Why have all the angels gone?

Angel investors, seed investors and early stage investors, in that order of severity, saw their investments wiped out when venture capital and private equity valuations collapsed in late 2000 and during 2001. For many it’s a case of a lesson they feel no need to repeat, but others are coming back, strictly on their terms. Angel, seed and early stage investors are developing new investment models, some of which have already begun to emerge.

Given that most of these investors received unsympathetic treatment at the hands of later stage venture capitalists it should come as no surprise that these new models are unlikely

to offer much benefit to the later stage venture capital community. This could be a worrying development given that later stage venture capitalists have traditionally relied on these earlier stage funders to create at least a part of their deal flow. Lisa Bushrod reports.

As is so often the case with developments in the financial markets the story begins in America. But being venture capital, it begins on the west coast of the US, rather than the east. Perry Yam, partner at SJ Berwin, explains: “If you look back 10 to 15 years at British venture capital, early stage investing was structured as a combination of fixed rate preference shares providing a fixed rate coupon, (and this quasi-equity slice was often redeemable) and a layer of ordinary equity. More recently, at the start of the tech boom (coinciding with the development of the Bay area and Menlo Park on the west coast

of America) ‘concept companies’ with no revenue and no sales were being backed by American VCs.

It was at this time that deal structures began to change with VCs opting instead for some form of participating preferred equity, which benefited from cash out ahead of others on a participating basis. This structure migrated across the pond.”

“Linked to these participating preferred share structures were a number of downside protection mechanisms including price anti-dilution rights. This said that in circumstances where VCs were paying, say, 50p now per share if at a subsequent fund raising shares they were priced at, say, 25p the company contractually agreed to issue additional shares (at par or by way of a bonus issue) to the VC on either a weighted average or a full ratchet basis. This was to ensure that overall the price paid, including the price paid originally, was adjusted,” says Yam.

Anti-dilution rights applied during the high of the dot.com bubble were a way to overcome the problem of multiple investment rounds at ever-higher valuations, according to VCs that used them. They argue anti-dilution was the quid pro quo to protect their exit values when they were being asked to pay top dollar to participate in a funding round.

You might also infer that some of this cautiousness was actually a protection against some of the sloppy funding agreements during the dot.com bubble, which saw things like new option pools being created at every new investment round. Good practice, to which the industry has since reverted, dictates that the size, or percentage, of the option pool is set at the outset of the investment and new tranches are released only up to that maximum. But this sort of dilution, so long as management wasn’t terribly impacted, was tolerated in a market where the only way for valuations was up.

Liquidation preference is the other major innovation, alongside anti-dilution rights, to hit the venture capital market during the dot.com boom and bust. “Multiple liquidation preferences are frequently brought into question, particularly if the company is likely to need further funding. In any future round, these are likely to get thrown out of the window when a new investor puts another equity layer over the existing one,” says Martin McNair, director of Advent Venture Partners.

But one clear advantage is that VCs sometimes get away with it, even if in a watered down form. And McNair points to another advantage: “To the investors, one perceived benefit of a liquidation preference is that it effectively lowers the effective entry valuation in cases of poor exit performance.” The reason for this is the structure of liquidation preference. One times liquidation preference simply means the VC holding

that card will get its money back before anyone else. If the agreement stipulates two times or more then that is what the VC is able to recoup on the investment before anyone else on the same equity level gets a look in. So it is easy to understand that, depending on the multiple applied to the liquidation preference, new investors will be reluctant to pay top dollar because the hurdle for getting their money back and going on to make a healthy return is not only creditors but their co-investors on the equity as well.

Applying a multiple is one way to structure a liquidation preference; another is to apply a management catch up clause. This could mean, for example, after the VC takes a specified return any remaining money in the pot will be split on a pre-agreed ratchet or percentage between the VCs and the management team. Double dipping refers to a combination of multiple liquidation preference and management catch up.

Although according to some (mostly the VCs) anti-dilution and liquidation preference were understandable introductions during the heady days of the dot.com bubble, in fact others (mainly the advisers) believe these clauses gained real ground in the panic to stem the flow of value out of portfolios.

