When Angel Capital Is Not So Angelic

Skimming the recent spate of somewhat rosy articles touting the resurgence and benefits of angel investing, I was persuaded to dig through some of my older posts to examine whether my somewhat caveat emptor position on raising angel capital had been swayed. With a few exceptions, it hadn’t.

This is not to say that I am a critic of the practice of start-up teams chasing investment dollars from individuals. Capital coming from private individuals is still how many, if not most, start-ups initially get off the ground. Additionally, in a challenging funding environment like the one we currently inhabit, finding individuals ready and able to “top off” institutional investment rounds is often a key element in getting those rounds closed at all. Indeed, one of my more popular posts over the last couple years, The Rise of the Pledge Fund, focused upon the emergence of “fundless” or non-committed funds that were targeting seed stage deals and offering individual angels the administrative, post-investment supervisory and deal flow benefits of a traditional venture fund without some of the drawbacks of being in a committed fund. On balance, I was a fan.

First, let’s define our terms: Most on the venture side prefer to delineate capital raised from well-meaning friends and family from capital being sourced from sophisticated private investors or assorted “angel funds.” While the money coming from either source may still be green, what it tells a professional (i.e. venture) investor about the opportunity is quite different. Your Aunt Bea putting $25k toward the development of your first prototype tells me she’s a pretty great Aunt and loves her nephew, but tells me nothing about how compelling your opportunity is and whether it’s right for venture capital — now or ever. That same $25k (or better, $250k) coming from well-recognized angel groups like Band of Angels and Tech Coast Angels, or from individual angels like Google backers Ron Conway or Andy Bechtolsheim, however, carries with it some significant gravitas.

This is not simply because these groups and individuals have been highly successful and have been investing for many years, but also because each has a highly competitive screening and deal selection process which has the effect of winnowing mediocre deals from consideration. Whether I should admit it or not, all things being equal, a Ron Conway- or Band of Angels-backed venture will simply rise higher in the stack of Exec Summaries on my desk than will the summary of a company that did not secure capital from such recognizable investors. I would expect that to be case with most in the venture community.

What I am referring to in this post are friends, family and fairly unsophisticated investors where, in my experience, the greatest pitfalls lie. Recognized, sophisticated angel investors aside, where things get a bit tricky is around how, when and upon what terms a young company should accept capital from these well-meaning investors. Generally speaking, the traditional investment path is that a young company collects anywhere from $25,000 to $1mm in friends and family funding to get through Version 0.0 and toward an offering demonstrating enough early validation that it can attract a respected professional investor that can put greater sums to work, open up its extensive rolodex of contacts, and accelerate the company’s growth. Of course, in the current environment these notions of what constitutes “traditional investment paths” are being widely re-evaluated and re-assessed as companies are confronting a particularly tight funding market and being forced to go back to early investors–often angels–and new potential angels to extend the runway, get the product/service further along, and hope the institutional funding market will open up in the months ahead. For those such companies, some pointers to consider:

1. Keep the Cap Table clean. I cannot stress enough to young management teams to do everything in their power to do things right the first time. Put bluntly, there’s rarely the time (or even the chance) to fix it later. Upon incorporation, hire good counsel, and get proper advice on how best to manage the early financings. Despite the best of intentions, it can get hairy fast.

The $10k and $15k investments you might be receiving from your Uncle Ted and your college roommate could be the difference in getting things going in the early days, but make sure you have a clear, consistent way of recognizing those investments. There is also the likelihood that, being a cash-starved start-up, in addition to the stock options grants you will need to make to early employees you will need to compensate attorneys, landlords and other professional services providers with some combination of cash, stock, warrants and/or other derivatives. Be careful.

Early stage VCs expect to see some small commitments from friends and family but if your Cap Table starts to look like the starting roster for the New York Mets with bits and pieces doled out to every Tom, Dick and Harry you’ve met since junior high school along with different pricing and different vesting schedules it can cause a deal to stall….or to fall apart completely. Cleaning up a compromised Cap Table is at the top of most “I hate to do” lists for many VCs. It tends to cast a pall on a potential funding because, apart from the headaches of cleaning up a messy Cap Table, it also implies a start-up team that is either desperate for funding, or unsophisticated, or likely both.

