Where's the Exit? 

Everyone knows start-ups rarely make it into the IPO pipeline. by Louise Witt
So what are other ways you can get a return?

“Angel investors could drive harder bargains. They don’t focus on how they can be hurt and how to exit the company.”

Being a director gets the angel inside, more able to make sure the entrepreneurs stick to their business and exit plans.

Entrepreneurs have lawyers representing their interests, so hire your own lawyer to review the term sheets.

A good exit strategy can make all the difference. Just ask George Chryssis. The former entrepreneur has had his share of good angel investments and bad ones. Sometimes the only distinction between the two is whether Chryssis has been able to get his money back out of the deal.

Chryssis worked out all the details with John Pyrovolakis, a Massachusetts Institute of Technology doctoral student, before he invested a single penny in Pyrovolakis’s start-up, Collegescape, in March 1997. While not everything was spelled out in ink, the two men discussed their exit plan at length. Both agreed they’d sell the company if the right offer came along. Collegescape developed software that let students apply to colleges on the Web. A little over a year later, Peterson’s, which publishes college handbooks, bought Collegescape. Chryssis’s final return: 400%. “I had a feeling that the Internet had merit and there was business potential for the right enterprise,” he says. “I guess I was right.”

A few years before getting into Collegescape, Chryssis invested in another company, but he still hasn’t seen a dime. Chryssis made the fatal mistake: He failed to hammer out an exit strategy with the entrepreneur, assuming, since they were friends, that they shared the same goals. Ten years later, the founder still tells Chryssis they should wait to sell the company, arguing that it will be worth more later. He may be right. In the meantime, Chryssis’s money is trapped. Total return: zero.

The difference between these deals taught Chryssis a valuable lesson. Now he always figures out how he is going to realize his return before he ever writes a check. “I know now to ask the founders what they want to do with the company and make sure their exit strategy coincides with mine,” he says. Finding the right company is the first step, getting out is the ultimate goal. These days he’s far more businesslike in his negotiations. A lawyer and an accountant look over his contract, called the term sheet. He asks for convertible preferred stock or convertible debt. That way he has more rights as an investor and he has the potential to earn money even before the company is sold. He also asks for a board seat. And last, but not least, he always has an exit strategy—in black and white. “Don’t rush to sign an agreement unless you and the entrepreneur understand and are comfortable and satisfied with all the finalized terms and conditions,” he warns. “After the agreement is signed, it’s too late.”

Many angel investors—especially those who are just starting out—don’t consider how they’re going to get their money out of their investment. It’s as though they’re afraid that if they take the time to negotiate a better deal, they’ll miss out on the next Microsoft, Yahoo!, or Red Hat. “Their goal is to get in early and make a lot of money,” says Andrew Zeif, a lawyer with Gray Cary in Palo Alto, California, who represents entrepreneurs. “They don’t focus on how they can be hurt and how they are going to exit the company.” Zeif says entrepreneurs these days are more willing to make financial backers happy. “Angel investors could drive harder bargains,” he admits.

Angels may not be so demanding because they may not fully realize, or they forget, their enormous clout. Without them and their money, a lot of entrepreneurial companies wouldn’t exist. As Murray Alter, a PricewaterhouseCoopers tax partner in charge of high-tech and venture capital in New York City, puts it: “The ones with the gold make the rules.” Another reason angels may not dwell on exit strategies is because they’ve already accepted that investing in start-ups is a high-stakes gamble. They’re right. Out of 10 angel investments, they’ll only hit the jackpot on 3 or 4. Maybe fewer. Two or three will be complete busts. The rest? Known as the “living dead,” these are mediocre companies that aren’t bad enough to fail but not good enough to have an exit, either.

Because private-equity investments are extremely illiquid (they aren’t registered with the Securities and Exchange Commission, they aren’t publicly traded on a stock exchange, and they can’t be marketed to other investors) and the chances of picking a winner are slim, it becomes doubly important to improve your odds of a successful exit. Informally, angels can ask friends, family members, or acquaintances to buy their shares. If they have close relationships with their brokerage houses, they can ask their firms to buy the stakes, as a favor. Michael Granoff, president of Pomona Capital in New York City, rarely looks at single-company parcels from clients. But, he says, “If an angel who owns an interest in 10 companies wants to sell them, we might take a look at it. More common, though, would be for us to purchase someone’s limited partnership stake in one of the A-player venture capital funds, where we know that the portfolio companies are being managed by some of the best people in the business.” There is some movement toward creating a secondary market for private-equity deals, though, and many investors see it as inevitable that such efforts will grow. Says Granoff, “We are at an inflection point, where there will be a demand for more liquidity across the board.” OffRoad Capital, a San Francisco firm where accredited investors—those with $1 million in net worth, $200,000 per year income—can take stakes in private offerings, is working on a program that will let its clients trade their shares on the Internet. OffRoad plans to launch this secondary market in 2001. The company doesn’t think it will run into any regulatory problems with the SEC because the securities won’t be promoted and only accredited investors will be able to participate. “I’m confident it will work,” says Susan Woodward, executive vice president of OffRoad’s research and a former SEC economist. “Investors are really enthusiastic. They ensure us that they’re willing to pay more for a stake in a company which has liquidity.”