“In the 1990s it was straight forward: B round was at a high valuation than A and C round higher than B. Although you got diluted it was minimised by achieving greater valuations. Then it all went sour. I think every investor in a new round tried to protect their investment at the expense of previous investors,” says Stewart Binnie, partner at Augusta Finance.

For many VCs using anti-dilution and liquidation preference clauses was seen as a way for VCs to stop others doing to them what they were doing to others. Although many VCs probably assumed they had shored up their value, often at the expense of existing investors in a company, in many cases (probably because they weren’t aware how long the slump would last) they weren’t the last funder into the company and so suffered

the same fate as the investors before them.

Now the market has stabilised and people understand the absolute impact of such mechanisms, some VCs and advisers are inclined to think that overall anti-dilution

and liquidation preference may actually have created more problems than they attempted to solve.

As Joanna James, managing director of Central and Eastern Europe at Advent International, points out: “If you are faced with the choice between a company

going bust and losing all your money and giving up your anti-dilution rights then what are you going to do? It gets more complicated even where you have a controlling stake if you have a syndicate. In a big syndicate one fund could say, ‘I don’t care, let it go

down.” So what happens is you all pay [that fund] off because he knows you don’t want to lose all your money. If you write in anti-dilution you are actually handing a big stick to your small partners.”

Most VCs are called on to play this game of brinkmanship at some point in their career. James relates an incident earlier in her career when an investment had reached the point of a bank workout group. The lead VC on being told by the banks that it was being written out of the deal, to the horror of the management team, proposed to walk away thereby imposing its position on the bank. The bank then relented, bringing the VC

back into the deal.

Aside from the perverse effect of creating a real problem for the investor that inserted the anti-dilution clause, anti-dilution, along with the multiple liquidation clause, can mean a company loses all attraction to new potential investors. Julie Meyer, co-founder of investment and advisory firm Ariadne Capital, currently faces just such a situation. She says: “We are raising a next round of funding where the current investors have created a company that is not financable. They have put in terms that are not enabling the company to get the next round of funding. They have killed the upside.”

The existing investor is facing portfolio problems, which no doubt goes someway towards explaining its intransigence on the issue. But time delays create real problems for portfolio companies, quite apart from the fact that attention is diverted from running the

business to solving its funding issue.

While VCs do not appear to have too many qualms about wiping out the interest of those investors that went before them, when these protection mechanisms leave the management team in a similar situation most VCs quickly move to realign management’s interests with theirs.

“If the exit valuation is likely to be of the order of the money that has been invested, management’s motivation could be severely compromised and VCs have to address that. In a moderate or borderline distressed sale of a company that has not performed to plan the VCs have to get into discussions upfront with the management team as to how proceeds might be split at exit, which completely throws liquidation preference out of the window. Otherwise it’s like asking turkeys to vote for Christmas,” says McNair.

If a sale is a realistic possibility and is imminent VCs will act quickly. One fear otherwise is that during negotiations a management team disaffected by its lack of economic interest in the deal, despite probably years of total commitment during a difficult market,

will either not wish to be part of the sale or, worse, look to the buyer to add an incentive to get them to stay. Inevitably that would taint exit value negotiations, causing downward pressure on the price. And as Meyer points out: “[People] have to be careful that [they are] not just creating employees out of entrepreneurs.”

Some management teams are acutely aware of what these new structuring techniques have done to their economic interest. “We have seen structures with particularly heavy liquidation preferences of several folds. And the entrepreneurs are now looking to raise

new money hoping to obliterate the old stock so a more traditional and equitable structure can be put in place,” says McNair.

Others are less aware and require advice to see them through. “Some [management teams] are sophisticated and others are not. The ones that are not might ask questions about what percentage of the company they should be asking for. The percentage is irrelevant. They need to find out what the VC model is and what that percentage is going to get in terms of absolute money,” says Jeremy Hunt, partner at Allen & Overy.

Joanna James says: “I wrote our term sheet in 1996, we have amended it, but not substantially. The important thing is to try and not make it sound like a legal document. My heart sinks when an entrepreneur brings lawyers to term sheet negotiations because it goes from six pages to 60. It’s an interim document and the point should be that when the transaction document appears, which will be five or ten times the size, there should be no surprises.”

