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November 2007 Presentations

Angel Investor Panel: What do investors look for when a company has no revenues and no financial track record?

On November 20, GCVA hosted a panel of angel investors who answered the question most asked by entrepreneurs: if I have no financial history, what will investors use to evaluate my company potential and determine if they will invest?

Jim Cunningham, president of C-Cap, the resource hub for linking entrepreneurs with angel investors, moderated the panel of three early-stage investors with very different backgrounds. Tom Bobenread is a Queen City Angel who came from the commercial banking world, having spent most of his career with Fifth-Third Bank; John Habbert is a former Procter and Gamble executive who also ran an entrepreneurial venture and who has spent nine years with QCA; and Dov Rosenberg is an investment banker who currently runs Blue Chip Venture's Validation Fund, which invests in early stage ventures in Ohio.

Traditional Financing

Jim started the meeting by asking Tom to provide an overview of how traditional banking works. Tom agrees there are significant issues of difference between funding pre-revenue versus operating companies. "It was a real culture shock to join the Angels," he laughed, "but one thing is clear: cash is king."

Commercial bankers are unquestionably focused on security in the financing they provide. "A banker's first question is, 'How will you pay us back?'" he says. "With an existing company, there are historical numbers and a business model." These, of course, do not exist with a pre-revenue company, so everything is based on projections, which increases risk significantly. "When there are certified independent financials, an existing management structure, defined advisors and a revenue stream, the information is apparent and available for bankers, making it easier to make a decision."

Because of the lower risk, a company's cost of capital through a bank is significantly less, making this an extremely appealing alternative when a company is ready for it. But when does the transition from high-cost investment capital to lower-cost bank financing occur? Tom says this is always a tough question. "Angel groups definitely make our job easier," he feels, "since they fund viable companies we were forced to turn away. Then, these companies can come back to us in the future after they've had some success." In general, he feels a company needs 2-3 years of positive cash flow, showing a legitimate upward trend, in order to be considered for traditional financing.

Tom explains that most lenders look at 3-5 years of financial statements, focusing on balance sheets and profit/loss statements. They then use a spreadsheet program that calculates a series of ratios and trend reports that bank analysts use to evaluate risk: "These ratios show the key performance issues of the company." Another area banks are looking at more and more is cash flow, since as Tom says, "having a profit does not necessarily mean you have the money to operate." This spreadsheet program is adapted for industries, taking specific trends and ratios into account. It is hard for a non-banker to use it since it's not really "one size fits all," but instead a tool an experienced banker can use to help analyze the data provided by company management.

Once they have the ratios and reports, the banker will listen to what the management team's opinion of the financials is. "We compare our own ratios with those in the prior financial history. If they match up with what management is saying, then the company has greater credibility; if it doesn't," he laughs, "then we have to have talk."

Some of this forecasting is easy to do based on historical trends, but if assumptions are not communicated clearly, it can take a great deal of extra time. Tom explains, "The decision matrix is evenly based on historical data and forecasts. I recommend you spend more time on defining assumptions clearly in projections." He also says the economic climate will affect the analysis. "If times are 'normal,' it's easier; but when the economy slows, historical numbers mean a great deal and will probably be the basis for the lender's decision." He feels one of the biggest problems bankers see is nominal preparation: "Numbers are often pie-in-the-sky, not believable - but this is key to getting your money."

Many people feel assets are important in the process, but Tom says they are really only a factor to the extent they produce revenue. "Liabilities and operations define cash needs," he says. "Too often, a profit does not equal cash. Because of this, it's very interesting to the banker how management went through the process, how prepared they are, how they present their case."

This brought Tom to the point where traditional lenders and angels have the most in common: their concern with the quality of the management team and its ability to drive revenue, to generate and manage cash. "This is the most important thing in the end - do they have a good handle on cash flow management."

In summary, Tom points to the similarities between bankers and angels more than their differences: "Our basis is our faith in the team and the business. We're the same as angels in that regard, albeit with a financial history at our disposal. Banks are not rewarded at the same level as angels, but they also don't take the risk."

