Seven Investors To Avoid
Martin Zwilling, 12.08.09, 5:04 PM ET

In a tough economy, all capital is created equal, right?

Wrong. Even in a credit-starved environment like this one, the source of your money matters. A lot.

When it comes to courting angel investors–well-heeled individuals looking to put some of their stash in promising young companies that could yield juicy returns–entrepreneurs should take great care. Some angels can be a mild nuisance, others downright conniving and unscrupulous.

Here are seven types of fallen angels to avoid.

Suit Slingers. These nettlesome types look for any excuse to take you to court. Rather than try to help your company grow, instead they try to make money through intimidation, threats and lawsuits. They know you don’t the resources to fight them and most likely will cave to their demands.

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Smart Guys. Successful business people who become angels often have a prodigious sense of superiority. They tend to be overbearing, negative people hypercritical of every decision you make. Their money may spend, but don’t let them intimidate you into bad decisions.

Control Freaks. This kind of angel starts out looking like your new best friend. Don’t be fooled. As soon as you hit a pothole, he’ll trigger a “gotcha” clause in your agreement that gives him more ownership and operational control of your company. Only your Board can save you here.

Hand Holders. The tutorial investor is not after control, but he wants to guide you on every niggling issue. What feels like benevolent mentoring before he writes the check becomes a painful nuisance soon after. Unless you have an overabundance of time and patience, keep your distance.

Has-Beens. These angels take to wing with every perturbation in the economy. Typical profile: former high-fliers with a liquidity problem. They are still at the country club every day, but now are running up a tab. They will meet with you, ask a thousand questions, but never get around to closing a deal.

Numb Skulls. Wealth is not synonymous with business savvy. You can spot a dumb angel by listening to the questions they ask. The more superficial the questions, the less value (and more potential harm) they will bring to your organization. (That goes for financial journalists too.) One caveat: Numb-skull angels may have important and much smarter friends, so don’t disregard them entirely.

Brokers In Drag. Deal brokers posing as angels (they may be lawyers or accountants by trade) have little intent to invest in your company. Their goal: to get you to pay them to introduce you to actual investors. Brokers may be worth their fees, but don’t mistake them for angels.

General rule of thumb for avoiding fallen angels: Eschew investments from private individuals and focus on credible, professional angel-investing organizations. Even then, do your own due diligence: Ask what other companies they’ve invested in and talk to the chief executives of those outfits to get their feedback. Finally, make sure your lawyer–not the investor–writes the initial investment document or term sheet. This should be a standard document and not negotiated on a one-on-one basis. Beware requests for last-minute clauses that could come back to haunt you.

Yes, money’s tight. But choosing the wrong angel could put you on the flight path to perdition.

Martin Zwilling is the founder and chief executive officer of Startup Professionals, a company that provides products and services to start-up founders and small business owners. Check out his daily blog at http://blog.startupprofessionals.com or contact him directly at marty@startupprofessionals.com.

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By Matt Marshall for Venture Beat

Chris Shipley and I hosted a breakfast last week with 16 leading Silicon Valley investors about the state of the start-up community.

It was frank and engaging.

Some participants requested their comments remain off the record. Below are summaries of some of the remarks of participants who agreed to be referenced.

Here are the two main trends I picked up from the conversation:

1) The art of VC dealmaking is changing — Investors are no longer just investing in the two guys just of out Stanford with a new idea. They’re doing things like joining with boutique investment banks to craft new sorts of financings, or hooking up with entrepreneurs to buy portions of companies and spinning them out. (Examples: Real estate company HomeAway raised $250 million to conduct a rollup strategy. Another group of investors bought StumbleUpon, spinning it out from eBay a year and a half after eBay bought it.)

2) VCs are in serious danger of strangling companies by depriving them of cash in their early years — There was significant disagreement between investors about how much companies should be allowed to go into the red while building their businesses. Some investors said they prefer to invest in businesses that can be profitable quickly. Others feel this is short-sighted, and runs the risk of forcing them away from building bold new platforms. Companies with big ideas (Facebook, for example) should focus on growing those ideas and not worry about being profitable from day one or two. See bold below for highlights on this theme.

