Angel and venture investors in startups and early-stage companies frequently have the option to determine the extent to which they intend to contribute intellectual capital, beyond their financial commitments. “Value-added” private venture investors often lend their business skills, resources and rolodex to their interests, helping the company solve tough problems, prioritize objectives, build a great team and even seek out strategic partners and potential customers.

Equally compelling to private venture investors is the ability to influence the terms of engagement of their capital in a manner that increases the opportunity for a favorable investment outcome. Unlike conventional public investment vehicles and most alternative products such as hedge funds, the investment terms for private venture investments are generally negotiable…depending on the size of the contemplated investment and stage of the company and the funding history.

Evaluate—Negotiate–Allocate

Between due diligence and the investment decision is the opportunity to influence and negotiate investment terms in a manner that increases the probability of a positive asymmetric outcome. It surprises me when angel allocators, particularly lead investors in a seed round, simply accept the offering terms of a private venture without fully leveraging their currency to negotiate the best deal for their capital. Startup capital for new ventures is scarce today relative to the halcyon days of the 1990’s. That tilts the advantage in favor of capital and provides early-stage venture investors with an opportunity to materially improve upon their position.

Angel round investors are a unique breed. They take on startups at the riskier seed stage (in pursuit of higher-multiple exits) at a point where venture capital firms will typically not engage. VCs and institutional investors are more apt to require some evidence of progress with a startup…whether with regards to financing, product development, a proven business model or market traction. Yet that does not prevent VCs from coming to the table with their own terms for a Series A financing.

On the other hand, angels too often let the entrepreneur set the terms for the seed and bridge financing rounds.

So, which provisions in an angel round’s term sheet are generally negotiable? All of them.

I am humored by entrepreneurs who describe their terms as being “market”. Because there is no market without the angel’s capital, and that means that valuation, liquidation preference, anti-dilution protection, dividends, various protective provisions, board composition and even the vesting of the founder’s stock can and often should be subject to negotiation…particularly in a smaller financing round.

Each of these terms may have a critical influence on the outcome of an early-stage investment, but valuation is arguably the most difficult for angel investors to negotiate as there is little meaningful company history to assess…rather, merely a vision around an idea, a market and a management team, and perhaps a business plan.

The “market” (of angel investors and entrepreneurs) has responded to this quandary by predominantly relying upon Convertible Notes to fund seed-stage companies. Rather than dickering endlessly about the present value of a future uncertainty, angels and entrepreneurs agree to lend their capital to the new venture in the form of a note (often secured with some form of collateral and offering a dividend) and agree to convert their debt to equity at the price set in the subsequent round of financing.

The theory is at that point in the future, much more will be known about the business, market, competition and opportunity and that it will be easier to agree on a valuation.

Consequently, Convertible Notes have become the primary template for seeding young companies and providing “bridge” financing from the concept stage to a larger, subsequent financing round.

Early-stage investors should engage the growing universe of online content that speaks to best practices, suggested deal terms and negotiation tips for investors in early-stage ventures. Most critically, tyro angels should engage a securities attorney with ample experience in private venture financings to advise them on term sheet negotiation.

In Woody Alan’s 1994 crime-comedy Bullets Over Broadway, the gangster-financier played by Chazz Palminteri exploited his angel status by casting his girlfriend in a lead role and rewriting the play’s script.

In early-stage financings artful angels should always consider opportunities to leverage their currency to rewrite the script of the bridge note and positively influence their investment’s ultimate optionality and outcome.

Album:   Script of the Bridge, The Chameleons, 1983

I have noticed that VCs tend to talk to the public and with their peers more about their home runs than their strike outs. Angel investors, on the other hand, prefer to relentlessly revisit their pain—often comparing their battle scars like veteran samurai. Probably because angels put up their own capital. Because they truly do eat their own cooking it’s harder for angels to forget their fallen soufflés.

VCs achieve their highs from the opium of OPM…so even a bad trip is still a free trip.

I recently had lunch with an inveterate venture investor (aka “angel”) whom I had co-invested with in a biotech, as well as, a med-tech company, several years back. Our conversation inevitably turned to peck at our past portfolios.

The biotech company was a true home run—a high-multiple exit realized in a 2004 IPO. (When was the last time you saw biotech, high-multiple and IPO in the same sentence?)

But, rather than relishing in a reminiscence of our raison d’être, we chose to get muddy in the mire of our miss—the medical device company that (nearly seven years later) was still trudging along with neither an exit, nor a write-off in sight.

There is the baneful scenario–five or more years in an illiquid private investment that just keeps rolling over but never plays dead, and, there is the painful scenario–a company running profitable for several years straight but no IPO, acquisition or distribution on the near horizon.

