Parts of this article were first published on Charlotte Agenda by Justin Agans.
How Startups Raise Money
As a business lawyer who works with startups every day, I regularly speak with entrepreneurs about raising capital. One of the recurring themes of those conversations is the question of how startups raise money. Charlotte has a growing startup scene, but the path to investor funding is not as well-worn in the Queen City as in more mature entrepreneurial ecosystems like Silicon Valley.
Entrepreneurs raising capital for the first time in Charlotte understandably lack knowledge about the process. What are local investors looking for when considering whether to invest? How do you actually get in front of an investor for a face-to-face conversation?
Charlotte Angel Investors
In an effort to give aspiring entrepreneurs some answers, I interviewed Greg Brown, a major player in the startup-investor world here in Charlotte. A bit of background: Greg Brown is the administrator of the Charlotte Angel Fund, Charlotte’s largest group of angel investors. Greg is also the founder of Cardinal Finance, a company that provides fractional CFO (Chief Financial Officer) and accounting services for companies that have neither the need nor budget for a full-time CFO.
My Q&A with Greg discussed startups and investors in Charlotte, as well as opportunities for both sides of the table to improve. We discuss angel investors and funds, how much traction a startup needs before it can realistically hope to raise a seed round, and how much upside a market needs to be attractive to angels.
Greg, for those who don’t know, what is an angel investor?
Greg: Angel investors are normally non-professional investors. Very few people say, “I’m a full-time angel investor.” There’s actually only one that I know of in Charlotte. They’re typically people who have acquired capital somehow—either they just have a big W-2, or they sold a business, or they have family money. But they have some capital. They’re willing to make investments in very early stage private companies. Very high-risk, high return. Many times it’s about more than the economics of it. They like it. They have a passion for entrepreneurial activities, they’re entrepreneurs themselves, etc. It’s very rarely a 100% financial thing, at least not at the angel stage.
You’re the administrator for the Charlotte Angel Fund. Generally speaking, what’s an angel fund and how is that different from just, say, an individual angel investor?
Greg: Well, an Angel fund is an aggregation of capital from multiple sources. That’s what a fund is by definition. A venture capital fund, for example, receives money primarily from institutions, as well as from some very high net worth individuals. With one exception, the Charlotte Angel Fund members are all individuals or an LLC consisting of a couple of individuals. Fundamentally, the money is coming from individuals who pool their capital, with investment decision, either made collectively or by a manager who they have assigned to do that.
By aggregating their capital, investors are able to make investments in larger increments. It also gives them the ability to have a broader portfolio. If you had only 100,000 dollars, joining a fund makes sense to you from a portfolio allocation point of view. Let’s say you really want to spread your 100 grand across 10 deals, that’s 10 grand per deal. Most companies are going to say, you’re not going to get in the door for 10 grand. But if you put your 100k into an angel fund, it’s aggregated into a pool of some larger amount, you can get that spread, you can get a 10-company portfolio.
For Charlotte Angel Fund you’re looking at early stage companies. But what is the upper and lower bound of what you consider an early stage?
Greg: In the software space, to date, every company that was pre-customer engagement, we have judged to be too early. What that means is, we’re not funding the beta version of a product. We’re generalists. One of the questions is always, is this truly meeting a need in the market? Is it a unique solution?
Imagine that you come in and you pitch to me software for running shoe stores. You say to me, there’s nothing like this and every shoe store in America needs it… I’m not familiar with that environment. If you could show me some customer traction, it gives me somebody I could talk to in due diligence and it sort of demonstrates—look, you’ve got 20 shoe stores that are using this. Clearly, you must be meeting some need they have, right? The users are paying you something. You’re meeting some need they have, and I assume they looked at the landscape of solutions that they could use before they decided to use yours. It’s a good piece of evidence as a generalist.
That’s true in the software space. Now, there are some industries in which that doesn’t work. If you’re a medical device company, we’re not going to demand customer engagement. That company is going to have to spend millions of dollars before there’s any customer engagement. Angel investors won’t have an opportunity to invest in such a company post-customer engagement. You have to accept a different risk profile or just exclude the category.
The software space is easiest to define. I can often say, look, if you’re not beta, if you’re not engaged with customers in some form, it’s probably too early for us. I understand you need some money to complete the beta, but it’s probably not going to come from us.
The preponderance of the deals we see, are software related.
So you’ve done three deals in the medical devices or biotech space. Do you have certain sectors that are definite “Nos,” based on your membership profile or what you guys feel comfortable with?
Greg: We don’t, by definition, exclude anything. But there are certain industries that just don’t lend themselves to angel investing at all, right? They’re not scalable or whatever. It could be a nice business, but it’s a corner Italian restaurant.
