Educating and Connecting Investors and Entrepreneurs. Rockies Venture Club is an Angel Group whose mission is to advance economic development in the Rocky Mountain Region by actively connecting investors with the most promising entrepreneurial companies.
In a panel on angel return data at the Angel Capital Association Summit recently the speaker went back and forth between data using ROI (multiples of the original investment) and IRR (internal rate of return). These metrics are very different and it is important for angels to have a good understanding of how using each of these will impact their investment strategy – in many cases for the worse!
Why Hunting for Unicorns May not be a Good Strategy for Angel Investors
There is a mythology among angel investors about going for “unicorns” (private companies with a valuation of $1 billion or more) in their portfolios. In many cases, real returns from unicorns may be less than hitting solid singles and doubles that exit at under $100 million. Here’s why:
While unicorns may appear to give great returns, our speaker gave an example. He had invested in DocuSign which is now readying itself for an IPO. (Initial Public Offering) After multiple follow-on rounds after his angel investment, his percentage ownership had been significantly diluted, but even worse – it took twelve years for DocuSign to get to exit from the time of his investment. While he expects to receive an investment ROI multiple of 4.8 times his original investment, that comes out to only a 15.3% IRR. Getting $480,000 back on a $100,000 investment sounds good initially. When the amount of time that the investment takes comes into the calculation, the unicorn doesn’t look as good as some of the same investor’s exits that came along in five or fewer years and yielded $100 million or less. In fact, his average IRR over his portfolio was 27%, so this unicorn was bringing his average down!
Angel Investors should think about their investments from a portfolio strategy viewpoint.
Smart angels will target 10X their investment back within five years or less – that’s a 58.5% IRR. After calculating winners and losers over time, angels who invest through angel groups will typically see a portfolio return in the 23-37% range, or about 2.5X. Getting 4.8X your money back sounds good, until you think about what you could have done with that money if you could have reinvested it after five years.
What if the investor had taken his $100,000 and NOT invested in DocuSign, but rather invested in ten deals at $10,000 each with half of them returning nothing and the returns from the others averaging 2.5X return over five years? And what if he had reinvested the returns from those investments? At that rate, including winners and losers, he would have received $850,000 at the end of twelve years for an 8.5X return or 27% IRR. Clearly, taking time into account, but also taking the opportunity to recycle exits into the next deal increases profits.
The likelihood of any one investment being a unicorn is something like 1,800 to 1, but the most prolific angel investors I know have portfolios of maybe 100-150 deals. On the other hand, getting a 2.5X in five years on a ten company portfolio is fairly common among angels. Unicorn hunting, even when successful returned almost half the cash that the diversified angel did. Using IRR instead of ROI helps angels to understand the best way to think of their strategy.
How do Venture Capitalists Differ from Angels?
Venture Capital funds often talk about how they need to go for the big multiples “because they need to return large amounts to their Limited Partners.” This is partly true, but not for the reasons they would have you think. Angels have the same return targets as VCs, and, when they invest in groups, they tend to outperform Venture Capital funds by a good margin. Over the past fifteen years VCs have been hunting for unicorns and missing out on the singles,doubles and triples that angels enjoy, but their returns averaged 9.98% – less than half of what angels have earned during the same period.
VCs are limited by time in their investments. The average VC fund lasts for ten years, and many funds have a policy of not “recycling” their returns into new investments, so they are motivated to get large multiples of ROI rather than focusing on quick returns with high IRR. It’s better if a fund can recycle its returns into new investments, with the caveat that they must return all capital to Limited Partners within ten years.
VCs also shy from using IRR to measure their fund’s performance because of the “J Curve” which refers to the shorter period between investment and failure compared to the longer period between investment and large-multiple success. Using IRR can make the fund’s performance look sub-par early in the fund’s lifecycle.
Finally, the institutional investors that are the VC’s Limited Partners often earmark their funds for long investment periods and the last thing they want is to get a 30% IRR on an investment that comes back in the first year. They would rather deploy the capital for longer periods for larger returns. Because institutional investors have a high cost of analyzing investment opportunities, it’s not as easy for them to re-deploy as it might be for angels.
So, angel investors differ from VCs in investment strategy, and if they invest in groups and pay attention to using IRR as their performance metric, they can outperform VCs and create significant returns for their own portfolios.
If you’ve read ANYTHING about cryptocurrencies and ICOs (Initial Coin/Token Offerings), you’ve read opinions from people who believe that the value of these coins will go up 100 times and others who believe that they will all crash to zero because there is “nothing there”. If you believe either of these groups, you’ll be in big trouble if you’re an entrepreneur or angel/venture capital investor in this space. Some cryptocurrencies will indeed go to zero and others will likely rise by 100X, but out of thousands of deals, how would you know how to pick the right ones?
It’s not just cryptocurrencies that have a lot of uncertainty today. We’re seeing unprecedented change in blockchain, artificial intelligence, Internet of Things, self-driving cars and more. These trends are all going to become a big part of our future, but which companies are the ones we should invest in?
Experience can be a guide in helping decipher the trends in fast breaking industries. The cryptocurrency ICO market reminds me a lot of all the dot.com startups in the 1990’s who were going public without having much more than a URL like etoys.com, socks.com, pets.com, etc.
