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Frank R. Ruderman T'72
Berkeley HeartLab and Tenex Medical

Visit Date: November 12, 2002
Class Topic: Angel Investing

Center for Private Equity and Entrepreneurship: What do you look for in a business plan?

Ruderman: It seems somewhat trite, but I consult my gut first. I ask, "Does this feel right?" I sniff around and see if it smells right from a basic perspective, and, if it does, then I use my analytical capabilities to evaluate the plan from a rational point of view.

During the last 15 years of running companies I've learned that businesses with a really large potential marketplace are the best bets. In that situation, all you need to do is get a little piece of the action and the business will be OK. The market needs to be vital and growing. Entrepreneurs need to be able to make a lot of mistakes and still not get hurt.
I also like to know that I can prove the principle behind the business plan by rolling it out on a narrow, regional basis. I don't want to have to go national in order to prove the concept. If the business can be rolled out with a few salespeople, a limited marketing effort, and reduced infrastructure, then it can demonstrate feasibility and become cash-flow positive before a national launch.

Of course, every business plan I've ever seen, including the ones I've written, has been wrong. It's right at the time it's written, but over the course of five to seven years, it's going to have to evolve. Given that reality, the quality of the management team is very important. I take a look at the CEO and his one or two key lieutenants and ask myself: 1) Can they implement the plan? 2) Do they understand the market so they can not only implement, but iterate? 3) Can they sell the product to the outside world? If I can answer "yes" to all those questions, then I make a bet.

Center for Private Equity and Entrepreneurship: When you are negotiating term sheets with an entrepreneur, are there any red flags that that make you less interested in getting the deal done?

Ruderman: If the entrepreneur is really preoccupied with control, I walk away. If the entrepreneur is driving the conversation about the company's valuation by saying, "I want to retain 60% or 65% because I'll get diluted to below 50% in the next round and I don't want to lose control, "-that's a problem. It sends all the wrong signals, especially in the early stages. The conversation should be driven by different metrics in order to come up with an appropriate valuation and to determine how much cash is really needed. Entrepreneurs need to truly understand the cash requirements. They also need to accept that they are entrepreneurs and that they initially aren't going to get what their value would be (compensation value) in the corporate world because they are getting equity instead.

To sum up, a good entrepreneur isn't obsessed by control and appreciates what I call "opium"-OPM-other people's money; he recognizes that the company's first responsibility is a return to the shareholder. Finally, they need to be able to really listen, respond and be realistic. I see a lot of entrepreneurs who are not realistic. We get deals that come back to us six or nine months after the entrepreneur rejected our terms, thinking he could get a better deal elsewhere. They don't, and then they come back. The problem then is that the deal has sort of become stale and old and no one is excited about it anymore and you have a hard time convincing other people to participate.

Center for Private Equity and Entrepreneurship: Post-funding, what are the signals that tell you that it's time for the founder to move aside so that professional management can be hired to run the company?

Ruderman: We usually know that from the very beginning and we try to set up the transition before we even close the deal. Right now, for example, we are in the middle of negotiating a deal where we know the business guy that is associated with the scientists is not the CEO for the go-forward. He may be able to do something for the company over the next 12 months, but we don't want to go through the cataclysm of him leaving after a year because it causes a lot of angst; you spend too much time dealing with corporate issues and not enough time on commercialization of the technology. So you have to structure a transition up front. Before you even fund the business, you put it on the table, you let everyone know where you're going. And if it is prudent to have the person participate in the first phase, then you structure him in as a consultant with a finite term on the contract and an ability to extend the contract. In the life sciences industry, entrepreneur-scientists usually don't want to be CEOs. I have seen very few scientists who want to get off the bench and move in general management.

Center for Private Equity and Entrepreneurship: Historically, VC firms and angels have been different animals, competing for different deals and operating separately. Now, for various reasons, it's beginning to make sense for angels and VCs to merge their concerns. Can you talk about that development?

Ruderman: The hybridization of venture and angel investing is just beginning, so to talk about angels and VCs coming together across all levels of private equity would be misleading. The early-stage or seed financing space for emergent companies has traditionally been where angels have played and where venture capitalists would like to play because of the leveraging of valuations. But, the way things have evolved, it is very difficult for either angels or VCs to really participate in early-stage investing in a rational way.

