There are obviously two sides involved when financing a start-up company: one side provides the capital and the other side uses it. Over the past couple of months I’ve read a number of articles on financing start-ups. Some of them are aimed at angel investors and some of them are aimed at entrepreneurs. This post will discuss articles relating to angel investors and a follow-on post will look at raising capital from the entrepreneur’s perspective. Luke Johnson, who runs Risk Capital Partners, a UK private equity firm, and writes as a columnist for the Financial Times, knows about start-up financing both as a entrepreneur and as an investor. Not surprisingly, he has a few ideas to share on the subject [“My rules for being an angel investor,” 5 October 2010]. Johnson writes:

“Making investments in private companies is like panning for gold. You are forever searching for that elusive nugget among all the shiny pebbles. There are no immutable laws for achieving high returns, but there are plenty of rules of thumb that may help. As well as assembling my own tips, I asked my colleagues at Beer & Partners, an investing network, for their advice for those beginners thinking of making an angel investment or two.”

Here are Johnson’s tips:

“Expect subsequent rounds: usually the first financing is not enough to achieve success. There will probably need to be second and perhaps further calls for cash. Predicting when these appeals come, and how much money is needed, can be very difficult. Judging when to follow on and when to walk away separates experienced investors from amateurs.”

The requirement for subsequent rounds of financing can run the gamut of reasons from a company getting off to a slow start to a company getting off to an unexpectedly fast start. Obviously, investors would prefer the latter reason to the former.

“Back teams: few companies are built by one man or woman alone. You should look for a duo or even a triumvirate that has the breadth of skills to make a project work.”

No single individual can do everything that needs to be accomplished even in a fairly small business. The larger the business becomes the greater the need for a talented team. One way to judge a good entrepreneur is by the talent he or she is able to assemble.

“Margins matter: decent gross and net margins are vital. If the business is too low margin it will always struggle to deliver value to the shareholders.”

I agree that margins matter, but investors also look at how a company will eventually be valued. Johnson touches on that point later. Remember, in this post we are looking at financing through the eyes of the investor. Investors want the best ROI they can get. Although most entrepreneurs are also in business for the money, many are happy just to see their dream achieved and margins may not matter as much to them.

“Own the intellectual property: be wary of firms that do not own their own brands, patents, copyrights, designs, trademarks and so on. If the operation is a franchise or license model, it is difficult to control your destiny, and the upside will always be limited.”

Most angel investors aren’t interested in backing someone who wants to open a franchise. They believe banks are better for doing that. Johnson’s point about owning intellectual property is an important one. To read a cautionary tale about what can happen when a company doesn’t own its IP, see my post entitled Entrepreneurship: The Benefits and Pitfalls of Partnering. In that post, I relate the story of a start-up called Infoflows who started working with Corbis before it had patented its intellectual property. Needless to say, the situation turned nasty.

“Understanding: if you do not know exactly what the business does and how it makes money, avoid it. I never back ‘black box’ deals involving technical stuff that goes over my head – I like straightforward propositions that can be clearly analyzed.”

Although this post is looking at financing through investors’ eyes, one lesson that should be learned by entrepreneurs is that it is important to be able to explain your business in plain and clear language. Entrepreneurs are often told they need to develop an elevator speech (i.e., a quick, captivating description of their company). It’s true; but that speech needs to be backed by a solid business plan. For their part, investors need to be a bit wary of elevator speeches — more on that topic below.

“Price is not the biggest issue: do not get obsessed about the valuation placed on the company. If early stage investments do well, the multiple is likely to be big in any event. Focus instead on the quality of the management and the overall proposition.”

As I noted above, profit margin is not the only thing that investors look at. They are also interested in how a company will eventually be valued. Most of them are looking for the capital gain from selling their stock rather than the steady income they might receive from holding on to it. Investors and entrepreneurs seldom see eye-to-eye when it comes to valuing a start-up company. Basically, Johnson is saying to investors: Look at the potential upside. If it good, then where you start doesn’t matter all that much.

“Try to add value: backers who contribute more than just cash are likely to be preferred. So pick investments in sectors where you have experience – you will have greater insight and can offer better advice.”

Most investors are successful business people. Often they are approached by entrepreneurs with great ideas but little business experience. It’s not difficult, in these situations, to see how an investor can add significant value to the start-up business.

“Take references: do background checks on those in whom you are trusting your savings. Find out from independent sources the truth about their records. Never simply accept what you are told.”