What happened during the .com boom? Lots of companies got funded quickly and at valuations that didn’t make sense. It kind of looks like the ICO boom now. When companies get too much money too quickly, they tend to accelerate their failure rate because they haven’t figured out their product-market-fit or how to scale up quickly. We’ll certainly see some of that in the current ICO boom, but, just like in the .com boom, we’ll also see some VERY BIG winners. Google and Amazon looked crazy in the 1990’s but now they are today’s biggest companies. We will see the same thing with blockchain, cryptocurrencies, AI, IoT, intelligent cars and more.
The people who predict wholesale failure or wholesale success are bound to be wrong. The people who are diligent in digging into who the winners and losers will be with a futurist attitude will succeed. Investors who think like the hockey player Wayne Gretzky who famously said “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”
Great venture capital investors have to be like great hockey players and invest where the market is going to be.
Predicting the future is hard, but we’ve got some help for you. The upcoming Angel Capital Summit, produced by the Rockies Venture Club will be focusing on Funding the Next Wave of Innovation. We’ll be interviewing CEOs of companies that have gone through major trends in social networks, cyber security and more in order to learn how to identify and ride the trends.
The Angel Capital Summit will also feature 16+ companies that are riding the trends of their industries, pitching to angel and venture capital investors. The event is open to the public and is free for RVC Keystone and Active Investor Members. (If you’re not a member yet, click HERE for more information).
The Rockies Venture Club is the oldest angel investing group in the U.S. and is a non-profit organization focusing on furthering economic development by educating and connecting angel investors and great startups.
Denver, CO – Rockies Venture Club (RVC), one of the largest and most experienced Angel investing organizations in the country, led and closed 15 funding rounds over the past year. RVC has created a community of accredited investors who are passionate about helping early stage companies raise the capital that they need to grow.
This trend of early-stage investing in Colorado is encouraging considering the fact that there has been a downward trend in early-stage activity worldwide. A November 2017 report by TechCrunch shows that despite record levels of Venture Capital being raised, the number of funding rounds has been cut in half since 2014. This indicates that capital is being concentrated into larger, later-stage companies. With this being the trend, it would seem that Rockies Venture Club and more largely Colorado as a whole is providing its companies the capital they need to grow.
According to RVC Executive Director, Peter Adams, “One of RVC’s leading principles is to be as diversified as possible when investing in companies. We believe that investing in a variety of sectors allows our Angel investors to diversify their personal portfolios while having fun learning about industries they don’t have past experience in.” This is something that the Angel group truly puts into practice if their 2017 portfolio is any indication. Among the 15 new companies that RVC backed in 2017, there was industry representation within CyberSecurity, AgTech, FinTech, Medical Devices, and Consumer Products; just to name a few.
In addition to engaging local capital through its network of over 200 active Angel investors, Rockies Venture Club also syndicates many of these deals with other Angel groups from across the U.S. Dave Harris, RVC’s Director of Operations, states, “RVC has been working to develop strong partnerships with other Angel groups for several years now. This allows companies to more quickly and easily close their funding rounds, bring deal flow to other areas of the country, and ultimately results in a greater amount of capital being invested directly in Colorado companies.”
Among the 15 deals, RVC led the seed-round in the female founded, Fort Collins company, The Food Corridor (TFC). TFC is the first online marketplace for food businesses to connect with available commercial food assets. Food businesses can find and book commercial kitchens, equipment, commissaries, processors, co-packers, and food storage spaces. CEO Ashley Colpaart put together a $550k round through Rockies Venture Club, Rockies Venture Fund, and other Northern Colorado Investors. Peter Adams stated, “I believe that RVC investors were especially interested in this deal due to Ashley’s deep industry knowledge and the promising early traction they have gained with food entrepreneurs and commercial kitchen spaces.”
RVC Angels also invested in CirrusMD’s $7 Million Series A Round. CirrusMD is a company that gives patients immediate access to providers via secure chat so healthcare organizations can excel in a value-based care environment. This was the third round that RVC has participated in, having first invested in the company in 2014. Since then CirrusMD has expanded access to care to over a million of patients and formed strong partnerships with some of the largest health systems across the country.
Beyond closing the 15 deals, in 2017 Rockies Venture Club created the Women’s Investor Network(WIN), an initiative created to address the lack of diversity in Colorado’s investor community, launched the Rockies Venture Fund, an early-stage VC fund that invests alongside RVC’s Angel investors, and collaborate with the Colorado OEDIT to create the OEDIT HyperAccelerator, program that helps Advanced Industry grant recipients raise the necessary matching funds.
Looking forward to 2018, the club will be hosting the 11th annual Angel Capital Summit (ACS) in March. The Angel Capital Summit is the largest Angel investing event in Colorado, bringing together over 300 investors, entrepreneurs, and community members together under one roof. This year the conference will focus around current, past, and future waves of innovation that have had or will have lasting impacts on the venture capital industry. RVC is excited to announce that there will be two keynote speakers at ACS this year: Divya Narendra, and Colorado’s own Andre Durand. Dyvia is the Founder and CEO of SumZero, and co-founded ConnectU, the inspiration behind Facebook. Andre is the Founder and CEO of Ping Identity who lead the company through a $600M+ acquisition by Vista Equity Partners in 2016.
Colorado Life Science Night
Tuesday 2/13 | 5-7:30 PM | Polsinelli 1401 Lawrence St.
