Disclaimer: nothing on this site is legal advice, and I am not an investing expert.
This post is continued from Part I.
Part I explained how, instead of getting an MBA, I invested the tuition dollars into angel investing. To recap, my current stats for the two-year “Tim Ferriss Fund” look like this:
15 or so total investments
2 successful “exits”, or sales (including my own company)
If we look at the value of my remaining start-ups on paper, based on subsequent funding and valuations, the portfolio is probably up well over 4x. This means nothing (remember Webvan?), but it’s fun to look at the spreadsheet.
This post will look at how I’ve found deals, how I filter deals, and the rules I’ve set for myself. The latter can teach broader business lessons, even if angel investing never enters your life…
Before we get started: you almost always need to be an “accredited investor” to angel invest. If you aren’t comfortable lighting your money on fire, you shouldn’t invest in start-ups–period. That doesn’t mean, however, that you can’t learn a few things from the sidelines.
Before we get started – part deux: angel investing can be complicated. I’ll be using some fuzzy math and simple examples to get the point across. This is intended as a primer, not as a guide to the intricacies of investing.
Last but not least, I’ll use a gender-neutral “he” for the sake of simplicity instead of “he or she”, which is cumbersome. Both sexes can play well in this game (check out Esther Dyson), and both can screw it up equally badly.
For those who want some resources upfront, here are a few:
If you want to be an angel investor:
Read – How to Be an Angel Investor
Read – Is it Time for You to Earn or to Learn? by Mark Suster – this is a must-read reality-check that takes into account dilution and other nasties. Though written for people thinking of joining start-ups as employees, it applies to angels.
If you want to recruit/be an advisor:
Read – Everything you ever wanted to know about advisors, Part 1
Read – the above Suster piece if you think advising a few start-ups will make you rich. Run the numbers first.
If you want to find angel investors:
AngelList (go here to pitch me or anyone else in their roster)
Consider applying to a “seed accelerator” program that will cultivate you. For a complete list of such programs and upcoming application deadlines, visit Kaljundi’s site. Here are few well-known examples:
Investors vs. Bootstrapping – Some Warnings
As exciting as I find the start-up game in Silicon Valley, it can also be depressing.
I see capable first-time entrepreneurs, full of piss and vinegar, run into fundraising and get their asses kicked by seasoned venture capitalists (often affectionately called “vulture capitalists”). Two or three years later, their start-up baby is either dead or their ownership has dwindled to the point where their enthusiasm is gone.
Here are some questions and warnings that might help avoid this:
1) Why do you need funding?
If you can bootstrap to profitability and one of your goals is to work for yourself, I’d suggest thinking twice. If you take a few million dollars, you will–on some level–be working for investors. If you make a mistake and allow investors to have board control, which can happen if you spend funding faster than expected, you no longer run your start-up. :(
2) Avoid angel investors with few or no prior start-up investments.
The family dentist wants to put in $50,000 and will give you whatever terms you want? Sounds great! Don’t do it. Ditto for the successful CEO who’s never done angel investing, as seductive as it will be.
One good friend just had her start-up implode (after millions of investment) because her primary investor, a former tech CEO, didn’t have the stomach for start-up investing. He panicked when things deviated from the business plan (um, welcome to start-up land), and began doling out funding in two-week increments and insisting on near-weekly board meetings. He became the micromanager from hell. No longer was the real start-up CEO able to make CEO decisions, and the company was doomed.
Only take investment from people who have invested in a few start-ups. Having run a start-up doesn’t qualify one as risk-tolerant enough for start-up investing.
3) Don’t take a ton of money just because the valuation is sexy, or because you give up less ownership.
This problem is more common with venture capital (VC), but it worth learning early: it’s a bad idea to take money from someone simply because they offer a high valuation. Let’s say two investors want to be your lead investor. Investor A thinks your start-up is worth $3 million and offers to buy 33% of the company for $1 million — to fund you with $1 million. Investor B thinks you’re worth $10 million and offers to also give you $1 million, but you’ll only give up 10% of the company!