OffRoad’s secondary market wouldn’t provide up-to-the-minute pricing found on the New York Stock Exchange or the Nasdaq. Instead, the San Francisco firm would hold quarterly or semiannual auctions, depending on what OffRoad’s customers prefer. Two weeks after a company’s quarterly results are released, clients would be notified via the Internet that trading will take place. A trade takes place when the bid and sell prices that are posted cross.

If OffRoad’s secondary market proves successful, other financial firms may create markets for their private-equity investors. EarlyBirdCapital.com, an online private-equity community that offers private-equity deals to accredited investors on the Internet, is eagerly awaiting the results of OffRoad’s endeavors. Steve Fu, the company’s chief Internet strategist, says, “Should a secondary market develop, you’d see an explosion in private equity.”

That’s the future though. In the here and now, angels have to nail down an exit strategy. To make sure it’s enforceable, angels should put everything down in writing in the term sheets; in the industry this is known as “papering the deal.” Angels should ask for preferred convertible stock or convertible debt, registration rights, rights of first refusal, put options, and a board seat. (Investors have considerable room to negotiate if they put in substantial amounts of the capital, let’s say $750,000 in a $3 million deal.) Entrepreneurs have lawyers representing their interests, so it’s a good idea for angels to hire their own lawyers to review the term sheets as well.

If a group of private investors throws anywhere from $100,000 to $250,000 each into the same $3 million deal, they won’t have much bargaining power. Ira Hecht, a partner at the law firm of Goodkind Labaton Rudoff & Sucharow in New York City, says angels in a large group who throw in small amounts are usually presented with a set term sheet that they can either accept or reject. “Typically, it’s a take it or leave it type of deal,” he says.

Common or preferred? David Larkin, a New York City businessman, has received both kinds of stock in angel deals. When he invested a couple hundred thousand dollars in Startups.com’s third round of financing (called Series C financing, which means it’s close to an IPO), he didn’t have much room to negotiate. He didn’t worry though. Startups.com, based in Redwood City, California, helps entrepreneurs handle all the headaches of starting a company. Larkin had confidence in the founders and the dot.com’s business plan, and agreed to the terms already negotiated by the other investors, which included common equity. “I’m sort of old-fashioned,” Larkin explains. “It wasn’t a metric calculation. They were just smart people and a great idea. And it isn’t so much money that I’m sweating it.”

Larkin wasn’t so laissez-faire when he invested a larger sum—about $500,000—in CrunchTime! Information Systems, a Boston company that helps food companies manage their inventories. For that amount of cash, he demanded convertible debt, which he’ll be able to convert to equity when the company is sold or goes public. And Larkin is on the company’s board of directors. Why did he negotiate for more? “Because I could,” he says. “I came in earlier, so I had more opportunity to tweak the terms.”

The most important item angels should ask for is convertible preferred stock or convertible debt rather than common equity. Preferred stock will not only give the angel a dividend but also a return on his or her investment. (Depending on the company’s financial health, it could pay dividends right away or defer them until it is profitable.) With convertible preferred shares, angels switch them for common stock if the company is bought or has an IPO. Having preferred stock protects the angel’s investment if the founders raise additional funds in another financing round. As preferred shareholders, angels have to receive their entire investment back before the founders see one penny of profit from a sale or acquisition. If the angels hold common shares, the founders could use the money from subsequent financing rounds to buy out the angels’ shares. And the angels will miss out on the upside potential of an acquisition or IPO.

Convertible debt Similar to convertible preferred stock, convertible debt gives the angel investor two things: interest income and the option to convert to stock ownership if the company is sold or goes public. And if the company files for bankruptcy, debtholders will be paid back before preferred shareholders and common shareholders. If angels must accept common shares, they should also ask for warrants that will give the right to own more shares.

