HOW TO INVEST IN A STARTUP BUSINESS The rewards of betting on a new venture can be as great as the risks. Pick carefully, travel in a pack, and get the right terms.
By Alan Deutschman REPORTER ASSOCIATE Gabrielle Solomon

(FORTUNE Magazine) – Henry Kloss was wiped out. A lifetime of creativity and risk taking had left him strapped for cash. He had put $2 million and ten years into promoting his own invention, a large-screen projection television, and he had lost the long struggle. Now he couldn't pay his own living expenses, let alone scrounge up the grubstake for a new venture. Kloss called a friend named Henry Morgan. Back in the Sixties they had worked together at KLH, one of the first makers of high-fidelity stereo systems. Kloss (the ''K'' in KLH) went on to launch another successful audio company, Advent, which produced the best-selling speaker of its era. Morgan became a Polaroid executive and later the dean of Boston University's business school. Semiretired at 62, he liked helping entrepreneurs with advice and money. Without hesitation he gave Kloss checks for $250,000; in a deal sealed only by a handshake, Cambridge SoundWorks was born. Result: In its first year, ended in July, the company sold 8,000 sets of speakers, employed 45 workers, and turned a profit on $4 million in sales. If growth continues apace, Morgan will get his wish -- a 25% annual return. Morgan exemplifies an intrepid breed of investor -- people who put up their own money to bankroll new ventures. Often self-made millionaires who have started successful companies of their own, they offer valuable guidance as well as high-risk capital to would-be tycoons. William E. Wetzel Jr., a professor at the University of New Hampshire and a pioneer in studying the phenomenon, calls these financial angels ''one of our most potent and least understood economic resources.'' A recent Small Business Administration study reckoned that ''informal investors'' of this sort sink $56 billion into some 450,000 companies each year. Granted, many of those billions are squandered on doomed enterprises. Otherwise clearheaded people are forever getting roped into underwriting a brother-in-law's unpropitious scheme. Restaurants and marinas are particularly suspect. But betting on a new business doesn't have to be an act of folly or a grudging familial favor. If you stick with the careful, patient strategy outlined herein, it can prove soothingly profitable. Howard H. Stevenson, a professor at the Harvard business school, says the highly inefficient market for small, private companies makes possible 15% annual returns over the long run: ''It's different from buying a stock and waiting for the greater fool.'' The trick is to find nascent businesses that can zoom to annual sales of something like $20 million within five years or so, with net margins of 10% to 15%. Says Morgan, who backs niche outfits that include an educational toy company and a mail-order garden seed merchant: ''These will never be the Digital Equipment Corporations. But if there's a good cash flow, they can buy me out in a few years at a nice return.'' Although hard to spot, many such opportunities lurk out there. Wetzel pegs the number of ''high-potential startups'' at 50,000 a year, far eclipsing the 600 or so funded by professional venture capitalists, who look only for the biggest plays. Hunting the right deal takes lots of time. Angels rely on informal networks of friends, past or present colleagues, lawyers, and accountants. They tend to invest in small packs, with inexperienced souls following the lead of seasoned ex-entrepreneurs. Angels scout for contacts at meetings of so-called venture capital clubs, such as the New York Venture Group, which convenes for breakfast monthly in Manhattan. Participants pass a microphone from table to table, hawking their deals in uninhibited three-minute pitches that sometimes sound like ads from the personals sections. For those who prefer doing their prospecting by mail, Bill Wetzel runs the Venture Capital Network in Durham, New Hampshire, a service that has gotten 45 investors involved with 25 companies since 1984. VCN now has 16 affiliated networks nationwide that bring investors from farther afield. When angels scrutinize potential investments, profit projections aren't all that matter. In a groundbreaking 1981 study, Wetzel found that angels are strongly affected by considerations other than financial returns: ''First, the deals have to make underlying economic sense, but then the hot buttons sway them to pick one deal instead of another.'' The hottest button, cited by 45% of investors, is the feeling of adventure and accomplishment they get from helping entrepreneurs. Typically angels are successful, self-made people themselves who are eager to give something back. ''They feel a sense of obligation, a need to repay, a desire to maintain the vitality of the free- enterprise system,'' says Wetzel. Their idealism goes further. Some 40% said they would readily accept lower returns or greater risks to support a company with a socially useful purpose. Favorite causes include improving education, creating jobs in blighted urban areas, aiding businesses run by minorities or women, and hatching new technologies to clean up and preserve the environment. Betting money on ventures like these, however public-spirited they may be, makes sense only for the well-heeled. A typical angel lays out $10,000 to $50,000 for a small ownership stake and holds shares in several companies at the same time. That could well mean $50,000 to $200,000 plunged into the riskiest and most notoriously illiquid of investments. Prudence dictates putting only 5% to 15% of your investible assets into new ventures. Before taking part in a deal, investors must often sign a document, required by the SEC, attesting that either they are worth at least $1 million or they earn $200,000 a year or more. In some states others can play only if they meet more complicated criteria, such as having a financial net worth of at least $150,000 (not counting residences and cars) but no less than five times the investment's pretax cost. ''Managers of a venture should take pains to make sure investors are wealthy enough,'' says Wayne Wall Jr., president of Roots Inc., a two-year-old startup. Wall led the search for angels when his New Haven enterprise developed an organic product that enhances the root growth of trees and grasses. In 1987 he raised $10,000 from each of 12 people, ceding only 5% of the company's equity in return. Then he filled out the management team by bringing in Robert F. Weltzien, formerly CEO of Timex, and Mike Davison, a young Georgetown MBA. The company targeted potential buyers such as sod farms, golf courses, nurseries, and papermakers, and lined up a mail-order distributor for the