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Angel Funding Framework – Structure

In my attempts to engage in angel financing, I have seen the typical concerns that potential angel investors have. Many of these have to do with the investment parameters, and figuring out how investors can get their money back (or returns) – especially given the inherent immaturity of these businesses in being able to outline an exit potential. Investment then gets limited to businesses where investors perceive a high probability of creating a breakout business. Many other diamonds remain in the rough. I have been thinking of ways of addressing this issue so that seed financing is available to a larger base of startups. This should allow for great businesses to “emerge” rather than being “envisioned”.

To start, I am sharing some thoughts on a potential investment structure that should allow this to happen. There are several other elements to making this successful, besides the investment structure, and I will talk about some of those over next few weeks. In the meanwhile, comments and critiques are welcome on this – both from entrepreneurs and angel investors!

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  • http://www.vijayanand.name Vijay Anand

    Alok, Great initiative, but I am not sure how this would scale. Here are my thoughts:

    1. As Rajesh Sehgal rightly pointed out and you agreed, this is not the most pleasant of means to raise capital. It almost seems like we are setting up for the ones who wouldnt have the means to raise any other capital, and in which case, this is a no starter to begin with. Success begets success, and the odds are a bit against us here.

    2. Unfortunately the problem with collateral free loans and with trying to structure it, is that, you end up having to frame means to protect the entrepreneur and the investor, and most or less it ends up becoming as complicated and tedious as a bank loan or worse the case of a money lender. I can think of a few ways an entrepreneur can run away with the money here, and a few instances where the investor will become a bit of a pain in the wrong place. In reality, both happens.

    3. I have come across lots of financial institutions doing this model – for much larger sums (Min. 2-5 Crores and above) – ICICI’s Venture arm for one is following it. It seems to work there in some cases – where the entrepreneur is experienced and is capable of handling cash (Isnt managing cash almost THE defining character of an entrepreneur?), but isnt a big hit there either. In most cases, its becoming a case where they are eventually resorting to the loan+convertibles model.

    4. My biggest beef with this: Why glace this so much? Shouldnt we call Angel investing as such and Money Lending, for what it is? This isnt much than a case of formalized money lending. Isnt there a difference between the two?

    As you know I’ve been in the same track of thought about the Angel investment scenario in India. I think 50 “true” angels would lead the way much better than 800 Money lenders glaced, and sugar coated. The sad part unfortunately will be that, none of this will actually help the part where it takes a long time for a startup to scale in India. In some cases only throttle the company and make it focus on shorter milestones. But ofcourse thats altogether a seperate topic by itself.

    Ofcourse all cribbing and no suggestions is bad: In my understanding, I have met a quite a few VCs who also are struggling with constraints, but would love to do early stage. In some cases there is an expression of interest that if an Angel invests (around 100K USD), they wouldnt mind matching it, with an uncommitted follow up round as the startup scales, and with the angel taking the board position initially. Wouldnt that mitigate an angel’s risk significantly and in the long run also build the culture of actual “angel” investing?

    Just my two cents.

  • Akshay

    I would not take this route if I had another option, but otherwise, some money with terms is better than no money at all.

  • http://www.canaan.com Alok Mittal

    Rajesh – nice acid test. Let me put it this way – if I had a better option, I wouldnt – end of the day, its the market which prices deals. In my first venture, we gave away 50% of our company in the angel round. Would I do it today? Probably not. Would I redo it in the same circumstances? Yes.

  • Rajesh Sehgal

    Alok, Let me ask you a question: Will you agree to these terms as an entrepreneur? If yes, then we have a nice alternate structure for angel investing that can be useful in certain cases.

  • http://www.moneyoga.com Deepak Shenoy

    Krish, also “relationship” falls under this category you mention “Unless the borrower has a steady cash flow from repeat business customers” – the business I know had about 1 year of steady cash flow, but the business was from abroad, so no “verifiable credit standing” etc.

    ALso, to buy assets – with those assets as security – institutions like KSFC offer entrepreneurs loans for 50-80% of the asset cost. Assets = land, machinery or stuff.

    And there’s free stuff. Companies like Intel have even offered hardware at much reduced or no cost if you do something specific to their hardware, and Microsoft has an early entrepreneur program for ISVs.