So I think one of the things that would be helpful for people to understand is how you choose the investments you do make. Are there any lessons you could share that would explain why you chose the portfolio companies that you did versus other good companies that just weren’t the right fit?
Greg: Sure. I think it’s important to understand when we do due diligence one of the things we’re looking at is could we ever make 10 times on this investment. That gets to market size, scalability, some of those phrases that people hear. It’s a math equation. You say, “Hey Greg, I want you guys to invest $500,000 and I’ll give you 10% for that.” Okay so could that $500,000 turn into 5 million?
Let’s assume there’s a future financing, so in the end we own 5% instead of 10% If I have to get 5 million on the back end, and I’m going to own 5%, this thing has to be worth 100 million. Valuations in this space are 5x revenue, so that has to become a 20 million revenue company. How big is this market? If it’s a 100 million dollar a year market you will need to have 20% market share to get that $100 million exit, and 20% market share is very rare.
So then you’re asking what’s the competitive landscape is like?
Greg: Let’s say 20% market share as a hurdle is too high. 20% of a market is a huge number. We have to be able to get there on something more like 2% of the market.
Justin: Yeah, I was going to say 1%.
Greg: Right. The tension is between market size and valuation, because we can make the math work, but instead of 5% of your company I need to own 50%. But the problem is I can’t take 50% of your company because you’re then totally demotivated as an entrepreneur. So I can’t make an investment in this hypothetical market. That’s a big part of it: is this market big enough?
What are other common reasons things don’t make it? Market size, stage, sometimes it’s the team or lack thereof.
Justin: That was my next question.
Greg: You could convince me that the market’s there. You can convince me all this other stuff, but fundamentally if I don’t have confidence in the team … The 10x thing is sort of easy. That’s a very objective sort of thing. We’re going to do the math and figure that out.
The other piece is very subjective. How do you feel about those people? That’s very intangible. It’s hard to calculate. But that’s so critical because no business ever goes on a straight path. So are these people who, when you get to the point that a pivot’s required, will they recognize it? Can they accept that their initial vision might be incorrect? Can they execute it?
So how would you describe the overall quality of the applications that you’ve received through CAF? And the companion to that is what do you want people to know before they’re applying?
Greg: The deal flow comes to us in different paths with varying quality. There are the deals that come through other investors, which honestly tend to be higher quality because those people have talked to them.
If I talk to a VC who recommends a company, the VC may say it’s promising but just not right for the VC. Maybe the money the business needs is 250,000 instead of 2 million. Or they’re a little too early. The VC will refer that startup to us because we would typically invest a little earlier than the VC would. That sort of deal flow tends to be super high-quality. It’s also good to know that somebody that could be a follow-on funder cares about this company in some way.
A lot of the volume that comes in is organic via the Charlotte Angel Fund website—and that tends to be the lowest quality.
In the middle there’s a platform called Gust that we use that tends to be a little higher quality. It’s specifically targeting startup companies and requires them to complete a profile, include financials, etc. It’s super easy to send just a one-line inquiry, “Hi I’m Greg. I want to open a skateboard park. Can I get some money from you?” I don’t have to fill out a form. I’ll just sort of send Greg a note, see what happens.
So in terms of the process specifically for Charlotte Angel Fund, you said you’ve got other investors who send referrals, the website and then Gust. So what does the screening look like on your end?
Greg: I am the screening committee. My function is to meet companies and select those that come to the meeting. It usually starts with, “Can you send me a one- or two-page summary that I can read before we have a phone call?” Then we have a call.
In that call I want to make sure I really understand what you do, what stage you’re at, what you’re trying to accomplish from a funding point of view, and if all those three things are reasonable then I’m going to want to see your presentation. Show me the presentation that you would propose to our group, so that I can try to view it as our members will see it and how are they going to react to this.
So essentially you have them provide you more information, and then you follow up with a phone call to make sure that you understand the business—and that it makes sense to bring them in for what is essentially a test pitch. Then if at that point you feel like it makes sense to bring them in front of the whole group, you do.
Greg: Yeah. Three of the startups present in front of the group every month. We decide which if any we want to do due diligence on—if it’s interesting enough, market size, whatever. The norm would be one out of those three, could be two could be zero. It’s never been three.
And that’s what you’re saying. You’re a gate keeper and you’re not going to put people in front of the members until there’s actually a legitimate chance of success.
Greg: I think it’s important to understand that sometimes the group says no, but there’s still a positive outcome for the company. Because an individual in the group might have interest in doing something or might introduce them or can in some way help this company. So even if it isn’t a Charlotte Angel Fund check … If the group says no, any one of our members can do whatever they want. Maybe two people put some money in, or they know someone in the industry they can introduce to the company. There are positive outcomes other than getting a Charlotte Angel Fund wire transfer.