Go with Investor B, right? Well, not so fast. If you come out of the gates with very little to show but a $10 million valuation, things can blow up in your face a few ways:
- Your exit options become fewer. If Investor B needs a 10x return for his portfolio and has the ability to block your sale for less, this means you have to sell for at least $100 million. If you’re a first-time founder, putting $1-2 million in your pocket with an early sale for $10 million could have changed your life forever and given you “f**k you” money to do anything you wanted. Now it’s home run or nothing.
- You run the real risk of a “down round”. If you don’t make it to profitability with that $1-million round, you’ll need to raise more money later. If you haven’t made a ton of progress, including a ton of new customers, the fundraising community will be skeptical and probably insist your $10-million valuation was too high, or that you’ve lost value since that round. Now you’ll need to do what’s called a “down round” (some examples here). In most cases, this spells the end for your start-up.
OK, with those warning out of my system, let’s look at some definitions and how I’ve done things so far.
Investor vs. Advisor, and Some Definitions
When dealing with tech start-ups, the following terms are important to understand. Below are some very general definitions, keeping in mind that almost everything is negotiated and on a case-by-case basis:
“Seed” or “Series-A” = two early rounds of financing common in the start-up world. “Seed” is first, and often either family and friends or $100,000-$1,000,000 from angels. “Series-A” might be around $1,000,000-$5,000,000 and comprise primarily angels and perhaps 1-2 venture capitalists from larger firms that could later participate in larger “Series-B” or “Series-C” rounds, if needed for profitability or to compete. These “B” or “C” rounds usually involve many millions of dollars, which few angels will put up as individuals.
“Dilution” = Having your percentage ownership lowered when new investors come in. If, for example, you own 1% of a start-up at seed stage, if there are any future rounds of financing, your portion of the pie will almost always shrink–you will be diluted. This is critical to keep in mind when calculating potential outcomes as an investor or advisor.
“Investor” = someone who writes checks in exchange for equity (a certain % ownership) in the start-up.
“Advisor” = someone who advises a start-up in exchange for equity over time. “Advising” can include key introductions (to customers, partners, important hires), “syndicating” financing (getting other investors on board), developing/improving the product, helping with PR/marketing/customer-acquisition, or anything else a start-up might need.
So what percentage do advisors get? For someone who’s just doing a few intro’s, or whose name you’re using to get investors, it might be 0.10 – 0.25%. For someone who’s investing real time and helping to build the company, or someone whose involvement could make the difference between success and failure, it could be as high as 2%… or even more. There are start-ups who think giving more than 0.25% is ridiculous, and there are start-ups who find 2% a steal if they can get the right person.
Advisors generally receive their equity over a period of time, often 12-24 months.
This means that if an advisor signs an agreement for 1% that “vests” over 12 months, he would get 1/12 of one percent each month, and the start-up can cancel the deal at any time. If the start-up gets fed up with this advisor after six months, it means he gets the 0.5 percent that vested, but no more.
Different strokes for different folks, but all-star advisors generally = better investors, better investment terms, and faster outcomes. To me, that’s a legitimate no-brainer.
If I were to found a tech start-up and aim for the fences (IPO or sale), I would do what several successful tech CEOs I know are doing right now: give 3-5 bad-ass advisors 1-2% each, depending on time required, and self-fund until you hit break-even or profitability. Then, go out to raise $500-750,000 from key angels who can open doors to potential acquirers and help you get to “scale”. “Scale”, in this context, meaning the point at which you can go big, as in millions of users or nationwide, with the simple addition of money: the costs and revenues of your customer acquisition are predictable. Money in = more money out.
Last, you go to potential acquirers (often potential competitors) to see if they’d like to discuss “partnerships” or funding you; both approaches are used to start conversations that hopefully end with “why don’t we just buy you instead?” from their side.
If that doesn’t work, you get more funding, grow a lean monster, and eat their lunch.
The Start-Ups and Deal Flow
Here are the start-ups I’m involved with, whether as an investor or advisor, in no particular order:
[TIM UPDATE FROM 2013: OK, three years later, here is a more current list. Hilarious that Uber was called "UberCab" back in the day!]