It’s not that management teams are unduly stupid: VCs are said to be past masters at making an offer you can’t understand, rather than one you can’t refuse. Given that

the British Venture Capital Association currently has a working party looking at producing a standard term sheet, this is obviously an accusation not taken lightly.

The idea being that management teams will be able to drill down to the meaning quicker and perhaps, if they are lucky enough to be in the position, even be able to make genuine comparisons between competing offers; not something that VCs are necessarily ecstatic about. It’s easy to understand why VCs aren’t jumping for joy. They are all too aware that entrepreneurs appear to make their decision based only on the information presented to them. “Entrepreneurs very rarely ask to talk to [our] investee companies. We take references on them so I am surprised they don’t take references on us. I think they rely on their advisers,” says James.

Keith Willey is assistant professor of entrepreneurship at London Business School and COO of Sussex Place Ventures, a seed fund originally borne out of London Business School (LBS.) He is also involved in the non-life science investment done by the University Challenge Fund of which University of London (to which LBS belongs) is a part. As well as watching the developments in the market from an academic perspective Willey has also experienced their harsh reality. He says: “If I was an entrepreneur I would think very carefully about investors because what can really paralyse you is angel and VC conflicts. If the entrepreneur did as much due diligence on the VCs as is done on them it might result in some much better situations. I would try to find out how the VC works when things are not going so well and how much they will engage in working through any problems that arise. Similarly I would ensure that discussions with angels are kept realistic, sometimes loyalty to the original backers can get in the way of sensible deals needed to keep the business going.” Not the easiest conversation to have if the angel is about to be dropped from a great height, particularly given that angels and seed investors are quite adept at playing the loyalty card if it looks like all else will fail.

With angels, seed and early stage investors facing such an unfriendly investor environment Willey suggests the best place might be to stay home. He says: “There

is clear financial logic for not investing when you are not seeing exciting returns because we cannot see the trade sale or IPO markets opening up for a while. A lot of people are holding onto their money; they may be too emotionally attached to the business to do the right thing for their investors, which can be to give the money back. Others are investing all the way through the cycle. The only way that you can do that is to club together

so that the early stage investors are not subject to this great washing out.”

Binnie believes that when the markets pick up conditions will improve for angel, seed and early stage investors.

“As the pendulum swings back and VCs compete for companies again then they will behave properly. The casualty has been all the business angels, seed investors

and early stage investors. Nobody wants to do them anymore. Why be an early stage investor if you get blown out of the water by these devices appearing in subsequent rounds?” he asks.

With so few angels and seed investors in the market it may be that there is a return to relying on family and friends. Some of those angels that have come back into the market already are attempting to play the VCs at their own game. But Willey questions the effectiveness of such an approach. “Angels would go in as ordinary shareholders but now you see them with what looks like a VC term sheet, including things like preference shares, guaranteed IRR, 20% rolled up dividend, anti-dilution and liquidation preference. It’s all totally meaningless if you subsequently go to a VC because if a VC is looking at an investment and has got someone sitting on those they will say no, so it’s really an opening gambit,” he says.

Posturing might drag out a deal but isn’t likely to address the structural issues that angels and seed investors could once again find washing them out of investments. Even staying involved and on the side of the management has failed to save the bacon of most angel and seed investors. While commentators theorise that this may be a way around some of the problems the reality is that by the time a company moves to later stage funding

it is not just about money.

Equally important is the fact that the company has moved into a new phase in its life cycle, a phase where later stage investors should, in theory, be better equipped than their earlier stage counterparts to add value. This greater value added proposition applies all the way along the investment cycle and is why the last in should if all goes well make more relatively than those that came before it. This is also one of the reasons why successful early stage investors often move up the value chain when they raise their next fund, having been somewhat aggrieved by the returns enjoyed by the next funders into the company they nurtured.