Angels only want to participate if they know that their resources (both in terms of time and money) are going to gain value over time. Once they put their money in, they could go 12 or 18 or 24 months working with a company and then, because they don't have the money to participate in subsequent financing rounds, they get crammed down. So that's not good.

On the other hand, venture capitalists now have big, big funds. They have $400, $500, $600 million funds, $1 billion funds. Their returns are lower and thus the partners aren't making as much money. There is subsequently a hesitation to bring on new partners because that would spread the wealth even more thinly. Early-stage deals don't make sense for them because the demands of an early-stage deal are essentially very little money but a lot of time, and this is the antithesis of what the venture firms have to offer. But VCs want to get in at the early stage because no one has visibility on the IPO window and you get in at very attractive valuations ($1, $2, $3, $4 million pre-money) in early-stage deals. Everyone recognizes that the ROI equations assume five to seven years of gestation, and the assumption is that something good will happen over the next five to seven years so that you can maintain your historical rates. VCs want to populate their portfolios with some of these bets, but they don't have the resources or infrastructure to do that.

So angels have time and expertise but not a lot of money and venture firms have a lot of money but not a lot of time and also not necessarily the depth of expertise.

Before the unique period of 1995-2000, angels were really super-angels. They were typically entrepreneurs who had cashed out and had enough money to fund a company from beginning to end. So those angels basically acted as their own funds and worked with one or two companies that they stayed with for three or four years. In the 1995-2000 period, a lot more companies emerged that needed money. Concurrently, there was an increase in affluence among angels—but not to the extent that they individually could be super-angels for all the companies who needed financing. The result was a horizontal aggregation of angels into groups: Band of Angels, Angels Investors, Tenex, etc.

Tenex horizontally aggregated in terms of angels, but stayed very narrow or vertical in terms of sector (life sciences). It had enough money to do a lot of deals and place a lot of bets; it was horizontally aggregated to allow that. Because of the sector focus, it had enough expertise to be able to weigh in and increase an early-stage company's probability of success. What it didn't have was the ability to do follow-on rounds because it didn't have that much money.

So Tenex began to associate with the venture capital firms who had similar interests in terms of segment/sector (and I don't think this is unique to life sciences; it could be done across a lot of IT and high tech). We put together a hybrid, a captive fund called Tenex Greenhouse Ventures, where VCs became part of the horizontal aggregation for the first round and then they could assure follow-on funding for subsequent rounds if milestones were met. This way, the angels don't have to keep any dry powder; whatever they raise can be deployed in the first round.

It's a very obvious trend when you look at how early-stage companies have been funded over the last 20 years. You can get a lot more intellectual capital involved if you can horizontally aggregate and then create a hybrid with the VCs. Horizontal aggregation allows more than a select few (the Bill Gates, Paul Allens and Jim Barksdales of the world) to be angels. The hybrid with VCs, who can guarantee follow-on funding, creates a lot more "super-angels."

Center for Private Equity and Entrepreneurship: What is the impact of this new, emerging structure on term sheets? What can entrepreneurs expect?

Ruderman: Since there are a lot more angels in the process, you don't need a CEO full-time in these early-stage deals. You really need what we call "adult supervision." We are not making managers and CEOs out of scientists. For the first 12 or 18 months, with the angel group involvement, you can allow the entrepreneur to focus on the science or the technology instead of on general management.

Secondly, an entrepreneur has to learn how to achieve consensus because no one is going to drop $2 to $10 million in his pocket and let him go buy a building, put in his corner office and play "entrepreneur." He's going to have to work with these angels, and not just view them as dumb money. The angels are going to be involved, so the entrepreneur has to decide that he wants to work with these people, that these folks can really help him, that they enjoy being with each other.

Third, the money is going to come in milestone tranches. So, if things aren't going well, we are prepared to cut our losses. When I say, "We're going to do eight deals at a million a quarter," what's really happening is that we are distributing eight deals but we're probably going to have done 10, 11 or 12 and we would have cut three or four because we made mistakes, and milestones weren't met.

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