AQ BioMed has developed an aqueous shunt used to prevent blindness due to over-pressurization in the $3B glaucoma market. The company was recently awarded a Colorado Advanced Industries grant and is currently raising mating funds to bring the device that has over 20 years of R&D, 5 issued and 2 pending patents, to market. The average selling price for the device will be $775 in and is reimbursed in the US. Cost of goods is less than $20. AQ BioMed believes it can enter the $100M+ glaucoma shunt market and achieve over $15M in sales in the next 3 to 5 years. aqbiomed.com.
MFB Fertility is an early-stage medical device company focused on women’s health. Our expertise is developing innovative immunoassay test systems that will revolutionize the way infertility is diagnosed and treated. 1 in 8 couples struggle to conceive or carry a baby to term, but only 1⁄4 of them have access to care. Our innovative products will increase access to care and grow the now 2 billion dollar market. mfbfertility.com
PharmaJet has developed user-friendly, inexpensive device platforms for fluid injection into the body without a needle. Able to compete with traditional needle-syringe delivery, which inherently poses costly needle-stick, re-use and pass-along disease issues, PharmaJet’s devices have been optimized for vaccine administration, a 2.8B annual immunization market growing in excess of the 140m annual birth cohort. Unique in the field of jet injection because of its ability to reach target tissues accurately and comfortably, PharmaJet has unique scientific claims and wide regulatory clearances. pharmajet.com
PrecisionProfile is focused on enabling the precision medicine community to “make sense” of genomic profiles to create personalized treatment plans for patients. The University of Colorado Cancer Center has developed a genomic analytics platform and a “patients like mine” cohort analytics approach, and PrecisionProfile has been formed as an Anschutz Medical Campus spinoff to create a product to advance the practice of cancer precision medicine. precisionprofile.com
The paradox in impact investing is that a large percentage of impact investors are hurting the very companies that they want to help. Neophyte impact investors have not yet figured out the difference between philanthropy and Impact investing, resulting in a confusion that causes serious damage to the Impact business community.
There is a big difference between philanthropy and Impact investing. The organizations receiving funding are focused on doing good in the world and it doesn’t matter whether they are for-profit of not for them to do good. In fact, many for-profits outperform non-profits on execution and core metrics for outcomes. Impact investors should understand their motivations for investing and they should have clear financial and non-financial metrics that they use to create their investment thesis.
A non-profit, by definition, does not make a profit. It is also owned by no one and when it has come to its end or fulfilled its mission, all assets must be donated to another non-profit. Value creation is strictly focused on mission and core metrics include outputs as well as key ratios between operational costs vs. direct program delivery.
Social and Environmental Impact investing, on the other hand, creates value on three ways. The business generates a profit. It creates measurable positive social and/or environmental outcomes, plus it creates positive economic outcomes for investors and founders. The fact that the company creates these positive economic outputs doesn’t in any way diminish the company’s need for capital nor does it diminish the impact created by the company’s operations.
To help clarify how investors and CEOs should think about impact investing vs. philanthropy, I’ve put together a sampling of six common arguments that some, mostly new, impact investors put forward, and some responses to those arguments which I hope will clarify the power of impact investing and a more productive attitude towards profitability and liquidity events.
Six Common Arguments from New Impact InvestorsArgument: “I don’t want to invest in a company that is just interested in selling out, so I advise companies I invest in to never have an exit strategy.”
Even non-impact investors are wary of investing in a CEO who appears to be in it just for the money, or is planning for the quick flip. These CEOs likely w
on’t have the grit it takes to overcome the many obstacles in their way and will quit half way through, losing everyone’s investment. There’s a fine line between the quick flip mentality and the strategic CEO who is looking for ways to maximize value and leverage that to increase outcomes for all.
CEOs who hear this argument sometimes change their strategy to exclude an exit strategy, which often means that the net impact the company will have is DIMINISHED because of the short sighted demands of the Impact investor who wants to feel good about themselves in the way that philanthropy makes people feel good. By focusing on data oriented approaches to strategy, investors can come to understand the exit as a way to expand outcomes, not diminish them.
Argument:” If the companies I invest in are acquired, the acquirer may have different values, thus hurting the beneficial impact that the company creates.”
This argument suffers from a lack of understanding how exit strategies and execution work. The exit strategy entails identifying the best acquirers for whom the company will provide the greatest value. This exercise naturally involves understanding the values of the potential acquirer and seeking to build relationships with acquirers who share the impact company’s values and will likely expand on them after acquisition.
So, a company that does not have an exit strategy is more likely to be acquired by a company who has misaligned values and may fail to carry on and expand the mission of the company. Rather than decreasing the risk of a values misalignment, the impact investor increases the chances of misalignment by refusing to support talk of an exit strategy.
Argument: “Impact companies should just focus on creating a positive impact and growing a significant company and not on an exit.”
This is one of the weakest arguments against an impact company’s focus on exit, and it is one that is commonly waged against tech startup CEOs, leading to confusion and underperformance in many cases.
Let’s start by remembering the Second Habit of the Seven Habits of Highly Successful People – “Begin with the end in mind.” This habit is just as important for impact companies as it is for people. Those who focus on the end and develop a clear path to get there are 65% more effective in achieving those goals than those that try to “just build a big company.”
Impact companies create value in three ways, and I don’t just mean the Triple Bottom Line. Impact companies create value through creating a valuable good or service which is able to compete in the market and create revenues and profits. Impact companies create value because their goods or services themselves create positive social or environmental outcomes. Finally, Impact companies with exit strategies understand how to create value for their acquirers, and those acquirers are often willing to pay a multiple of revenue to get it.
