Angel & Venture Capital Cases

If entrepreneurs were able to put themselves into the mind of an angel or venture investor, what would they learn that would help make them investment-worthy? We put that question to two local attorneys and an accountant, all of whom are accustomed to advising entrepreneurs. Their counsel is to be prepared for thorough due diligence, perhaps the most complete business exam they will ever have, and be ready to defend every financial assumption in their business plan.

In terms of venture capital, more help is on the way. Venture capital legislation would create a Wisconsin Venture Capital Authority to invest $400 million in qualified businesses, and lend support to an increasingly active and sophisticated network of Wisconsin angel investors.

"We have to start relatively small, let it run its course, and build a successful strategy," said Ed Maginot, a partner with Grant Thornton. "If you throw too much money at it without the proper infrastructure to administer it, that can lead to problems."

Venturing out

An estimated 80% of all start-up companies are self-funded and later financed through friends, associates, and private angel investors (usually in that order), and it's rare for new businesses to attract venture capital. Most entrepreneurs operate in the angel space with the notion of positioning themselves for venture capital (VC) later on.

Both angels and VCs will test the fundamental premises of a business plan, which must be well thought out. It must explain the business story, including: solutions to a problem, revenue model, and growth plans; how much needs to be raised, what the money will be spent on, and how far it will go; a timetable with key milestones; and the legitimacy of any patent claims related to intellectual property.

Attorney Mike Klinker, a shareholder with Whyte Hirschboeck Dudek, said angels want to hear two coherent stories. The larger story is about how the company will reliably make money. With respect to angel investors, who are getting better at putting entrepreneurial feet to the fire, the smaller story is to explain how the money will help the start-up business reach its objectives. "The entrepreneur needs to be able to put together a coherent story of why this company will make money," Klinker said, "and how it will become consistently profitable over time."

No aspect of a business is immune from examination because the source of funding, an angel or VC fund, has a fiduciary responsibility to its investors. They will expect entrepreneurs to justify every financial assumption or projection in the short, medium, and long term (about five years hence), and to show a plan to liquidate the investors' position (pay them back) in an "exit strategy." The exit can take several forms, including an initial public offering of stock, a private transaction involving a financial or strategic buyer (the most common type for Wisconsin exits), or a leveraged buyout.

The other key considerations involve a potential change in business entity, and the eventual loss of majority control to venture capitalists. Maginot (Grant Thornton) said "S-Corps" that want private equity investments must change to a C-Corp or a Limited Liability Company because they allow for third-party investment.

With angels, it's the exception for investors, especially in an initial round of funding, to get majority control. At this stage, angels are willing to take minority positions, especially if they can gain some limited control through contractual guarantees. "If you can find an angel that understands your industry and can help you navigate those waters, that's the best situation," Maginot added.

To secure venture capital, entrepreneurs must be willing to give up majority ownership and decision-making control to investors, plus some type of preference that will enable them to either be paid first (preferred stock) or turn their investment into equity when the next round of financing occurs (convertible debt).

At what point do the venture capitalists get involved? Entrepreneurs should know when they are going to seek venture capital, which will require a different elevator pitch than angel capital because the company will be at a more mature stage. They also have to pinpoint the source of that venture capital relative to their business space.

"Are they in a space like social media, where maybe they are sexy enough to get West Coast money?" asked attorney Paul Wrycha, a partner with Foley & Lardner. "If they are not in a space like that, they may need to focus on Midwest venture capital, or a combination."

If entrepreneurs get a couple of different offers from VCs, they should turn the tables and conduct due diligence on the venture funds. "Talk to some of their portfolio companies," Wrycha suggested, "to determine whether the VC funds are themselves good business partners."

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