned about negotiation (and human psychology) from that simple exchange. A lot of people are quick to doubt themselves in a negotiation, and unfortunately that lack of confidence can be preyed upon. It’s a living demonstration of the Matthew Effect.

In such a scenario, a good defense would to rest on the rationale that led that hypothetical customer to make the $4000 down payment offer in the first place. Such a defense comes from within. And it might not be a bad idea to do thought experiments with certain scenarios ahead of the actual event. “What would happen if I went with a $4500 down payment?”

That way, you have a better idea of how to handle the situation if your first moves don’t go exactly to plan.

Week 5: Structuring

The structure of a deal is a lot like the capital structure of a company. If the company is primarily financed by the dispensation of stock, the capital structure is said to be equity-driven. If the company is primarily funded by loan, the capital structure is debt-driven.

When an angel investor prepares to write a check for the entrepreneur, it’s essentially a microcosm of that dynamic. The deal may invole the assumption of debt or the transfer of equity. In some ways, the scale of this transaction can give the exchange a more personal feel than what you would get at a bank.

Involved might be only one entrepreneur and one angel investor, who with trembling hand writes out the check on his coffee table before giving it to the entrepreneur sitting across. Here, the investor is betting on the entrepreneur because he believes in him on some level. And on the other side, the entrepreneur is accepting the funds because he believes the investor is, if not an oppotunity, then at least the lesser of two evils.

A good deal gives both sides something they want from the other. In any given society we often see people getting by solely through putting their hand in the next guy’s pocket. But usually that practice proves a Pyrrhic victory – particularly where reputation is involved.

This isn’t to say the deal at hand can’t hold fearful and wrenching trade-offs. But a good deal gives each party something they can be content with and justify it to themselves.

Many entrepreneurs prefer to dole out equity for funding when compared with the alternatives. In the pre-IPO days equity is essentially a promise to make good on the funds that have entrusted to the startup, and it is one of the rare enticements a startup has in its arsenal.

Upon starting Amazon, Jeff Bezos traveled the well-worn path of injecting his own money and then tapping family and friends for additional funding. Equity shares were exchanged for the funding.

A short while later, when Amazon needed additional funding from angel investors in the Seattle area, Bezos appears to have exchanged more equity for money. The SEC’s S-1 Filing prior to Amazon’s IPO indicate that Bezos possessed a 48% share of the company by the time it went public.

Looking back, it’s safe to say that the Amazon investors who decided to take equity over a bond made the best financial decision of their lives that day.

These days, a convertible bond is pretty popular, in that it provides the investor with the best of both worlds. Convertible bonds allow the lender to convert each bond into a certain number of shares of common stock. If things are taking off for the startup, the investor continues to enjoy the ride…instead of suffering the indignity of being wise yet poor.

Convertible bonds have advantages for the entrepreneur as well. Convertible bonds sell at a higher price and require a lower interest rate than bonds without this feature. So the burden of the liability is lighter than it might otherwise be.

Lastly, there are times where the entrepreneur or business might actually want to possess a debt-heavy capital structure. Interest expense incurred when borrowing money is tax-deductible, while dividend earnings from stock holdings are not.

Like many things in life, deciding which financial instrument to obtain funding with is situational and should be tailored to fit in accordingly.

Week 4: Valuing

In the HBO comedy Silicon Valley, a group of IT nerds finally get the big break their startup has been waiting for. A venture capitalist is ready to put down serious money and fund the company. And indeed the figures bandied about are eye-popping: the VC estimates the value of the startup at $100 million. The VC will put $20 million into the company immediately.

However, a knowledgeable advisor warns the founder not to take the deal. Why?

The advisor’s rationale revolves around her belief that the $100 million valuation is too high – the logic being that valuation would put the startup into a situation it can’t possibly meet expectations in, and eventually lead to a “down round”. So the founder ultimately asks the investor to put in $10M at a $50M valuation.

All things considered it probably wasn’t a bad move: the Silicon Valley guys were coming off a huge wave of hype which created a backlash down the road.

Although this situation is fictional, it brings up the question of just how to value a company. Is there any logic to the process? Sometimes there is and sometimes there isn’t. Let’s review a few of the ways one might get a sense of how much a company is worth.