The breakfast was part of our preparation for the DEMO conference in September. Chris and I are looking for the very best companies to launch on a stage before the world. Here are some notes I took from some of the participants (not direct quotes).

Asheem Chandna of Greylock — He agrees that the nature of deals is changing. His firm bought public stock in a company (Aruba networks) for the first time ever. Public tech companies are cheap. His firm also has a couple of companies with large revenue increases in the first quarter, suggesting there’s opportunity even in the downturn. The online security sector, for example, is robust because of the continuous rise of new threats. Virtualization remains a key macro trend.

Rob Theis of Scale Venture Partners — Contrary to what we’ve seen in past downturns, there’s still a robust angel investor network willing to invest. However, these angels have gotten smarter. They’re getting close to actually resembling VCs in that they’re actually raising small funds. As for trends, there’s an increased awareness among the younger population for new technology. Kids are carrying RIM BlackBerrys very early, and they’re learning about computing much earlier, skipping the whole desktop learning process of the previous generation. He agreed with others about the trend towards new types of deals, including more spinouts, as companies focus on core competencies (Symantec focusing purely on security, for example). He’s concerned about clean-tech, because companies in the energy sector generally have higher capital investment requirements. A lot just won’t make it.

John Lee of Silicon Valley Bank — Big questions also surround the hardware sector, which requires large capital expenditures. Prospects of raising capital are not very good right now. Semiconductor companies, in particular, are facing a challenge. Later stage companies are increasingly seeking to work with groups like Inside Ventures (which is a new company trying to hook up mature private companies with institutional investors for investment in those companies while they’re still private, even though institutional investors have typically preferred to wait to invest in public companies).

David Chao of Doll Capital Management — A lot of what we’re seeing now is deja-vu from 2001, 2002 and 2003. The difference is that the value chain of capital has been restricted, which is making investors more panicky. The problems we’re having are caused by the subprime crisis, not tech. If you look around the corner, there are some interesting shifts going on, and he’s optimistic. One is that kids these days are playing on Facebook, and Facebook apps. They’re doing it on MySpace. These companies have become open platforms and are thriving. His guess is that Apple is going to fall flat on its face again for being too closed. Another trend: a lot of cleantech companies are going to die. However, in Europe and Japan, anything green sells. Finally, the globalization of technology is exciting.

Phil Sanderson of IDG Ventures — He’s going to do deals locally (responding to some VCs who said they were increasingly investing globally). He said there’s a migration of Silicon Valley companies to San Francisco over time. The original chip and computer wave decades ago saw most companies located in San Jose or Cupertino. Then the software boom was headquartered in Mountain View and Palo Alto. Now new media companies are locating in San Francisco. More than half the returns from his last fund were from companies within San Francisco, even though fewer than half of the companies he backed are actually located there. You’re seeing other SF firms emerge, such as Alsop-Louie and True Ventures. The amount of money a company needs to raise before getting to liquidity is about $10M, compared to $50 million during the bubble era a decade ago, and $20M before the bubble. The reduced costs today stem from things like open source, viral marketing, cheaper Web infrastructure. He gets scared if an early stage companies needs to raise more than $10M and agrees with others that new dealmaking is on the rise. More public companies should consider doing PIPEs (private investments in public entities).

Sergio Monsalve of Norwest Venture Partners — The venture industry, like its other financial industry brethren (hedge funds, ibanks, etc) are woven into the global economy. His view is that the VC industry will have be more globalized than today and will include more action in Asia. It will resemble later-stage investing. His firm has made as many early as late stage deals in the last six months. He hasn’t seen a tectonic shift in the industry that resembles the client-server or web movements that happened in previous decades. He doesn’t see the same sort of multiple returns on investments. He sees mobility and telepresence as interesting areas (his firm invested in LifeSize for conferencing, seeing it as a way to help people needing to travel).

