Michael Gruber joins Nick on The Full Ratchet to discuss Angel Groups, including:
- What is an angel group?
- What are the key functions of the Angel Group Leader or Coordinator?
- What value does an angel group provide to its investors?
- When investments are made, how are they typically organized?
- We’ve discussed previously how VC’s typically make money via a yearly mgmt fee and a % of fund returns called carry or carried interest…. What’s the economic business model for Angel Groups.
- What differentiates one angel group from another?
- Why do investors join an angel group, as opposed to angel investing on their own or investing in a VC fund?
- For those new to start-up investing, what advice would you give on how to choose the right angel group?
- Is it reasonable to expect a return on investment when investing with an angel group, or is it just a hobby?
- Deal sourcing and dealflow… investors get access to more deals and higher quality deals
- Broad expertise… b/c groups are made up of many successful, accredited investors from a variety of industries and disciplines, you can access a wider breadth of expertise when evaluating startups
- Leverage… both angels within the group and then also networks of angel groups can participate in deals together to get better terms, structure, liquidation preferences, ongoing governance and even board seats.
- Pooling resources… so for diligence and other administrative activities, you have more people to share the burden.
- Fee structures… often the fee structures in an angel group are lower than that of a VC fund
Tip of the Week: Easy Problems, Tough Solutions…
Michael Gruber is with us today. He is the founder of Cornerstone Angels, and is a Partner of Independence Equity, an early-stage Venture Fund. You know, there’s a number of very strong Angel Groups in Chicago and I was very fortunate to meet Michael and have learned quite a bit from him over this past year.
Nick: Michael, I am glad to be a member of the group and glad to have you with us today.
Michael: Thank you very much.
Nick: I want to start out with some detail on Angel Groups and Angel Syndicates, but before we do that, can you give us a sense of how you got into the start-up investing world?
Michael: Well I spent a lot of time with operating companies, both within software and hardware and I spent over ten years out in Silicon Valley with a variety of start-up companies, some being private and other that that actually went public as well as I am actually spent some time in Japan with a large software gaming company, so I spent time building companies from the development standpoint, marketing as well as business development and through that effort I then later on joined a early stage fund and through that effort I got to know an Angel Group in the Bay area with one of the founding members of that organization and that really started the path of which I’m on now; but I have moved then from Silicon valley to Chicago. I was looking on what to do starting a new company, hoping to run a new company or team and what I did then decided then was to start build out my network within Chicago and I basically created the Chicago Midwest Chapter for this Angel Group and then that started the process when then evolved into Cornerstone Angels, as it is today.
Nick: So we talked a little bit in the past about Angel Groups and Angel Syndicates on the podcast. We are going to go deep today, so first of all Michael, what is an Angel Group, what is an Angel Syndicate and how do they work?
Michael: So an Angel Group is a network of individuals all high net worth individuals who are accredited, who meet the accredited definition, by the SEC so they idea of the group is; one you bring it together many different folks who have a diverse set of experiences, both functional, as well as sector wise and through that amalgam of experiences you are able to get to a much better set of results of deciding on what to invest and what not to invest. So as an example, I’ll first talk about Cornerstone, but also sort of in broader terms, it is a membership based organization, and most groups are like that. They pay an annual membership fee that people pay so this means that not only do they have the money, but they are willing to pay an annual fee to belong, so for entrepreneurs, that is a good thing. You know they are not just there to sort of hear pitches, but they are investing money to be involved in the group; and what the Angel group does, it provides a structured process to evaluate opportunities, and also by being a group, it winds up by being a good magnet to attract quality deal flow, by being a group that is out there in the community , the group gets to see that more opportunities than any one individual might get to see, and then through this structured process , there are multiple steps that probably get through that are able to make a pitch to the entire group and then the group as their is interest will follow a due diligence process to figure out if there is an investment and if we get to that point, then usually there will be a subsequent process for structuring and negotiating and deciding to about making the investment itself.
