I’ve seen a number of posts lately discussing the ‘changing face of venture capital’. Paul Graham talks about the change in dynamics caused by the low capital requirements of technology startups. Fred Wilson discusses the need for a market for privately held common stock. There seems to be a general consensus about the growing role angels play in the startup ecosystem, and sadly there also seems to be a general consensus indicating that angels should basically write off their investments the moment they make them.
This last point rings true for me. Before coming to India I made a number of investments in tech companies. During my chapter in Los Angeles I also put money into a couple of independent films and a big event with uniformly poor results.
“family, friends, fools & freeman” – Joke by John Mullins at the Venture Capitalist development program at ISB.
While the returns on these investments were uniformly bad, the journey the ventures took was not. One tech company has seven figure annual revenues which support the two founders in adequate if not lavish lifestyles. The founders / promoters in each case saw money on the way. Little made it back to the investors.
In iAccelerator.org we’re fortunate to have a team as advanced as HashCube.com. They are profitable with a proven record of developing and deploying casual puzzle games for social networks and mobile devices. Recently MySpace opened up its platform to developers and HashCube has done well as an early provider of games for it. They see an opportunity to scale – more games, more platforms, more promotion, more revenues .. more investment required.
Even if HashCube can reliably replicate the success they’ve had with their initial games, the question of whether their success can translate into a meaningful exit for its equity investors remains uncertain. What if it is simply a profitable business heavily dependent on the founders? Far from being an aberration, this maybe the common case for technology companies. 37Signals.com promoter David H. Hansson argues that creating small (compared to Facebook) profitable companies which serve the needs of real customers is a far more reliable path to startup success, than the traditional Venture backed Big-Bang approach.
To address this scenario, I had the thought that HashCube could offer investors the right to invest in a pack of games taking a % of the revenue generated by those games until achieving a certain IRR. The goal being to produce an automated mechanism in which investors get paid as a normal part of the company operations rather than being dependent on an exit event.Â
<p>Chetan Pungaliya spent some time here in Ahmedabad mentoring our companies, and had some interesting observations on this. He didn’t like the idea of selling the game pack as the founders needed the flexibility to apply both, the money and their time, where it would do the most good. This may be promoting the existing games rather than building new ones. For the same reason, he was resistant to carving revenues out for the investors early as he believed that HashCube could be ‘big’, and may need to reinvest all revenue back into the company to fully realize their potential. He suggested an alternative financing scheme as a compromise between the game pack based revenue share approach and the traditional equity model. His idea was to allow founders to reinvest all the revenue for the first few (say 3) years, but to cap founder compensation during this time. At the end of three years the rev share kicks in. This provides the founders with full flexibility to grow the business quickly during the initial period, and provides a clear path for investors to recoup their money if an exit isn’t apparent and the founders are taking the startup along a ‘lifestyle’ business route. Presumably, if the company raises a significant venture round angels at this stage would either be bought out, or would convert to shares on similar terms to those of the VC.
I’d be curious to hear from other potential angels about whether this kind of structure would make it more likely for them to invest in very early stage tech ventures.
- A Different VC Model - March 22, 2012
- Alternative Startup Financing Schemes - May 26, 2009
- iAccelerator – Supporting Early Stage Tech Ventures - March 18, 2009
This is an interesting post. As a budding angel investor myself I agree with Freeman’s post. I see angel investments as a write-off with low expectations of payback. I am proposing revenue sharing with the startups I am in touch with and option to exit when the first stage of funding is raised. the problem there is of course that I as the angel investor have a conflict of interest. I may be “robbing” the startup of vital cash by diluting my stake and/ or I may be forcing the startup to raise more investment when that may not be required. I think the profit/ revenue sharing works much better. I think this is relevant in the Indian market where many of the startups are not new to the world big market type ideas but more translating american business models to the indian context – a much smaller market. i see many startups becoming lifestyle businesses much like what Freeman talks about in his post and hence revenue/ profit sharing is more appropriate rather than waiting for the big IPO or buyout type exit.
I liked Krish’s solution. It sounds theoretically speaking financially appropriate. But I see many practical problems plus as angel it does not solve the problem of risk in the early stage. most of the startups i see from an investment perspective i worry about the first 12-18 months. that is where i feel the write-off mentality. if they survive beyond that then i hopefully will make my money back. so bank giving debt will not change that coz if in the first 12-18 months when there is maximum risk the start up goes belly up i have to pay up. same as before. i still enter with the write-off mentality.
hope it makes sense
Before the startups reading this get scared and feel that this means that they are getting only about years to prove themselves, I will try and elaborate this a bit more based on the discussion Chetan, Freeman and I had at iAccelerator in CIIE.
