Small Business

Private investing: After the handshake

Written by ProfitGuide Staff

Harry Coleman is undoubtedly blessed. As one of the investors in Surrey, B.C.-based Disc Go Technologies Inc. (Disc-Go-Tech), he has watched the company’s annual revenue quadruple and break the $5-million mark, profitably — an accomplishment that shareholders in most young, private companies pray for but never receive.

Then there’s Mark Chaplin, founder, president and CEO of Disc-Go-Tech, which manufactures DVD- and CD-repair products used by pawnshops and video-rental chains such as Blockbuster and Movie Gallery. Although today Chaplin enjoys an ethereal existence relative to the average business owner, the stairway he climbed to heaven sometimes had seemed like the highway to hell.

When Chaplin began commercializing his disc-repair technology in 1996, he started the way most entrepreneurs do — by emptying his bank account and asking friends and family for financing. He raised $50,000, but needed thousands more to lift his company off the ground. “Neither myself nor my partner had any credit or assets, so the banks wouldn’t look at us, and venture capitalists weren’t interested unless we were looking at $1 million to $5 million,” says Chaplin.

So, in 2003, he began pursuing angel investors — high-net-worth individuals, usually former executives or entrepreneurs, who regularly invest in high-potential startups and early-stage businesses. Months of networking and research culminated in a 12-minute presentation to investors gathered at Vancouver’s semi-annual Angel Forum, at which Chaplin caught the interest of two angels: Coleman and Paul Geyer, who had each founded multiple businesses of their own. After several months of meetings and due diligence, Coleman and Geyer paid $300,000 for a 20% stake in Disc-Go-Tech. Naturally, Chaplin was elated: “We went in looking for financing but also hoping to get somebody who would come into the company and help us, especially on the financial and accounting side.” But he ended up with more help than he’d bargained for.

Although Geyer was a passive investor, Coleman immediately assumed an active role in the business, both to help move the company forward and to keep a close eye on his investment. He worked in the Disc-Go-Tech office three days a week for nine months, providing financial and managerial support. Eventually, Coleman’s support trickled into Chaplin’s sales department.

“Harry had an issue with our sales manager, a personal friend I had hired at an early stage,” says Chaplin. It wasn’t long before tensions began to bubble. “Harry had come from a sales background and had ideas about how the sales cycle should go,” says Chaplin. “Because of our manager’s lack of experience, Harry didn’t think he was the right fit.” A three-way power struggle ensued, followed by the demotion and ultimate departure of the sales manager a year later.

“Mark had said he wanted me to be involved in the day-to-day operations, but we had nothing in writing yet,” says Coleman, who had little angel-investing experience at the time. “This particular situation came down to trusting Mark to do what he’d agreed to from the outset.” And while Chaplin eventually concurred with Coleman’s desire to dismiss the sales manager — an act validated by a post-departure jump in sales — Chaplin also realized something much bigger: his business was no longer his alone. For someone just getting used to being his own boss, suddenly being accountable to others was a hard pill to swallow.

Chaplin’s epiphany isn’t uncommon. Many entrepreneurs looking to tap private investors, especially the sophisticated financiers of Canada’s growing angel sector, spend ample time learning how to raise equity investment. But most dedicate no effort to forming a concept of how the relationship with their would-be backers will affect business life as they know it. “The biggest eye-opener is that, like any investment from neutral third parties, angel investment can be a double-edged sword,” says Sean Wise, president of Toronto-based Wise Mentor Capital, a consultancy for entrepreneurs seeking funding. “Entrepreneurs will bring them on for their cash and expertise, then some are shocked to find that angels want a say in the deployment and accountability of that investment.”

Moreover, outside investment is always accompanied by new pressure to deliver results, often quickly and in ways the founding entrepreneur might not agree with. That doesn’t necessarily mean angels should or will always get their way. If you partner with a compatible investor, set clear expectations of one another, define the parameters of the relationship before it begins and actively nurture that relationship, you’ll accrue the many benefits of working with angels without suffering too much pain.

Angels act primarily as investors in search of high returns, anywhere from two to 10 times their investment within three to five years. That makes them akin to venture capitalists, but with one notable difference: whereas VCs invest other people’s money, angels have their own skin in the game. And, as seasoned executives and entrepreneurs, angels have a secondary motivation: “They also want the warm, fuzzy feeling you get when you’re working on something you really enjoy,” says Bryan Watson, executive director of the Toronto-based National Angel Organization.

Combine those two interests, and it’s easy to see why angels often want an active role in management and decision-making. Such a high level of engagement makes finding an angel who is aligned with your vision and business goals as crucial a task as perfecting your investment pitch. Austin Hill, a Montreal-based investor and serial entrepreneur, says the most common mistake business owners make is treating private-equity financing as a mere business transaction. “I had one entrepreneur show up at my house on a Saturday morning, shove his product in my face and ask me if I was ready to invest,” says Hill. “Entrepreneurs need to understand it’s a relationship, something they should begin nurturing well before thinking of asking for money.”

For Benjamin Yoskovitz, CEO of Montreal-based Standout Jobs Inc., developing that relationship began with volunteer work for BarCamp Montreal, a conference for the city’s bustling technology-startup community. That exercise led to chance meetings with Fred Ngo, his eventual co-founder and chief technical officer, and Hill, who became one of his investors and chairman of Standout Jobs, which develops Web-based recruiting tools. Chaplin networked and took seminars at the Angel Forum to find the investor best suited to him and his business. “It was an excellent window into that world,” says Chaplin. “We learned what to expect before and after our pitch, how to write a presentation and how to calculate valuation and share price.” His most important learning: if you’re looking for so-called “dumb money” — capital from a passive investor — then angels are not for you.