    But most of this cost reduction is only available AFTER You start up, and opportunities open up only then. So it won’t be usable in a business plan :)

  • http://www.moneyoga.com Deepak Shenoy

    Krish,

    Debt of any kind is either first or second charge on assets anyhow so in that sense it is secured against assets of the company; but what I mean by unsecured is that it is not secured against any particular asset (a property/car etc.). The person I speak about did not give any personal guarantee either.

    My point is: Startups can use relationships to build this kind of financing also – banks do provide it. It will take time of course, but unlike most private banks, PSBs give individual branches some leeway in lending/advances. And if they ask for a charge on (unnamed) company assets in case of default that is the standard concept of debt; we do that for even our personal loans (i.e. if we default, the bank has the right to recover it from anything else we own with due court process)

    “Unsecured” is “with recourse” in this case; I don’t know any lending institution that would lend without recourse and without security, has to be one or two, or both.

  • http://www.kmonyb.wordpress.com Krish

    Deepak,

    There is nothing called `unsecured’ working capital finance based on `relationships’ issued by PSB’s that go strictly by Basle norms (previously Tandon committee recommendations). The principal document that binds the arrangement is a “Deed of Hypothecation” (of receivables or inventory or WIP) that creates a firm charge on the underlying assets. This applies even for temporary overdraft facility. Unless the borrower has a steady cash flow from repeat business customers of verifiable credit standing (as appraised by their bankers), the norms do not permit working capital gap to be financed.

  • http://www.moneyoga.com Deepak Shenoy

    One extra covenant: if the company finds debt at a lower rate, and the company will take that debt to prepay the loan – the debt holder/investor HAS to allow that debt on the books (i.e. cannot deny that debt regardless of equity holding) , or lower his interest rate to match.

    Funda is at high interest rates it may become a lifestyle business for the investor – or if the company wants to go down the lifestyle route for the founder, the right way is to pay out the debt.

  • http://www.moneyoga.com Deepak Shenoy

    Alok: Good point about lifestyle business exit strategy and credit cards having recourse to promoter’s other assets while angel debt is on the company instead.

    WCTLs and Bill discounting are different from the unsecured wc finance I was speaking of – which I’ve seen happen from PSBs to service businesses also based on relationships. Typically this is a line of credit or overdraft facility ANd Im speakign startups with no real fixed assets – one I knew needed it for a couple month mismatch between billing cycles and payroll, for instancce.

    I’m not complaining of the RoI – it can be anything, really, because there is no other source or that the conversion is at a reasonable premium. For instance if I could get a 50L debt that converts at a 4cr. valuation in a year, I might be happy to pay 50% fixed rate if I’m confident enough.

  • http://www.kmonyb.wordpress.com Krish

    Deepak,

    You say “banks give lower for working cap lending even when unsecured”.

    Not quite. Both Working Capital Term Loan (WCTL) and Working Capital assistance by way of Cash Credit/Bill Discounting/Packing Credit are “secured” by a first charge on receivables and inventory of finished goods/Work in Progress and for added comfort, by a second charge on fixed assets with NoC from the first charge holder, if any. This is a product that is available to companies that have a regular manufacturing/sales cycle and come with limits (that get exhausted and replenished cyclically) that can be enhanced/reduced by the lenders from time to time depending upon their realization experience.

    In the context of seed stage, angel funded startups that we discuss here, WC assistance has little relevance.

    The debt extended by an angel investor will always be unsecured with a mere service of interest / principal repayment obligation upon the seed stage founders until conversion clause is triggered. It will be based purely upon the angel’s perception of the likelihood of the venture getting past the gate and no more. That explains the higher asking RoI.

  • http://www.canaan.com Alok Mittal

    Deepak – my impression is that in absence of a good track record of seed investments working and companies scaling up fast enough, the debt piece provides a good way of getting basic minimum return in case some of these companies land up becoming lifestyle businesses. Credit card default rates are nowhere close to startup failure rates – credit card funded startups fall back on promoter guarantee in effect, which is not the proposal here,

  • http://www.moneyoga.com Deepak Shenoy

    Alok, thanks for that

    1) If valuation is not an issue why not just let it be equity with the standard clause of 1x liquidation preference? Much easier and stamp duty is lesser and is not classified as debt for ROC and all that.