Two questions dominated our discourse. First, what would become of the med-tech investment? And secondly, what can we do differently as investors to avoid non-outcome outcomes in the future?

My most previous venture ovation opined, “There is very little that is binary about venture investing outcomes. It is not just feast or famine…outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater…”

That list of outcomes would be just fine if it was indeed comprehensive, but I employed some autistic license. The reality of the absence of binary outcomes in private venture investment occasionally includes the potential absence of any outcome at all.

In an amusing piece “10 Exits”, Angel Capital Association’s chairman John Huston further parses this purgatory. He evokes the venture vernacular “Zombie” as “a walking dead venture that will never become a great company, nor will it die so I can declare the loss.”

There are a number of ways to euthanize a zombie but what do you do about the investment that Huston calls, “My Grandkids’ Company…a company that is successful but there’s no exit in sight”? (“Maybe it will occur after my grandchildren inherit the portfolio.”)

That is the second question, and yes, there are methods that an investor can apply at the outset of the investment that mandate distributions from profitable private companies.

I have developed some effective term sheet and funding mechanisms that enhance the optionality of a private investment’s outcomes that avoid inadvertently gifting your grandchildren. I will share them in an upcoming post. They are the byproduct of my own experiences, and as you know, experience is what you get when you were looking for something else.

Album:   Hits and Exit Wounds, Alabama 3, 2008

One of the few commonalities among the thousands of VCs and angel investors is the consensus that the process of identifying an attractive private venture investment is “part art, part science”. The art part speaks to the inherent absence of certainty with respect to any venture’s viability. There are no absolute truths…no bankable checklist to follow that ensures a successful outcome for a private venture investor.

The science part? That’s simply hindsight, which of course is an exact science. Of the ways that I have derived knowledge as a private venture investor, hindsight is the most expensive, the least merciful and the most valuable.

When it comes to separating the wheat from the chaff, my primary screen is simple. For a private venture investment (PVI) to be worthy of the costly, time-consuming, bandwidth-bogarting process of evaluation, consideration, due diligence and deal term negotiation, it must initially meet these four criteria;

1.  There is a large market for the firm’s products or services

The size of the market must be material for a PVI to potentially achieve a high cash flow or high-multiple (positive asymmetric) outcome. The success of category-killer app, product or service in a small market lacks the potential of an exponential payoff and does not proportionately offset the risk of a loss.

Ideally, the market should not be merely mature—it should be a growing market. The market can be newly-emerging (alternative energy, for example) or non-existent (Twitter) at the point of the venture’s introduction of its product or service, but it’s potential must be measurable and meaningful.

The values set forth in the modern business classic Blue Ocean Strategy often come to mind. Blue oceans denote industries untainted by competition. In blue oceans, demand is created rather than fought over…competition is irrelevant because the rules of the game are waiting to be set.

I am predisposed to the notion that the initially contemplated product, service or business model rarely succeeds, and consequently ventures are frequently forced to adapt to new data points. This requires the room to maneuver that a large market provides.

2.  The firm has a sustainable competitive advantage

The venture must have a sustainable edge to attract and retain its market share. The location or lease of a real estate development can be an edge. The celebrity chef to a restaurant, the IP portfolio of a technology or medical device company or a strong distribution channel relationship can be a critical edge to a consumer product.

The more tangible, unique, defensible and proprietary the edge (such as patents)…the better. The competitive advantage should discourage competition and create a barrier to entry. The edge will vary according to the venture’s industry. First-mover status is often meaningless (like many others I prefer second-mover) and certainly not sustainable in a market of compelling size.

A sustainable edge to compete in a large market is critical to potential acquirers or public markets and the objective of realizing compelling multiples on an exit.

3.  The management team has compelling expertise in the contemplated market

You must have a great execution team. Visionary founders may be inspiring but they alone cannot bring a great idea home. Get an experienced and accomplished operator in early.

In a couple of my early investments I failed to hone this rule to its proper endpoint. Naively, I believed that the serial entrepreneur with prior liquidity events was a proven winner and worthy of the wager. The first time that formula fell short I failed to make the proper connection, the second time I learned the lesson. There will not be a third time.

Successful entrepreneurs too often become deal junkies fueled by the fumes of their prior triumph. Some become self-anointed business “generalist” experts (contradictory, eh?) that no longer feel restricted by the limitations of their actual core competencies.

The founding partners and management team must include an accomplished C-level executive or highly accomplished operator with a track record of proven experience with the specific business model and target market. Moreover, the operator must have the authority and discretion to execute the business plan. Serial entrepreneurial ego in the absence of domain expertise is a formula for failure.

4.  The deal terms are no less than fair, and ideally—favorable

Valuation, investor rights, board representation, management discretion and transparency with respect to material events, protective provisions, anti-dilution protection, liquidation preferences and optionality issues must incentivize and respect the source of the capital. The investor’s capital is the great enabler… the sine qua non for any venture.