"Outside the Company" Factors

Jim then turned to Dov to discuss the first steps in evaluating a company when no financials are available - what he calls "outside the company" factors. "In lieu of having a bunch of data to analyze, pre-revenue evaluation is somewhat easier, but on the other hand, it's harder simply because there is no data," Dov feels. "We have to go with how interesting the idea is, and how good is the team."

Dov looks for four main points when evaluating "outside the company" factors:

Compelling value proposition
Market size
Competition and differentiation
Sustainable competitive advantage

Value Proposition: Dov explains it's extremely important to predict sales likelihood. "This can be done in a variety of ways, such as customer interviews among obvious customer candidates. You need to engage people, find out if they would buy, how much they'd pay, what problem they see solved, and so on." Of course company management should do this, but the angel investor will also. "It may be something simple, such as a handful of phone calls, or something more extensive, such as focus groups. If you have an investor experienced in the industry, a lot of it is gut feel."

The basic information desired from this research is an economic view of the company: what problem does it address, what is the cost to address that problem today, how would the new product either reduce the cost or generate revenue, what's a sense of pricing. By answering these types of questions, it gives the angel a good feel for the likelihood of the new company's ability to enter the market and generate revenue.

Jim stressed that when an entrepreneur is looking at the market, it's important to look at all aspects of the problem. "If an entrepreneur says there's no competition, then he's not looking hard enough," he feels. Dov agreed, although he says, "We like companies with no direct competitors. It's really hard to pick successes - if there are a lot of options, we not only have to pick a product, but also a company." That said, he reaffirmed Jim's statement, saying that competition comes in all forms: "A new company will always supplant an old product or process," he describes. "For instance, online services replace magazines; new software replaces pen and paper. Products are generally competing for consumers' time."

Market Size: Dov explains that a product's market has many different levels. The first is the addressable market: if every possible customer in the target set would pay the charged price, that's the addressable market. It's the absolute maximum in your market set.

The next level is what percent of the market is likely to be interested in and willing to buy the product (not your product, just the product in general). This is the market penetration.

The last level is of that set, what percent is your company likely to capture, which is your market share.

Market size is important but can be looked at in several ways. Dov says, "If the market share potential is several hundred thousand and that's it, it may be great because an investment of only a few million will get us in and out; on the other hand, if the company needs a lot more, then they will have to operate in a larger market in order to generate enough revenue to justify the initial investment."

Both unit and dollar volume are considerations in market size. "A limiting factor is how much you can charge, how much people will pay for that type of solution," explains Dov.

Competition: Dov did not spend more time on this aspect since it was covered under Value Proposition.

Competitive Advantage: This is important because, even if you are the only provider of your product or service today, that does not mean there will not be others in a year or two. "You can't stop others from entering the market, especially if you are successful," says Dov, "so what do you do?" He sees three primary approaches for start-ups. The first is "pure execution:" be better than everyone else. Dov tends to shy away from this, since the management team in an unproven company is so difficult to judge.

The second is the "first mover" advantage - being the first to market. "However," Dov cautions, "just because you're the first to market does not mean you have an advantage." There are certain times where being first is truly a benefit. The first is if the product is "sticky" and provides recurring revenue. "If your product is sticky enough, it's difficult for new competitors to take your customers," he explains.

The second is where your product/service has a network effect, such as an online or telecommunications product. Dov says in this case, "The size of the user base corresponds directly to your value." Linked In is a great example of the network effect. A competitor is going to face both having to convert current Linked In users, and also convincing new users to go with them (with a limited network) versus Linked In (with a large network).

Jim added further to the discussion of stickiness. "If you can design stickiness in to your product, you are not just fulfilling an immediate need, but also making customers very reluctant to leave you," he explains. The longer a customer is with you, the more valuable you are to them and them to you. He also discussed how if you are a network-based company, you have to move very quickly: "You've got to grab those customers before new companies enter the market."