This sort of investment structure is probably more relevant from the point of view of startups which have higher probability of becoming a “lifestyle” business. If you are one of the startups which would probably need to raise money quite a few times, the early angels would (hopefully) get an exit sooner or later. Thus, they will probably pick up a simpler structure. But what if you are one of those who do not need a lot of money to get going, hit it soon and have quick cash coming? This might give the founder a comfortable $200k equivalent or more lifestyle early on and he might just decide to make the startup into a comfortable beach side resort rather than a hotel chain. Beach side resort is a good idea, but all it gets for angel is rooms at discount during travel.
Chetan’s idea helps the angel out in such cases.
The other important point is what happens to the equity once the revenue share kicks in. It could come back to the company based on a pre-decided multiple.
I guess, if the growing phase is happy-happy, there will be a nice discussion even before the revenue share kicks in and the angel/promoter will have another interesting offer before the three years.
This a a good observation and a discussion that is interesting to me.
Firstly their are exits for such cash cows. There are many folks that roll up multiple such companies by buying out the founders.
But lets assume that the company would like to stay independent. I am also assuming that the time to significant cashflow is quick. Now the question is – should the excess cashflow be invested in growth or should it repay the investors.
I would construct something where the first set of investors get paid back quickly and well and then a second set of investors replace them. The terms for the second investors would not be as good as those given to the first since the risks are lower. This gives the early investors a quick decent payback while letting the entrepreneur keep more of his subsequent cashflow.
I had done this once when I invested in the building of a hotel. I was an early investor and once the hotel was operational the builder/operator paid off the early investors as per predefined terms. New capital was brought in from traditional banks.
This is one scheme that may work and I am sure there are many other such schemes but it will probably take too much time closing these deals, especially when you consider that capital that these startups need is small.
A standardize structure would help but the key issue would be that the type of investor this would appeal to may not easily understand the risks and so basically sit on the fence forever.
“Consensus indicating that angels should basically write off their investments the moment they make them†is a bit baffling. If one were not sure of making a home run, wouldn’t they be better off throwing darts on stock exchange bulletin boards and invest where there is a higher, quicker probability of payback? In the angel investment scenario, the level of complexity simply is appalling.
For those fired up by passion and risk appetite, the idea of early years diet seems plausible. But if the objective were to de-risk the investment or free up more funds for risky early stage ventures, individual angel investors will have limitations. A more prudent case can be made by enabling institutional lenders “lend” to these ventures in the form of debt if backed by affluent individual angel(s) by way of personal guarantees (collateral) to the satisfaction of the lender. The gurantee shall be a tripartite agreement between (a) the angel (b) the lender and (c) the company, as the confirming party. Under this agreement the angel shall agree to invest in the company at a pre-agreed price per share, at a later date to the extent of debt raised by the company from the lender as and when its due for repayment. The debt instrument can be made attractive with a calibrated coupon of interest rates (zero for earlier years and with higher than average market rates during the latter years until its maturity with an early put and call option, as may be acceptable between the parties) that creep up with incremental revenues as years pass.
This solves several issues, viz. (a) the startup gets a fair valuation for its stock early (b) it has a valid collateral to raise “secured” loans that bear lower rates (on an average) (c) in the books of the lender it remains as a debt advanced and can even be securitized forward (d) in the books of the angel, it is not an `unquoted investment’ that has little or no mark to market value (e) lenders’ p&l account might as well show accrued interest income as per coupon until maturity or exercise of put option whichever is earlier and, (f) In the books of the lender, the loan shall qualify as a “standard asset” even during zero coupon early years and is not classified as “non performing asset†and so no charge against its P&L for making provisions against sub-standard asset that erodes its profitability / EPS (g) For the angel, there is no initial cash outflow unless the venture goes belly up and the guarantee gets invoked by the lender (h) lastly, if the venture is a success, all that the angel will have to do is to invest in the company at the earlier agreed price per share on a later date nearer to maturity and the company shall use those funds to repay the loan and cancel the collateral guarantee.
To me it looks like a rather surer, simple yet viable arrangement – just that it’s a bit old fashioned way of doing business (risks are hedged at every step, cash is brought in only when it’s needed) and not so “cool” 🙂
That would make sense for existing industries, but not so much for a new unexplored market….nevertheless, its an interesting view point.