    3) 27% comparison to credit card rates: interesting though the debt isn’t as unsecured and there are warrants/board provisions/lien on company assets to cover it (banks give lower for working cap lending even when unsecured) But I doubt this is vanilla debt – any figure will work when the entrepreneur is really desperate, and if they’re not, loans will be forthcoming from other sources. And as you said, figures are malleable…

  • http://www.canaan.com Alok Mittal

    Prashant – The interest rate will get determined by the market. The intent is not to make this cheaper than friends and family, but to provide a fundraising mechanism where friends and family can not step in. The issue with pure convertible is that startups in India seem to be taking longer than in the west to get to their institutional rounds, and many may survive as cash flow companies which will never raise another round.

    Krish – welcome your thoughts on the other aspects. In spite of the carnivals, I think we are far away from problems of plenty :) I like the thought on feeling up (no really!) – i think the constraint is that of time. I agree with you that the “control” that angel investors have can not be huge.

    Shantanu – please explain why – this is not debt with an external/personal collateral.

    Vivek – the structure I am proposing here is not convertible debt. Its debt with an option to put equity capital over a longer period of time. Somewhat different.

    Suresh – My view (and somewhat counter-intuitive perhaps) is that if its a cash flow business with little chances of exit, keeping the valuation high might be ok. Returns are largely expected from debt returns and thats great. If the upside kicks in, it doesnt have to be huge since most of the return expectations are based on debt. If the business is the opposite (no cash flow for a while, potential for high upside) then I would reduce the debt rate, and increase equity upside (by decreasing valuation) – kinda falls back to conventional angel/vc model.

  • Suresh Jayanthi

    Alok:

    I think this is excellent. Personally, it helps me put fwd a proposal to a few HNIs that we are talking to for funding.

    Point 4 refers to pre agreed valuation level. How will one decide the valuation of a company like ours, which is a good cash flow business but might not scale into an exitable company in its current form. We realize this and we are making attempts to build larger revenue streams thru allied products and that is changing the complexion of our company on a daily basis. I am sure every entrepreneur is making similar attempts.

    So my question is how will decide how much to give away for a x INR when I am not sure how much my company is worth. This might put the brakes on the investment process as it is too much of a grey area for the angel…

  • http://www.kmonyb.wordpress.com Krish

    By the *more immersive way* referred in my previous post, I meant –

    a) allowing the potential angels (as are domain experts) to feel up the team `on the shop floor’ for say, a 3 month term on each occasion, in return for a tiny lumpsum (not as investment, more as an `earnest money’) that could cover a portion of the actual fixed costs of the startup during the length of the stay of angel (say 50% of monthly rent, utility bills and consumables) – in a non-binding arrangement (NDA/Fixed Term Non Compete’s are in order);

    This will eliminate shallow pitchers and hollow domain experts from wasting each others’ time. It will also help channel the resources to productive purposes only.

    In case if there is a strategic difference of opinion between the team and the angel, the angel just refuses to foot that portion of the bill but has no right to stymie the effort. He just stops at airing his dissent so that it doesn’t stun the progression of disruptive innovation that invariably begins with a few random throws of dart.

    [The angels can be domain experts themselves (let's say *proprietory*) / those sponsored by investors that warm up to the opportunity. To ensure continuity, the sponsored domain expert will serve on the Board till the exit of the sponsor investor, if the investor commits to the venture relying upon his feedback]

    If this warm-up initiative proves useful, early attainable milestones can be set for the team that now includes the angel as well.

    Non-binding arrangement continues together with earnest money clauses, upto say 12-18 months beyond which the angel + team will have to bind themselves with definitive agreements with investment commitment from the former and consensus on defined exit strategies from the latter.

  • http://deskofvivekjain.blogspot.com/ Vivek Jain

    I believe this structure (optionally convertible debt) has been tried by TDICI (earlier avtaar of ICICI Venture) in early 90s when it was still operating in venture capital mode (VECAUS-I). If I recollect correctly, this was their preferred instrument of choice. It will be good to get some feedback from ex-TDICI folks on this model.

