Angel Investors and Entrepreneurs - Living a Bad Dream
Bill Warner Monday, October 06, 2008
Watching the economic news unfold over the last week was like living a bad dream. Like most dreams, it was a slow moving series of events that brought us closer and closer to economic disaster as the flow of credit became more and more constipated.
Financial institutions are failing, including our own Wachovia Bank, coming off the failures of Lehmann Brothers, Fannie Mae, Freddie Mac and others. The administration put guns to our heads telling taxpayers that they had to pay $700B or else the world as we know it would end. Congress denied all accountability and served up some more pork to fix the problem, moving us closer to the abyss of socialism. McCain gave a head fake of leadership, while Obama again ducked and weaved his way to looking like the almighty savior with a few good speeches.
So, there in that bad dream stand angel investors, whose portfolios of investments are being crushed by the resulting market downturn. But, the dream is not over. We still have not gotten a complete awakening of what is going on and what else is going to drop on our heads. What does this mean for angel investors and the entrepreneurs that need them?
The Angel’s Perspective
Angel investors are high net worth individuals who have a broad array of investments, less than 10% of which is in high risk start-up companies. Their issue now is what is happening to the other 90%.
- If they are invested in the public markets, they are seeing at least a 10-15% decline in the value of their investments.
- Depending on what they are invested in, their losses could be astronomical especially if they are invested in financial institutions or the real estate market.
- Their own companies are feeling the impact of the slow movement of credit as they try to borrow money for business operations.
This all adds up to a need to conserve cash and reprioritize their investments to lower risk opportunities.
- Depending on their investment strategies, they may decide to sell the securities that have been irreparably harmed.
- They may conclude that the depression in the market is not over and that we are going to fall deeper into depression, and therefore put their money into very low risk investments.
- They may actually increase investments in areas that are fundamentally sound, getting great deals in this depressed market.
So what happens to their investments in start-up companies, that 10% of their portfolio? These are not liquid investments, so they will certainly continue, but they will want to see more aggressive strategies for exits as they will be willing to take a lower return to cash out earlier. Entrepreneurs will have to focus on creating earlier exit opportunities and creating greater shareholder value faster.
Chances are they are going to pull back on making any further investments until the economy stabilizes and they find out exactly where they stand. Getting them interested in a new investment in a start-up is going to be extremely difficult. Entrepreneurs will have to really focus on putting together their business plans to show not only an attractive opportunity but a substantial return more rapidly than ever before.
Many of them are going to move to more mature companies that represent lower risks, as the venture capital world did coming off the downturn in 2001. This will challenge entrepreneurs to form businesses that can reach profitability and positive cash flow earlier.
The Entrepreneur Suffers
Entrepreneurs already have a tough enough time getting their companies launched without investment money and credit drying up. This is not just a bad dream, it’s a nightmare. They are hit in two fundamental ways:
With continuing market depression, it will become even harder to find financing for start-up companies:
- Government budgets are going to come under scrutiny which will impact the lucrative grant programs that are available today. This means that the proposals that are submitted for these programs have to be even more compelling and address a strong and urgent need.
- Foundations whose investments are also in the markets are going to experience lower returns which will reduce the amount of money they will be able to offer to new business ventures. As with government grants, the pressure on the entrepreneur to have a stronger and convincing story to justify the foundation grant.
- The limited partners of venture capital firms will also feel the pinch in the markets, putting further pressure on venture firms to perform. Raising further funds from limited partners for venture capital will be more difficult as well. As entrepreneurs approach venture firms, they are going to have to show greater returns over a shorter period of time, and the risks have to be well mitigated.
- Angel investors will back away from new investments, unless they see a clear winner that they will be able to get into at a very attractive price. Start-ups are going to have to show a very attractive market opportunity and accept lower pre-money valuations as they have to offer more of their company in order for investors to mitigate their risk.
Existing start-up companies are going to suffer in their day-to-day operations:
- For the limited amount of credit that will be available, the terms for borrowing money for new equipment are going to be more onerous, almost making it worse than spending valuable cash to purchase equipment outright. In the same manner, leasing will become tighter as well. Entrepreneurs are going to have to be even more inventive about finding used equipment or align themselves with partners to share in the use of equipment. Outsourcing the need to companies who have it will have to be a strong consideration.
- Investors are going to find companies that have strong credit worthiness more attractive. Entrepreneurs are going to have to establish strong credit, mainly through the credit worthiness of the company’s founders and of the company’s business partners who are willing to back them.
