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Dave Taylor has been involved with the Internet since 1980 and is widely recognized as an expert on both technical and business issues. He has been published over a thousand times, launched four Internet-related startup companies, has written twenty business and technical books and holds both an MBA and MS Ed. Dave maintains three weblogs, The Business Blog at Intuitive.com, focused on business and industry analysis, the eponymous Ask Dave Taylor devoted to tech and business Q&A and The Attachment Parenting Blog, discussing topics of interest to parents. Dave is an award-winning speaker, sought after conference and workshop participant and frequent guest on radio and podcast programs.

Fixing the world of Angel Investing

I've been working closely with the DaVinci Institute on some of its entrepreneurial efforts, and recently had a chance to interview Kevin Johansen, the sharp and charismatic head of the Entrepreneurial Standards Forum, about the world of angel investing and how it could be significantly improved. It's a long interview, but darn interesting for anyone who's ever thought about raising capital...

Q: I think that historically angel investing has been not just erratic and characterized by poor diligence on the part of investors, but also a crap shoot in terms of results. What are your thoughts?

Investing in startups is a gamble that's more likely to pay off if you know the rules of the game and play the percentages. By comparison, if you go to Vegas and watch the professionals you'll quickly learn that they know the rules inside & out and that they play the percentages with a great deal of discipline. This generally means that unless they know *exactly* what their next move should be, they don't move. The amateurs, however, are there for fun and the off chance that they might hit it big. As a consequence, they generally don't think much before they act as doing so lessens the element of surprise and can take the fun out it.

Investing in a business in the early stages of its development is sometimes thought to parallel this phenomena, as one of the primary motivations for an investor in an early stage Company is to roll up their sleeves and make a contribution that goes beyond the dollar investment. For a lot of investors, Angels in particular, 'fun' and the feel good aspects of helping someone put their business on its feet are significant drivers in their decision to invest. The difference is that in Vegas the rules are more clearly defined and the odds are more easily computed.

Q: Isn't one obvious area where angel investing could improve would be to streamline the mechanism by which investors and startups are paired up?

Absolutely! The question is 'How?' and the answer is complex. This complexity is generally where attempts at solutions fail. Historically, the people trying to solve this problem have come to it from accounting, legal or engineering perspectives. These are linear disciplines, and as a general rule, they start by trying to scale the ambiguity from the process. However, markets are dynamic, non-linear things. Were they as simple as arbitrage, contract or software development they'd be more predictable and yield more often to disective analysis & reductionism. As a consequence, the result of the lawyers, engineers & accountants work is generally a very linear process that's easy to explain via flow charts - but that sometimes has very little to do with reality.

Disective analysis and reductionism are great tools for figuring out how simple, linear processes work, but with non-linear processes (Examples: The weather and most anything involving people.) They're an exercise in frustration at best. Investing in early stage companies is a dynamic & complex process that exists within a complex system. As it is a complex system it requires a systems appproach to problem solving if you expect to get anywhere. Unfortunately, the necessary computing power does not yet exist that can effectively model this system. This relegates us to the observers role when what we instinctively want to be is experimentalists. So be it. There are still highly workable paths to solution available if you can step away from linear perspectives on problem solving. One of them is open source.

Q: Tell me how you think the process of doing "due diligence", of fairly evaluating the strength and probability of success of a startup, can be improved?

There is no mystery to due diligence. It's just work. Like most processes that are "just work", it can be made more efficient through standardization. The problem with standardization, however, is that the validity of a standards is tied directly to the number of people using it. A standard is only a standard to the people who have agreed to work with it as a standard. So the question then becomes: "How do authoritative standards develop?" In markets they evolve through two processes. One is through accretion of market share - you buy & earn your way through to being the dominant service provider and then dictate the standard to which everyone else comforms. The other is through open source in which the community of Users makes decisions collectively about what the standards should be. Autocracy works well with simple systems. Democracy works well with complex systems.

The Entrepreneurial Standards Forum [link] is being built out to be an open source, investor-centric initiative in which the community sets the standards. If enough of a community forms around it the standards developed will have validity. Building this standards development community is the challenge in front of the ESF.

Q: Your team has been talking about a model of angel investing that's based on the stock market. I love the idea! Tell me a bit more about the specifics, though?