Back to Basics: The Accounting Equation

In the first week of the first semester of an accounting class, the accounting equation is presented as follows:

Assets = Liabilities + Owner’s Equity

Under this measure, if you have a company that has taken out a $100K loan (a liability) and the founder himself has injected another $100K of his own money into the company, you have a company worth $200K. Although that $100K loan is a liability, the idea is that you will use that money to buy an equal amount of assets – say, $100K worth of vehicles if you are a package delivery company. The vehicles (an asset) balance out the loan (a liability). Then you have the remaining $100K injected by the founder to cover expenses, purchase more assets, and so on.

You can ultimately use these figures to determine the book value of the company. The book value gives you a more accurate value about what cash-producing assets the company truly has available. Book value takes into account expenses like depreciation against assets and rules out intangible assets like goodwill.

The accounting equation and its resulting information is a hard-nosed, dispassionate gauge of what a business is worth.

The Multiplier Effect

Now things start to get interesting.

The thing that stops the accounting equation from being the final word is that the world changes around us. The accounting equation is more of a historical record than a preview of things to come. Businesses can grow and expand, sometimes exponentially. A good question to ask oneself when valuing a business is: “do I expect this business to grow?” If so, it can be useful to find a unit-based measure of the business.

Our package delivery company makes $0.10 every time it delivers a package. Every time it delivers 10,000 packages, the business generates $1000 of revenue. If the delivery company is expanding into a new territory where it expects to deliver 50,000 packages a day total, the business can expect to generate $5000 of revenue a day.

If the business is operation for 360 days per year, you can project revenue to come to around $1.8M per year. Add the company’s assets to that and then subtract its expenses and liabilities, and you start to get a general idea of what this business is worth following that projected growth.

The next question is to ask what percentage of the company you might like to own. Which leads us to…

Discounted Cash Flow (DCF)

Discounted cash flow can be a nice compliment to the multiplier effect, in that it has the capability to tell you what your future profit is worth in today’s money. This information can guide how much money you should invest. Instead of providing a glib and potentially misleading overview of DCF, I would recommend Investopedia’s take on the subject.

Speaking from past experience, one of the trickier parts of DCF when first starting out is the concept of future value. Future value is the underlying concept between much of finance and investment. That dollar in your pocket might not actually be worth a dollar; it depends on when you spend it.

If you were to lose that dollar for two years under the sofa, you would find two years from now that dollar could not purchase as much if you hadn’t lost it in the first place. In 2017, a 12 oz. can of Pepsi cost perhaps 79 cents. In 2019, that can of Pepsi might have gone up to $1.25.

Since the norm for paper currency is steady devaluation, any investment that promises future returns should be viewed in light of the future value of money. DCF factors in future value and present value to arrive at an estimate of what one might ought to consider when weighing an investment.

Summary

Today we covered a few of the methods available to arrive at valuations of companies. In practice, things like book value, DCF and projections are only part of the picture. One might argue they are merely the surface reflections of the business. More important is the idea, the strategy and the people in the business.

Week 3: Evaluating

There is no shortcut to good judgment. Many of the most important lessons can’t be taught – they have to be learned. Successful investing is no exception to this rule.

Luckily, we’re not cast out on the road without a map. Mentors can guide and tutor proteges, shortening the trial and error process considerably.  And books have always provided a wealth of examples from the life experiences of others. These and other aides can help greatly.

Harvard professors Sahlman and Howard developed a framework that helps break down the evaluation process into something manageable. The four major parts of that evaluation approach consists of:

• People
• Opportunity
• Context
• Deal

The thing is…this framework never gets past a situational approach. Then again, how could it? One investor sees a startup CEO and writes him off as too inexperienced. A different investor sees the same CEO and decides the industry needs a fresh set of eyes. Which is right?

The typical investing approach of angel investors – spread your risk across a basket of investments – indicates that this framework at this level is not normative but merely descriptive. You might take it a step further and say that the angel who invested in a failed startup had an imperfect analysis of the situation. Their evaluation broke down in some fundamental way.

There is an expanded version of this framework, and the main concept I like there is the “old product/new market” and “new product/old market” approach. These approaches actually explain quite a few success stories. Amazon was a new product – internet-based book sales – in an old market (book selling). McDonald’s introduced assembly line techniques – pioneered decades earlier by Henry Ford – into the restaurant business.

Overall, the framework outlined here is a good start. If I had to expand on it, I would begin with the assumption that the smaller you are, the more we see that variables play their part. Some of these variables you can control for and others you can’t.

We see this in team sports vs. individual sports all the time. When Lebron James has an off-night, he has eleven other teammates that can pick up the slack and carry the team to victory.

