It’s All In The Terms: What To Prioritize In Angel Term Sheets

Terms term terms! Angels, new and veteran alike, agonize over what terms are to ensure the proper incentives and to properly compensate for risk. Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article on this topic. Her full article (with her permission) appears further below.

An essential part of angel investing is setting and agreeing to the terms of the deal.  Many angels recognize the importance of deal terms, but often wonder which components of the term sheet to prioritize. I’ll reveal the answer, but first some background about term sheets.

A term sheet outlines everyone’s intent for a deal. It is typically provided by the angel with help from their attorney. For this article I worked with angel investor Katherine O’Neill and attorneys, Ben Straughan, Partner, and Jim Carroll, Counsel, for the Perkins Coie Emerging Companies & Venture Capital practice. They also shared their insights in a recent Angel Capital Association webinar, The Key Points of Term Sheets.

A well written term sheet is critical because it leads to a great contract and creates investor-entrepreneur alignment needed for a positive relationship because it delivers the returns everyone wants, assuming the company is successful. O’Neill, executive director of Jumpstart New Jersey Angel Network, underscores this point: “This is the time you have the greatest opportunity to really control the main factors that allow you to make a good exit.”

So what deal terms are most important to angel investors?  Tapping their years of experience, Carroll and Straughan suggest five critical terms for a series seed preferred investment (otherwise known as a priced angel round):

Pricing: This represents the value of the company and helps determine how much of the company you will own. It is important to get the valuation of the company right in the beginning, which can be an art with startups and early-stage companies with few assets and short track records to build on.

Participation Rights: These define an angel’s right to invest in future funding rounds, often providing the angel with a better chance of a good return. “Angels should focus on participation rights,” Straughan said. “It allows you to double down by continuing your right to invest in future rounds.”

Board and Information Rights: These rights outline whether you (or someone from the investing organization) will be on the board of directors or be an observer at company board meetings. They also determine the information you will receive from the company and how often you will receive it. For example by explicitly asking for quarterly financial statements and annual budgets, everyone can keep their eye on the ball on the status of the business while ensuring the company doesn’t have onerous requirements (because these are documents that a company needs to produce anyway).  Related to these, I like the idea of shareholders having the right to vote or at least have veto rights on key strategic issues such as selling or liquidating the company or developing entirely new lines of business.

Liquidation Preference: If the company is sold, these preferences define what preferred shareholders are paid e.g.  X times the original purchase price before any other assets are paid common stockholders. 1X liquidation is normal for angels.

Redemption Rights: These rights can help angels to achieve liquidity by selling their shares back to the company if management wants to continue running the company but investors want out.

Although these five components provide an excellent guideline for what to prioritize, term sheets can quickly get more complex, and most include many other terms which are also important.

Most experts recommend that angels start with a standard term sheet to help simplify the process and to reduce legal fees.  I’ve provided sample term sheet examples in this article and there are a wealth of other online resources.  These are a few of my favorites:

Term sheets are critical and that is exactly why they can sometimes be overwhelming. Beyond these resources I always recommend talking to other angels and learning about new approaches, trends and ideas at regional and national angel events. With resources like these there’s no reason to sweat the terms on your own.

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Tips For Angels To Assess Startup Business Models

Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article with tips for analyzing startup business models. Her full article (with her permission) appears further below.

Can the company you are considering investing in scale and get to a good exit? How is it going to make money, really?  These are some of the most important questions every angel investor needs good answers for from the entrepreneur. Successfully evaluating a startup business model can make the difference between success and failure of your investment.

Business models can be stated simply – like “razor blades” (offering a high margin shaver at a good price in order to increase sales of razor blades) and “freemiums” (offering basic services for free and charging for premium services) – but they involve the detailed overall strategy of the company.  A business model is how the company defines the market and its products, along with how it gets and keeps customers, how they get to the market, and how its resources are set up, all while eventually making a profit.  Startup business models are even more complicated because most startups are essentially experimenting with their strategies and will evolve their model as they test it out.

Many entrepreneurs and investors use the Business Model Canvas by Alexander Osterwalder to develop and evaluate business models.  Brigitte Baumann, founder and CEO of international angel group Go Beyond Investing and 2014 European Business Angel of the Year, takes more of an economic approach.  I’ve been working with Baumann to develop a set of free resources for new angels to get started successfully and connected with her recently on how angels evaluate business models.