- For the many rapidly growing companies who need to partially finance their early success through AR financing, they will see even tighter restrictions on the quality of AR backing. Entrepreneurs will need to negotiate more attractive payment terms with suppliers in order to survive, or choose to grow slower, within the limits of their cash flow.
- Lines of credit, the vehicle by which short term cash demands for payroll and other payables are sometimes met, are going to be tougher to get, putting cash-squeezed companies at great risk. This too will force entrepreneurs to reconsider payment terms and other means of conserving cash will be even more important.
A Perfect Storm of Incompetence
We have been deceived and let down by about every agency that should have been protecting us. No matter what you hear from whatever biased news source you encounter, there is blame everywhere:
- Henry Paulson, Ben Bernanke and Christopher Cox, as well as many others in the administration, have known of the implications of providing sub-prime mortgages to unqualified buyers for years. Where were their loud and assertive voices? What did they do to prevent this from happening? They drove us right into a ditch.
- Congressional leaders like Barney Frank and Chris Dodd, the committee members they lead, and the oversight groups that were supposed to protect us have materially caused this whole debacle. Starting in the Carter era, they and others that preceded them have pushed opportunities to the financial industry to offer mortgage loans to low income people, often asserting great pressure if they didn’t. Over thirty years later we have trillions of dollars in bad mortgages. This was not a problem of deregulation. It was a problem of bad oversight.
- Financial institutions took the bait and caved to the pressure to provide questionable loans, knowing that they would be bailed out by Fannie Mae and Freddie Mac. Now, they look stupid, having had foresight as to what it would mean, but did it anyway.
We now are living in a perfect storm created by their incompetence and it is not over. Meanwhile, the taxpayer is going to pay the bill for the results of a dysfunctional congress and an ineffective administration, all of which have not looked out for the best interests of the public and the businesses that drive our economy. The fear lingers as to what further surprises are on the way.
What a great week! I can’t wait to see what is coming in the weeks to come. Now I am going to paint the porch, rake some leaves and scream at the birds. But, tomorrow, the optimism and opportunism of angels and entrepreneurs will continue to prevail.
Filed Under: Angel Investment, Financing a Company
Bill Warner is the Managing Partner of Paladin and Associates, a business consulting firm in the Research Triangle Park area of central North Carolina, and is the Chairman of the Triangle Accredited Capital Forum, an angel investor network with over one hundred members throughout the southeast.
Bill Warner is the Managing Partner of Paladin and Associates, a business consulting firm in the Research Triangle Park area of central North Carolina, and is the Chairman of the Triangle Accredited Capital Forum, an angel investor network with over one hundred members throughout the southeast.
Bill,
Very good article. As an aside:
The debt markets dwarf the equity markets; when debt of all maturities can’t be sold for fear of liquidity and return of principal (much less return on principal) there is little hope that “pure risk” dollars will flow into the market. I think we would all agree that Angel dollars are about as risky as they come.
Thanks for your insight - Joe Spratt
Bill another thought provoking article.
What is interesting is that money (in the generic sense) is a proxy for agreed transacted value and credit is a proxy for trust.
When it became accepted practice to transfer the risk of credit default by contract we did not require a full accounting of the information needed to determine the value of that risk and consequently set the contract counterparties to fail.
So with our current credit crisis we can only work our way out of it by generating trust and providing full information about our own personal risk and counterparty risk. Being trustworthy, informed and frank creates (but only over the long term) the ability to trade personal and business committments and reduce global risk between ourselves, business partners and business community..
The burden to overcome the current crisis is ours and our rewards will be what we make of them,
Thanks Joe. I think the debt market is in measured in many trillions, three orders of magnitude larger than angel investing which is the riskiest form of equity investing. When the debt market stops flowing, its like a train wreck effecting everybody, businesses as well as private individuals, especially those invested heavily in public markets.
Man, there are so many moving parts in this dissaster that it is almost impossible to predict anything with any certainty.
Thanks for your feedback..........................Bill
Very thoughtful point Graham. Our trust in government oversight to protect us has been shaken to the core. Our trust of the incumbant administration has been shaken because they let this happen without doing something to prevent it. Our trust in the financial industry is nearly destroyed due to the greed and stupidity of those firms that exploited the bogus regulatory umbrella that protected them while making and trading these unqualified mortgages for the last 30 years.
I don’t know where it will start, but a whole new cast of people will hve to emerge to rebuild trust. That includes the cabinet officials that oversee the financial industry, congressional committees that also provide oversight, and executive leadership on Wall Street. I guess it starts with the next election as we make a change in the administration. Which party is going to be the best to clean house in government and protect the American people.
Thanks for your feedback.......................Bill