Perhaps the first potential point of tension between entrepreneurs and angels is the due-diligence phase. “It’s a feeling out and ‘getting to know you’ process that should be from both sides if you want the relationship to work,” says Watson. “It might take two meetings, it might take five meetings, and it might even include your angel going on site visits and talking with clients.” If, after the discovery period, the parties still want to get hitched, the next step is usually to draft a prenup: a shareholders’ agreement that states the conditions of the investment. Among them: the financial structure of the investment (debt, equity or otherwise), company valuation, acceptable use of the proceeds and the milestones at which angels will invest their money in the company — say, completion of product development, achieving positive cash flow or signing customers. (Angels typically manage their risk by investing in tranches rather than an up-front lump sum.)

Unfortunately for Disc-Go-Tech’s newly betrothed partners, their marriage vows had been vocalized in general terms but never captured in detail in writing. Furthermore, it took time for Chaplin to internalize a sense of accountability to his new business partners.

On more than one occasion, he ignored Coleman’s advice, assuming he had the final say as CEO. Chaplin borrowed from the company to pay for personal items and purchased mass supplies of a part for a product in development without consulting his angels. “In my infinite wisdom, I thought we’d be able to get it to market within six months,” says Chaplin. “It ended up sitting on the shelf for a year and a half and tying up a lot of capital.”

To make matters worse, Coleman discovered these peccadilloes in quarterly reports rather than hearing about them from Chaplin. “Nothing is more frustrating for an angel than to be locked in a private-equity investment with an entrepreneur who shares very few details about the business and what’s really happening,” says Coleman. “I insisted that we get a shareholders’ agreement in place as soon as possible to ensure everyone was on the same page moving forward. If I could do it over again, I would clearly lay out what I expect in terms of communication and ensure that there is proper paperwork and a proper board [of directors] from the very beginning.”

Fortunately for Chaplin, his deviances had less to do with entrepreneurial ego than with a lack of clear operating guidelines. About six months after Chaplin and Coleman shook hands, the board of directors penned a set of rules governing multiple aspects of the company’s management, such as spending limits. (Anything over $50,000 would need the board’s sign-off.) How do minority shareholders acquire such rights? Angels and venture capitalists almost always secure an “enhanced veto” as a condition of investment. “This essentially means that even though they only hold a minority position, they have the ability to overrule certain key decisions, such as the issuance of additional capital, major borrowing and variations from business plans,” says David Pamenter, business-law partner in the Toronto office of Gowling Lafleur Henderson LLP. More important, the entrepreneur loses the absolute control that may have been his or her primary motivation for starting a business in the first place.

Accordingly, the development of the shareholders’ agreement is a crucial stage at which an entrepreneur should spell out his or her expectations of investor involvement, reporting mechanisms and authority over budgets, hires and company direction. And never forget to agree in writing on how the business will operate in the event of a serious dispute between shareholders, and how such a dispute will be resolved. Spelling out a dispute-resolution process could be the most important part of the entrepreneur/investor courtship, because breaking up is very difficult to do where private companies are involved. “You can attempt to find another angel to buy out your current angel,” says Hill, “but that’s so rare, and it hardly ever happens.”

Apart from the money, the biggest benefit of having an angel investor on your side is the vast expertise he or she brings to the table. But while angels are generally more motivated to hold your hand than, say, bankers or VCs, they also want to know that you want their guidance. For Yoskovitz, that meant securing office space in his angel’s building to facilitate the mentoring process. He also made clear to his angel that his immediate goal for Standout Jobs was to raise even more money. “I funded them for the initial year,” says Hill, “but because I knew that they wanted to raise venture capital, I immediately began coaching them on how to go about it.”

Chalk one up for collaborative financing: in January, Standout Jobs secured a $2-million placement from Montreal’s iNovia Capital that produced a surprise benefit. “The acceleration that resulted from this new funding put an extra layer of pressure on top of the business,” says Yoskovitz. While pressure to deliver might make some entrepreneurs quiver in their loafers, Yoskovitz says it was just the motivation he needed to ensure he continually works with his angels to accelerate the pursuit of success.

Indeed, the best entrepreneurs leverage their angels by keeping them in the loop with regular updates, which is key to resolving problems before they occur. And one of the best ways to do that is by creating a board of directors that, ideally, has a few impartial members who can objectively mediate disputes and avoid deadlocks. “It’s a strategic tool for building relationships, getting advice in areas you might not be familiar with, such as marketing, and access to more contacts that you need to grow as a young company,” says Watson. “It’s one of the best ways to leverage your investors.” It’s even better to have a board in place before you search for funding, as it gives you extra credibility.

Today, Chaplin and Coleman meet only at their quarterly board meeting, but they are in contact all the time. Because of their constant communication, Chaplin was able to get his hands on Coleman’s list of international contacts, which led to Disc-Go-Tech signing up a distributor in the U.K. with more than 15 subdistributors throughout Europe. Coleman is now among the first to know if problems arise, and also among the first to offer a lifeline. “It took time for me to get used to reporting regularly to him,” says Chaplin. “But being accountable to the board, and to the mandate, keeps me in line.”

Coleman and Geyer eventually developed enough confidence in Chaplin to make subsequent investments in Disc-Go-Tech, raising their combined stake to 30%. And Chaplin credits his angels with helping him strengthen his business.

“There’s no denying that we’ve enjoyed some significant growth over the past few years,” he says. “There were a lot of contributing factors. But, without a doubt, having angels on board — and building that relationship — was a big one.”

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