The Red Herring published an interesting summary of two research reports that looked at US Angel investing trends in the first half of 2007. Although the figures don’t relate to Canada the overall trends are just as relevant.

Overall, angel investing totaled $11.9 billion in the first six months (of 2007), a 6 percent decline versus the year-ago period, according to a study by the Center for Venture Research at the University of New Hampshire.

A 6% drop perhaps, but that’s still a massive amount of risk capital – and 42% of this went into seed / early stage company’s. The average investment size was $US 211,000. This amount is in the ball-park of what we would define as a “seed stage” investment (ie not $1-2,000,000).

“More investors are seeing there are advantages to being part of groups,” said Marianne Hudson, executive director of the Angel Capital Association. “There are advantages in being able to pool your resources, see better deals while remaining anonymous yourself and learning the investment process from others.”

Angel Groups are a great place to learn how to make venture capital investments – local initiatives such as Les Anges Quebec, Angelus, NAOQ and Montreal Angels should be encouraged and supported. Angel investing can be very profitable but Angel’s need to understand how to structure deals and protect their investments from future dilution.

More than 54 percent (of Angels) complained that their equity positions were diluted through recapitalization and more than 20 percent charged later investors with changing investment terms to gain better returns.

M&A’s provide the most likely exit routes and as such Angels should be looking at investing in businesses areas where M&A activity is traditionally high.

The Center for Venture Research reported that 61 percent of investment exits by angels were through acquisition by another firm, 33 percent through bankruptcy and 6 percent through an initial public offering.

So, consider this – as an entrepreneur, who has accepted external money, your responsibility is to provide a good return to your investors – likewise, your VC investor has accepted “external” money and the VC has the responsibility to provide a good return to it’s investors.

With this simplistic view it would appear that, as long as the business is moving in the right direction, everyone’s interests are aligned and everyone will benefit from it’s success.

So why then do conflicts still arise even when things are going well?

The majority of conflicts arise from three main areas – personalities, perceptions of success and timing.

Personalities

Personality conflicts can occur in all walks of life and require patience and maturity to overcome. These conflicts and their resolution are however a major drain on the business and as such my advice is that you endeavour to ensure that as an entrepreneur you choose a VC who you like and/or respect.

Perceptions of Success

A VC has fundementally the same business pressures as an entrepreneur – in generating an income a VC will inccur costs. These cost include salaries, office expenses, travel, general overheads and – very importantly – the cost of money. A $20 M Fund may well go through $500K a year in expenses and will be “loosing” value on the uninvested money it has drawn down from it’s investors. Thus a Fund might need to be making in excess of 7% per annum just to tread water. And of course, not every company a VC Fund invests in will succeed!

What does this mean for an entrepreneur? It means that a VC Fund expects a very high return on it’s money and each entrepreneur in whom the Fund invests will be expected to be successful enough not only for themselves, but also for all the other failed investments and operating costs incurred in making all the Funds investments.

For this reason an entrepreneur may feel that a VC is never satisified, however it is important to understand that a good business in an investment portfolio is sometimes used like a star quarterback that has to make up for a week defensive line.

Timing

The VC has an objective – to provide the best possible return on investment for it’s Limited Partners (investors) in a given period of time. A VC fund will typically have a life of 7-10 years and needs to plan on liquidating the Fund’s portfolio of investments within this time frame.

Should the VC make it’s investment later in the life-cycle of the Fund they will be more inclined to sell out of the company early, which may not suit the Founders of the company – or even other shareholders – but they have the expectations of the Fund’s investors to meet. The contrary situation may occur when the Founders believe that they have been presented with a good offer for the company but the VC believes that a better exit will be offered sometime later (this may often be related to the “perception of success” issue raised above).

Having read over this post before publishing, I realised that it might sound like I was trying to justify some of the attitudes and actions that VC’s might take (and the same might be said for the first post on this subject). That however is not the intent. The intent is to present to entrepreneurs some background to the VC’s motivations and in doing so provide the entrepreneur with insights that might allow them to choose their investors wisely and avoid conflicts with these investors once you become partners. I hope it helps!

As we speak to first time entrepreneurs a common theme that comes through is that VC’s are not to be trusted. Most people have a horror story that has been handed down to them about the VC who …. (fill in your own story).

I have my own hard luck story – in 1999 I was part of a small team that raised $US30 M for an internet start-up. Following disagreements over “strategy and personnel” I found myself on the outside of “the circle of trust” (as in “Meet the Fockers”) and so decided that I would rather leave than follow what I believed was a half-baked plan being driven by a bunch of inexperienced MBA up-starts (I still sound bitter – but i’m honestly not – I let it go after I was given the opportunity to buy the company back for $US1.3M after they had invested over $70M !).

It was this experience that actually caused me to establish my own investment business as a way of trying to bridge the gap between VC’s and entrepreneurs.

So does that mean I’m now on the “dark-side”?

I hope not – but what I hope it means is that I can now reflect on the motivations of VC’s and entrepreneurs with mutual degrees of empathy.

So here is my double take on how the VC/entrepreneur dance goes:

VC’s view

You came to me with a vision and a requirement for some money to help you realize that vision. I gave you feedback and input that helped you to refine the vision and then gave you the money you said you needed to execute that vision – and …

a) … you delivered ! Please let me fund your next vision!

or

b) … you didn’t deliver on your plan ! Now I have to do whatever I think is right to try and save this company and along with that, restore my reputation with the people who trusted in my ability to pick good ideas and good people in which to invest. There is the door and have a good life.

Entrepreneur’s view

I came to you with a vision and a requirement for some money to help me realize that vision. You gave me feedback and imposed conditions that caused me to refine my original vision and then you gave me the money you said I needed to execute our new vision – and …

a) … I still made you rich ! I’ll let you fund my next vision – but on better terms for me !

or

b) … things have not worked out as planned but remember that I had to change my original vision, which would probably have worked, to implement things based on what you told me was best – we were wrong and now that I have worked out a new vision, that i’m sure is going to be successful, you are going to get all the upside and I, who has worked so hard for so long, will be left with very little for my efforts! No thanks, i’m leaving .. have a good life – not! (phew says the VC – I thought we were going to have to fire him/her).

Now these might sound like extreme scenarios and in reality the situation might fall somewhere along the continuum between these outcomes, but these scenarios can be used to highlight a key principle that all entrepreneurs should remember when dealing with VC’s:

It doesn’t matter how much input a VC has in the development of a business plan or it’s implementation strategy, the business plan always belongs to the entrepreneur ! Even if an entrepreneur accepts the input of the VC and changes the business plan accordingly, it never becomes a shared plan with shared responsibility for failure. Why ? Because you’re the CEO !

Perhaps you don’t completely agree with the plan but feel obliged to execute it? Then you have three choices -

If you ever get to the stage where you feel you are implementing someone else’s plan (ie the VC’s) – watch out ! This means that you are probably not the right person to be running the company and something’s going to change pretty soon.

What does all this mean when you are negotiating with a VC ? Don’t over-promise anything and be conservative in your predictions – even if it effects your company’s valuation – because once you take someone’s money your credibility as a business person is on the line. Losing that credibility is akin to losing your right to lead the company.