Twitter (investor) – micro-blogging platform
Digg (investor) – see what’s most popular on the web
StumbleUpon (advisor) – Pandora for the coolest content on the web (this is how I find much of my most popular Twitter material)
Evernote (advisor) – capture anything in the world you want to remember
Posterous (investor, advisor) – the simplest blogging platform in the world
CrowdFlower (advisor) – crowd-source just about anything for pennies; 500,000 workers in 70+ countries.
SimpleGeo (investor) – on-demand geodata infrastructure
Graphic.ly (advisor) – the next (gorgeous) evolution of comic books
Foodzie (investor, advisor) – find and buy incredible artisinal food in the US (my favorite cookies in the world are here)
Shopify (advisor) – beautiful and easy e-commerce for selling anything
RescueTime (investor, advisor) – time and productivity tracking
ReputationDefender (investor) – monitor and repair your reputation online
TaskRabbit (advisor) – get any task done, from dry cleaning to research (use code “FERRISS10″ for $10 off your first task)
UberCab (advisor) – Fully automated car dispatch with built-in reputation system – ride like a European diplomat.
Badongo, DocumentHosting.com (investor) – file and document hosting/sharing
DailyBurn (investor, advisor) – exercise and diet tracking
iMarket Services (advisor) – creating hubs for niche markets like stand-up comedy
Samasource (not-for-profit – advisor) – outsource your tasks to those most in need (refugees, etc.)
Donorschoose.org (not-for-profit – advisor) – eBay for helping public school children in need of basic supplies.
“Deal flow” refers to how you find the start-ups you invest in, or how they find you. All of the companies except DonorsChoose.org and iMarket Services (respectively: have known the CEO for ages, chance meeting at SuperBowl party) were found through:
- Referrals from friends who are angels and tech CEOs
- Y-Combinator (Posterous, RescueTime)
- TechStars (DailyBurn, Foodzie, Graphic.ly)
- Facebook Fund (fbFund) (TaskRabbit, Samasource)
- Twitter DMs from me to the founders (Evernote, Shopify)
What makes me interested in a start-up… or rules them out?
These are the considerations I run through when looking at start-ups, but it doesn’t mean that all of the companies in the portfolio passed all of the criteria.
In no particular order, and written as a stream of consciousness:
- If my readers won’t shut up about them, I listen (this led me to reach out to Evernote and Shopify)
- I generally look for these questions to be answered via email, but I now much prefer to have them answered through the AngelList form. If you don’t know the terms (“deck”, “traction”, etc.), you need to learn them before pitching Silicon Valley types.
- Does it offer the possibility of at least a 5x return? Good angel investors in Silicon Valley do not invest in lifestyle businesses or profit shares–they want to turn their $100,000 into millions. 5x return potential is just the entry point for working with decent angels at the seed or Series-A level. Many will be filtering for 20-30x potential, depending on the size of their fund.
- If it’s a single founder, the founder must be technical. Two technical co-founders are ideal.
- Have the founders ever had crappy service jobs, like waitering or bussing at restaurants? If so, they tend to stay grounded for longer. Less entitlement and megalomania usually means better decisions and better drinking company.
- I must be eager to use the product myself. This rules out many great companies, but I want a verified market I understand.
- I must understand their customers and be able to recruit, in military terms, HVTs–High Value Targets.
- Do the founders actually test some of what I’m recommending? My data is based on 15+ start-ups and more than $1M in direct response advertising–there are a few things I understand very well, sign-up conversion being one example. I will usually suggest 1-2 elements for testing in an initial meeting, well before investing, and if at least one element isn’t tested within a week, they’re out. If the product (usually a website) isn’t split tested or “iterated” fast enough, it usually foreshadows death for tech start-up. Speed is often the only competitive advantage smaller guys have.
