Startups And Investors: Which Comes First?
Friday, March 8, 2019
Posted by: Gregory Glass, Editor, Asia IP
Raising money goes hand-in-hand with a startup company, right?
Entrepreneurs and investors alike in a Spotlight Plenary say that might not always be the best choice.
Which comes first, the business or the fundraising?
If you—or your clients—are like many entrepreneurs, you may be putting the chicken before the egg, according to a panel of entrepreneurs and investors speaking at the 2018 LES Annual Meeting in Boston.
"The premise for this is that most of you are not involved in fundraising either on the investor side, nor are you involved on the company side, but that almost all of you have friends or colleagues that are," said David Powsner, a partner and patent lawyer in the IP and emerging companies practice at Nutter McClennen & Fish in Boston, who moderated the session. "When this is over, I'm hoping that when you all are confronted by your colleagues [who say] 'hey, I'm thinking of starting a business, I'm going to raise some money first,' that you'll have a better sense of whether that is the right order. Maybe you should be starting the business first and raising money second."
Powsner set the session up as a discussion between two entrepreneurs and two investors. Although most of the four panelists had spent time on both sides of the entrepreneur-investor equation, each would answer his questions from his assigned perspective. Powsner's first question—why raise money?—required some basic background from the entrepreneurs on the panel.
Boston-based entrepreneur and investor Sanay Manandhar, who set up the first ISP in Nepal in the late 1990s, is more recently known for founding software IoT company Aerva, a horizontal play in software which allows users to manage digital content on any screen in the world using a browser.
The margins the business earned, and the fact that it required very little capital to get off the ground, put Manandhar in an uncommon position when it comes to startups: Aerva was generating cash from the beginning.
"My view is to think of capital as fuel, and to think of the company building a really fancy red car that goes fast, and think of the market as the highway." said Manandhar.
But from the year 2000 through the great recession of 2008, it was a very rocky road, he said. "If you have a rocky road in front of you, no matter how much gas—capital—you put in your car, it doesn't really go very fast. Raising capital is almost always about speed."
But while raising capital in the tech world may be about speed, sometimes it's more about getting off the ground, said Edward Ahn, chief technology and strategy officer at Anika Therapeutics, a Boston-based medical technology company that focuses on pain management, tissue regeneration and wound healing.
"My experience is completely opposite to Sanjay's. In the world of med tech, health care and biotech, you can't go fast. We need capital to get started," Ahn said.
"The fundamental issue we deal with is that the time from idea to commercialization can be anywhere from three years to 12 years, so investors have to wait a long time to see real commercialization. A lot of things that we're talking about, at least early on, is speculation, so when we look at capital, capital is not about fuel, it's about decreasing risk so I can actually get more money to go to the next stage."
Ahn explained that in the med tech business, capital raising is all about meeting milestones. At a particular valuation and level of risk, the company can only raise so much money to get to the next milestone, which must in turn be sufficient to get to the next point.
Ahn used a baseball analogy to describe what he is up against as a med tech fundraiser: "For us, from the entrepreneur to the investor perspective, we always have to go for home runs. There are no singles or doubles or triples. If we're going to raise money, we have to do something that will be really, really valued by society, and to do something society will pay for."
Angels and VCs
Much of the morning's discussion focused on the differences between venture capitalists and angel investors, and what each category of investor is looking for. VCs and angels are largely differentiated by the source of the money they intend to invest, with VCs generally using money pooled from investment companies, large corporations and pension funds, but generally not any of their own funds. Angels, on the other hand, use their own money to invest in businesses. In the U.S., angels are accredited investors who must have a minimum net worth of $1 million and an annual income of at least $200,000. Many angel investors are friends and family of small business owners, and came to invest in the companies through that relationship.
Further, the often pre-existing relationships between angel investors and their investments mean that angels tend to invest early on in the life cycle of a business, even to get the business off the ground. Angels often choose businesses they are personally interested in, and usually take more risks than venture capitalists. VCs, on the other hand, seek established businesses, which will reduce the risk of their investment.
Angels usually invest much smaller amounts of money than VCs. The U.S. Small Business Administration says that the average VC deal is worth $11.7 million, while the average angel investment is $330,000, though a typical angel investment could be for as little as $10,000.
Wan Li Zhu, an early stage venture capitalist and partner at Fairhaven Capital in Boston, said that the difference between the two was largely a question of scale. "There has been so much capital come into the venture asset class in the past few years, venture capital funds in the range of $200 to $400 million are considered small these days. There are some West Coast funds that are north of $1 billion. And to move the needle on a fund like that, you've got to return $50 to $100 million to the fund, and the fund's ownership at those deals at exit is 10 to 20 percent. So now you do the math on that, and you're looking for companies that can potentially generate exit values north of $200 to $500 million."