Jeff Clavier, angel investor — He says things have changed significantly over the last last year in angel investing. Beginning in 2004 with the emergence of cheaper Web 2.0 technologies, angels backed a company with an initial check of $20,000 to $100,000 each, for a total angel round of about $250,000. It would then take another $500,000 or $1 million to get to market. Now that capital is scarce, he’s backing companies with slightly more money — $750,000 to $1.5 million –because they need to be able to get enough traction to be either attractive to venture capitalists or already profitable. Also, while before, a company needed about 500,000 users to prove it had traction, it now needs to have 1 million. So he’s funding a company to last it 24 months, enough for about 18 months of execution and then six months to look for capital. This is what keeps him awake at night: Are the new realities forcing him to build a company so cheaply that the company isn’t being given a chance to build a real business? By focusing on getting a company to profitability too early, investors may be stunting their ability to build real platforms. Prices are down 50 percent. A company raising a first round a year ago at a $4M pre, would today raise at a $2M pre. (He’s got a $15 million fund, raised in mid 2007. He’s done 37 deals from that fund so far, and his goal is to have done 50 total by next year. He’s done five deals this year.)

Reid Hoffman, angel investor, Chairman of LinkedIn — Typically, angel investors have used their “house money” to make investments. When the market dries up, they stop investing. Many have been uncertain about how to move to become more of a VC (by raising a fund that is not based on house money). The good news is that many angels are now making that transition.  He started LinkedIn in 2002 because he thought social networking was going to change the way people do business. Now, in addition to that, there’s been a knock-off effect: People are using tools in the cloud, applying more data and analytics to their businesses, making them more efficient. With the emergence of Facebook’s platform, he decided to invest in social games. He backed Zynga. Much of the transformation in this area is still being played out.

Gus Tai of Trinity Ventures — One big problem has been the over-capitalization of the VC sector. He points to respected venture firm Sequoia Capital as an example of how firms have become larger. Its fund in 1990 was merely $31M. By 2000, during the bubble, it became $1 billion. Now, in 2009, it’s $450 million — down from the excess of the bubble, but still significantly higher than the early years. The shakeout will continue. A few years ago, Harvard professor Josh Lerner chose 40 VCs firms to put in a database he used to analyze the VC sector. However, of those 40 firms, 10 are no longer in business and five have changed their business model. Tai says he thinks another 15 will disappear over the next three years. That means entrepreneurs may be wasting more time raising money, because VC firms will be less decisive as they change their model, or back off from investing.

Josh Hannah of Matrix Partners — He’s brand new to investing, having only recently joined the firm. He says he’s been talking with his new colleagues in the industry and finds that they are enamored with investing in capital efficient businesses. He said entrepreneurs are thus trying to be more capital efficient in order to get that funding. However, he suggested they may be putting the cart before horse. He said that successful entrepreneurs have always sought to be capital efficient. He spent $100,000 at eHow, and returned capital to investors within 1.5 months. Survey Monkey was boostrapped: Nine guys built a business that had $40M in revenue and $30M Ebita and took it to an investor who paid a nine-figure valuation to invest.

David Hornick of August Capital — He vehemently disagreed with Hannah, saying he doesn’t think there are a lot of interesting companies in that category. Maybe three? When companies get interesting, they often require an enormous amount of capital. He did say the model of VC investing has to change. He agreed with Clavier that the “just-in-time” VC backing of companies that had previously been supported by angels has disappeared. He fears that the 18 to 24 month “runway” set up by Clavier and other angels for a company to find backing from VCs may really be a proxy for “forever.” In other words, startups are being forced to recognize they won’t get funding and are curtailing their ambitions. Fewer real businesses get built. When you focus on getting cash-flow positive on $100,000, you’re under-optimizing.

