SOAR Innovation — powered by Kentucky Innovation — is the #1 partner for entrepreneurs in Eastern Kentucky.
Funding is one of the most significant barriers facing our business community. To help form connections with potential sources of capital, we’re interviewing funders that support economic growth and innovation in our region.
We’re speaking with 2 Eastern Kentucky angel investors in today’s post.
- The Appalachian Investors Alliance (AIA) is a network of angel investors operating in 11 states.
- Tri-State Angel Investment Group are the AIA members making early-stage investments mainly in Kentucky, Ohio, and West Virginia.
Jim Hart is the Executive Director of the AIA, and Don Perry is the Chairman of the Tri-State Angel Investment Group. Both represent organizations with several decades of collective experience partnering with and funding successful entrepreneurs. Colby Hall, the Executive Director of SOAR, recently interviewed leaders from both organizations to bring their insights to our SOAR Innovation community.
Let’s jump into the most valuable snippets from our conversation — including advice on what not to bring to your funding pitch meeting.
Tell us about your investment groups.
Jim: The Appalachian Investors Alliance has the non-profit mission of bringing together impact-oriented angel investors in small- and mid-sized communities throughout Appalachia.
We provide the technical knowledge and support necessary to help investors put their capital to work funding startups and local small businesses. Think of AIA as an “umbrella organization” facilitating a network of 14 funds from Mississippi to southern New York. Two funds—soon to be three—are located in Kentucky.
Most people don’t realize that managing a portfolio of investments in startups and small businesses requires professional staff. Most small funds can’t afford the cost of maintaining a regular, professional management staff. There’s a need for AIA to offer administrative and technical support to funds on a shared or fractional-service basis.
Thanks to a grant from the Appalachian Regional Commission, AIA also offers educational outreach to entrepreneurs based on lessons learned and knowledge shared by our investors. Achieving joint understanding between investors and entrepreneurs is pretty critical to making impact investing partnerships work.
Don: In addition to serving as the Chairman of the Tri-State Angel Investment Group, I’ve also been a part of the AIA leadership for several years.
The Tri-State Angel Investment Group is currently on our third fund. We formed back in 2014 with 20 investors. Currently we’re a fund of over $1.2 million pooled from over 40 accredited investors.
As Jim said, part of the goal is to organize local capital, and we begin by identifying local/regional investment sources. We go out and speak with prospective investors and explain how we’re trying to impact economic development in the tri-state region. From there, we’ll try to get them interested in joining our group.
AIA provides support to our funds when we need technical services, such as detailed due diligence, deal structuring, and documentation. They also support the entrepreneurs we work with to help them present more effectively to our investors and networks. AIA offers consistency to how deals are structured, papered, and go through due diligence. This enables us to scale our efforts across the entire AIA network.
You said this was your third fund at Tri-State Angel Investment Group. Tell us about your first and second funds.
Don: We bring groups of investors together and pool their money into one investment fund, from which point we invest in several different companies. In our first fund, investors had to commit at least $50,000 to subscribe to the fund. This first fund invested a little over $1 million across multiple businesses in the tri-state area.
Our second fund was a different configuration of investors, a lower subscription license of $25,000, more members, and $800,000 total in investments.
We have seen great success from both funds in terms of ROI, especially with our second fund. So now that we’re onto our third fund, we’re fielding a great deal of interest.
Tell us about your members. Who are they? And how do they interact together as members of a fund?
Don: Our fund members are business men and women in the community. Some are retired, some are actively working, and many are entrepreneurs themselves. Several members started their own businesses and had successful exits or are still involved in some capacity.
It’s amazing once we’re all in a room and start talking about the big picture opportunities on the horizon. We work well together and recognize what’s at stake. Most of us have a good sense of the risk-reward balance, and it leads to sound decision-making.
These investors care about economic outcomes in the tri-state area. They want to try and help fund the next idea and entrepreneur trying to get their business off the ground.
Don: It’s very true. These people have deep roots in the tri-state area, and they want to see everyone do well here. And yes, they’re also aiming to benefit financially.
Jim: Out of the 41 Tri-State investors, only 3 don’t actually live in the region.
Don: Many of them come from similar circumstances, 30 to 50 years ago, and are trying to make a meaningful impact with their investments. A large number of them give back by promoting other entrepreneurs.
What are the differences between capital from AIA or Tri-State funds versus traditional financing from a bank or CDFI?
Jim: I’ve heard an entrepreneur describe it as: “Our money comes with a muscle memory associated with it.” We’re not passive investors. In most cases, we anticipate being very hands-on.
If you’re looking for money that’s more transactional, where your funder issues you a check then for the most part steps away from being involved in how you manage your business — that’s a traditional bank loan.