home-gardening market. Over the past year the company has raised another $913,000 from 41 angels, including a number of initial backers who upped their antes. Despite all this fund raising, the managing troika has been able to hold on to a 66% stake. What's to stop them from selling out to a third party, fetching a hefty premium for their controlling interest? That would strand the minority investors in a financial Bermuda Triangle (the real one, as it happens, is where Roots gets warm-water seaweed, a key ingredient of its product). Not to worry; experienced angels protect themselves against such contingencies. Bob Giel, one of Roots' early backers, insisted on a ''take me along'' clause that gives angels a right to the same terms as managers in any sale of the venture. If, for example, the CEO finds an outside buyer at $12 a share for 33% of his own holdings, that buyer must also offer $12 a share for one-third of each angel's block. Roots Inc. had sales of $500,000 last year. If it reaches its goal of $40 million in annual revenues by 1993, it could become a candidate for a public stock offering. Wall and colleagues are already scouting for a corporate giant that could bring its biostimulant to the vast crop-farming market. But most startups can never look to be big enough to go public or to attract a deep- pocketed suitor, so it's difficult for investors to cash out. Says Howard Stevenson: ''Liquidity is the No. 1 problem you have when you invest in a small, growing business.'' He has seen few angels convert their stock back into greenbacks in less than ten to 15 years, although most investors set four to seven as their target. He views these constraints as salutary, because they force angels to take the patient, long-term view characteristic of all sound investing: ''The best question is, 'Would you want to own this company forever?' As in real estate, you can't sell when you shouldn't.'' Still, smart angels try to negotiate in advance a way to get their money out. Some take preferred stock carrying a high yield, with warrants for common stock thrown in to give them a crack at capital gains. Henry Morgan structured his investment in Cambridge SoundWorks as pure debt at 25% interest -- until he discovered that he was committing usury under Massachusetts law. Paradoxically, Henry Kloss didn't mind at all; he considered the money ''incredibly cheap capital'' because it was an unsecured loan with no equity position. Morgan later did the deal with slightly altered terms that didn't run afoul of the law. The most widely used device for establishing liquidity is common stock with a ''put'' enabling investors to sell their shares back to the entrepreneurs at a price set by a predetermined formula. For example, assume the angels hold 15% of the company and the business plan envisions annual sales of $20 million in five years, with $4 million net income. Take the current price/earnings ratio for the industry -- 14, say -- and discount it to 10, since we're talking about a privately held outfit. That would make the company worth $40 million in five years, so an agreement might provide that when 1994 rolls in, the founders will pay $6 million for the investors' share if the angels want out. What if the company is struggling and may not have the money to pay? Investors might protect themselves against such unhappiness with ''rubber warrants,'' provisions that boost their equity stakes gratis when the company misses its targets. But, more important, they should act before the worst happens. Says James Mann of Westchester County, New York, a former lawyer and manufacturer who holds shares in ten ventures and often leads a choir of angels: ''We sit down with the entrepreneurs and try to rectify the situation. We have the leverage to say, 'It hasn't worked.' '' The point is not to bludgeon the company's founders with accusations of incompetence but rather to produce new ideas through as constructive a dialogue as possible. Even in the rare instances where angels hold a controlling vote, they may be loath to replace stumbling managers. Says Henry Morgan: ''I've been in situations when the founders get squeezed out by venture capitalists, and I'm not fond of that. My main interest is to help people succeed.'' The most frequent cause of crisis is a startup's insatiable need for capital. An investor may put in $20,000 and think that's it, only to be ground down subsequently by impassioned pleas for still more money. The best bets to avoid this are companies that can bootstrap themselves by quickly generating positive cash flows and financing their own growth. Cambridge SoundWorks' unusual approach to marketing helps it deal with the cash flow problem. The company advertises in national magazines and ships its products directly from the plant. When a customer phones in with his credit card to order a set of speakers, the company can deposit $500 in the bank that same day, Kloss says. This new way of selling audio components provides another competitive edge: By selling directly, the company can undercut the prices of retail stores, which have steep markups on high-fidelity components. With such techniques -- and Henry Kloss's name attached to a good product -- Cambridge SoundWorks quickly attracted a loyal cadre of enthusiasts. Bootstrapping startups are ideal, but investors should also be ready to up their stake when a company gets its second wind. James Mann first met Matt Kubitsky, co-founder of CyberResearch, a startup computer accessories sales company, at a gathering of the Connecticut Venture Group. In early 1985 Cyber needed capital to expand the print runs of its mail-order catalogue, and Mann signed on for $50,000. By 1987 the catalogue business had stalled badly. But in searching for ways to cut its own costs, Cyber had unwittingly created an impressive desktop publishing setup, linking together disparate technologies through its own software. The company's founders raised another $300,000 from Mann and other angels and began marketing the new system, christened CyberChrome. Now the combined operation is profitable, with sales of $4 million. For entrepreneurs as well as their backers, it pays to know when to give up -- and when not to.


--Unless you have run a startup company yourself, join forces with someone who has. -- Look for ventures with modest capital requirements ($50,000 to $500,000) that can grow to sales of $20 million within five years, making net margins of 10% to 15% along the way. -- Make sure you can afford to risk not only the initial investment but also further rounds that may be necessary. -- Be prepared to wait five to ten years, maybe longer, before you can take home a cash profit. -- Insist on a ''take me along'' clause that cuts you into any deal the entrepreneur might make to sell stock to outsiders.