Justin Fishner-Wolfson of The Founders Fund — Uncertainty has clouded the fortunes of every player in the cycle. If a venture firm doesn’t know where its money is going to come from, even if it’s a good venture firm, then the angel is going to feel the same uncertainly, and then the entrepreneurs are too. He’s worried that many entrepreneurs are getting sidetracked by going after dollars from the U.S. stimulus package in areas such as cleantech, healthcare or genomics, for example, creating businesses where they get tax rebates if people buy more of their service. Washington’s spending may be creating a massive dislocation. He also says the tools for building a company have never been easier to get. Before, you needed to rely on an IT guy. Now you can just call on services provided by companies like Amazon, and you don’t have to do any work.

Michael Goldberg of Mohr Davidow Ventures — He’s investing in healthcare companies. He’s looking for capital efficient companies that have no risk from FDA regulation, especially those using measurement, computation, information technology and material science in new ways. He’s looking at personalized medicine. He’s looking at companies building wearable devices, such as those that use wireless and bluetooth technology to message vital sign information straight to the cloud.

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By A VC

We did a call today with our investors and one of the questions was about how the macroeconomic environment is impacting our portfolio companies. We explained that for most of our companies, there has not been much of an impact, but we are seeing several companies bring down aggressive numbers for 2009 to more realistic growth projections. It got me thinking about how those changes are communicated from the CEO to the board and investors.

Our portfolio companies experience both positive and negative changes to expectations on a regular basis. There’s not a lot of art in communicating positive changes to expectations. Everyone loves good news and most people are happy to share it the first chance they get.

But there is an art to communicating negative news. Investors and board members can be spooked by negative changes to expectations if they are not handled correctly.

My first piece of advice is to share the news as soon as you have it. There is never a good reason to have information about your business that your board and major investors would want to know and not share it. You could argue that it’s time consuming to communicate with investors and that it’s more efficient to wait for the regular board meetings to do that. But whatever you gain in efficiency with that approach, you lose in trust and confidence building with an important group of stakeholders in the business. It’s not worth it. There are efficient ways to communicate with the board and major investors. A quick email will normally do the trick.

My second piece of advice is to communicate frequently enough that you can gradually lower expectations. Let’s say that you are now three and half months into the year and you now know that you aren’t going to make your plan for 2009. Well that’s not going to be a huge surprise to anyone given that we are in a very difficult economic environment. But if you ended the March board meeting on a high note and you start the April board meeting with “we have to take down our numbers”, then you are giving your investors the feeling of being on a roller coaster and that’s not what investors want to feel.

The better approach in this situation is to say in the February board meeting something like “it’s too early to know how things are going in the first quarter but given the economy, we are on full alert for any negative surprises.” Then in the March board meeting say something like “we are starting to see signals that we may not be able to grow as much as we’d like this year, we’ll have a recommendation in the April board meeting”. Then when you show up with the recommendation in April to take down the numbers, everyone will be expecting it.

My third and final suggestion is when you make a substantial change to expectations, make sure to get that change right. There’s nothing that is more of a confidence killer than “death by a thousand cuts.” There are some companies where you don’t have much visibility. I don’t like investing in those kinds of companies and I imagine that most CEOs don’t like running them. The truth is most companies have a decent degree of visibility and by the time you are into the second quarter of a year, you should be able to figure out where the year is headed. So if you choose to take down your numbers between now and June, take them down to where you know you can meet them. To do otherwise is just asking for problems.

Most of this is common sense actually. The hardest part for many CEOs is executing on it. Managing a board and investor group doesn’t add value to the business on a daily basis. It doesn’t make the product better. It doesn’t generate more revenues. It doesn’t recruit an amazing team. And so on and so forth. So many CEOs blow this off in favor of the things that do move the business forward. A good board will remind the CEO that he or she has to do these things and why.

One final thought. Taking down numbers this year is not likely to get many people fired. It’s expected at some level. But mismanaging the process might. In a tough year, set reasonable expectations from the start, do your best to meet them, and be proactive in managing and changing expectations and you’ll be better off and so will your team and your company.

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