Registration rights If investors think a company has a shot at a public offering, they should ask the founders for registration rights, defined as the ability to register their shares as common stock at the same time as other investors. If you don’t get registration rights, the other investors—venture capitalists or institutional investors—in subsequent financing rounds may try to put “lock-up” provisions on angels’ shares. A lock-up forces the angels to hold on to their shares for a certain period of time after the company goes public. “This is a major gut issue” if the angel thinks the company will have an IPO, says Joel Negrin, a lawyer with Goodkind Labaton Rudoff & Sucharow in New York City, and wise angels will push hard for registration rights in major angel deals even though the VCs don’t like seeing it in a firm’s financing. “Having some [entrepreneur] promise you that you can sell your shares is meaningless,” says Negrin.

Hal Nissley, chairman and CEO of Angelinvestors.org in Los Altos Hills, California, found out just how meaningless an entrepreneur’s word can be. He invested in a company that went public four years ago, but the founders refuse to register his shares so he can sell them in the public market. “I’ve been notified by the president that the management has no intention of registering the early shareholders any time in the next several years,” he says. The company’s shares are trading on the over-the-counter market.

The company’s managers know that if the angel investors were able to sell their shares, the stock price might fall. Nissley agreed to take common shares in the company and didn’t ask for registration rights because he “fell in love with the technology.” He says he and the other angel investors should have had term sheets that spelled out registration rights. “It’s a sound company,” he says. “But I can’t get my money out.”

Other rights Angels should also ask for the right of first refusal. This gives angels the right to buy additional shares from the owners before other investors in subsequent financing rounds. Angels can use the right of first refusal to control the company’s direction. If the angels think the entrepreneurs are bringing in the wrong partners or selling the company to the wrong acquirer, the angels can block these moves by buying the owners’ shares. By buying the owners’ shares, the original investors have a greater say in the company’s decisions.

The same concept applies to antidilution rights. That means if an angel investor owns 30% of the company after the first financing round, that investor has the right to buy more stock in the subsequent rounds to maintain the same ownership percentage. Once again, this is important if the private investors want to retain greater control over the company’s direction. Sometimes entrepreneurs will try not to give antidilution rights to investors in order to protect the entrepreneurs’ vision for the company.

Angel investors should include put options in their contracts, even though they are rarely exercised. Put options give investors the right to ask the company to buy their shares back at a set price after a certain amount of time. Usually the put option will give back to the investor principal plus interest. An angel could threaten to exercise put options to force the founders to sell the company, a draconian tactic not often used. If the company is struggling financially, the founders may not have the money to buy out an angel’s stake and paying back the investors may force the company into bankruptcy. If that happens, investors are likely to get cents on the dollar. Still, having the put-option clause could encourage an entrepreneur to grow or to go.

One of the most important concessions angels should ask for is a board seat. Being a director gets the angel investor inside, more able to make sure the entrepreneurs stick to their business plan. And directors have a say in mergers, partnerships and alliances, or plans to go public. If the company won’t give up a seat, then ask for observer rights. Then you can sit in on board meetings even if you aren’t able to vote. If you are in an angel group, designate one person to be the representative on the board. An effective board member can keep the group’s exit strategy on track.

No matter what provisions you negotiate, you should also review the company’s performance. When working out the deal, ask for quarterly statements. Planning for an effective exit demands that you constantly monitor performance. And angels often have to pitch in to save their start-up, supplying guidance, industry insight, or business contacts to the entrepreneurs.

Carol Sands, founder and managing member of The Angels’ Forum in Palo Alto, says, “When the company hits the bump in the road, it’s a very decisive moment in its history if the angels desert them.” Last fall, The Angels’ Forum, a group of 25 investors, had to decide what steps to take to save a new software company. The company was quickly burning through its seed money after a customer delayed signing a contract. One of the Forum’s members who sat on the company’s board knew this development was a major setback. Before a crisis erupted, the Forum arranged a meeting of all investors. The decision: ante up more money to give the company time to continue developing its software. Because the Forum kept on top of the situation, the company is still in business. Other angels tell of having to give a weakening company a makeover, strengthening it for a sale to another company for a successful exit. Former entrepreneurs who form the backbone of “next generation” angel investing are well suited to these tasks.

“An angel investor may not avoid investment failure,” says George Chryssis, who learned his lessons the hard way. “But it may be minimized if every investment is approached in a professional manner.”

Louise Witt is an editor for Fortune Small Business Online