Any company needs to understand its core value proposition for its customer. What smart Impact CEOs and their investors will do is to ask what the value proposition is for its second customer too – the customer who buys the whole company. That value proposition is not always the same as the value proposition for the first customer and having a clear understanding of those differing value propositions can be the difference between success and the walking dead.
So, companies with an exit strategy are 1) more likely than others to be successful and 2) will create wealth for investors and founders which can 3) be reinvested into new Impact companies to create an evergreen cycle of positive social and environmental impact.
Argument: “You can’t control the exit, so it’s a mistake to try to pretend that you can.”
People who don’t believe they can control the exit, may also believe they can’t control the market or the customers for their products. They might just as well stay in bed – they can’t control anything and are fairly weak leaders of companies.
Great Impact leaders create their futures. They may not be able to control all aspects, but they can create an environment in which their thesis succeeds. Great leaders will drive towards scenarios that align with their values and
business goals. Just because you can’t control every externality does NOT mean that you must throw up your hands and refuse to plan for the future. It is exactly because of the uncertainty of the future, that exit planning is imperative.
Argument: “Social and Environmental Impact companies are not acquirable, so they should just focus on impact.”
Companies should BEGIN with the end in mind and create all three Impact value propositions (profit, impact, exit). Companies that create profit and
impact should be highly acquirable, and by thinking about it from the beginning, value of all three kinds can be baked into the core strategy.
When it comes time for exit, it’s not a cop-out or sell-out of values. I think of it more like a “commencement.” Just like when someone goes through Commencement at the end of high school, it doesn’t mean that they’ve ended their path towards education, but rather it means that they’re graduating to a higher level of execution by going on to university. Few would say that commencement in any way diminishes the quality of the person going through graduation.
So too with a company going through an exit. By being acquired the company can further its mission tenfold or more by leveraging the capital, sales channels, R&D, brand and other resources that the acquirer can bring to the Impact company. The net result is the opposite of a cop-out, but is rather a commencement of something even bigger and the Impact investor should be right next to the Impact CEO, helping them to achieve that end.
Investors who believe that making a profit is bad should stick to philanthropy. If they need to lose money to feel good about themselves, philanthropy is a quick path to 100% financial loss. Even a zero interest loan to a non-profit results in a profit of zero which is 100% more than a philanthropic gift. Investors who have a problem with Impact companies being profitable should stick to philanthropy rather than dragging down promising Impact startup CEOs and limiting the evergreen effect of reinvestment.
The more that Impact investors focus on achieving positive social and environmental outcomes along with value creation, the more capital will be available to support Impact startups and the more good will be done in the world.
Impact investing is at an inflection point and is growing at an astronomical rate. The global market for impact investments is expected to top $300 Billion by 2020. Capital is chasing Impact deals because of a new breed of Fund managers who apply the discipline and expectations of venture capital to Impact. The more we see of this kind of investing, the better the Impact Investing space will be for everyone.
We’ve known for years that Colorado has more startups per capital than anywhere else. Yes – per capita. It’s a great location to start up a company and maybe you’re wondering if there’s a Venture Capital infrastructure to support that? Well, now there’s incontrovertible evidence for Colorado’s leadership position in MicroVCs and it all comes down to … beer.
Just check out this CB Insights research relating MicroVC Tech Deals to Microbreweries. That’s right – the more microbreweries you have, the more MicroVC deals you get. And take a look at Colorado’s number 3 position in Microbreweries – what does that tell you?
Yes – a vibrant MicroVC community is brewing here in Colorado. We’re seeing a huge influx of MicroVC and NanoVC funds as the state begins to mobilize its local capital to support its burgeoning startup community.
Ok, maybe that’s just a facetious stretch of statistical comparisons – but there is definitely a rapidly moving trend in Micro Venture Capital and Colorado is feeling the benefits of new sources of capital coming on-line!
This trend mirrors a national trend in increasing Micro VC firms. Following the drastic drop in VC firms from over 1000 to just over 500 after the economic downturn in 2008, MicroVCs have flourished. There were fewer than fifty active MicroVCs in 2011 and today there are over 550 in the U.S. A tenfold increase in just a few short years and many of them are in Colorado.
MicroVC is changing the venture investing landscape and is responding to the needs of startups who need small amounts of capital to prove their product market fit and grow big. MicroVCs offer a scale that the big firms can’t efficiently provide and they get companies up and going quickly and efficiently.
MicroVCs aren’t just for small companies though. Check out these results from MicroVCs who are growing a new crop of Unicorns (private companies with valuations of $1B or greater) It’s not just the big funds that are hitting the grand slams – the Micro’s are slamming it home as well.
MicroVCs are creating a huge impact in the startup world and Colorado is the place to see this transformation taking place on a rapid pace.
You can learn more about MicroVC, NanoVC, and how accelerator VC funds are changing how startups get funded, and how angel investors can get involved in new ways previously unavailable to them. You’ve got just a few days to sign up for the Colorado Capital Conference coming up November 6-7, 2017 in Denver, CO.
The conference is hosted by Rockies Venture Club, the longest running angel group in the U.S. Membership is NOT required to attend the conference, but if you’re an entrepreneur or angel investor, this would be a good time to look into the savings that RVC members enjoy on conferences, angel groups, workshops, masterminds and classes.