Few things are as humbling as the successful venture that does not translate into a successful investment. I respect the often repeated axiom that a fair deal is one where both parties feel that they got a bad deal, but the end game should always be to negotiate favorable deal terms.

The probability of an attractive outcome is diminished if a private venture investment cannot meet these initial thresholds. In VC-speak you are nursing a newborn “zombie”…a walking dead venture…the ship is already sinking and it has not even left the port.

Album:   We Were Dead Before the Ship Even Sank, Modest Mouse, 2007

Private investments in venture and early-stage companies are characterized by their potential for positive asymmetrical outcomes (PAO). The risk of losing the entire investment is offset against the potential for high-multiple ROIs. But asymmetric outcomes refers to more than the non-linear relationship between risk and return…it also refers to the appeal of investments where multiple liquidity and exit outcomes are possible.

This is often referred to as optionality…current knowledge of the potential for multiple future outcomes.

According to his book, In an Uncertain World, Robert Rubin, the nine-figure alumni chairman of Citi, is said to have developed his appreciation of optionality in his prior days of risk arbitrage at Goldman. While practicing risk arbitrage, Rubin developed a penchant for optionality (keeping ones options open) and avoidance of a mindset that restricted decision-making to binary and zero-sum outcomes.

It is believed that Larry Summers ultimately coined the phrase “preserving optionality” back when he was deputy secretary of the treasury under Robert Rubin in the Clinton administration. It was meant to describe a strategy of keeping options open and fluid, before all of the uncertainties have been resolved in dynamic environments where there is a high likelihood for the emergence of new and material information.

The phrase is relevant in venture circles for investors, as well as, entrepreneurs.

Preserving Optionality for Investors and Entrepreneurs

For entrepreneurs, optionality in rapidly evolving scenarios (such as a start-up) means leveraging real-time data and experience before making important decisions that are either resource intensive or cannot be easily reverse…such as pursuing a market vertical, developing a new technology or application, embarking on a joint venture or contemplating multiple exit strategies.

In most instances these options were not conceivable at the outset of the venture because, at best, a start-up’s business plan is to an entrepreneur what a treatment is to a script writer…it’s simply a first draft. It is the actual, real-time development of the story line and its characters that ultimately determines the final draft of a movie script…or the path to monetization for a new business venture.

Investors and experienced entrepreneurs know this. I have rarely seen a startup that successfully monetized itself based upon the mission, objectives and milestones envisioned in its original business plan. That’s because time in the market is often more valuable than time to market with respect to improving the quality of the critical decisions that are of material consequence.

Technology consultant Sean Hull of the Heavyweight Internet Group notes this nuance…“preserving optionality is a philosophy that takes some getting used to. It involves having a sense of humor, and realizing our own human limitations.”

Author-epistemologist-investor Nassim Taleb gets it as well. In Fooled by Randomness he characteristically opines “people overestimate their knowledge and underestimate the probability of their being wrong“. He suggests that by being ever aware of our limitations of prescience, and keeping our eyes and our options open, we can make better, more educated, and lower risk decisions. He is correct.

This implications and realities of preserving optionality, often positions entrepreneurs at odds with investors. The interests of optionality must be balanced.

For the entrepreneur, preserving optionality is an interest that frequently requires a balancing act against intrusive, non-strategic, no-value-add investors who view accountability and measurability as metrics preeminent to the benefits of prudent executive flexibility and strategic discretion.

On the other hand, the investor’s needs for optionality is particularly relevant today in light of the macro market malaise and minimal marquis exits. With venture-backed IPOs now more an exception, venture investors need to stipulate optionality with respect to cash-flow and exit rights as a contingency to their investment commitment.

Investors need to see visibility to alternative liquidity events such as dividend distributions or return of initial capital beyond the sale or merger of the company or its assets, or a less than likely IPO.

It is of no surprise that investors have a preference for positively-skewed outcomes and hold an aversion to negatively-skewed outcomes despite the fact that linear or variance-based risk measures generally weigh the outcomes equally.

Yet, investors seeking the potential for multiple and positive asymmetric outcomes on their commitments must also apply the measures of asymmetry and optionality to their deal diligence and terms. More than ever, investors should require visibility on multiple paths to liquidity. The investor has the responsibility to appropriately balance their interest in ROI with the survival or expansion cash-flow needs of the portfolio company.

Why so many “professional” investors are so passive on this issue is puzzling.

Investors and entrepreneurs alike both benefit from preserving optionality and having the pre-negotiated discretion to pursue a prudent Plan B.

We will discuss those some of those options in upcoming posts.

Album:   Balance & Options, DJ Quik, 2000