Enter the dragon’s den
Nadim Zaman, Senior Corporate Layer, Keystone Law
To accompany our regular feature where entrepreneurs share their start up challenges, we asked Nadim Zaman, senior corporate lawyer at Keystone Law, to share some thoughts on how business owners should approach the important funding stage.
Many business angels are looking to get actively involved in the companies in which they invest. This means that they, typically, prefer local investments and investments that they understand, often on account of their own knowledge in the relevant business sector. The average size of an angel investment is £42,000 per investor and the average percentage stake acquired is 8%. Though on occasion a business angel will invest alone or invest more than £100,000 in a business. There is an even 50:50 split between angel investments in revenue generating businesses and pre-revenue businesses, though recent surveys suggest the average may be moving in favour of revenue generating companies.
What are investors looking for?
Investors typically look for the opportunity to make ten times their investment in around five years; the less the risk, the lower the return they expect. They tend to look for the right team to back to produce a successful exit and always like a good track record. They favour opportunities with a large addressable market undertaken by a company that knows its target customers, how to sell to them and how to generate revenue from each sale.
They like businesses they can understand and help with to some extent. Many investors will open their “black book” of contacts and often this is every bit as valuable as the cash they provide. They also like tax efficiency!
What are investors looking to avoid?
Failing to describe what your business does: Many entrepreneurs struggle to describe, succinctly, what their business has been set up to do and why it differs from the competition. The old idea of the elevator pitch really holds true for most angels and you need to get to the point in a minute or less. Experienced angels can assess an opportunity quite accurately in the opening minutes of a presentation - because we see so many ideas it’s essential to focus on the key points. So work hard on that opening presentation, it’s absolutely vital.
Entrepreneurs who over-value their businesses: Early stage entrepreneurs are frequently unrealistic about what their businesses are and what they will be worth over the period of the investment. They see headlines about massive valuations for the likes of Google, Facebook and Twitter but fail to appreciate that these are the exceptions rather than the rule. They also often apply the ‘hockey stick’ approach to sales forecasting, where their expectations of massive growth determine their overall valuation.
Investors typically look for the opportunity to make ten times their investment in around five years.
Valuation issues aren’t reserved for “naive companies”; 90% of the businesses which excite us still fail to receive investment due to valuation issues. It’s important to be brutally honest and realistic about valuation – aggressive and ambitious numbers are great news, but only if you have the evidence to support them. As a rule of thumb we are looking to achieve at least a 10 times return on our investments.
Entrepreneurs who don’t research what investors need: It is not unusual for businesses to seek investment without doing any research about the potential partners they are pitching to. There is little point in pitching a business idea to an angel who has no interest in the entrepreneur’s market segment. Similarly, most venture capital funds are not going to be interested in an investment of a few hundred thousand pounds and most angels are not going to look at multi-million pound funding rounds.
Large founder salaries, large debts: Angels worry if the business owners plan on paying themselves a large salary. What’s the objective? Is it just a lifestyle business or is everyone involved going to earn a real return? Equally, a business looking for investment when it already has large debts may be looking to survive rather than excel.
Bad funding models: Growing businesses need their management team working on what makes them a success, not constantly raising finance. So, a business which plans to raise one tranche of money and then more again in six months can quite easily be held back by the sheer effort this process requires. As investors, we want to see the company raise sufficient capital to ensure that they have a realistic chance to reach critical value milestones – at least 12 months cash on prudent financial forecasts is a good figure.
No clear exit strategy: It can be difficult to imagine exiting from a business when you’re still on the road to success. Entrepreneurs will often at best have only a rough idea but it’s a vital consideration for us – who are the likely buyers? When will our investment mature? What strategy will get us all to the point when we can meet the objective of the exercise, which is to make a profitable investment?
Business owners who can effectively address all these issues early in their relationship with any potential angel investor have a much greater chance of success – not just in securing financial backing, but in realising the ambition which has brought them to us in the first place.
Nadim Zaman is a senior corporate lawyer at Keystone Law, who acts for Angel Investors, including Lord Stanley Fink and a host of other high net worth individuals. This article was co-authored by corporate and commercial lawyer Albert Mennen.