Nick: You are a leader yourself; an Angels Group leader. What are the key functions of that leader or coordinator?
Michael: Well, a lot of it is organization administration, unfortunately, but the nature of the beast is that, Group, if composed of the right people, the Group of successful, professional, busy people, and the idea is tone; needing to ensure that you provide a quality set of opportunities for people to look at, you need to provide an efficient process by which they can be a part of and the group, both the entrepreneur companies, as well as the investors to be able to network interface with other investors; both other Angels, other Angel groups, Venture firms. In the end a lot of this interaction in the group is about business networking but also making money and for others, it is also about the mentorship they are providing those entrepreneurs, so we were just being a shepherd, about shepherding folks within this process, but it is also about providing a strong operational platform to get deals through this whole funnel, to get good deals done and then we are all going to be judged based upon the success of these companies, so ultimately, the goal is to continue to build up processes, so that we are able to monitor and provide good governance over our whole portfolio of companies.
Nick: So we’ve kind of touched on this already, but if you take an Angel who is on his own trying to find start-ups to invest in, structuring deals, etc., and you take an Angel Group like your own, what’s the difference and what value does the group provide to those angel constituents.
Michael: So, number one, any individual, unless they are incredibly successful or well known in the community will only see a few deals, and most of the deals that they do will are probably not going to be of high quality; so the angel Group by itself going to be receiving, one; a higher number of opportunities, and by being in the business, like any company that is kind of focused on a particular are, they will then attract a much higher set of opportunities; that’s number one. Number two is any individual angel, if they are just going into a deal, typically each company has an investment minimum when they are going into a company. That could be twenty five thousand, that could be fifty thousand, it could be a hundred thousand, as a group depending on how it is structured, and depending on our group, Cornerstone, we allow folks to invest, depending on what they are interested in, either directly into a company or through an entity. We have a group called Cornerstone Opportunity Partners, OLC, we then are aggregating capital and it then allows individual angels to invest smaller amounts. It could be five thousand, it could be ten thousand, it could be fifty thousand, but it could be lower than what the individual threshold would have been, so one of the things which we haven’t yet talked about in this portfolio theory and diversification; and to be an angel, and which, hopefully some people will listen to understand whether or not this is the right place for them to be, but these are high risk opportunities. Someone should b involved if they are getting into a lot of these, you never know which one is going to be successful. So they key is to invest in a number of them and to hopefully spread out those bets across a good number of them so, the Angel Group, by virtue of its opportunity, allows the opportunity, a lot like the one we descried to see the opportunities, but through certain structures, to be able to invest smaller amounts across a larger amounts of opportunities. Some other points there, again, as an individual you are relying on your specific expertise; you may go outside to outside friends, but an Angel Group, depending upon how large it is, could have twenty people, forty people, or a hundred different people with different views that provide you insights into that opportunity. Sometimes, it may not be what you want to hear, but sometimes the best advice which make you not invest in an opportunity versus investing, that may just save you a good amount of money so there is a lot more diligence. It is always to good to have a secondary opinion, so that’s another guiding factor trying to make better investment decisions.
Nick: Yes, certainly when I’m on my own looking at opportunities, I’m constantly pulling in subject matter experts, with an expertise within certain industry to help me evaluate and I’ve noticed since joining the group a spectrum of folks that are part of Cornerstone, it helps tremendously from a time standpoint and domain expertise standpoint.
