Your Angel Investment Questions, Answered
This week, we teamed up with Branch Venture Partners to host a webinar on angel investment for food businesses! Many food entrepreneurs are in search of additional capital for their businesses, but aren’t sure where to start. Is an angel investor right for your business? And if so, how do you find the right one? And how does it all work, anyway?
Joining us were Lauren Abda and Marcia Hooper, both co-founders of Branch Venture Partners with extensive experience in food industry investing. Branch Venture Partners is the largest food-focused angel investor group in North America, and we were thrilled to benefit from their knowledge.
While the full webinar video can be found through our partner, Foodboro, we wanted to share some of the best questions asked by participants and how our friends at Branch Venture Partners answered them.
First things first! What is angel investment?
Marcia: The first people that tend to help out entrepreneurs are friends and family, and they usually get somebody started with the ingredients to make their first prototypes and get going. As the company starts to take off, they usually need more capital than the business will generate on its own. That’s when the entrepreneur has tapped out their friends and family and they move to the next people who can help them get funding and deliver advice.
Two decades ago, early stage venture capital would step in here. Venture capital as an entity has matured, and now they really only get involved with companies with substantial revenues. This leaves a pretty big gap that has been filled by angels. So angels are category of individuals that come in after friends and family, to help get you started, but before banks or institutions get involved. It’s broad, and it’s growing. They fall into two categories.
The largest group is known as accredited investors. That’s a government term, meaning that you have the resources to make risky deals. The SEC doesn’t want people hawking a product and raising money from unsuspecting people who can’t afford to invest, so they’ve set up requirements. There’s also non-accredited investors. A piece of legislation called the JOBS Act allowed non-accredited investors to put small amounts of money in investment, but typically they can’t fulfill the needs companies have.
What are angel investors looking for in potential food businesses?
Lauren: Typically, the startups that our members invest in are very early stage. They have a product in the market, they’re selling to between 20 to maybe 100 stores, they may be selling online, and they have some traction and customer data to be able to see how their product is doing in the market.
We’re interested in the brand, their differentiation in the market, and we’re particularly interested in categories that haven’t experienced a lot of innovation. In terms of other aspects of the business, the team is important. Do they have industry knowledge and expertise? Have they worked together in the past, and what is their dynamic? How many of them are working towards this goal?
And then capital efficiency. Has this team or entrepreneur been able to achieve certain milestones quickly with the resources they’ve been able to muster? And demonstrate that there’s a need for what they’re bringing to market?
Finally, an exit strategy. With angel investment, there’s a reason why people are giving you their money – they want to grow it. What does that picture look like for the brand, to grow the capital that’s being invested?
Marcia: The capital intensity of the business matters. One of the great things now when starting a CPG product is that you can have co-packers, and people that design your packaging. A decade ago, you might have needed to purchase manufacturing equipment, or go hire agencies, and so they cost of entry used to be higher. In turn, investors want to see how you’re using that traction in the market. How much are you able to be efficient with the capital you’re using?
The last thing is commitment. What’s your motivation to build this company? Typically it takes 3-5 years to know how big and successful a company will be. That may not seem like a long time, but it can feel like it.
What does an early stage company need to be prepared for in terms of scrutiny during the diligence phase?
Marcia: Spending time to understand the business model is really important. A lot of people think that if they have a product that tastes good, and if they can reach a certain store velocity, everything will be great. But what they don’t take account for is things like higher slotting fees if their distribution changes. You don’t understand until you start to map out all those assumptions.
Whatever you put on the paper, it will never come true. But think and ask those critical questions, because an investor wants to know how you make the business more resilient. Some businesses know that they need to have 8 SKUs because stores want to pick 4. So they have to go make all this investment, formulations, packaging, inventory, without really knowing. These are the things you have to plan and think about – and that thinking is really important, so you understand what could go wrong. Recognize your critical assumptions and be able to evaluate what’s really necessary.
What are the expectations from angel investors when it comes to equity?
Marcia: Financing falls into two buckets. There’s priced equity, and convertible debt, which at some point in the future will convert to equity. The priced equity turns out to be, from a legal point of view, fairly expensive. It’s about $25,000 to draw up full equity sets of agreements between investors and a company these days. A convertible note is inexpensive, it’s usually somewhere between $5,000 and $10,000. For young businesses who are raising $100,000, it makes no sense to go right to a priced equity round.
More typically, you’ll see a convertible note, where somebody agrees to come in and get a discount for future rounds when the company is ready to raise equity. The investor is guaranteed that they have a cap, that if the company does very well they’ll never pay anything more than a few million dollars. They have some safety to know that they have some price protection and they’ll get a discount going forward, but they provided flexibility to the company.
This varies by investor. Some investors only like to do price equity, because it’s like if they’re buying a car; they want to know the price. And there are some investors that understand that it’s hard to know what’s the right capital to raise, and they don’t want you to raise more than you need. They like a debt, so the company can continue to add debt as they need.
With everything going on with a company, especially if you don’t know your true capital needs, it’s generally my recommendation to start with convertible notes. They provide the flexibility to go and try, but if you need a little bit more, you can add to it.
You don’t want to back yourself into a corner where you priced the company high, it didn’t get you far enough, you have to go back, and now everyone says it’s too expensive and doesn’t want to pay it. Convertible notes work well and are less expensive for early companies.
What’s an example of a simple convertible note?
Marcia: In financing, you either have equity, which is ownership, or debt, which is a promise to pay the capital back. Mortgages or car loans are examples of debt. The problem with that is that every month, you have to pay the bank money. To commit to have to pay back a bank is difficult and very risky.
Convertible debt is debt that becomes equity. If you have an energy bar, you raise $100,000 in a convertible notes, you think in your next round you’ll be able to raise it at $5m, and that note would buy 5% of the company when it converts. But if you end up having to raise $200,000 because you need more, it’s easy to just add an additional note because you can make changes without having to spend a lot of money.
When do investors expect to get their money back?
Marcia: The rule of thumb is that it takes 5-7 years minimum. There are some capabilities now to exit earlier by selling to another investor if the rules allow. In some cases, if the company has grown to the point where institutional capital is being raised, they may often make a request to buy out angels because they don’t want to deal with a number of investors.
But there’s a diversity of angel investors. There are some people that want to come in and go out, and there are some people that will keep their money in the game and see how far it goes.
What is the expectation around founder salaries?
Marcia: I’ve seen a lot of financial plans where the founders are making little to no salary, and that doesn’t work. You need to be paid. Extravagantly? No. But you have to be paying yourself. The salaries we see are anywhere from 70-80% market value. If you’re going to work for another CPG company, you’d certainly make more money. But you can’t live off peanut butter, because that’s not sustainable.
The first year, you’ll often see that they’re spending very little on themselves, but by the time we have our angels put money in, they’d better have a plan that supports standard salaries. What may look like a healthy business is unhealthy if no one is being paid. By year 2 or 3, everyone should be paid a market salary. You’ll also be recruiting people, and there’s nothing more destructive than going out to hire someone at full salary while everyone else is working at half salary. You should get paid.