2. Be smart about who’s on your Board. Sun Tzu might have been right when he said, “Keep your friends close, but your enemies closer,” but he probably wouldn’t have made a very good venture capitalist. Building a well-assembled, complementary and collegial Board of Directors (BoD) is critical, but especially so in the early days when things are happening very rapidly, capital is scarce or non-existant and everyone needs to grab an oar and help in any capacity they can–early customer meetings, investor introductions, crafting and gaining alignment on product strategy, recruiting, legal, etc.

Dysfunctional BoDs are a disaster. Be cautious of an angel who is demanding a Board seat as a condition of his or her investment but cannot really bring germane operating experience, investor relationships, or more capital to the table. Early stage investors also become very leery if they perceive that upon investing in a company they will be inheriting a bad BoD or a problematic, unsophisticated or obstructionist Director that they will be tangling with to get things done.

For many VCs, there aren’t that many “I have to do this deal” deals, so most will simply shrug and move on to another opportunity that doesn’t present itself with so many wrinkles that the VC will need to iron out once he or she joins the company’s BoD post-investment.

3. Insist on a No Bully policy. This is not quite the same as the No Jackass Policy I referred to sometime back in a recent post of the same title. That piece was concerned primarily with bad hires. Bullies, on the other hand, tend to appear in the form of angel investors during difficult times. This is one of those times when the term “angel” could hardly be more of a misnomer.

When there appears to be blood in the water with a young company, an “angel” can appear that seems willing to fund the company through the rocky patch until the markets improve, but the terms get more and more onerous each time an investment is discussed. At first, the angel seems excited and willing to be part of the business. Correspondingly, the other BoD members and investors are excited at the prospect of fresh outside capital coming into the company to help accelerate the business and get through the rough patch. In time, however, the angel perceives that there is no real competition for the deal and begins to insist on more term concessions until the ‘death by a thousand cuts’ phrase begins to get quoted and re-quoted at the BoD meetings when the investment prospect is discussed.

Paired with the increasingly onerous investment terms coming from the angel prospect is often new demands on altering the company’s strategy or its mission, or even the principal business it is in. As company management perceives they could be losing the angel prospect, they often make the mistake of “single-tracking” the investment discussion at the risk of other, more promising prospects and investing hundreds of man-hours responding to document demands, diligence requests, and consuming thousands in legal fees. Inevitably, the terms get progressively worse: The new angel now wants a BoD seat, when that was never a deal point to begin with. Now the angel wants to demand the removal of another BoD member he perceives as “not on board” with the new strategy. Now the angel wants sweeteners and more warrants and a lower valuation and pro-rata investment rights and…and…and. It becomes the proverbial onion that stinks all the more with every layer that’s removed.

Once that happens, it becomes a death spiral. Accepting the investment with all the new dreadful terms might buy the company some short-term runway but virtually cripples the business, substantially dilutes everyone’s ownership, saps enthusiasm and motivation from the team, and sets the stage for fights at the monthly BoD meetings where everything happens but the exchange of gunfire. Adding insult to injury, even if the business continues to grow and execute with this unwelcome dynamic at the company, should a professional investor show interest in the company for the next round of funding, that investor will almost undoubtedly lose that interest once he realizes that this less-than-angel investor crammed down the company severely at the last funding and now owns a significant percent of the company for his modest investment. Any experienced VC will sense that something is amiss at the company, that the “angel” and not the management team is driving the business decisions, and he will simply Control-Alt-Delete on participating in the investment.

In summary, capital from friends, family and outsiders still has a critical role to play in start-up development. It fills a key void that, even with venture fund sizes falling and more firms focusing on earlier stage companies, will not likely be filled by the institutional class anytime soon. Properly leveraged, it can fill essential gaps in a company’s development and pave the way for follow-on financings led by institutional class investors or, in some cases, even pave the way for long-term commercialization of a product or service. What is paramount, however, is to not let financial stress force the management team to compromise on the core values and mission of the business or to partner with someone whose brief capital support might only serve to damage the company’s long-term survival.

Jonathan Tower is a Managing Director at Citron Capital, a global private equity and venture capital firm, where he focuses primarily on Enterprise Software, Consumer Internet, Media, Web Services and Infrastructure investments. His blog is called The Adventure Capitalist.