Michael: One other thing that just came to me which we didn’t talk about was just the other big aspect with a group is, that is the nature of structuring the deal or getting a good value for your investment. So again, if you are an individual and you are about to invest twenty five thousand through a company, you don’t have much leverage in that twenty- five thousand dollar investment. If that company already has the term sheet out, you are investing based on that term sheet. But if you are part of a group or you are working with a syndicate of different groups, you then have financial leverage, you are able to sort of dictate terms to that company, so that is one of our key goals for Cornerstone and the benefit to the member is, if we collectively come together, we all have to agree and we leave it up to each individual to decide which one they want to invest in, but if we could waive up to a quarter of a million check or a million dollar check, we have the direct ability to interact with that entrepreneur and founder, dictate terms, and structure and liquidation preference or even board seats; and in the end, which I have found over the years, of which we have forty-five plus portfolio investment companies being able to have an ongoing interaction with the company, being able to have monitoring and governance, it is incredibly important, because the truth is the CEO, of which you may have invested in, may not be the CEO in few years, and so you may not have structures in place to continue to get the right information in a few years down the road.
Nick: Yes. I have noticed the minimum to even participate is $25K, $50K and that doesn’t give me a tremendous amount of bargaining power, ability to influence terms, not to mention my lawyer’s fees end up to be a significant portion of that amount, so certainly that illustrates the power of the group. So when investments are made, how are typically organized?
Michael: As a group we allow our members to make their own investment decisions, and again I am speaking for our Cornerstone group, so if there happens to be an interest, we shepherd that that sort of diligence process to get to that decision, but if there is only a few members that are interested, we don’t try to get into the middle of that, we allow those individuals to invest directly. So as we said before, people have different experience, likes; everyone can’t always get on the same age, but the goal going forward is wanting to have more governance and monitoring, and so we see ourselves trying to put more effort through this structured investment vehicle., this Cornerstone opportunity Partners is a part of that vehicle, and that’s where we see that there is enough dollar interest as well as individual participation, and through that effort, we have what’s called a Series LLC vehicle which allows it to be pretty cost effective to establish investment on each company as they come to be, each individual commits the dollars that they want. Some, we may have a specific minimum dollar requirement, others such as a secondary investment in the company. We allow for the minimum to be pretty low, we just want to allow folks the ability to invest more. But the way it is structured, it is similar to a venture fund. We have a one-time management fee which, we as a sort of the managers, have to manage the entire life of the investment which includes legal administration, travel, K1 accounting, all that, and it’s on my back that somehow if expenses go higher, I shoulder the burden, I bear the cost of that, but it’s trying to minimize the cost to our members to provide this good structured vehicle to get a better deal, but then we have an incentive if the deal does well, that there is a backend carried interest which the Cornerstone Opportunity partners manager gets as part of that success.
Nick: So is it similar to a VC Fund in the way that you have a management fee as well as a percentage of carriage?
Michael: The big difference is that a typical Venture Fund gets a management fee every single year. They, in trying to do this it very investor friendly, they pay a one-time fee of which the manager is managing the cost of the life of the investment. Obviously, each investor wants the life to be as short as possible, and even though we state three to seven years time arises, you never know, you never. If it is only two years that’s wonderful, but some of these investment could be five, seven, nine years, and so it is managing the cost over that life, so compared to a VC the management fees are significantly lower, but then the carried interest is like a VC, but I would say it is more preferential to investors. It is a lower carried interest. It’s actually 15% versus the typical 20% for a venture fund, and actually for our members, it is actually 10%, though we always try to give an incentive to folks to get more involved with Cornerstone as a member, and so that backend fee is less, and plus we require a preferred hurdle rate of all investors to get our capital back, plus a preferred return before there is ever any carried interest.
Nick: So just to clarify that point, if the vehicle doesn’t return over a certain percentage then you guys would not collect that carry.
Michael: Correct. We want all the investors to get a good return. If that investment does not have a good return then yes, us as a manager who put that whole investment together will get nothing.
Nick: So there are Angel Groups across the nation. Small markets, large markets, very different focuses, what differentiates one group from another?