As the cost of starting a tech company has gone down, VCs have moved upstream, funding bigger and bigger deals while angels and angel groups have taken up the sub-five million funding space. Meanwhile, accelerators and platforms have also taken a place with funds to jump start companies going through their programs. MicroVCs are venture capital firms with assets under management of less than $100,000,000. That sounds like a pretty big fund to angel investors, but in the big picture venture capital world, these truly are micro venture capital funds.
MicroVCs have taken on a huge role in filling the gap between seed and angel funding and big scale unicorn-track venture funding. If you think about basic fund structure, a $100 million fund will invest about half of committed capital, or $50 million into its first round investments. The fund will want to diversify to twenty or more investments, so you might see an average of $2 million for a first round. Then they’ll have the remaining $50 million to continue investing in the top winners from the portfolio. $2 million is a great amount for a post-angel round, but is far less than the $10 million that an average VC deal is doing today.
The MicroVC area is more understandable if we look at what kind of entities fill this space. There are sub $25 million funds, also known as NanoVC Funds which operate very differently than $100 million funds. Then there are the accelerators which are actually MicroVCs. Also, more and more angel groups are creating funds (Like the Rockies Venture Fund) and are moving upstream a bit to do larger deals. Finally, angel groups are syndicating actively, so they can move into larger and larger deals. Some examples of the power of angel groups leveraging their investments by working in syndicates include Richard Sudek’s work at Tech Coast Angels who syndicated a $10 million raise via syndication and similarly Rockies Venture Club Participated in a Series F syndicate for PharmaJet locally. These are not deals that we would typically expect to see angels playing in. This means that angels, when working together can start filling the space occupied by the MicroVCs. Rather than competing, we’re seeing angels investing alongside MicroVCs at an increasing pace.
There are other considerations, however. MicroVCs will typically hold back half of their fund for follow-ons, while angels are less predictable and many still use a “one and done” approach to their investments. Even with MicroVC follow-on investment of up to $10 million, this is still not enough to propel some companies to the scale they’re shooting for, so they’ll still need to engage with traditional VC once they get big enough.
Angel investors should help startups to figure out their financial strategies so that they can work on building relationships with the right kinds of investors from the beginning so that they don’t paint themselves into a financial corner by working with the wrong investors. Similarly, startups need to understand the goals of any type of VC so that they don’t waste their time barking up the wrong tree.
To learn more about the evolving role of MicroVCs, consider attending the RVC Colorado Capital Conference. It’s coming up November 6-7th in Denver, CO. Visit www.coloradocapitalconference.org for more information on speakers and presenters. This event is on of Colorado’s largest angel and vc investment conferences of the year and there are great networking opportunities. We hope that the audience will come away with an idea about how all these types of capital are evolving and the different strategies that companies can take in choosing who they want to pursue for their capital needs.
It seems like a majority of pre-Series A deals are done with convertible debt these days and I’d like to point out a few reasons why this is a bad thing for entrepreneurs and investors alike.
Just to get definitions out of the way, we’re talking about the decision to raise funding for startups by either equity investment in stock of a company, or in a convertible debt instrument. Equity is pretty straightforward – invest money, get stock. Convertible notes, on the other hand are not widely known to those outside of startup investing. Convertible debt works like regular debt in that there’s a promissory note and an interest rate. The interest is rarely paid in cash for convertible notes though, and it’s usually rolled into equity when the note converts into equity. There are usually a few “triggers” for h
aving the note convert to equity, but the most prominent one is that there is a “qualified financing round” which is usually around $1 million. The idea is that the professional investors at that stage know how to value the business and set the terms. The first early investors who invest will convert at the terms set by the VCs, but usually with a 20% discount in price to compensate for investing earlier. Convertible notes today also have a “valuation cap” which is equal to what the equity valuation would have been if the deal had been a stock transaction in the first place. So, when the qualified round causes the note to convert, it converts at the lower of the 20% discount or the valuation cap.
Ten Reasons to Avoid Convertible Debt
Reason 1: Convertible Notes do not qualify for Section 1202 QSBS Tax Breaks
Angel investors get a 100% capital gains tax break if they invest in equity in early stage companies that meet certain criteria such as being a C Corp., being under five years old, under five million in revenue and they hold the
investment for five years. Convertible notes don’t qualify for this tax break, so if all things were equal, the investor makes 20% LESS on convertible note deals since they have to pay capital gains tax on the investment, whereas investors who invest in equity do not have to pay any tax at all.
Reason 2: Equity is cheaper than convertible debt
You may have heard that it’s cheaper, faster and easier to do a convertible note, but the fact is that convertible notes are going to end up costing the company approximately 25% MORE than an equity deal. The reason for this is that when the note converts, then it converts into EQUITY. That means that the company pays twice for the legal: once to do the note and another time to do the equity. So if a convertible note cost $2500 in legal fees and the equity deal cost $10,000, then the convertible note all-in is going to cost the company $12,500. Why not just do it right in the first place and put all that money to work for the company?
Reason 3) 80% of Angel Investors Prefer Equity
If you’re selling something to a customer, wouldn’t you want to sell them what they want and not some more expensive and inferior product? The American Angel Survey shows that investors prefer equity and I suspect that if the remaining 20% of angels read this blog, they’d prefer equity too.