- They need to understand the eco-system in which they play. What recent companies have sold for what amounts? Who are the most likely acquirers? Who are the most formidable competitors, and what types of funding (even investors) and resources do they anticipate needing to compete? It it a winner-takes-all market where only one company will reign supreme (e.g. businesses dependent on network effects), or can many large profitable companies co-exist?
- Founders must pass the “mall test”: if you were to see them in a mall, would you walk in a different direction, would you walk over to say “hi” and move on, or would you invite them to join you for coffee or whatever you’re doing next? If the founders don’t fall in the last group, don’t invest. This is a close cousin of the simpler “would you invite them out for beers just to catch up” test.
- Am I following my rules, but are other investors turning them down? These days, I take this as a positive sign. Mike Maples explained this to me: breaking your rules to co-invest with well-known investors is usually a bad idea, but following your rules when others reject a start-up can work out extremely well. DailyBurn, my only exit to date, was a mild example of this. They hit my checklist boxes, but the majority of the investors (but not all) I asked to participate declined. It thrills me that this start-up–from Alabama!–has so far outpaced most in Silicon Valley. Bravo.
Now the rules that require a little explanation:
1. Don’t do it solely for the money, but know your minimums.
Investing in start-ups has to be, on some level, a labor love. You need to love helping entrepreneurs. That said, don’t actively waste your money and life by failing to do basic math.
Set a minimum threshold for each start-up investment. The minimums could be what a success should cover, or a minimum dollar amount. For example:
A. Each start-up, if it exits at 5x its current valuation, should be able to cover 2/3 of your total fund.
Most entrepreneurs think their start-up will be the next Google, but you can’t base your investment strategy on the assumption that each company has the potential to exit for a billion dollars. Look at comparables (similar companies) that have sold, and their average purchase prices. If you want to keep it simple, you might use 5x at Series A round as your assumed “success” multiple.
What this means:
Let’s say a company is raising $500,000 in a Series A. Investors decide it is currently worth $1,000,000, so–after receiving the $500,000 infusion–it will have a $1,500,000 “post-money” valuation. (For sake of simplicity, we assume that Investors don’t require an option pool for new employees to be set aside in the pre-money valuation. For more on that, read this) Let’s also say that you put in $15,000, so you “own” 1% of the company post-money.
Remember the rule of the header: “Each start-up, if it exits at 5x its current valuation, should be able to cover 2/3 of your portfolio.”
Most of your start-ups will fail, so the successes need to make up for losses.
If we’re using the “2/3″ rule, and your fund (like mine from 2007-2009) is $120,000, you shouldn’t invest $15,000 in this start-up, as 15K x 5 = $75,000. 2/3 of $120,000 is $80,000, so you’d either have to invest slightly more, lower the valuation, or add in advising and get more equity in return. This isn’t even accounting for dilution, which is likely in most cases.
B. Each start-up, if it exits at 3x its current valuation, should allow you to walk away with $300,000.
This is one of my preferred methods for qualifying or disqualifying a start-up.
As much as I might love them, I’m not going to take another part-time job for 1-3 years for a $50,000 pay-off. This is where first-time entrepreneurs who refuse to give advisors more than 0.25% often lose the forest for the trees.
Let’s say a start-up ends up with a 3-million (3M) post-money valuation. If I help them more than triple the value of their company to 10M, how much do I walk away with if there are no more rounds of funding? If they offer me 0.5%, I walk away with $50,000. If, considering the time invested, I could earn 5x that doing other things, it makes no sense to do the deal if this is my rule.
Woe is the angel who bases his or her decisions on all start-ups having the potential for a billion-dollar exit. Rule #1 in angel investing is, as far as I’m concerned, the same as Warren Buffett’s first two rules of investing:
Rule #1: Don’t lose money.
Rule #2: Don’t forget Rule #1.
2. Move from investor –> investor/advisor –> advisor
Let’s assume you have committed to spending $60,000 per year on angel investments, just as I did. This means two things:
- You aren’t going to be able to satisfy the above rule of “2/3″ or the $200,000 minimum for many companies. At best, you’ll have 1-3 investments.