Michael: There is as you look at groups across the country I would say predominantly, many groups are very localized. They only invest within their city, within their state. The investments may only be particular to technologies of products that may have emanated from a university sectors you will find some folks that may be predominantly focused on the life scientist field, consumer product. In the last few years you have had a number of groups that are focused on women-led entrepreneurs, or even minority-led entrepreneurs; so over the last 10 years ,the number of Angel Groups in the country has skyrocketed and just like with any bigger market you find splintering and specialization across what I would say for our group we try to do the best and find the best deals and so I think we are pretty unique Angel Group in the sense that although we are based in the Chicago Land area and we look at a lot of deals in the Chicago Land as well as the greater Midwest we are one of the unique groups that investor led groups across the country so I would say more than 50% of our investment portfolio coverage today are outside the greater Midwest on the East Coast, West Coast. The second part is about also how Angel Group syndicate or co-invest with others. There is a number who like to take most other deals the take. They may just do small deals, couple hundred thousand or will take the entire things. Others are more open to co-investing. I would say as our organization, we are looking for the best deals regardless of where they are; whether it is in Timbuktu or Chicago, or anything else; we want to try to find the best deal and we try to leverage our network so we are very open and want to co-invest with others because the deal is outside of our market. We would like to have a local partner so we find ourselves investing with other large angels, other angel group venture funds; and in the past we have actually had other large strategic; corporate strategic as investors as well; and then the last thing I’ll say, some groups also invest across very different stages of investment whether, be it back of the envelope, pre cede or cede companies versus ones that are in their growth stage or in the later stage opportunities. For our organization, we define early stages the companies having developed a product or service but they have at least shown that there is some customer validation. They could be pre-revenue, but typically they are early revenue generation, so we will not invest in companies that will require a lot of development in engineering work. That would just be considered too early for us. There are other groups who will invest and get more comfortable with that. But we also as a group look at some diversification opportunity versus later stage opportunities ones where we saw that you can never guarantee what looks like there could have been two or three years time rise and there was more than a year term to get to an exit, and we have had a few of these where we have had companies gone public or have been acquired within a few years, so that the diversification sort of element of that; and then the last thing where some major groups differ is also whether or not they are very strict in the valuations by which they are investing companies. There is a number of groups which will say we will not invest in any company beyond the 3 million valuation, or beyond the 5 million valuation, and I understand that as a general philosophy because there is delusion that goes on in the end, and you want to try to minimize that and sort of in the future by being able to take a larger stake of the company. My personal opinion is that I don’t want to be that restrictive in the types of opportunities that we go after. If the company happens to be really good or if it’s at a letter stage and just a unique opportunity for us to get involved just by the very nature of the valuation, I don’t want to restrict it from us. For us and our members they will define whether that valuation is appropriate and a lot of times valuation does knock a company out; but I want the company and the management to be able to prove to us why it a good investment regardless of valuation.
Nick: We already talked about why one would join an Angel Group instead of just going solo. Can you talk about why one might join an Angel Group and choose to invest via that vehicle as opposed to choosing a VC fund to invest in?
Michael: It depends also in the Angel Group because a lot of Angel Groups have actually creates their own funds themselves. Vicar Funds and other attractive types of vehicles which really act almost identical to a venture fund so let’s just quickly go back; a venture fund typically is taking in other people’s money and again they are paid for managing that money and the typical venture you have capitals called on an ongoing basis and it’s really the general partners of that fund which make all the investment decision. So it is sort of a blind pool; the general partners have that capital with the investors not knowing which companies are in that. The model for most angel groups is it allows the angels to decide which deals they are going to do before they invest it, so they have then a discretionary capability to decide yea or nay on deals so although there is still some leveraging of the expertise and knowledge and deals sourcing of the angel or the Angel Group leader, the investor, the angel member still have the final say on whether or not they want their money to go toward that deal and that is really the primary difference if whether or not the individual member has access to deciding what deal is to be done or not. It is a little bit of comprising being passive versus active and I think there is room for both but certain people don’t have the time or they don’t want to get involved in as much of the diligence. They like to look on and just see where there could be mentors so they rather just be able to give money and know that they are going to have a diverse portfolio across the range. Other people, and we leave it up to discretion, want to be more involved where their money go. I think each person in deciding which group they want to be in or even the type of structure should evaluate where their comfort level is and their involvement in that decision making process.