  • http://www.kmonyb.wordpress.com Krish

    If the accent of this post is on finding `diamonds in the rough’ and to help them `emerge’ as you rightly put, then is financing structure the point to start it off? Hasn’t this wrong sequence (coupled with ready open wallets, however few) been the principal reason why startup ecosystem got morphed into lifestyle business petri-dish for easy going funkies?

    I think Post #1 will have to be on how to get angels, entrepreneurs and experienced executives together on a few executable ideas – in a more immersive way – than the event style carnivals that have clearly proved worthless banter and business card exchange forums. That initiative by itself will be a magnet for potential investors and entrepreneurs can focus on business building than on financial structures that will anyway happen only if it is mutually acceptable.

  • http://prashant.sachdev.googlepages.com/ Prashant Sachdev

    Alok good to see your thoughts on making seed funding more accessible to startups.

    Making the investment more like debt is good for startups who can focus on getting cash flow in a year time. However, I doubt 2% monthly compounded rate of return would work. What credit card is to US startups; Friends, Family and Relatives is to Indian startups that is available at much cheaper rate.

    To me for all kinds of startups here in India, a simple convertible debt would be a good start. 10% interest per year and discount in the range of 10% – 30% on next round of financing depending on risk involved (if opted to convert) looks good enough.

    Another point I want to raise is more than financing, I see the problem of right angel with expertise been available for startups in India is a problem.

  • http://www.canaan.com Alok Mittal

    Deepak – thanks for the thoughts. Some followups:
    1. I dont think the issue today is ability to set a valuation – I think the issue is that startups take forever to scale up, and many times may become lifestyle businesses. Thats where the debt structure helps.
    2. Note that these are not convertibles – those get into the kind of issues you have mentioned.
    3. 27% rate is great, but if one in two/three fail, effective yield is much lower. 27% in absolute terms is lower than credit card rate, which seems to be an acceptable startup financing vehicle in US :)

    4. Bank debt can be senior to this debt, but the investor might need a protective covenant to require approval for such debt.

  • http://www.moneyoga.com Deepak Shenoy

    Like it. Best of both worlds for the investor – gets full debt protection and gets equity prerogative.

    It can work really well with say a slight premium on the equity portion to account for extra money earned through the interest portion of the debt.

    Valuation is still an issue though – if you could value properly then why bother with debt, as unsecured debt isn’t all that safe a deal at startup levels. Maybe put a blanket figure like 4 cr. as the floor, with the floor being revised (upwards) to say a 10% discount to latest round of funding if achieved prior to conversion. (Can look at no shareholder protection allowed to debt holders/warrant holders to deny such funding – otherwise the incentives are all screwed up)

    There are some legalities about warrants needing some minimum portion paid up (lost on non-conversion), IIRC. There’s also a debenture route but I think the regulators want either compulsorily convertible or totally non convertible ones, so the “option” bits are out of the game. Maybe CA/Company Secretary folks on the list can confirm.

    I think Goldman had exactly such a deal with Buffett and since then a number of such deals have happened.

    BTW, monthly compounded 2% is 27% simple on the year; a mighty good return if you can get it. But like you said, actual numbers will be malleable.

    Some issues I can think of:
    1) Company will find it difficult to get working capital/other loans from banks etc. until the debt is cleared off the books. Not of concern to most tech startups, but a slight pain when you have to deal with letters of credit etc. with a different kind of export business (for example)
    2) Example of interest will actually end up like this: 10L at 2% monthly compounding = 12.68L after a year. That is the new principal after 1 year. So monthly payment required will be 25K interest, and 5K principal repayment. (Co will take 8 years to repay at that rate, but yeah, business should accelerate – or the company an refinance from a debt-only source if it’s available). Most angels though would struggle to get more than 1% a month (compounded monthly) on their money so that might be a more usable figure. (Just thinkin)

  • http://UdbhavAssociates.com Shantanu Bhagwat

    Alok: My (kneejerk) reaction: No seed/early-stage start-up should take debt (friends and fmaily excluded)…

    Admittedly this is a “kneejerk reaction”…hope this gets the ball rolling on comments!