Red Flags that Turn Off Venture and Angel Investors
This is the second installment of notes I took at the New York Venture Summit on a hot summer day in Manhattan, July 25, 2011. These notes came from the fourth panel entitled “What Should You Do to Get VC’s and Angel Investors to Say Yes?”. When asked what will quickly kill an investment presentation without further investigation, they answered:
Too many features in the product, making it too complex.
No way to protect the IP.
The entrepreneur is obsessed with obtaining an NDA.
There’s no business plan behind the slide deck.
The presentation is too technical.
The presenters did not rehearse.
There is a significant regulatory risk, such as from the FDA.
Unrealistic valuation expectations.
The valuation rises over time because the business area is trendy.
It’s a copycat company; not an original idea.
This was only a short list since the panel did not have time for more answers. A longer list of red flags can be found in the Insider pages of the Intelliversity website at www.IntelliversityCampus.org, but there are some unique ones here that I hadn’t heard before. It’s important to pay attention to all of these red flags because no matter how much hard work you put in preparing your presentation, business plan, team, etc., if you make just one of these mistakes, your time will be wasted.
The problem for you as a presenter is that not all investors will agree with all of these red flags. For example, some investors like copycat companies so long there is reason to believe you’ll do it much better than the other company. So I think it helps to explicitly ask each investor group or individual you present for their list of red flags.
This applies particularly to “unrealistic valuation expectations.” Here there are large differences between different investors. Organized angel groups tend to want lower valuations than free-lance angel investors. Just this month, a company in San Diego was funded heavily by independent angels at a valuation of about $5 million but was turned down at the same valuation by an organized angel group. So there are large differences in acceptable valuation.
Let’s digress for a moment to point out that the valuation of a startup or early stage technology company has little to do with its sales projections. It doesn’t matter to most sophisticated investors I’ve met if you project sales to be say $50,000,000 in 5 years and compute the present value of that projection. It doesn’t even matter if you intelligently factor in the rate of failure of similar companies in the past. Experienced investors know it’s impossible to rely upon such projections since the unknowns are so large. So they don’t try to compute the valuation of a young company this way.
For experienced investors, valuation is simply a device to compute how much of the company the investors will own after their investment. For example, if a company has a pre-money (before investment) valuation of $1,000,000 and anticipates an investment of $500,000, the post-money valuation will be $1,500,000. Therefore, the investors will end up with 33% of the company after this investment ($500,000 / $1,500,000.) Investors will determine how much of the company they want to own, and reverse-engineer the pre-money valuation. They will compute like this: “We plan to invest $500,000 and want 33% of the company, so the post-money valuation is $1,500,000 and therefore, the pre-money valuation is $1,000,000.” It’s the percentage of the company that the investors want to own that is important, NOT the pre-money valuation. You as an entrepreneur should never be offended by any particular pre-money valuation; you should only decide if you want these particular investors to own the amount of the company they want to own.
The good news is that the right investors bring a great deal of value to the companies they support. Giving away 20% to 40% or more to the right investors is worth it if they bring a great deal of experience, contacts, and so on. You already know that it takes a village to make a company; it’s very hard to do it on your own. Just make sure that you do in fact get the kind of experience and contacts that you think you are getting.
On the other hand, here’s a tip: if you are a highly enrolling and persistent individual and your product solves a clear problem that the general public would understand, and you already have all of the experience, advisors, coaching and contacts you think you need, you can find unsophisticated inexperienced angel investors who will invest in your company for a smaller share of the company than will professional angel investors. In other words, unsophisticated angel investors will accept a higher valuation than the professional angel investors if they are charmed by you and your vision. I’ve seen this happen many times and it’s always surprising to me. The problem with bringing in unsophisticated investors at a high valuation is that it creates a red-flag for the next round of investors if you need more money. This last point is a complex subject that will have to wait for a later blog post.