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Working With Your Angel Investors

Make sure your angel investors won't hold your business back when it's time to graduate to larger investors.

These days, investors at medical services company Inoveonin Oklahoma City are a pretty happy lot. The company recently celebrated its 40,000th customer and revenue has passed the $1 million mark, so investors have much to celebrate. But Inoveon co-founder Dr. Lloyd Hildebrand will tell you that bringing together three founders, seven angel investors and five VCs was not always a party.

When Hildebrand, 48, and his partners decided to commercialize the technology they had been working on at the University of Oklahoma, they started the way most entrepreneurs do--by digging into personal savings and asking friends and family for help. In total, the three founders and seven outside investors put together about $250,000 in seed capital.

From the outset, however, Hildebrand and his team knew that the angel investors' capital wouldn't be enough to get the company off the ground. If Inoveon's technology to diagnose eye disease in diabetic patients was ever to see the light of day, they'd need millions more. Still, they couldn't afford to worry about that in the beginning.

"At that time, we needed dollars to demonstrate the concept would work," Hildebrand says. "Money was more important than smart money at the beginning. We needed capital to stay alive."

That's a typical--and potentially dangerous--predicament for a young company, says Jonathan Karis, partner and chairman of the Business Practice Group at Boston law firm Nixon Peabody. Karis advises entrepreneurs to consider the time when their company may need more money than the angels can provide. Too many unsophisticated or inexperienced angel investors create management headaches and get in the way of raising future capital from VCs.

On Whose Terms?
The real problem for most angel investors comes when the business has outgrown the angels' ability to contribute growth capital. Karis notes that venture capital may come with terms and conditions that significantly devalue or dilute the original shareholders' value. A VC firm may even insist on renegotiating the angels' original investment terms.

Such was the case at Inoveon. Hildebrand says that both of the subsequent rounds of venture capital that Inoveon received were at a valuation substantially below what the angels had negotiated. So the new VC investors actually paid less for their stock than the original angel investors, and as a consequence, the ownership and control held by the angels was drastically reduced. Investors call this a down round, referring to the falling valuation. Of course, down also describes the mood of the early investors. "I don't think anyone was happy about it," says Hildebrand, "but we all understood the realities of the marketplace and of building a company."

Karis says that it could have been much worse. He's seen angel investors refuse to allow VC investment even though their refusal cripples the business. To prevent such a predicament, Karis advises entrepreneurs to look for either one very experienced angel investor or an organized angel club to take the lead role in the initial investment.

As an additional precaution, every company owner should anticipate future funding needs--including possible down rounds--and limit early investors' ability to torpedo negotiations for subsequent funding. "Position your angels legally so you facilitate venture funding instead of hindering it," Karis suggests. "Traditionally, VCs will require approvals of next funding rounds, so angels may ask for the same thing. But I don't want my angels to have too much control over the next round."

By anticipating a funding shift, you can set reasonable investor expectations, backed by the legal framework that gives your company the flexibility to grow. "If you're ready for a $10 million [VC] investment, then the angels just need to come along for the ride," says Karis.

Part of the dilemma is that setting the valuation (i.e., the stock price) for an early stage company is more of an art than a science. As a result, angel investors are more likely to worry about the rights they have as shareholders than about price. Later, when the VCs get involved, valuation is more obvious and often well below the lofty price projected by the early business plan.

As much as they need each other, VCs and angel investors often butt heads over issues of valuation and control. The key to defusing this situation is to set out a fair and flexible agreement in writing before accepting the angel's capital. The agreement should specifically prohibit early investors from blocking subsequent funding rounds under certain conditions. "It's a hard negotiation," says Karis. "But if you build flexibility in when you go to them, that's when you have leverage with them. Once you have their money, it's more difficult."

Even in the best of cases, Karis compares managing investors to herding cats, but a reasonable agreement upfront can make the task less painful.

David Worrell is author of the e-book Finding Funding.

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This article was originally published in the November 2005 print edition of Entrepreneur with the headline: Growing Pains.

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