One of my favorite Internet words is "disintermediation". It means getting rid of the middleman, and over the last 10 years we've watched information technologies disintermediate the middlemen in market after market as the providers of a product or service figured out how to go direct to the consumer without using a broker. Using the airlines as an example, they began the disintermediation process in the early 90's when they started charging the consumer less for tickets if they bought direct from the airline and not from an agency.

This change in business process was made possible by information technologies and the Internet. As a consequence, the number of travel agencies has dropped from about 36,000 in 1990 to about 27,000 today and it continues to decrease. Good examples are everywhere. And there have also been some exceptional success stories by companies that aggregate access to products and/or services and then facilitated transactions between parties without taking enough of a percentage to disrupt the transaction. eBay, Google & Amazon come to mind. These are very effective middlemen in part because they're easy and inexpensive to use, but also in part because they're 'long tail' aggregators.

[The 'long tail' is a concept integral to the Internet's value to business. You can learn more about the long tail at wikipedia, but, in simple terms - and for the purpose of this conversation - it means that when the marginal cost of selling a product or service is the same regardless of the volume of product sold, the whole of a market can organize itself under a single provider.]

Q: A big buzzword for startups seeking angel investment is "qualified investor". Can you explain what a qualified investor is and why it's so important when raising capital?

"Qualified" has several interpretations when it comes to Angel investing. The most common usage is the one that is equivalent to "accredited", which generally means "millionaire". The definition of "accredited" are different State by State, but they generally means that the investor has at least a $1,000,000 in assets and/or make something more than $200K a year. The assumption on the part of the government is that if you have that much money you know enough about investing to make informed decisions. There are also 'blue sky' provisions in most States that allow unacredited investors to invest in private equity deals. There is generally a limit to the number of unaccredited investors that can invest in a deal per State. In Colorado it's 35.

But these are just the definitions. The prospecting process is more important to the final result as most Entrepreneurs that need capital to get their business going simply don't know enough millionaires to get properly funded. And as of this writing, there is no commonly accepted process that an Entrepreneur can use to source capital, or that an Angel investor can use to source investment opportunities. This is not because there have been no attempts at creating them. There have simply been no visibly successful attempts. This is in great part because the entities that have attempted to create bizdev processes that become standards didn't build means into the developmental process for the standards to become valid and authoritative.

Valid is a function of market share. That which is the most valid is that which gets used the most. Authoritative is a function of effectiveness. That which is most authoritative is that which works best. Without valid & authoritative standards the only draw to a standardized bizdev process is money. Designing a process with money as a primary draw is problematic, as the majority of new businesses don't need it, or don't need it enough to rationalize the effort necessary to get it from Angel investors outside their personal networks. As a result, 'money centric' processes designed to generate deal flow for an Angel network or a VC don't address the needs of the larger market. And this generally means that the community of Users that organizes itself around the process never gets large enough to become self sufficient and operate independent of the investors running it.

The solution, then, is to design a process that works for everyone, with those businesses that need investors being a subset of the larger whole. We think the only way to do this and get validity & authoritative standards from the process is via an open source initiative. If the community that organizes itself arounnd the Entrepreneurial Standards Forum gets large enough, there will be enough critical mass in this subset to customize a service offering for. One of the services in discussion is a stock exchange that growing businesses could source capital from. The ESF value proposition in this conversation is speed. Businesses that are developed within ESF approved protocols will have less time & dollar cost to the due diligence process.

Kevin Johansen is the founder and CEO of the Davinci Business Catapult, a Director for Capital Markets Group, the Entrepreneur in Residence at the Davinci Institute and the founder of the Entrepreneurial Standards Forum. With a deep concern for the ecology of commerce, he works with select companies and nonprofit organizations whose purpose it is to improve the overall health of the business environment. [more]

Posted by Dave Taylor at June 15, 2005 7:17 AM

Comments

All very relevant comments, especially "there is no commonly accepted process that an Entrepreneur can use to source capital, or that an Angel investor can use to source investment opportunities."

I see that there are two problems: 1) We simply don't have the language tools for an entrepreneur to accurately characterize the nature of their product and service and market and business "vision", other than loose prose and overly-rigid analytical models and keywords, and 2) We don't have the search language tools so that the funder most appropriate for a given venture will *happen* to enter in search criteria than will zero in on that venture.

Classic database or search engine keyword-based tools simply won't cut it. Even if you have an entrepreneurial specialist whose job is to encode and classify ventures, and funders as well, we have the same old garbage in/garbage out computational problem.