- 1-3 investments doesn’t work in angel investing, where most pros would agree that 9 out of 10 (on a good day) will fail.
- It’s therefore impossible for you to get a good statistical spread with $60,000 per year. The math just doesn’t work.
The math especially doesn’t work if you f*ck it up like I did (see Part I) by getting over-excited and dropping $50,000 on your first investment. Oops!
Here’s how I dealt with this problem:
First, I invested very small amounts in a few select start-ups, ideally those in close-knit “seed accelerator” (formerly called “incubator”) networks like Y-Combinator and TechStars. Then I did my best to deliver above and beyond the value of my investment. In other words, I wanted the founders to ask themselves “Why the hell is this guy helping us so much for a ridiculously small number of options?” This was critical for establishing a reputation as a major value-add, someone who helped a lot for very little.
Second, leaning on this burgeoning reputation, I began negotiating blended agreements with start-ups involving some investment, but additional advisory equity as a requirement.
Third and last, I made the jump to pure advising. Since the end of the first year of the “Tim Ferriss Fund,” more than 70% of my start-up “investments” have been with time rather than cash. In the last 6 months, I have written only one check for a start-up. The goal is still the same as in the first phase: deliver above and beyond the current value of my potential equity (if fully vested) as quickly as possible. The next post this week will give an example of this.
Comment from a proofreader and experienced angel, Naval Ravikant, who was also a co-founder at Genoa Corp (acquired by Finisar), Epinions.com (IPO via Shopping.com), and Vast.com (largest white-label classifieds marketplace):
One thought – if someone really wants to invest $200K as an angel investor, you’re right in that they can’t spread it across enough companies to diversify it or have it be worth their time. In that case, they could do advisory work as you suggest – or they could fork it over to a super-angel fund. They’d end up paying a 15% in management fees and 20%+ of the profits in carry, but most of the super-angels have pretty good returns and they would get startup exposure for basically a $30K + 20% of the profits cost, and their time is surely worth more than that…
Moving gradually from pure investing to pure advising allowed me to reduce the total amount of capital invested, increase equity percentages, and make the $120,000 work, despite my early slip-ups. This also, I believe, produced better results for the start-ups.
The reason for the better results is related to a common objection.
Some counsel against pure advisors, the belief being that pure advisors have no “skin in the game.” To address this, start-ups might insist on an investment before advising can be discussed. The logic isn’t bad–that an advisor will do more if they have something to lose–but this argument has never compelled me, and I don’t know many good advisors who are compelled by it.
I feel more compelled to help companies that I have pure advising relationships with for two reasons.
First, if I’ve given a start-up capital, I’ve already given some value. If it’s pure advising, I need to prove my value within the small world of start-up investing or my reputation goes downhill. Second, because my reputation is at stake, I do more due diligence than with pure investments to ensure an excellent fit (their needs + my capabilities) before signing up. Just as important: before offering real equity for advising, a start-up will do likewise, and our marriage–if we get to that point–ends up better as a result.
The start-ups that aren’t great fits, those who haven’t mapped my strengths and weaknesses to their own, look at me, laugh, and ask themselves: “Tim Ferriss wants what?!?”
They’re right, I’m not a good fit. If their desire for me as an advisor is contingent upon an investment, they probably haven’t thought enough about how I’d be able to help (or not help). Either I really can’t help much, in which case I shouldn’t be offered advisor equity at all, or I can really help, in which case they should get me on board with a compelling arrangement for everyone. Start-ups often forgot that the advisor equity vests monthly–advisors still have to earn it or they can be fired.
It’s a hell of a lot of fun advising start-ups with good product and personality fit, even if the companies don’t become the next Google.
But, I do miss a lot of great opportunities by focusing on advising and tight fit. This doesn’t bother me. I haven’t yet lost any money. Rule #1.
Let’s be clear on one point: if you don’t deliver real results for your start-ups, you do not deserve to be an advisor. If you can’t point to a track record of some sort, you haven’t earned the right to ask for advising equity. Pull out the checkbook and pay your dues.
Posted on: July 5, 2010.