Thoughts from an angel investor

[Spider]

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For the past 10 years, I have made myself available as an angel investor for local small businesses. In all that time, only one person has come to me with anything like a sensible proposal. All other proposals have been non-starters due to a total lack of financial comprehension and all attempts at negotiating an equitable arrangement have fallen on deaf ears. I thought some comments from this side of the fence might help would-be borrowers.

1. Banks do not invest in businesses and investors are not banks.

2. Many approaches have been along the lines of "If you will invest $20,000 (or whatever sum) I'll give you 10% of the profits." Only trouble is, they aren't making any profit and the possibility that they will make a profit some time in the future is supposed to be sufficient incentive for me to give them $20,000 now. Not going to happen.

3. Most wanted money but could not tell me in any detail what they would spend the money on. I was left suspecting it would be used to pay themselves a salary - until it ran out. This was not going to happen, either.

4. One person wanted to sell me 10% of his business for $20,000. This, of course, valued his business at $200,000. He could not tell me exactly how much his business was worth and could only talk of his dreams to grow the business. No growth strategies seemed to be in place. All the hard assets that I could see (equipment) were purchased with a loan, so it looked like the business was worth nothing, although it was earning enough to pay the loans and provide a meagre income for himself and three employees. Further negotiations went nowhere.

5. Some wanted a straight loan. They couldn't get a loan from the bank and wanted me to lend them the money. They seemed to think 50% increase on the bank rate was a great offer - they offered 8% interest against the 5% interest they couldn't get at the bank. They didn't think I was taking any risk in making such a loan.

Observations:

a) When an investor puts any money at all into another person's business, he is taking on 100% risk. There is a risk that he will lose 100% of his money.

b) The business owner who has no money in the business risks very little. If the business fails, the investor loses eveything but the business owner still has his idea and can on and start another business with the same idea.

c) If an investor is going to risk so much, he will need a high rate of return to compensate for that risk. Doubling his money over the course of 5 years is not sufficient incentive in most cases - it represents only 15% per year. Doubling in two years - 40% p.a. - is not excessive.

d) It is so obvious, in most cases, that the business owner has little understanding of money that a prudent angel investor would insist on controlling the money and, thereby, controlling the business.

I hope these thoughts help business owners understand how money works in the real world beyond their dreams.

[ArcSine]

Good and valuable points all, Frederick....I hope they'll hit home with some would-be entrepreneurs before they go drilling for start-up dollars.

I've always noticed a huge disconnect that I suppose is only explainable by human nature. On the one hand...

Every start-up advisory book, article, or website includes the mantra "Develop a solid business plan first."
Biz plan guides, books, and templates are a cheap (free in many cases) and widely available commodity.


Yet...it seems as though the entrepreneurs who actually devote some of their pre-financing efforts into developing a decent BP are squarely in the minority.

A good business plan / financing package is no substitute for any of the critical success drivers, but neither can it be disregarded on such a large scale.

Interestingly, had those funding-seekers you mentioned spent a little quality time first in developing their BP, they would have already (as a natural consequence thereof) had their thoughts developed and crystallized w.r.t. your points 2, 3, and 4---how much capital is required and why; specifically how it will be deployed; what kind of profit and cash flow patterns can be expected; and exactly how the angel is to share in the expected pie so as to make it an attractive investment.

As I say, if your advice finds a home with the right audience before they go dialing-for-dollars, it'll be to their great benefit.

[Harold Mansfield]

Frederick, very interesting, but not surprising. It seems to me that most people that I run across have a romanticized vision of business and not any cold hard data or facts. I would guess that the hardest part would be the numbers because frankly, they are all BS. Unless you have definite contracts, or clients waiting on you, there is no way to know if anything will make any money.
I guess you can speculate, which is pretty much what a business plan does..."If we do this, then we make this"...but they are all pretty much based on "If".

I would guess that you would be more likely to take a risk on an existing start up that has already invested their own time, money and resources and have already started the ball rolling with at least some money coming in, and just need money to grow or tackle more lucrative projects, than a start up that hasn't done anything except shop for money.

What you have described is pretty much the attitude that I see from friends and acquaintances that dream about having their own business. They go from a decent idea, to made up numbers of how much money they will make with nothing in between.
Everyone thinks that their idea is great and people will be flocking to give them money, but you can really tell how much they believe in it and themselves by what they are willing risk personally.

[cbscreative]

I guess you can speculate, which is pretty much what a business plan does..."If we do this, then we make this"...but they are all pretty much based on "If".

As much as I hate math, I did gain a few benefits from being forced to take it as part of my university pursuits. One of those realities of math can be illustrated using your own town of Vegas as an example. The entire casino industry is built on the fact that the law of probabilities always works out in the end. Because of this, casinos do not lose money. If a certain activity is repeated enough times (such as a card game), the end result is mathematically predictable and consistent.

