Why Investors Demand So Much

Insider secrets about the factors that influence venture fund and angel negotiations with entrepreneurs

Q.  My cousin and I are starting a web company and have prepared a business plan which predicts a very successful company. We need $50,000 to startup. We don't want to accept money from greedy angel investors who want to own everything. Rather, we'd like to work with lenders who won't require any collateral. What are our odds of finding these people?

A.   It's often said that venture investing is a gamble. It's a gamble for entrepreneurs who pour their heart and soul into an enterprise, often going without a market-based salary for months or even years. And it's a gamble for investors who bet that they can make more money backing a young company than investing in an FDIC insured bank account.

But when is too much, really too much? Are the cards really stacked in favor of investors at the expense of hardworking entrepreneurs? Your good questions got me thinking about the odds of venture success and its affect on so-called astronomical deal pricing.

For fun, I contacted the American Gaming Association for published statistics on the "house advantage." There are some interesting comparisons to be drawn between Vegas gambling and venture investing because any single bet can turn quickly into nothing.

For example, a nickel slots player can expect to lose $7 to $12 for every $100 played. Keno is particularly costly at $25 to $30 per $100 wager.

Risk adverse gamblers should hang out at the blackjack table where the average house advantage costs only $.50 to $1.50 for every $100 wager. Granted some hands are big winners. But the odds are gamblers will have many more losing hands than winning hands.

Unfortunately, the same odds hold true for venture investing. Despite the promises of optimistic business plans, even the smartest individual investors called "angels" and "early stage" venture funds will invest in more money-losing companies than money-making companies.

Here are the numbers. According to Venture Economics, venture funds lose all or some of their money in 35% of deals. Venture funds score a "breakeven" in about 30% of deal investments, which really means they would have been better off putting their money in a secure certificate of deposit.

venture funds did make money in the remaining 35% of their portfolio investments. But just 7% of venture fund portfolio deals produced astronomical returns of more than 10 times their invested capital. You can also assume that the stats for angel investments are more discouraging because angels tend to invest in more risky raw startups than more conservative venture funds.

So, now you know what really drives deal pricing. Angels and venture funds have to make sure that their winning investments more than cover the money-losing portfolio "dogs." For this reason, they are likely to turn down lending opportunities that pay a modest interest rate. They are also likely to turn down investment opportunities that don't give them a reasonable chance of making big money.

Now back to your question. You may be able to find an "unsophisticated" angel investor who doesn't know the going rate for startup capital. You may also come across a first-time investor who hasn't yet been burned by the Keno-like realities of venture investing. Good luck has to be on your side to find these treasured investors in a reasonable amount of time.

Fortunately all over the US there are an increasing number of active angel organizations that provide startup capital to entrepreneurs just like you. However, the odds will work against you until you accept that startup capital is expensive. Don't bother to play unless you are willing to pay. Good luck to you!

Take Command Action Step

Check out the Angel Capital Association's directory of angel organizations at www.angelcapitalassociation.org. Attend your local chapter's educational events and ask members to share their thoughts about deal pricing with you. You can do it!

Do you need time-saving tips to help fund and grow your business? Ask Susan How! Write to small business funding expert Susan Schreter at susan@takecommand.org