However, if you are tennis player Roger Federer, you have no teammates. If your shots pull wide more than usual, that’s a hard situation to overcome. Some days you feel a step slower, and there is no recourse but to force yourself back up to normal. You just can’t rely on the inertia of a team to carry you to victory because there is no team.

Similarly, businesses develop their own inertia over time. We often think of inertia as bad, but sometimes it can be great. For example, my most successful times in an exercise regime happened when I didn’t think about it. I already knew what I had to do. I knew what time of day it was going to happen; I knew I needed to fix the kids’ lunches for school the next day before exercising. Only when I offered myself the choice of opting out of that routine did I get into trouble.

New businesses and startups share a lot of these characteristics. Much like the lonely tennis player, you have less support structure to fall back on to keep things moving forward. Your own inconstancy plays an outsized role in a company of three – far more than it would in a corporation of 200 people. On the bright side, in the company of three there is far less bureaucracy to stifle your talents.

Also like tennis, entrepreneurship is a game of inches. Small differences in abilities add up to lopsided scores. The guy who hits his backhand just. a. little. better than his opponent will likely win with a score doesn’t reflect the fact that these two players are pretty similar in skills. It just takes a little to win big.

Recognizing which player has that slightly better backhand – almost imperceptible to observers but clear to those in the game – is the sort of life experience angels profit from in their evaluations. Having the tactile experience of years on the court helps develop one’s perception. But there is no shortcut.

Week 2: Sourcing

Every business needs money, not only to pay operating expenses like electric bills and salaries, but also to keep developing the products and services that fuel the business. This amount of money can often surpass the individual resources of one person.

When entrepreneurs and business owners need money, a frequent pattern emerges: first they ask their friends and family for money, then angel investors, and then venture capitalists.

This series of posts will focus on angel investing.

Angel investing is in many ways venture capitalism writ small. Most investments lose money – often all money invested. The winners usually do well enough that they more than compensate for those losses. As a result, the angel hedges his bets, investing in numerous companies, with the expectation that most investments will fail and maybe one or two will knock it out of the park.

Some have argued that angels and venture capitalists don’t actually make money.

Profitable or not, an integral part of angel investing is access: access to learn about and invest in quality companies before the masses. The first section in David Amis’ book Winning Angels deals with this challenge and proposes varying ways to try and overcome this barrier. Some suggestions are better than others, but the meat of it is that successful angel investing comes down to getting referrals.

Just to state the obvious, the problem isn’t finding people to take your money to fund their dreams – the world is full of them – but finding businesses that possess a (seemingly) solid idea and are already on the launchpad with the fuse (seemingly) lit. When these businesses need money and seek it out through a second party, will you hear about it?

Geography is a big factor in this dynamic – perhaps the factor. It is no coincidence that angel investors often cluster in places like Silicon Valley and other urban hubs. One of the curious things about living in the age of the Information Super-Highway is that you need to live in a city to have this inside line. The number of angel investors potentially willing to invest in your business likely decrease as you move further away from those urban centers.

The internet has brought angel investing across wider expanses of territory though, and these have some potential. Angel List offers the ability to join investing syndicates or as a professional investor. I believe you need to meet the qualifications of an accredited investor to gain access to the professional investing port of the site.

The last couple of years has also introduced equity crowdfunding, but this is an extremely young industry and still developing from a legal standpoint. There are enough stories about pump-and-dump fraud in this area to give one pause about investing hard-earned cash into those ventures.

It really goes back to relationships. Angel investing is relationship-based, just like publishing and politics. It certainly isn’t impossible to enter into it, but there are definite barriers (financial and personal) to entry that must be overcome if you want to become an angel investor.

Perhaps the best way to become an angel investor (if that is really your ambition) is to first start your own business, make that a success, and along the way pick up the skills and wealth that can eventually be used for angel investing on your own terms.

Much of Amis’ advice for angel investors could be examined from the perspective of the entrepreneur. Just as there are bad entrepreneurs, there are bad angel investors: people who always think they know better or who can’t extrapolate beyond their individual life experiences to the situation at hand.

Also, angel investors are not always content to be ATMs, and the funding should be thought of as a wedding of sorts. Conflicting visions and priorities will not serve either party.

Similarly, entrepreneurs can seek out the same parties that would eventually provide referrals to those high-quality angel investors.

We’ll examine this topic in more detail in the weeks to come.