The entrepreneur has very, very specific needs, whereas the funder has general interests. There is a chasmic impedence mismatch between the concepts of specific and general.

The entrepreneur's venture is by definition very special. In fact, it's so special that the odds that even a funder with specific interests will be able to find it with search criteria are essentially zero. Sure, they might get lucky. Instead, the entrepreneur must either try to tailor their proposal to meet the interests of pre-targeted funders, or plan of knocking on lots of doors. Word of mouth, "networking", venture capital presentation forums, and a zillion other "hacks" are available to try to do the match, but it's quite problematic.

A particularly problematic case is when a mismatching pair of entrepreneur and funder meet serendipitously and discover that a variation on each of their parts will result in a dramatic alignment of their interests. Look around you; notice how many successful companies are radically different than their initial foray, or that a restart after an initial failure resulted in phenomenal success. The entrepreneur's initial idea and characterization of their venture may not be a very accurate rendition of their range of flexibility at all.

These issues are not specific to angel investing. In fact, I wouldn't characterize it as the investor's problem per se.

-- Jack Krupansky

Posted by: Jack Krupansky on June 15, 2005 1:49 PM

First off, let me thank Jack for the phrase 'chasmic impedence'. I'll use that again sometime...

Re: his specific points on language and how service offerings can drift and evolve around the talent in a business:

* He's right about the language issues. A rigid taxonomy isn't capable of following a market and being responsive to its needs. Rigid taxonomies like SIC or SOC codes are snapshots of moving pictures. Like all metaphors, they fail under pressure. The more rigid they are, the earlier they fail.

This issue is in part why this is an open source initiative. What we hope to see evolve from this is a natural taxonomy. Every data set can be plotted on a bell curve if there's enough data. Words & definitions are data. With volume, the market itself will determine how it wants to use the words it's using. The job of the ESF is to find what's in the center of the bell curve and publish it as the standard.

And note also that there are no perfect solutions. This is because this is by its nature a reactive, not proactive, process. By this I mean that most Entrepreneurs don't have this information in their knowledge bank when they begin to build their business. They have to go somewhere else to get it, and as a general rule they go to attorneys & accountants. This means that the archival knowledge in this market isn't 'owned' by the primary Users, but by brokers. That's inefficient. One way to look at the ESF is that it's a means in which to build a knowledge archive that's more accessible to the primary Users of the knowledge. If we can bring this new efficiency to the process it's a win for everyone.

* He's also right about how service offerings drift as co's mature. This is in part why I like working with Angels more than VC's. Angels invest their own money. This generally means that they also earned it, which means that they've some familiarity with the business development process. As a consequence, Angels generally have more patience with iterative business development processes than VC's.

By example, it took Edison about 10,000 attempts to figure out how to make a working light bulb. When challenged on the volume of failure he had to experience to get to success, he said: "I did not fail 10,000 times. I succeeded 10,000 times at discovering what did not work." This is an Entrepreneurs perspective, and often an Angels perspective, too. But VC's invest in success. This is as it should be. But this is also why only about 4 of the INC 500's fastest growing co's are VC funded.

So it's tough to hit a home run the first time up to the plate. Angels are more willing to play 'small ball' and work the runners around. Knowing this, the ESF could be interpreted as being more for Angels than VC's, but that's in great part because there are so many more of them than their are VC's. Colorado alone has about 25,000 accredited investors and maybe a couple of dozen VC's. The math on this is instructive. 25K investors w/ 3% of their million dollar portfolios set aside for risk = $75,000,000. Imagine that being poured into startups in CO that have been 'scrubbed' for quality by something like the ESF. That's an innovation engine of global significance. If the ESF can help streamline the process for them - and in the process lessen the risk - by generating an audited business plan that was built to clearly defined standards everyone wins.

Best,
Kevin Johansen

Posted by: Kevin Johansen on June 16, 2005 1:57 PM

As a follow-up to an earlier email I sent to Kevin & Bert, I’d like to make a few more comments on the ES whitepaper. As you know, I’m very much in favor of your idea of entrepreneurial standards in general, and a business plan standard in particular. But I want to harp some more on the role of business strategy in the standards (especially in Appx. A & C).

In Appx. A. of the ESWP, the contributing VC (who is quite successful and who makes very helpful presentations to the entrepreneurial community) gives short shrift to business strategy as an evaluation factor because he feels, especially as an equity investor, that he has a strong voice and can come back later to impact the strategy (primarily through his selected/approved management team).