Nick: So we have got some listeners that are new at start-up investing. What advice would you give on how to choose the right Angel Group?
Michael: Number 1; I’d recommend that it is best to try to pick a group that is local and convenient to wherever you may live so the best way to try to fund a group which is local is through the Association for Angel groups in the Us, which is the Angel Capital Association so that is angelcapitalasociation.org , you then be able to search for angel groups by geography; that’s number 1. It doesn’t mean that you have to restrict that because I would say us as an organization we have had members across the country elsewhere that have been part of the group and many of the groups have online software systems that allow you to access data rooms and documents for companies at any time 24 hrs a day so you have that capability, but the localized aspect is very important, because again this element of the power of the members in their experience is critical and I still believe it in a relation building and face to face and ability to interact with these people, develop that interaction relation and that rapport because they will be involved in help making the decision about which company to go to the next stage, and I think that is important, and I think that especially if someone is new it is important to be involved in every step of the process from a pre-screening to a screening, to the investor meeting, to the due diligence process , and so the more that you can be involved with that and other members to be shoulder by shoulder with them as they go through the process is very helpful. The other aspect is, there are different groups that may have different minimum in terms of dollars amounts, that they may required to be invested. Everyone has to look at their financial where-with-all, and where that is, the structure that we just talked about whether there is an upfront capital commitment or whether or not you are able to make individual decision is important; and then lastly but I actually think it is one the most important area in which I have great in our core star group is really the make-up of the individual member, so I would encourage anyone who is considering a group to ask to attend a meeting or several meetings depending upon the formats, See how the structure works, see the types of companies that are involved ad really try as much as possible to interface with the members. Hear from them about their experiences; see whether these are the types of people you would get comfortable on a social level with. See if these are the types of people you would trust in an investment setting. You are only going to know more and more as time goes on; but I think you are only going to learn more and more in time a lot of good sense within a few meetings whether these are the types of people you work with and I think that’s critical, and I think you don’t want to be part of an organization which is composed of a set of people which has different values than you, so I think that is the most important value that you could find in an Angel Group.
Nick: Michael, we have all heard people talk about how investing in startups can be a pipe dream or a little roll of the dice, you know part of the reason for me doing this podcast is to show that there is a discipline here and it can be a focused process with practitioners that know their craft. Is it reasonable in your opinion to expect a return on an investment when investing with an Angel Group or should it be treated just as a hobby?
Michael: I believe you should go into it wanting and expecting an investment. At the same time, I think everybody has to be realistic in understanding that this is a high risk activity that depending upon how many investments you make, there is likely to be a number of them, and very possibly a big number of them that would go bankrupt to zero. A few of them will worth a fraction of but it’s all about the promise in aggregate of what that return is. Again that goes back to the concept if you are going to be in this area, you have to make that decision; you have to be in it for the long term. You are going to have to make that investment and sometime you often do not know which companies are going to be successful and which are going to be the duds. Doing this an individual and to several venture funds and through Cornerstone and our Angel Groups and even some of our Angel Funds for which now will of them have been sort of successes; and then also just recently I’ve experienced some of the failures as well, and so it is humbling to sometimes see when you do get those, but the reality is, you should have failures and know that that is part of it, because I would say in this business if you don’t have those failure, you are probably not trying hard enough to get those big wins, but I think this is a high-risk; high reward space.. Cornerstone has been fortunate they have had a 100X returns we have had some other failures and the key is that there is enough of these companies which are continuing to raise additional rounds of capital. We’ve found other companies that have been acquired and I think; if there is a disciplined process across the whole spectrum of sourcing, evaluating, structuring, ongoing monitoring and governance, you increase those odds, which I think is a great success
Nick: Great. Moving on; do you have any recommended resources for more information on the topic of Angel Groups or Angel Syndicates?