When Baumann reviews a business model her first step is to sort the business plan information into four economic-focused building blocks:

  • Unit economics: the hard data that include the selling price of the product or service and the costs involved.
  • Customer economics: customer acquisition, retention and support).
  • Market economics: what it will take for the entrepreneur to actually create the market buzz or demand needed to acquire customers who will use the units.
  • Business economics: the development and overhead; this includes anything from additional offices that might open to support for handling finances, etc.

Thinking about a business model through these four lenses helps to get to an understanding about how much money an entrepreneur needs in order to become self-sustaining. It also makes the financial goals for each round of funding more obvious.

Knowing how entrepreneurs think about the business model is very important. To quote Baumann, “The entrepreneurial team should all ‘live’ the model. They touch it every single day in every action that they do.”

Naturally getting to those important answers requires analyzing the business model from two crucial perspectives: scalability and the break-even point.

Scalability – is a key indicator in whether or not a company will go public or be acquired and investors will get returns on their investments. It is about a company’s ability to multiply revenue with minimal incremental cost, creating a profitable and valuable business.  Baumann suggests that when angels meet an entrepreneur, we need to understand whether he or she is planning for 3x, 10x or 100x growth from where they are currently.

Knowing which level helps investors understand the amount of money the entrepreneur needs to raise and in how many rounds.  A company that is planning for a 100x growth is likely further along in their development and has the chance of a great exit for all involved.

The Break Even Point – Beyond scalability it is important to understand the company’s break-even point, when it becomes self-sustainable and doesn’t require more outside capital.  Baumann has a chart to determine break-even, incorporating fixed and variable costs, as well as the incremental costs that come with increased scalability in a new video.

To understand scalability and break-even points in due diligence, angels need to understand the economics of the company’s revenue growth plan and when they are a “real business.”  Questions to investigate how revenues will grow and all of the involved costs.  Make sure entrepreneurs are realistic about how much money they will need to get to break-even by asking them where the current round of funding will take them, how many rounds of funding they think they will need, what resources they need to get to each level of scalability and what milestones they accomplish in each round.

Many scalable business models involve big margins between true product costs and selling prices and/or pricing mark-ups.  But angels need to make sure the entrepreneurs have thought through all of the relevant costs, including the costs of customer acquisition, retention and support over the lifetime of the customer relationship.

Other critical things to check into during due diligence are the market economics, particularly whether they are using the true accessible market and whether their potential share of the market is possible.  These days, it is easier and easier to get data on the company’s existing competitors to get data to compare to.

The bottom line is it is key that entrepreneurs and investors understand the business model before reviewing the financials. Entrepreneurs need to know the drivers that capture market share, outmaneuver the competition and make the business succeed. And investors need to know how to get that information out of the business model or help entrepreneurs build a business model that provides those answers. Without this knowledge it’s difficult to properly evaluate a startup and to make a wise investment decision.

Time to revisit royalty financing?

Royalty financing is a relatively new concept that offers an alternative to regular debt financing (loans and trade credit) and equity financing (venture capital and stock sales). In a royalty financing arrangement, a business receives a specific amount of money from an investor or group of investors. The money might be put toward launching a new product or expanding the company’s marketing efforts. In exchange, the investor receives a percentage of the company’s future revenues over a certain period of time, up to a specific amount.

-Source: Inc Magazine article

Some other interesting aspects of Royalty Financing – It doesn’t require the sale of the company. This means:

  • Entrepreneurs retain control
  • Investors start generating returns without needing a sale
  • The company is more likely to stay in the region it was born in (vs being merged & moved to the acquiring entity)

This flavor of capital is less risky than equity, but riskier than debt. As such, it may be an attractive option for angel groups outside of major tech hubs (such as my own) to explore.  In fact, we’re now actively looking to try out a few royalty deals. Stay tuned to see what we learn 🙂

Validating sales, marketing, and customer service hypotheses

When my students are working their way through a Lean Startup/Launchpad-style curriculum, the most important thing is to conduct great interviews. New folks smartly lean on a number of interview script templates (here are the ones my students use) to help them avoid many first-timer mistakes! However, the scripts I ran into tended to focus on customer pain & product validation – which is critical. However, I had a hard time finding scripts to help my students validate hypotheses around sales, marketing, and customer service (AKA Get/Keep/Grow in Lean Launchpad language).

So my fellow mentor Rick Plaut and I put this Get/Keep/Grow script together. Please feel free to share, use, and/or suggest improvements.

