Tips For Entrepreneurs Seeking Angel Investment

By Cathy Yarbrough, Contributing Editor
Follow Me On Twitter @sciencematter

For a first-time entrepreneur who is seeking angel funding to launch a life sciences company, the “exit strategy” may not be top-of-mind. It is for angel investors, those high net-worth investors who individually or as a member of an organized group provide seed and start-up financing in exchange for an ownership stake in the company, usually in preferred stock or convertible debt.

The exit strategy refers to the merger, acquisition, venture capital (VC) funding or initial public offering (IPO) that will reward angel investors with a strong financial return five to seven years after their investment. “We have three objectives. The first is to make money,” says Lauren Flanagan, cofounder and managing director of the Wisconsin-based Phenomenelle Angels Fund. And, their goal is to make money now, not in the distant future. “Angel investors often joke that their investment should benefit them, not their grandchildren,” says Steve Flaim, Ph.D., who heads San Diego Tech Coast Angels.

Angels fill a gap in the ecosystem of financing life sciences start-ups that once was dominated by VC companies whose focus has shifted to less risky later-stage companies. While angels risk their own money, VCs invest institutional funds. “There is a huge funding gap,” says Flaim, “because VCs don’t want to invest unless they can put in at least $10 million. Since most start-ups can’t generate that much traction to attract that level of funding, angels have moved in.”

Before seeking angel funding, life sciences entrepreneurs typically tap their own personal bank accounts as well as those of their families and friends. “Typically the sequence of funding for start-ups begins with the entrepreneur, and then family and friends who collectively provide an average $100,000,” says Flaim. “Second are angel investors, who invest $100,000 to $2 million. VCs are last.”

Homework To Support “Great Idea”
An entrepreneur must do a lot of homework before “pitching” angel investors, who rarely provide financing for a “great idea“ not backed up with a lot of data. “Founding a company is based on so much more than a great idea,” says Leslie Williams, who last December launched the Cambridge-based ImmusanT with seed funding from an angel investor. “First and foremost, an entrepreneur must think through and define the need for the product — why is it different or better than what is already out there, and why will someone buy it?” adds Williams, CEO of ImmunsanT.

In addition to a market analysis, well-defined marketing strategy, and realistic plan for market penetration, angel investors want to know about the senior management team recruited by the entrepreneur and how the team will execute the idea so that the new product, service, or technology will be scalable with a clear path toward profitability. The entrepreneur also must present solid financial statements and plans for spending, raising funds, and meeting milestones.

Entrepreneurs’ number one mistake when communicating with angel investors is emphasizing the science behind the new technology, product, or service, rather than its competitive advantage in the marketplace, says Tarby Bryant, founder of Gathering of Angels, which operates in several U.S. cities. Entrepreneurs too often “ramble on about their technology or business rather than the financial opportunity: how you and the investor will make money together,” Bryant says, in a 2010 issue of Inc. magazine.

Other mistakes that characterize entrepreneurs’ presentations to investors:

• Not mentioning the unmet need during the first two minutes and explaining how the company will profitably address it.
• Ignoring the actual and potential obstacles to success. “An entrepreneur should tell me when and how we are likely to fail, and not be afraid to force it to fail,” says Russ Lebovitz, M.D., Ph.D., partner in Texas-based DFJ Mercury Ventures, an unusual VC because it invests in seed and start-up companies. The resulting start-up is “robust and likely will work in the real world.”
• Skimming over the exit strategy. “Angel investors want to know how the start-up will exit and when and why it will occur, and how much profit they’ll receive at exit,” says Dr. Flaim.
• Overstating the start-up’s valuation, or financial worth, which is determined by such factors as intellectual property and letters-of-intent from potential customers.
• Lack of passion and excitement about the product, service or technology. The entrepreneur should “tell a compelling story in a compelling fashion,“ says Dr. Flaim.
• Not preparing for obvious questions, such as whether the company will be the first to market and how it will sustain its competitive advantage.
• E-mailing or telephoning angel investors whom they don’t know.

Although he receives numerous business proposals from entrepreneurs, Lebovitz reviews only a few — those from individuals whom he knows or who are referred to him by people whom he respects. “Every stage of this business is based on trust,” he explains.

Networking For Angels And Mentors
Networking to meet and develop relationships with life sciences professionals as well as investors is regarded by Dr. Lebovitz as essential. “An entrepreneur should be out there networking for at least six months but ideally a year-and-a-half before pitching an investor,” he says.

Through networking, first-time entrepreneurs should seek a mentor, whom Williams describes as an experienced professional, “not an investor, but an individual who will answer their questions, hear their ideas and help them to avoid land mines.” Angels include solo investors as well as groups of investors, such as the Tech Coast Angels in Southern California, the Angel Healthcare Investors in Boston, and the Life Sciences Angels in San Francisco.

According to the Ewing Marion Kauffman Foundation, there is a growing trend for individuals not to go solo but to join groups, whose members collectively evaluate each investment opportunity. The success rate of entrepreneurs’ companies is much higher for those with angel funding, compared to those financed by solo investors, a recent foundation-sponsored study reported.

Angel groups total over 300 in the United States and Canada, according to the Angel Capital Education Foundation (ACEF). Angels tend to invest in start-ups located near them. “We like to kick the tires of the company without using jet fuel to get there,” says Flaim.
In many angel groups, members pool financial resources, with a majority vote determining whether a proposal is funded. However, in groups that do not pool members’ funds, each member decides whether to invest in the proposal.

Before writing checks to finance a start-up, angel investors conduct due diligence reviews on the details of the business proposal, such as the financial statements and capabilities of the management team, whom angel investors want to be sure are the “right group of people to do this deal,” says Flaim. Angel group members also work together to negotiate the term sheet, which the ACEF describes as a guide for preparing investment agreements and determining the relationship between the entrepreneur’s company and its angel investors.

Investing More Than Money
Angel investors expect to do more than write checks. “As organized private investors, we invest more than money; we invest our time, talent, experience, and contacts to help our portfolio companies be successful,” said Catherine Mott, CEO and founder of Pittsburgh-based BlueTree Allied Angels, which invested in MedSage Technologies, sold in early 2011 to Royal Phillips Electronics. The angel group’s equity stake yielded a 28.7% compounded rate of return.

For entrepreneurs, angel groups offer several advantages over solo investors. One is visibility. “Most solo angel investors fly under the radar because they rely on other angels and experienced service providers for deal flow,” says angel investor William Payne, in the Inc. magazine 2010 article, “How To Meet Angel Investors.”

In addition to sponsoring events for entrepreneurs, many angel groups have websites featuring information about the investment criteria as well as online forms for submitting proposals. If applying online for funding from an angel group, an entrepreneur may not have to create a formal business plan or proposal because the members may review only the information submitted in the website form.

Entrepreneurs never should provide a business plan unless it is requested by an angel investor. Angel investors initially want to see only the two-page executive summary that opens the business plan.

For both entrepreneurs and angel investors, the current economic environment is exciting because “corporate America is loaded with cash and is choosing to acquire small companies in lieu of expanded internal R&D,” according to the San Diego Tech Coast Angels. “The sweet spot for many large U.S. companies is $15 to $30 million, selling prices of great interest to entrepreneurs and angels but not generally to traditional VCs.”