I think there are twice as many positive things. I’d say for the five investments that we’ve made, there are probably 10 others where there’s been a positive event. Now, there is no way to promise a positive outcome. But there is no more efficient way to get in front a large group of people who could invest in the company.
Just generally speaking, what are the specific ways you’d like to see the entrepreneurial community improve in Charlotte?
Greg: I think Charlotte is a risk-averse community generally. I think conservative might be a better way to phrase it. I think we tend to be conservative socially, etc.
I think we also have more than the average number of founders who are working on a side project, are in the mode of “I’m going to be fully committed to this once somebody funds it because I don’t want to give up the day job” or whatever, and I get all that.
It’s a really, really hard thing to fund the person who is not there full-time. Or even worse, people say, “Well, I’m going to keep my job at the bank until the business is mature enough to pay me a salary equal to what I’m making at the bank.” You’re not going to get there, more than likely.
If you’re not working on something full-time, things just don’t happen. I meet people all the time where the next conversation goes something like, “How is your business doing? I met with you 90 days ago. What’s happening?” The response is usually, “Well I’ve been really busy at work and you know, we had vacation,” and whatever. It doesn’t happen unless it has to happen. Because it has to happen if you burn the boats.
Justin: Yeah, there is no necessity here.
Greg: In Charlotte as a whole there is no, “Oh my God, we have to do something” thought with regard to the entrepreneurial community or lack thereof. I think there are only 1% of us who have angst over the issue. The reality is that Charlotte’s economy is pretty good, so many see no need to change it. However, the issue is that Charlotte’s economy is concentrated in certain sectors, and those sectors have in the past and will in the future see down cycles. We need economic diversity to reduce economic risk.
Charlotte is technology deficient. By that I mean we don’t have copious amounts of R&D being done in Charlotte, either academically or corporately. Show me a big R&D center here. The Charlotte Chamber will state their strategy is to target corporate headquarters, and they do a good job of that. But that lack of R&D is a deficiency in the raw material for startups. Is there some interesting technology that you can get ahold of as an entrepreneur and try and develop? Less so here in our city.
Then along with that, I would argue the institutions here in many cases aren’t entrepreneurial by nature. They are not developing and rewarding entrepreneurial talent and traits.
Entrepreneurs aren’t the kind of people who tend to work at the bank long term. They don’t like working at the bank, or the bank doesn’t like them working there. Because this guy doesn’t fit in. To work at the bank you’re supposed to just follow the steps in the manual.
I think what we can do is focus on things like innovative business models. Amazon didn’t have some technology that nobody else had. It’s an innovative business model. I think as investors, we have to get comfortable with that and not have our first question be, “Do you have a patent on that?” What did Amazon have a patent on? I’m sure they have some patents, but what are they doing that the Postal Service couldn’t have done? I think the investor community has to be more open to those things
I think it’s interesting in trying to combat that conservatism on the entrepreneurial- and the investor-side. That’s a tough nut to crack.
Greg: Yeah. But they are there. People are there. For example, you’re starting to see some people coming out of Red Ventures. They were, from a career point-of-view, brought up in an entrepreneurial environment. Those are people who are either going to go out and start their own companies, or they are going to fund one.
You’ll have the same thing from AvidXchange. “I have been in this environment. I know what it’s like. I’m either going to go start my own thing because I have an idea of how to do that. Or I now have some capital and I’m going to fund some of these things.”
But if you made all your money in financial services, “high” risk is that the company only has a million of EBITDA.
True, and the people that have made their money in this city are mostly coming from financial services. That will be interesting to see—as more people roll out of positions in financial services—how many of them actually have the risk tolerance to be a true angel investor. You just need people who have a risk tolerance. You’re looking at a subset of people who can be investors, and then one subset of those care about entrepreneurship, and then only a subset of those have the risk tolerance for angel investing.
Greg: Charlotte is a banking town, and banking is all about risk avoidance. It’s the antithesis of angel investing. Why would we expect the banker to embrace this? We do have plenty of people who carry around BofA or Wells Fargo business cards who are investors in Charlotte Angel Fund, but it’s a tiny, tiny fraction of the people at those banks who have enough capital or income to consider the activity.
I’m not quite sure how we solve that problem, but I think one of the keys is what you touched on earlier. That people who grew up working an accumulating capital at the AvidXchanges and the Red Ventures of the world are the types of people who are more likely to be angel investors.
Greg: Yeah, you need people who have money in their pocket that they made doing stuff like this. That’s like, “Okay, I get how that works.”
Justin: The other thing is figuring out a way to pair entrepreneurs and people who have capital. I think that’s the benefit of something like the Charlotte Angel Fund. You get exposure to 49 people who may all have different areas of expertise.
This Q&A has been lightly edited for clarity and brevity.