As Homer Simpson would say, “Duh!” In another column, Johnson warns about buying into an idea based solely on a slick presentation [“Beware of charisma and buzz words,” Financial Times, 16 November 2010]. He writes:

“I have known a number of talented promoters who are brilliant at obtaining finance for new schemes. They move, apparently seamlessly, from one project to the next: a decade ago it was the internet, then China, then mining, then infrastructure – and so on. In their minds, possessing genuine technical expertise is not seen as a requirement. They have a great instinct for the zeitgeist – the asset class of the moment. They learn a script and recruit a gang of ‘experts’, and prepare a very persuasive business plan. They know all the buzz words – scalable, traction, leverage, burn rate, vesting and so on. They understand the intricacies of structuring transactions to benefit themselves. But none of this means they can execute their great vision in the real world. Yet institutional and sometimes private investors queue up to back them, desperate for exposure to the latest fashion.”

Johnson’s bottom line is this: “An ability to raise money does not necessarily signify an ability to make money. But investors forever confuse the two skills, and this leads to a damaging misallocation of capital.” Because investing involves risk, Johnson’s next tip recommends limiting that risk.

“Limit your exposure: angel investments should not comprise more than 10 per cent of any normal portfolio, because it is unquestionably a high risk/high reward asset class – with little likelihood of income. Similarly, you should diversify your venture investments across several companies to spread the risk.”

Sometimes old adages do make sense. “Don’t put all your eggs in one basket,” is one that comes to mind. Johnson’s next suggestion could become a new adage: Make sure all the eggs in your basket aren’t yours.

“Skin in the game: management must have plenty to lose. Do not back entrepreneurs who have financial resources yet commit little to the project. Management who want big company salaries and perks have their priorities wrong – they should be involved for the prospect of a capital gain, not high pay. The pain of failure needs to be shared.”

Again, this is just common sense. It’s too easy to walk away from something when it is painless. You have to pay for talent; but those charged with making the business a success should be given a stake in the business so that their financial future depends on their performance.

“Choose obsessives: winning entrepreneurs tend to possess an all-consuming passion when it comes to their business. Growing a new enterprise is a tough challenge – you do not want managers who give up too easily or have too many other interests.”

Although successful entrepreneurs are generally obsessed with their business, I would like to add one caveat to this tip. There are people who are obsessed with their business idea, but the idea is a bad one. They are so obsessed with the idea, that no amount of logic can persuade them to abandon it. Obsession cannot be the primary reason you back an entrepreneur. An article in The Economist brings this point home [“The pivotal moment,” 2 December 2010]. The article states:

“Having an idea and being passionately committed to it is important. But so is being clever enough to realize when it is not working, says Alan Patricof, a venture capitalist. He is looking to invest in young firms whose bosses know how to pivot: i.e., dump their old business model and adopt a new one. … This is a revival of an old argument: that investors should back people rather than ideas. What’s new is that the cost of starting certain kinds of businesses (especially web-based ones) has fallen, says Bill Sahlman of Harvard Business School. There has been a ‘remarkable increase in the degree of entrepreneurial experimentation,’ he observes. It is easier to launch and test an idea, and to pivot to another if it flops.”

Johnson’s next tip encourages investors to help entrepreneurs pivot when necessary.

“Form a partnership: the best investing relationships between capital and entrepreneurs are not a ‘them’ and ‘us’ arrangement, but a close alignment of interests. Solid partnerships are able to withstand the inevitable setbacks that characterize any young business.”

Often, large investors become members of the Board of Directors. This is one way to ensure that everybody is on the same team. If investors own companies that can become clients of the new business, all the better. At the very least, investors are generally well-connected in the business world and they should use their connections to help promote the business.

“Patience is a virtue: great deals can take years to mature. I have held some of my best investments for 10 years or more. Do not expect sudden windfalls – usually the flops are the first to be revealed.”

This is great advice. Like fine wine or good cheese, great companies often need to mature before their true value is achieved.

“Enjoy the ride: the objective is to make money, but the journey must be fun too. Finding and supporting smaller enterprises that create jobs and generate wealth is a hugely satisfying pursuit. Angel investors perform a vital economic function – they should be proud of what they do and enjoy the task.”

As an entrepreneur, I appreciate individuals and institutions that are willing to risk their capital by investing in start-up companies. As an investor, I want to make sure that risks are minimal and potential returns high. I believe that Luke Johnson has presented some pretty good rules of thumb to make that happen. Tomorrow we’ll go through the looking glass and see what raising capital looks like from the entrepreneur’s side.