Although there is a lot of truth to your point, Harold, and I do understand your intent in that statement, there are almost always ways to use math in your favor. That's where math has some real value, but I still hate crunching numbers. I'm thankful there are people like Evan who enjoy it because someone has to do it for a successful outcome.

As I make that point, I am also reminded of how much I hate business decisions being made strictly on bean counter data. There are plenty of things that make sense mathematically that don't take people into consideration. If nothing else, that proves that a balanced perspective is essential. I'm sure Frederick would likely say he wants to see both in the plan.

[nealrm]

There are plenty of things that make sense mathematically that don't take people into consideration.
I have found it is usually a case of people not taking people in consideration rather than the mathematics being wrong. Few managers are willing to take the time to determine the true dollar value of an employee, good quality or good service. Instead they will ignore those area and use the half formed "mathematics" to prove the point they wanted to make.

[Harold Mansfield]

...use the half formed "mathematics" to prove the point they wanted to make.

That's a good point. I've seen people do that many times. I've done it once or twice myself when I was looking for money in the past.

[ArcSine]

Agreed. Whether it's deliberate or just an instinctive reflex, every lender or investor will wisely go into "risk management" mode at some point in the vetting process, and try to debunk the rosy claims of the would-be entrepreneur. If the entrepreneur has chosen to
... use the half formed "mathematics" to prove the point they wanted to make. the debunking takes all of 10 minutes, and the borrower / investee is shown the door.

On a separate point raised earlier, I would immediately dismiss any biz plan that purported to forecast what WILL happen. Nope, the purpose of the projections should be to help clarify each party's thinking on the range of possible outcomes, and (where feasible) attach some idea of likelihood measures to the outcome space. Note that this is very different from saying what will happen.

It's more a matter of trying to quantify things like upside potential and downside risk exposure under a variety of possibilities, in order to bring some clearer understanding as to what uncertainties the parties are really dealing with. It's one thing to have a vague mental picture as to the various uncertainties; but there's no way to form a feel for just how much of an impact each factor (or better, each combo of factors) will have on the results, until you warm up the spreadsheet and do some real number-crunching. And since individual factors can interplay against each other in complicated patterns, you've got to use math that's up to the task.

Having done that, Part 2 is to develop deal provisions that anticipate at least the most significant factors, and provide for an intelligent way to share those upsides and downsides, should they occur, in a way that everyone can live with.

Nice discussion, all...cheers!

[Spider]

Talking of investors - I loved the "SHARK TANK" reality show. Apparently, it will be returning with a new season in 2011 and they might be casting entrepreneurs for the show now. The page I ran across has no closing date on it but says they are searching for entrepreneurs.

Anyone want to face The Sharks and ask for money? They have no mercy but millions are available, if you have the right bright idea!

ABC.com - Shark Tank - Casting (http://abc.go.com/shows/shark-tank/casting)

[NZPulse]

very nice insights spider. I started a business with a close friend on a fairly loose plan, but he only really invested because he knew I was 100% committed and that he would see returns eventually. I'd hate to think if he was some third party investor breathing down my neck!

[nocompanyguy]

Its true that banks are not investors. I spent time talking with many banks in my area-local and national-without success. They loan officers basically stated that collateral is everything and without it no loans are made. Two friends and I are managers at different medical offices where we are responsible for referring patients to buy medical equipment from medical equipment providers. We decided that we would work together to form a medical equipment company and we would refer to our company (especially since none of us can find a medical equipment company that is any good). We can cover the startup expenses. The problem is that the state where we live requires a substantial reserve so that if our company fails our patients can file claims against the reserve. Because we already will have a lot of sales from our referrals we do not believe that we would become insolvent. At any rate, despite having very experienced, credentialed professionals as an ownership team, a source of sales, and a solid business plan the banks are not interested. The thing we are lacking is collateral. We might go ahead with it at some point but right now we are not in a position to come up with the reserve. So much for banks!

[Spider]

...The thing we are lacking is collateral. We might go ahead with it at some point but right now we are not in a position to come up with the reserve. So much for banks!Not a fair comment! If you went to a bicycle shop and wanted to buy some vegetables, when they couldn't supply you, you wouldn't say, "So much for bicycle shops!"

What would your reaction be if a future customer wanted to buy pharmaceuticals from your medical equipment company, and they said, "So much for medical equipment companies!" when you couldn't supply them?

You were looking for an investment, and you already accepted the point that banks are not investors. Banks are lenders. Come up with the collateral they need and they will give you a loan. Simple, really. If you don't have the collateral, you have to find another way to get the money you need.