Introduction to the KISS Canvas

[This is part of a series on the KISS Canvas]

The KISS (Keep It Super Simple) Canvas (inspired by Alex Osterwalder’s Business Model Canvas) is a 1-page (or 4×3 foot poster) to help you quickly document (and then test) the key hypothesis behind your business model.

If you like to read, keep scrolling. For video lovers, click below!

OK, let’s dive in. It looks like this…

KISS Canvas-Easy2Read

The KISS canvas tells a story in the way entrepreneurs should pitch, with the most important elements first (on the left).

  • The Customer – Who do you serve?
    • Segments – Who are all the groups of people you will serve? Buyers, users, referrers, etc.
    • Pains – What problems do they have? Which are most important?
  • Value Proposition – What do you offer?
    • Features – How will you solve your customers problems?
    • Benefits – What promises are you making to your customers?
    • Competitive Advantages – Who are your competitors and how are you better at solving your customers’ Pains?
  • Marketing & Sales – What kind of relationships will you have with customers?
    • Get – How will you find and acquire customers?
    • Keep – How will you prove you kept your promises?
    • Grow – What new promises might you make?
  • Financial
    • Value Model – What value do customers provide you in return for your product?
    • Cost Structure –  What are the costs associated with running your venture?
  • Beard of Learning – When you disprove a hypothesis, move it to the bottom. If you’re using sticky notes they will eventually form chains and completely cover the bottom of your canvas. It kind of looks like your canvas grew a beard. Each sticky in that beard represents a hypothesis the student thought was true… and found out it was not! Thus the name my students gave it, the “Beard of Learning” :).

This Canvas is by no means a complete map but I have found it is the foundation of everything else that is to follow. To get a better feel…

Check out more KISS Canvas Content.

Nonprofit Innovation Accelerator 2.0

Innovation concept. Lightbulb in modern polygonal style with light effect

After running the Nonprofit Accelerator for just under a year now I’ve learned a few important things about my customers. They had the pains I thought they did, but they had other pains that were really important also, such as:

  • I don’t have any ideas to put into your accelerator OR…
  • I don’t know which of my ideas I should pursue OR….
  • Six months is a long time commitment for key team members when I don’t even know if the idea can work and yet…
  • At the end of the six months there is still a lot of polishing to do…

Meanwhile, I had greatly underappreciated just how much the nonprofits valued the sharks & mentors.

So, today I am proud to announce version 2.0 of the Nonprofit Accelerator that takes into account what my customers have taught me.  First of all, it splits the accelerator into parts:

Part 1: IdeaJam (1 half-day session)

Feeling light on innovative ideas? IdeaJam provides you a list of your organization’s super powers (AKA assets, skills, and connections) and their potential for unrestricted revenue.

Part 2: HitMaker (2 full-day sessions)

Unsure which of your ideas to enroll in the Accelerator? Hitmaker gives you a rank ordering of all your ideas based on their potential and risks.

Part 3: Customer Discovery (Every other week for 4 months)

Before committing the significant resources to turn your idea into a full-fledged program you need to know there plenty of people ready to pay for the thing you wish to sell! The Customer Discovery training provides the tools, mentoring, and introductions you need to secure the evidence.

Part 4: Funder-Ready (Every other week for 4 months)

People want what you have to offer, but how do you cost effectively make your offering and find your customers? Who do you need to add to your team? How will you fund it?

Pilot Design students graduate with a fleshed out business model, a plan for their pilot, and get to pitch to a panel of funders who, if impressed, will provide you seed funding to launch.

 

The next IdeaJam is coming up in July, so if you know any nonprofits that are making the creation of unrestricted revenue a priority, please feel free to share the updated website: www.UnrestrictedRevenue.com. Thanks!

HatTip to Birton Cowdan for the great name for the IdeaJam events!

 

Why Creating a Business Plan Is a ‘Waste of Time’

When I started exploring entrepreneurship in college, I was exposed to the education paradigm – write a business plan. I was a good student. I wrote 9 business plans in 9 months for my first startup.

It turns out, that was not the best way to spend my time. Yes, planning is essential. But it needs to be done in the right proportions. Less at the start. More as you mature.

Professor Carl Schramm recently wrote a carefully researched book called ‘Burn the Business Plan.’, listen / read to an interview about the book’s highlights here.

Hat tip to Jim Geissman.