Dov continued, describing a third way to gain competitive advantage: intellectual property (patents, trademarks, copyrights). However, he warns that IP is not foolproof: "It's tricky and industry specific," he feels. "Sometimes, patents are extremely valuable, such as in the pharmaceutical industry, where IP is respected by competitors and the time to market is long." He contrasts this with the software market, where a tiny change can design around a patent and where, by the time a patent is issued, the market often looks quite different.

Jim mentioned it's sometimes worth building an IP portfolio to stop competitors. "As a defensive strategy, it's sometimes quite effective," he says, "since otherwise you can spend millions of dollars and a lot of time defending your property."

"Inside the Company" Factors

With this discussion finished, John Habbert turned to the factors inside a company that allow angels to pick successes from failures. "The internal factors are very interesting at this stage," he says, "because your management team is probably not there yet." He explains that angels at this level are often evaluating the entrepreneur, perhaps the CEO, "the person who will drive the business to make it happen." This "person vs. team" situation limits the ability to see forward. John says the past thus becomes more important: "Has the person done it before? Has he lined up people who can help make it happen - 'If you give me money, I have the team.'" He also looks at the person's experience in the area and their work history - is he from a large company? An entrepreneur? "It's a very different situation if the person is an entrepreneur versus coming right out of a big company," he feels. "For instance, if you've been at P&G, you have all kinds of resources to help you; you don't have that as an entrepreneur." Jim laughed, "It's kind of the 'will the CEO clean the toilets?' analysis."

John continued by discussing the person's expectations and personal evaluations. "One thing I look for is if the person is realistic - do they think they're the best person for the job throughout, or do they recognize that they may need to find someone else to take over later? An angel is more likely to respond to someone who says he'll need help later on, who recognizes his own strengths and limitations."

Another aspect is the commitment the person brings. "They will need a financial as well as a psychological commitment," says John. "We look for entrepreneurs to co-invest with QCA; we've had people who say they'll mortgage their home, take out a second mortgage - those are the people we know are really committed."

And of course, don't forget the "simple stuff" like character - background checks, references, and so on. Still, John says, "It's gut feel - does the person have the personality, can I work with him? Will he take advice, and act on it? If I make suggestions, does he come back three days later with a revised plan, taking my suggestions into account? That's very encouraging. However, if he comes back saying he thinks what he's got is perfect, I'm going to question."

Of course, the key to success in any new company is how the product or service will be sold. "Usually at the beginning, the CEO is the CSO," says John. "I have to see that the person can be a convincing salesperson, that he can get out there and make it happen." A sales plan should take into account the web, the viral effect of the Internet, advertising, marketing, and PR.

"I also want to see projections that are interactive," says John. "I like to tinker with the spreadsheets. Assumptions should be spelled out clearly and projections should be formula-based so it's easy for me to challenge various assumptions to see what happens."

A cash flow projection is also very important - in fact, John says it's the "most appropriate report," since having cash is necessary for operations. "When you run out of cash, what do you do? Where do you cut back?" These are things a well-prepared entrepreneur needs to think through.

Other issues include who is working on the technology and IP, who is the company expecting to hire, to contract with (and why), will the company be outsourcing internationally, who's watching the finances? "Independent confirmation of the numbers is going to be extremely important in the early days," according to John.

And of course, what is the company's exit strategy? "We have to get our money out," John says. "This goes with the projections and is often part of the evaluation of the intrinsic value of the proposition. We look at what companies may need the products, what exits have taken place in the space, what the multiples are." He continues by stressing that it's unreasonable to expect an IPO these days: "You can expect an acquisition instead. But most importantly, we want to know the entrepreneur is driven to exit. We don't want to fund lifestyle companies."

With all of this analysis described by Dov and John, John reminds us that success is still elusive: "QCA has funded 30 companies so far and only one has hit projections - and that's good!" So in the end, what does it come down to? "Does it all hold together?" John asks. "Does it make sense? That's what we have to decide."

When Pre-Revenue Means Pre-Customers

Jim sums up the discussion with a simple statement: "Especially in the past seven years, pre-revenue means pre-customers. So how do you convince the investor there is demand, that there are customers who will buy from you?

"If there is a lot of demand and you can show customers early on, then half the battle is won."