1. Save hard.
2. Find an investor who has the money.

3. Find someone who has sufficient collateral (of the amount and type the banks want) and have them put that up as collateral in return for something the investor wants. Eg: A doctor who owns an office building could put that up to the bank as collateral in return for equity in your business. Another eg: the owner of a nursing home could put up his real estate as collateral in return for a management position in your company.

4. Another route open for investigation: The "reserve" the state wants -does that have to be cash-in-the-bank? Can it be value? Ie: could the above doctor or mursing home owner stand as security with the state using the value of their property as the required reserve? (This way you bypass the banks entirely.)

An added bonus of this type of thinking is, now you have even more credentialed people in your business plan - 3 medical professionals, plus a doctor and a nursing home owner (if you can get both on board.)

Be creative! That's what they mean when they say, Think outside the box!

[WmStout]

An added bonus of this type of thinking is, now you have even more credentialed people in your business plan - 3 medical professionals, plus a doctor and a nursing home owner (if you can get both on board.)

Yes, that is definitely thinking outside the box. And you might even be able to find them all in the same building.

[Spider]

... and the building itself being the collateral. Ooh! That should wrap up a good deal!

[nocompanyguy]

Well saving is good advice. Networking to find an investor/partner is also good advise. However, I found your examples to be very farfetched. It would be very difficult to believe that a physician or nursing home administrator would put their buildings up as collateral for equity or for a management position in a startup company even if it does seem like it is likely to succeed. Those buildings are attached to their livelihoods. Would you do that? If you honestly would answer yes, then please forward your information to me so that we can begin the process of putting your building up as collateral for my nonexistant startup business venture! I promise it will succeed. While thinking outside the box is a great slogan it has to fall within the realm of reality.

[CloptonCapital]

Exactly! The idea that borrowers only one to give a marginal amount of the profit in exchange for IF the business works is bogus. If the idea was so rock solid they wouldn't be trying to sell it to investors in the first place. It's amazing how people don't understand the risk/reward exchange.

[greenoak]

so interesting spider.....how did the one who got the money present to you...? and doesnt being an angel sometimes call for a jump into faith?
i really worry if the business plan was the main consideration..... it doesnt really cover the persons ability to run a business.... persistence, work ethic, discipline, honesty, just good judgement all around.... and what if the if the data and demographics arent really right? .....if they really fit the target area the business is aiming for...
and couldnt a good business plan writer come up with a good plan for most ideas?
i didnt know you did that... hope you like it...

[Spider]

so interesting spider.....how did the one who got the money present to you...? and doesnt being an angel sometimes call for a jump into faith?
i really worry if the business plan was the main consideration..... it doesnt really cover the persons ability to run a business.... persistence, work ethic, discipline, honesty, just good judgement all around.... and what if the if the data and demographics arent really right? .....if they really fit the target area the business is aiming for...
and couldnt a good business plan writer come up with a good plan for most ideas? ...All good considerations, Ann. In this case, there was no business plan offered, although I do not doubt this fellow had a business plan when he started. It was a new fitness center that was functioning but not getting off the ground. He said he had put $200,000 into it already and wanted to sell me 10% of the business for $20,000 which he would use for marketing.

My thought was that a fitness center is a sound business category but not one I would want to be locked into forever. And 10% ownership would mean total loss of control of the money once it was signed over, and no certainty of any payback for several years or until the owner chose to declare a dividend. In fact, he could pay himself a salary and might never declare a dividend, whch would mean no payback for me. Of course, terms could be added to any agreement to correct these possibilities but I negotiated a better deal for us both--

1. He didn't really want to sell any part of his company but felt this was the only way he could get the money to pay for the advertising that was necessary.

2. I didn't really want to buy into a company on such a small scale.

3. To keep it brief, I negotiated an advertising deal, where I would put up $30,000 (to remain in my account and under my control) with which I would take over the company's advertising and promotion. The company would pay me $X per new client, which would come out of the fees paid by the client.

4. Immediate benefits - he saved whatever he had been spending on advertising up to that point (effectively increasing his income.) He got more and better advertising. He got more new customers and the greater income that produced. I received an income that was dependent upon my ability only (his ability and business plan became immaterial.) I was paid out of income as it came in.

5. Outcome: Within a matter of months, his new inquiries increased 20%, new customers increased 10% and cost per new customer was reduced (ie. client aquisition became more effective.) And he received a system of client aquisition that he could continue to use and develop for the future. I made 40% ROI.

He didn't have to give up any of his company, and I wasn't locked in to something in which I had no longterm interest. Win-win, I call that!

[tuitionsource]

I like your solution Spider but...how much of your labor did you put in to get the 40% ROI? Was your money working for you or were you working for your money?

I do like your creativity.

[Spider]

As stated, I took over the company's advertising and promotion, so I did work with my money to earn the 40% return. My money was working for me and I was working with my money to earn the return.