The simple solution to keeping angel and seed investors in the wider venture capital picture ought to be to give them the option to realise some of their gain or redeem

part of their investment at the next funding stage. But this is pie in the sky. Any VC putting such a proposal to its investment committee would find the committee running the proverbial mile: VCs don’t like replacement capital. Money in is the only thing that makes sense to them. And even if the sums involved were not considerable and the investment proposition was robust the fact that an angel or seed investor wanted

out would ring alarm bells.

With no guarantee that they won’t get washed out again angels and seed investors that want to continue to invest have had to adapt their approach so they are not left in the position again where they have no control over their investment. “The historical model of angel investing is a dying breed because the risks for angel investors are so high and the upside is not big enough or often enough to compensate for the downside.

You simply have to be able to follow your money; you simply have to be able to provide time and resources to the company when it needs it. Therefore if [you are] part of a syndicate or club the burden is reduced dramatically,” says David Giampaolo, chief executive of Pi Capital. Pi Capital is effectively a club of angel investors with the capacity to invest between £1m and £3m per funding round.

Willey expands on the issue of what being able to follow your money really means in today’s climate of flat and down venture rounds. “When you are trying to get follow on funding you fight your corner as hard as you can. What really gets you a seat at the table is if you can put some follow on money in, that is the one thing that lets you use your position to negotiate. Otherwise you can stop the deal happening but you’d be mad to

turn it away [in this funding climate,]” he says.

VCs are already acknowledging this shift in approach by angel and seed investors. McNair says: “What we are finding is that seed investors are thinking more about

future rounds and they increasingly keep some of their powder dry. In a follow on institutional round they can then invest in the preferred equity, or possibly put a provision in the seed funders’ agreement that at least part of theirs can be converted [to the next tier].”

Aside from keeping some money back so they can participate and minimise their dilution at the next round, angel and seed investors are reverting to drip feeding funds, as was common practice pre the dot.com bubble.

“If a company is going out to an angel or to a seed funder [investors] need to find out what’s really driving the cash and if there is any way that the investor can defer part of the investment against some milestones, only putting in what the company needs this year and reserving the right to put in more funds in the future.

Four or five years ago people would have drip fed in [money] at seed funding stage,” says Baljit Chohan, partner at Wragge & Co.

The VC community largely accepts that angel and seed investors have, relatively speaking, probably suffered most from the fall out in valuations. James sums up the situation succinctly: “It’s a harsh, cruel world. If people can see they could squeeze you out then they will if they are never going to have a future relationship with you”

Amadeus Capital Partners, an early stage investor based in London and Cambridge, is worried about its relationships with angel investors and those of the VC community generally. Acknowledging that there is some disaffection with the VC market among the angel community it wants to reach, Amadeus has come up with a convincing structure to overcome the trust issue. This involves the Amadeus Mobile Seed Fund, which is run by Laurence John out of the firm’s Cambridge office.

“The [Mobile Seed] fund is a separate fund so it has to work as a seed fund in itself so I am very concerned about structures of deals and whether [the fund] would get washed out,” says John. Interestingly the investors in this £3m fund are not the same as are in Amadeus’ main fund so this counters the suggestion that the mobile fund might be tempted to wash out one investment if it allowed investors to catch up elsewhere. This is vitally important if Amadeus is to build trust and encourage angels to invest alongside

it. The mobile fund is structured so that whatever it and its angel partners put into a deal Amadeus’ main fund will match on the same terms.

John also says: “Make sure you can put more money in to protect the level of investment and put [money] in deals that have a chance of exiting very early.” Giampaolo underscores this point: “Seed round, angel round, VC A and B and so on: businesses that

have that type of capital structure are not meant to be supported by business angels unless [the angel is] extremely savvy, can add value or is extremely rich.”

Those are big caveats and ones that will apply in only the rarest of cases. So in reality it looks as though angel and seed investors are only going to participate in the market for the time being where they can continue to follow their investment and where they see a reasonable likelihood of exit with a two to three year time horizon. This ought to worry later stage investors because it could mean the relay method of investing from which they have done so well in the past begins to dry up. And if this happens later stage investors may find the companies where they invest in the future have not been used to the rigours of professional or institutional investors and are all the more difficult to manage as a consequence.