Michael: Again I would refer you to the Angel Capital Association, there’s a great treasure trove of information out there. One, there is a bunch of free resources out there and than anyone who does become a member of Angel Group which is member Angel Capital Association, there is bunch of other documentation which is available free to members, so i would say do your research, look there are lots of more interesting sites for Angels where you could participate as an angel and get deal flow, and I would encourage you to do that which allows again additional deal flows, but also allows additional interaction with other angels across the world.
Nick: So we’ve touched quite a bit on Cornerstone and some on Independence Equity. Is there anything else you want to touch on or tell us about what you are currently up to?
Michael: The one thing I didn’t mention which is in addition to Cornerstone, which I mentioned. I am part of Independence Equity which is an early stage fund; so it does many of the same things as Cornerstone but it is more of a traditional fund where there is a committed amount of capital, and for that we’ re much more focused in terms of the sectors. We are most focused in opportunity going to water energy, advance and agriculture and where we also predominantly focused on the Midwest, so that we have had number of companies which we’ve both as Independent Equity and then Cornerstone invested in. Other times they are separate, but it just an exciting time for right now where we are seeing a lot of opportunities in those spaces.
Nick: So that point, how is the current start up environment where we are located here in the Chicago area and how has it changed?
Michael: You know, I moved here at the end of 2002 we are already in 2014 its dramatically changed as they said even when I first moved there were a few Angel Groups but they weren’t doing much and that was really the reason why I started an gel group from scratch when I first moved here. I’d say it is not an easy task especially when you don’t have a network here when I started it but what you found is you found in our group as well the number of other Angel Groups that sort of build up since then and have become so very strong. We found a number of other venture firms a get active and we have some resources in space including 1871 which is a co working space and which is attracted a lot of investors in the country in addition to the Midwest and luckily, we have had a number of exits from companies whether Grub Hub, Groupon, Tickets Now, Field Glass, and others. There has been lots of successes both here and in the Chicago Land area, and which the bread and butter of creating a good entrepreneurial ecosystem is not only having good research town, which we have great institutions here, educational institutions; but that you then have good company successes, and you have those entrepreneurs reinvesting in companies in the future; and I think luckily for us in the last 3-4 years you’ve found an acceleration of that.; and then the one last point on that is where I would say when I first moved here it was very clicky and I would say pretty insular in silos where people were making investment, and there wasn’t much talking amongst each other. Nowadays you find most investor communication more with each other and you find just in today’s world that it is almost a requirement to have a syndicate of multiple investors in the deal, always knowing that you are probably going to have to raise multiple rounds of capital and having more of those folks at the table from the start.
Nick: If we could cover any topic in capital investing what topic you think should be address on the podcast and who would you like to hear speak about it?
Michael: The one thing, I teach or have been teaching some courses at Northwestern and a number of those classes are relating to entrepreneurship, entrepreneurial financing, as well as I co-teaching class and called new venture and energy which is focused on energy; new energy startups; but the one thing which i find missing from startups or it focuses is the art of selling and so the only thing I would say is I would I think a topic of really looking at t he companies themselves about their ability to sell themselves which constantly see themselves, they are trying to sell their company for investment, and they are trying to sell the company and the sense of partnership and alliances; the more that we could focus or find ways of promoting that capability within companies, I think would be very beneficial for entrepreneurs as well as investors trying to find out which companies which are good at the art of selling.
Nick: Okay. So what are the best ways for our listener to connect with you Michael?
Michael: Number one is, go to the Cornerstone Angels website. It has lot of information out there as ability to inquire about being a member or companies can inquire about submitting their information for consideration, and then beyond that, you could look me up on LinkedIn and send me information and search to see how I could be helpful and how we could connect.
Nick: Great. You heard it from Michael. You can connect with him on LinkedIn, the website is Cornerstoneangels.com. Good to see you as always Michael, and thanks for the perspective.
Michael: Thanks again, Nick.