Reason 4) You can lose your company if you default on a convertible note
When you take out the note you’re confident that you’ll have a qualifying follow-on round within 18 months, but many times it takes longer and the note comes due and payable and you’ve already spent the money and can’t raise any more. You’re in default and investors can take your company from you. Most investors don’t want to do that, but why go through the heartburn and stress of facing the potential loss?
Reason 5) Investors have to pay tax on interest they earned but never got
As interest accrues on convertible notes, interest is due. Investors need to pay tax on those notes, even though they didn’t actually get the interest in cash. So, if someone invests $100,000 in an 8% convertible note, they have to pay $2640 in cash to the IRS on that income. Nobody likes paying taxes on money they never got and also, BTW, there is no tax due for equity investments.
Reason 6) You have to come up with a valuation for convertible notes just like equity.
Many people think that using convertible notes lets them “kick the valuation can down the road.” Nothing could be farther from the truth. Every convertible note has a provision called the “valuation cap.” The formula for calculating the valuation cap is as follows:
Valuation Cap = Equity Valuation
This means that when someone invests in a convertible note, they should never have to pay more than what the company is worth today. If the valuation cap were higher than equity valuation, that would mean that note investors would have to pay more than the value of the company. Just because it may convert at a higher valuation some time in the future does not mitigate the risks that the early stage investor has today. In fact, the only way that the higher valuation comes about in the future is that the angel investor puts in the capital early, when risk is highest, so it doesn’t make sense that they should pay more than what the company is worth.
Many companies get confused about this. One company told us that the valuation would be $5 million, but it would be $7 million valuation cap “because it’s going to convert at $12 million some day.” It’s crazy to think that somehow using a convertible note makes a company worth $2 million more than one that uses equity. This kind of thinking makes no sense and hurts the startup community.
Putting valuations on early stage companies is something that is done every day and there’s no magic to it. Seed Funds and Angel Groups have well established valuation methodologies that work well on pre-revenue companies.
Reason 8) Entrepreneurs get diluted with convertible notes
Entrepreneurs should be cautious about the cumulative dilution that paying interest which will be rolled into equity will create. The longer the note goes on, the more startups will be diluted with the interest that they have to pay in the form of equity. It would be better to preserve that equity for future growth. Founders who chose equity over convertible debt don’t have to worry about interest accumulating and diluting their shares.
Reason 9) Equity creates better alignment between investors and founders
When convertible debt is used, there is a misalignment between investors and entrepreneurs. Founders want to use high valuation caps or worse, no valuation caps, and prolong the amount of time before conversion, so that investors get the short end of the stick. Some founders openly state that they want to use convertible debt to preserve their equity. Those are founders that every investor should avoid – not because they want to build a strategy that preserves equity, but that they want to create unfair terms that preserve equity at the expense of investors.
Reason 10) Equity deals have all the terms defined
With a convertible debt deal, the conversion price is negotiated, but all the other terms which are extremely important to the relationship between the founders and investors are left open. This represents a risk to investors and also leaves many matters unsettled. One example is that there are usually terms about board representation which are not found in convertible notes. Investors in early stage companies can offer much more to companies than just a check if they can serve on boards and help move the company along. While there’s nothing to say that companies with convertible notes can’t have boards, in fact many don’t and that’s bad for both investors and entrepreneurs.
With all that being said against convertible notes, they can still be useful for the FFF rounds with friends and family who don’t know how to value a deal and who are investing primarily to support the entrepreneur. Convertible notes can be better than some of the amateurish deals that get put together for early family investors who are often non-accredited that can make follow-on investments difficult or even impossible for the company, thus limiting its chances for success.
It’s a common misconception that angel investing and venture capital is extremely risky.
But when best practices for investing are followed, tax breaks and portfolio returns can consistently outpace even the best mutual funds. If you’re wondering how this can be true – read on!
Angel investing involves capital investments by accredited investors (people with a net worth of $1 million or more excluding the value of their primary residence, or with income of $200,000 or more per year/ $300,000 for a married couple). These investments are in startups, usually with less than $1 million in revenue and less than five years old. These startups have high growth potential and angel investors look to invest in companies that have a believable plan to be able to return 10X their investment or more within five years.
Yes, some of these companies will fail, but let’s compare two investors. The first one, Freddy Frugal, invests all of his money in mutual funds yielding a healthy 8% return. The second one, Andy Angel, invests his money in ten startups. Both investors hold their investments for five years. Let’s look at their returns.
Freddy’s returns are 8%, but he must withdraw $2,640 in the first year, and more each year to pay taxes, so the compounding is based on his after tax returns each year. After Freddy pays his taxes, his actual return is less than 5.93%. Not bad, given the relative lower risk of a mutual fund and the liquidity it provides when funds are needed.
Freddy Frugal – $100,00 at 8% compounding
Returns After Tax
Portfolio Value After Tax
IRR Before Tax
IRR After Tax
Andy’s returns are a bit more complicated.
First of all, because Andy is investing in a Colorado company he is eligible for state investment tax credits of 25%. (many other states have similar credit programs) This means that he gets $25,000 back immediately from the state government, so he actually has only $75,000 of his capital at risk. We’ve shown this below by adding the $25,000 cash returned by the state to the value of his portfolio.