That sounds reasonable, but if we look further, it isn’t so reasonable. The same VC has a chart (but not shown in Appx. A), showing % winners and losers in typical early stage venture portfolios. 40 % of the ventures are out-right losers. Another 30% more are only break-even to 2X over the life of the investment (the remaining 30% are the actual performers, returning up to 10X+). So at least half are bad investments.*

Note that these bad investments had all passed muster with the VC company’s evaluation criteria. The market and the business/product idea were judged to be good. An approved management team had been put in place. So what went wrong? This picture is shouting that the strategies that the management teams eventually put in place after the investment decisions had already been made were loosing strategies. Had strategy (HOW the business objectives were going to be met) been addressed up front in a serious way, it could have been determined that either there were no really viable strategies available (irregardless of how attractive the market or product/idea may have been or what management team was installed), or that certain critical strategic criteria had to be met or agreed to before the terms sheet got signed – thereby obviating strategically unsound deals.

So wouldn’t it be a good thing if strategic problems were identified before an investment was made? Wouldn’t the VCs and entrepreneurs, alike, be happy if a real dent were made in that 50% of bad investments? Wouldn’t it be great if the reduction of risk resulted in a reduction in the cost of VC money for entrepreneurs? And angel investors, who usually have less voice than VCs, should be no less happy to have visibility into how the entrepreneur proposes to actually make those business objectives happen.

Shifting attention to another part of the current revision of the ESWP, Appx. C (straw man standard business plan content), the subject of business strategy isn’t to be found. For the investment risk reduction purposes mentioned above, for some level of assurance that the entrepreneur’s objectives are realistic and that he/she actually has a handle on how she/he can make their main business objectives happen, I recommend that Business Strategy be a part of the standard business plan content, and be mandatory. And per my previous email on the subject, I think articulating the strategy design and the business model that embodies it, in the build-up of the business plan, elevates the plan from a collection of topics to a consistent, traceable thought process. So also for this reason, I recommend that design of the business strategy, and design of a corresponding business model be integrated into the next revision of the standard business plan structure. Doing this could have a significant positive impact on both the entrepreneurial and investment communities served by the standard.

Regards,
Bill Carson

* This is high risk ball, and of course the entrepreneur has to cover the VC‘s risk by forking over a very substantial amount of equity in his/her company

Posted by: Bill Carson on July 4, 2005 10:11 AM

Bill, et al,

The business plan should be full of strategy.

That is what a business plan is all about, the strategy of getting to product, be that product hard or soft, and customers.

I have just found ESWP and have not gotten access to it yet, but I would hope that the text around the business plan talks to the fact that your business plan should be a living breathing document that is the basis of your business strategy.

When I managed a $1B Private US Venture Fund a few years ago, I was able to give my Investors a, on average over 10 years, 64% annual return on the invested portion of the money, and only two failed companies. The rest of the companies I invested in were either sold to larger companies, or went public, all for a great return.

This was accomplished by working with the management team and making sure that their business plan matched the industry, was living and breathing (not something that was thrown on the shelf and forgotten once they had the money) and mapped how they were to move forward. As the business changed, and most business tends to change as they progress, the business plan was kept current with new directions, with updated data and updated road map.

I know some pretty large and highly successful companies that require all executives to have the business plan at hand during in house business meetings and at Board meetings, as that is what they are held to. I think ALL companies should be following that practice.

MASSIVE SUCCESS!!
Don Bell

Posted by: Don Bell on August 14, 2005 6:52 AM

Ok, I'm not even sure i'm at the right site. Maybe you can help me. I run a small business. I need an angel investor.I must say it seems fairly obvious to create a successful business one needs a real market/sellable item, a structured business plan,and an idea that is not only good but is current with the daily market and yeta staff looking forward to create the next market. Well, all I ask is some direction on where to look to find an angel funder. The product is related to baby boomers,recreation and includes a tested tool-which i need to finish a non-provisional patent for. Sorry if this is not the right place. just erase if thats the case.

Posted by: Susan brhel on December 6, 2006 1:43 PM

I am a professor at Case Western Reserve University who is writing a book about angel investing and am looking to interview unaccredited business angels. If you are an unaccredited angel or have received funding from one and would be willing to have a 20 minute phone conversation with me, please email me at sas46@cwru.edu

Posted by: scott shane on May 3, 2007 4:44 AM

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