Monday, November 29, 1999

Where angels need to tread

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Innovation is a critical ingredient that enthuses dynamism in economies and helps improve the quality of people's life. However, innovation only thrives in the presence of a vibrant, entrepreneurial and venture capital eco system. There is a symbiotic relationship between—the availability of good advice or mentoring and risk capital; and the number of bright individuals willing to go out and take the risk of being an entrepreneur on the back of an innovative idea, be it a product or service.In the life cycle of an enterprise, the entrepreneur first needs advice, mentoring and a small amount of capital from 'angel investors', who have "been there, done that" and are willing to take the highest risk. Once there are some runs on the board, comes venture capital which brings in larger amounts of money and takes a slightly lower risk. This is followed by growth capital and private equity, which brings in much larger amounts of capital and takes an even lower risk.Of all these, angel investment is the least understood and so I thought I would dwell on that today. Business angels play the most crucial role in the creation of a new enterprise. An angel is typically a first generation entrepreneur who has completed one or more cycles of wealth creation through starting and exiting ventures and is now ready to move from being a 'captain' to a 'coach'. In effect, he/she finds excitement in looking at a plethora of new ideas and backing promising entrepreneurs with money, time, mentoring and access to his /her networks. And this is precisely what the doctor orders for a start up.Friends and family provide support and some money but do not know enough about the founder's idea/domain to evaluate or critique the plan and, unless they have been entrepreneurs themselves, their ability to provide sage advice based on experience is limited. This is where business angels come in to help and guide the venture and take it to a stage where it can attract venture capital /private equity players or access capital markets.So what do angels look for when they decide to invest in a venture?Size and growth of the market: They want to ensure that the market for the proposed product or service is large and is growing at an attractive rate. This is because in such a situation, the venture has the potential to grow to a significant size and value, thus maximising returns. Also, a large market allows more than one competitor to survive and prosper and so even if the investee company does not execute brilliantly, it may still do well enough to give a decent return.Proposition: A key thing that angels want to assess is clarity in the minds of the entrepreneurs regarding the product or service they are planning to offer. How clear is the definition of the offering? Are they clear on precisely who or what is their target market? What pain point is this offering planning to address? Is it something that is a "must have" or just, "nice to have"? How are the founders positioned to create this offering? Have they tested the concept/product with some kind of engagement with the market?Competition: Angels want to understand whether the founders are sufficiently aware of their competitors, how strong is the competition and whether the proposed offering is sufficiently differentiated to be able to succeed. Is it doing something 'different' or 'differently'?Founding team: While satisfactory answers to all the above questions are necessary for an angel to consider investing, they are not sufficient. This is because angels do not manage a company but invest in a team that can do so and deliver. Angels would prefer to invest in an 'A class team' with even a 'B class idea' rather than in a 'B class team' with an 'A class idea'. This is because an A class team will modify its plan in response to the market and find a way to succeed whereas a B class team will make a hash of even the best plan.The attributes that angels are looking for in a founding team are: Past experience and its relevance to this venture; integrity (this is paramount and make or break); coachability (are the entrepreneurs open to heeding sage advice?); the founding team should collectively have the major competencies required for the success of an enterprise viz sales/marketing, technology, delivery, finance etc. The CEO need not be good at everything but the founder/founders should be smart enough to understand the need to expand the founding team to cover all these competencies.Angels do understand that if the venture is at an early stage, the financials are more a spread sheet exercise than reflective of hard reality.Nevertheless, the way that financials are put together and presented indicate to the angel—the quality and rigour of the thought process of the entrepreneur and the level of understanding of issues such as operating expenses, cash flows, P&L etc.Clearly angels expect to invest at a valuation that they believe will allow them to make a decent return when they exit and so if the entrepreneur is fixated on a higher valuation than they believe would accomplish this, they will usually not invest.And finally, exit. Angels will only invest if they believe that there will be a way for them to exit that investment. Without that, any return remains notional in nature. The entrepreneur must therefore convince them that he/she is committed to helping them exit by taking the company public or positioning it to be acquired or, as a last resort, even offering to buy out the angels.Once you understand what angels are looking for and what they can bring to the table, it becomes easier to establish a good partnership. And, if you have the right angels on board, they will provide invaluable guidance and attract the attention of VCs who see the presence of good angels as a vote of confidence in the business. Then, you are on your way.The writer is chairman CA and co-founder of The Indian Angel Network

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