Ziad Moukheiber, an entrepreneur who runs the angel investment group Boston Harbor Angels and serves as the managing partner of the EQX Fund, an evergreen angel investment fund, said that overall, the total investments of angels and VCs are both in the range of $23 billion a year, but that there are far fewer venture capitalists than there are angels, which explains the smaller average investment of angel investors.
Beware of Competing Interests
The entrepreneurs and investors on the panel both said that entrepreneurs need to be vigilant in protecting their interests.
"What I would say to the entrepreneurs is while the investors may come telling you your interests are aligned, please be forewarned that your interests are so misaligned it's not even funny," said Manandhar. "Investors only care about the three-letter acronym called IRR, internal rate of return. You care about bringing an idea to market, dominating the world, making life better, but because the interests are misaligned, you, as an entrepreneur need to start thinking about what gets the investors going. And what gets them going is the IRR."
Entrepreneurs will know in advance—if they read the shareholder agreement and term sheet, at least—that venture capitalist investors are going to get a liquidation preference and have a pretty good idea what kind of muscle the VCs can exert on the board.
"[They may say] they're nice guys who wouldn't do something like that, but it's all there. A lot of entrepreneurs are really naïve that it's not going to happen, but it happened to me," he said.
What it comes down to for entrepreneurs is a balancing act of which difficulty the entrepreneur wants to live with. "There's a difficulty with getting a high valuation in return, and there's a difficulty with all these shareholder rights. You have to pick your poison and be realistic about what you think your return will actually be and optimize toward that. When you get really greedy, bad things happen."
Speaking as an investor, Zhu advised entrepreneurs to do their due diligence on investors. "Investors do a lot of due diligence on your company and the business model. You should do your due diligence on the investor.
What Investors Want
Powsner next posed the question of what investors want—besides return on investment and some ownership percentage.
"We're early so we look at the entrepreneur," said Moukheiber. "Who is that person? That's number one. Number two is the traction. What have they done? I believe a company can do a lot with very little money, so what have you done up to now? And then, we look at where you're going, and that's the whole discussion of multiples and valuation."
The discussion eventually came around to the project's underlying intellectual property, particularly the patents the entrepreneurs hold. It quickly became evident that the importance of the quality of the intellectual property differs greatly depending upon the project is.
Zhu said that he cannot think of a tech investment he's been involved in where the investment group didn't invest because the IP wasn't strong enough. "In some sectors, it's more important, like artificial intelligence or autonomous driving, or if there's a hardware component, but broadly speaking, the IP is much less in important in tech than in, say, life sciences," he said.
"Most CEOs are not able to scale effectively," he said. "Hopefully the founding CEO will understand that at some point they may take a different role in the company, but we typically try to keep the team together, to keep that founder spirit that exists. The advocate, the evangelist is very important to the company."
"I always tell entrepreneurs to be cognizant about what raising outside capital means," he said. "I see a lot of entrepreneurs celebrating and throwing a party and getting the champagne out when they raise capital, but that is not success. That is the start of a very long process that hopefully will end in success. Raising your round is not success."
Money In The Middle
Following on a session about raising capital at the LESI Annual Meeting in San Diego, entrepreneurs and investors met in Boston at the 2018 LES Annual Meeting to discuss venture capitalists and angel investors from the "East Coast perspective." Although much of the session revolved around more general concepts for entrepreneurs and investors, it did include a brief look at how the investment system works differently between the U.S. East Coast and the U.S. West Coast–and how it might just be better to look between the coasts.
"West Coast valuations are absolutely crazy," said Ziad Moukheiber, an entrepreneur who runs the angel investment group Boston Harbor Angels and serves as the managing partner of the EQX Fund, an evergreen angel investment fund. "On the East Coast, they're up there, too. But there's amazing value in the middle, and that is where I personally spend a lot of time looking for deals."
Moukheiber described to the audience how he recently had a good exit in Ann Arbor, Michigan, in the upper midwest; and how he is currently looking at a company in Oklahoma and another one where the scientist is based in San Antonio, Texas; and how he is also looking at an opportunity in Calgary, Canada.
"In the middle, they come to us with weird concepts like, they already have revenue," he joked. "Companies on the coasts come and want millions. They do have an idea, but they don't have revenue. Some of the companies in the middle of the country are more realistic, the entrepreneurs are more humble and they're fantastic to work with because they are starting businesses, rather than raising money as a startup. They have solid businesses that can survive a recession. They're not chasing fundraising."