Also, Andy’s returns for his portfolio match the HALO report of thousands of Angel investing deals reported, so in the second, third and fourth years one company totally fails each year, resulting in a complete loss of investment and another is liquidated and returns $.50 on the dollar. This results in a tax loss of $15,000 each year which he can take accelerated write offs against ordinary income thanks to IRS Code Section 1244. This results in a cash benefit to Andy each of these years in the form of reduced taxes which we’ve calculated at $4,500 per year.
In the fifth year, the remaining four companies have exits ranging between four and ten times the initial investment amount, resulting in a $295,000 positive cash flow. Because Andy made equity investments in early stage C-Corporate startups and held the investment for five years, he is entitled to a 100% long term capital gains tax exemption thanks to IRS Code Section 1202, so his tax bill for that year is zero.
Andy Angel – $100,000 in ten startups at $10,000 each
Returns After Tax
Portfolio Value After Tax
IRR Before Tax
IRR After Tax
There is a lot of mythology about how many startups fail on average.
So, how risky was Andy’s Investment?
The statistics about how many startups fail on average can be deceiving. Many of those statistics come from the SBA or local Secretaries of State who report failures of hair salons, restaurants and lawn mowing services along with other companies. But, companies that receive venture capital investment have to reach a higher bar than just registering with the state. They need to have gained significant traction and have gone through a lot of due diligence and had to jump the hurdle of convincing dozens of angel investors to write a check. These companies are far less likely to fail than the general population of company formations. In fact, HALO report data shows that about 52% of these companies will return less than $1.00 for each dollar invested. Of that 52%, about 18% will be complete failures. So, we’ve been a little hard on Andy Angel and had him with three total losses and three returns of less than a dollar. On the upside, we’ve also been a bit conservative. About 5% of venture backed startups will return 30X or greater, and there’s a good distribution of returns between 10X and 4X. These winners more than pay for the losers.
Andy’s key to success was that he diversified his portfolio into ten investments. Smart angel investors know the value of spreading out the risk so that the winners can more than offset the losers.
Another point to observe is that we’ve valued Andy’s portfolio at the value of the investment only until the returns came in. Despite that conservative accounting, he barely dipped below his $100,000 investment amount in year four with a portfolio value of $93,500. This means that if the four remaining companies had returned only 1X, his loss would have been limited to $6,500.
But, his returns were a more typical 3X over the portfolio, resulting in a return of $295,000. We can add in the $25,000 state tax credit and his $13,500 in accelerated write-offs from the $45,000 loss, and his net cash return AFTER TAX is $333,500.
Andy was hardly more at risk than Freddy, and yet the internal rate of return on his investment was more than FIVE TIMES GREATER.
So, who is the smarter investor? Freddy Frugal with a 5.93% after tax return or Andy Angel with his 31.8% return and $333,500 in cash after five years? Angel investors have figured out how the system works and have been profiting handsomely from it for some time. Accredited Investors should consider contacting their local angel group, preferably groups that are members of the Angel Capital Association, like Rockies Venture Club, and consider membership so that they can benefit from great deal flow, a community of smart investors, group negotiation and high quality due diligence.
Life Science Investing is Different than Software Tech Angel/VC Deals.
Companies seeking early stage investment in their biotech, life science, medical device or digital healthcare companies face al
l the hurdles that software tech companies face – and then some more. Many of the hurdles have to do with misconceptions that people have about life science investing, and others have to do with the real differences that exist in this market. Companies raising money in the life sciences have to go through all of the things that tech companies do, plus more, in able to successfully raise funding.
Life Science companies should consider attending the RVC/CBSA BioScience HyperAccelerator to help them through the process. We guarantee participants will be amazed with the quality and usefulness of this unique content that can be found nowhere else!
What BioScience Companies Need to Know
Time-Lines – there are a lot of investors who think that all life science deals take ten years or more because of the huge regulatory hurdles that have to be overcome, and that the capital requirements could be in the hundreds of millions before the company gets to an exit. These investors are missing out on lots of great opportunities. What they don’t realize is that companies rarely move all the way down the regulatory pathway before achieving exits if they’re developing a novel drug, for example. Usually the hurdle is Phase 1 Clinical Trials before a company is acquired, so the pathway can actually be shorter than for some tech investments. Also, many companies are working on repurposing existing drugs for new uses. In this case, all they need to prove is efficacy for the new use which can be a relatively short process. Devices, in contrast to drugs, can achieve FDA approval in just months in some case.
FDA Regulatory Risk – many investors who don’t understand the biotech space have heard horror stories about the capricious, costly and time consuming process of FDA approvals. While these fears are not totally unfounded, most companies pass through the process in a relatively short time and at low cost. We budget about $50,000 and six months for a 510K approval process in some cases. Angel investors have special opportunities to invest in pre-FDA approved companies because valuations typically double or triple after FDA approval, resulting in good returns for investors.
Liquidity Events (Exits) are more obvious for many biotech, medical and life science companies because there is a clear playing field with companies that are regularly acquiring companies as a part of their innovation strategies. There are enough players that companies who are intentional about crafting the best exit can create a situation with multiple bidders to result in the highest exit valuation. Even if the exit pathway seems clear to founders, their presentations should include a clear description of their exit strategy in order to bring the most investors on board.
Intellectual Property is Critical – while most tech and software companies have dropped patent filing altogether, IP is the core to creating value in the life science and medical space. Granted patents are always best, but at least having patents pending with a strong defensive strategy is critical for success. Companies will also need to be able to demonstrate that they’re not infringing on the patents of others. We’ve seen companies who we’ve found to be infringing on patents which made them uninvestable. This is something that companies should research well and be able to demonstrate instead of doing a lot of work, only to have investors find that the project is dead on arrival after several years of effort.
Team Considerations – tech companies often suffer because they have a bunch of coders who’ve been working for years to come up with a product, but they don’t anyone on marketing, finance, or business strategy. Life Sciences can have these problems when they’re staffed with teams of smart PhDs who don’t have the experience or track record to be able to raise funds, transform from a research organization to a marketing organization, or to understand value creation for acquirers. Make sure your company has the appropriate finance and marketing team members on board before raising money.
Market Fluctuations – it seems like biotech is always way up or way down and the current market position may influence investors’ desire to jump on-board with these companies. Founders should be prepared to talk about trends in the industry and why their company will be providing value that either transcends the current market situations, or that the investment cycle is expected to be long enough to stretch beyond any current market challenges.
Marketing Strategies for life science companies are going to be significantly different than for tech or other physical product companies. Some life science companies build an expensive and time consuming strategy that involves hiring and training a sales force who then try to forge relationships with doctors and hospitals in competition with some of the largest and well funded companies in the world. If the company survives that process and gets to an exit, then the first thing that the acquiring company is going to do is to fire all those salespeople and add the company’s product line to their own and get their own sales people up to speed on marketing it. So, life science companies should think about how they add value to their acquirers. Is their value primarily the product itself, the team, the market share, the sales organization, research under way, or something else? Make sure that you’re not pouring resources into something that won’t create value for your acquirers. With that being said, companies will need to establish a market presence in order to validate that the product is of interest to customers and will be a success in the market. This benchmark may be achieved with as few as one thousand sales. These can be achieved through forging partnerships with sales organizations rather than starting from scratch.
Valuation for life science companies seems to have a significant spread which may be caused by inexperience on the founders’ side, or by the uncertainties in the market. Companies that want to raise funds quickly should price their shares competitively with other startups and keep in mind that not every startup ends up with a five hundred million dollar exit.
Life Science founders have a lot of opportunity in front of them if they understand their market and how to take advantage of it. Founders should be prepared to dispel myths and to focus on the clear strategy they have for product development, regulatory strategy, marketing and exit. These will lead to most investor interest and fastest pathway to funding. Life science and medical investments currently comprise about 30% of venture capital investment which shows that investors recognize the opportunities that this space brings. Founders and investors alike should have a clear understanding of the differences between life science and software/technology investments and how to take advantage of them.
All companies raising capital should be well versed not only in the specifics of their industry, but should also prepare solid strategies and complete the following steps before starting their fund-raising activities.
Ten Steps for LifeScience Companies to Prepare for Venture Capital
Exit Strategy Canvas – identify comparable transactions in the market for both dollar amount and multiples of revenue. Identify early, mid and late stage values the company presents to acquirers. Identify who the acquirers are at each stage of the company’s development.
Business Model Canvas – this is the core business strategy document that allows a company to understand their unique value proposition, their customer, the channels used to reach customers, core metrics, partners, and how they spend and make money. This one-pager is key to understanding the key concepts behind any company.
Strategic Plan – Not your grandpa’s strategic plan, but a two-page document that provides a roadmap from where the company is today through its growth. This is the difference between success and failure during Q&A with investors and for the company overall! Research shows that companies with written strategic plans outperform those without plans by 65%.
Go to Market Plan – people take this for granted when they’re heads-down in the science or tech development, but this is the key risk companies face – getting customers to actually buy the product. Without a strong go to market plan, you’re out of luck with investors who are always concerned about this key risk.
Proforma – you need more than a great idea to raise money, you’ll need to model out your use of funds, needs for capital, revenues and expenses. A good detailed proforma that is well researched and validated is a must for planning your business and for determining your capital needs and valuation.
Finance Plan – you need to know how much to raise now (this is harder than you think) as well as your future raises between now an exit. You’ll need to know this to help model your cumulative dilution and to understand what the major milestones are that you’ll need to achieve at each level of funding.
Valuation – let’s make this simple. You can’t raise money without knowing your valuation, regardless of whether you’re using equity or convertible debt. Go through five valuation models and play them off of eachother to have a defensible position when it comes time for negotiation.
Term Sheet – this is the key document used in negotiating the deal. Make sure that you’ve got a term sheet in your pocket before you meet with investors so you have a solid understanding of the key terms and how they’re used in venture deals.
Executive Summary – When investors ask for information, they’ll want a two-page executive summary and pitch deck. The executive summary has all the core elements of your company in a concise format that investors can use to determine their interest in moving forward.
Pitch Deck – when you get in front of investors you’ll need a pitch deck to present your information. Get this done professionally so that you can communicate effectively in a highly competitive capital market.
Life science companies can get templates, education and mentor assistance in creating all of these in a two-day BioScience HyperAccelerator hosted by Rockies Venture Club and the Colorado BioScience Association. The two day workshop is $995.00 per company and includes a one-year membership in the Rockies Venture Club for the primary participant and a free subscription to the IdeaJam platform to help companies securely get feedback and input on their Provisional Patent Application. Companies using the IdeaJam platform can file patent applications in a fraction of the time and cost of using patent attorneys.