But with that sort of transactional relationship, where do you go when you need more than just financial help? If you’re working with angel investors, you should be able to tap them on the shoulder and get their advice and assistance, especially when as an early-stage entrepreneur.
If someone has a business idea, when does it make sense to approach a bank or CDFI versus an investment group like yours?
Don: You should seek out the cheapest financing you can find. If you can get a reasonable loan from a bank or CDFI, it’s your best bet in most cases.
But if that’s not an option for you, you might want to speak with an angel investment group. We’ll require a higher return on our invested capital than a bank, but we’re taking a higher risk. So it’s a fair exchange.
We’ll only look into the areas of the business that we deem necessary for assessment to gain the confidence that we’ll receive a return on our investments.
I also work on the banking side, and sometimes commercial loan officers will call me up and say, “Hey, we can’t fund this business with a loan, but maybe they’re a fit for your group.”
It’s often a cooperative effort with banks offering secured debt financing and Tri-State Angel Investment Group providing the higher risk capital. This is especially true when there’s a gap between the required investment size and the entrepreneur’s funding ability.
How do you structure your financing deals? And what recommendations do you have for entrepreneurs considering debt versus equity financing?
Jim: So many entrepreneurs pitching to an angel group feel they have to present an exponential growth opportunity — that their only option is to sell you equity because that’s what the market says they’re supposed to do. It’s one of the first things that Don and I have to undo in the entrepreneur’s mind.
If you’re not genuinely high growth and high-tech, but try to pretend you are, you’re going to struggle to raise capital.
Be honest with yourself about how you anticipate your business will mature — specifically over the next 12 to 36 months. The capital you’re asking us for will be used during that time.
If it turns out you start as a lifestyle business, then 12 months later, you figured out a strategy to become high-growth, raise the equity round at that time. Just understand that offering equity in your business is not always the best way to fund your business.
How would you define high-tech/high-growth?
Jim: Novel technology that has intellectual property associated with it. Medtech, agritech, tech within industry verticals…
It has to be able to achieve some form of exponential growth with respect to market adoption — where keeping up with demand requires more free cash than can be generated by sales alone. To get that extra boost of capital needed to step-up growth is where venture financing comes in.
Angels come in and close the gap, but there must be significant evidence of that exponential growth potential. If a company has sales growth that builds steadily, but not explosively, over the course of a few years, there’s nothing wrong with that. But investors will view a slow and steady growth story as something other than an equity deal.
What’s the difference between investing in Silicon Valley compared to Eastern Kentucky?
Jim: Coastal investors don’t often have adequate insight into opportunities coming up in the American Heartland. They don’t always understand how our local and regional entrepreneurs think or what’s really needed to help them mature their businesses. Their model for identifying and selecting deals may not apply to most opportunities in our region.
As an impact investor, if I simply tried to follow the Silicon Valley-type approach I see online, it wouldn’t work.
For one thing, we don’t invest in business ideas that we don’t understand based on our personal and professional experience. Our resources are less abundant compared to Silicon Valley. We can’t throw successive rounds of capital at a business while both we and the company attempt to figure out a winning business model.
What are your thoughts on how venture investment will continue unfolding in our region?
Jim: It’s not probable that we’ll start to imitate the way dealmaking is done in Silicon Valley.
If one of our companies does fit the investing profile of a coastal VC, it’s very likely that one of those outside investor groups is going to scoop them and move them out of our region anyway. Venture capital likes to be close to the companies it invests in—and it’s easier to move a startup to be near the money than to relocate a VC fund outside of a money center.
Our goal is to ensure our most impactful new businesses aren’t escaping to other areas. We want to see clusters of self-reinforcing entrepreneurial activity develop here. Local success stories encourage other entrepreneurs to follow suit. So, it’s groups like ours that are helping this region to become more competitive.
Do AIA and Tri-State have an impact on the investment ecosystem in Eastern Kentucky?
Jim: Funds like Tri-State and the deals they do shine a beacon on the value being created here. This draws in other funds. When other groups don’t have insight into this region, they want to see that local investors have taken an interest first. Then, they can come in and complete a funding round.
Switching gears, let’s talk about the process of preparing for angel investment.
Jim: Entrepreneurs fall in love with their ideas, but investors need to fall in love with the business. So, we need to prepare entrepreneurs to be able to speak the same language as their potential investors.
Don: There are a few things that you’ll look at when approving a bank loan: tax returns, cash flow, and credit rating. It’s basic but essential.
Most of the same things get considered when making an equity deal, but what really makes a difference to angels is when the entrepreneur has skin in the game. If an entrepreneur is willing to put money into their business or has in the past, that makes a difference to us. We’re evaluating the owner at the same time as the business, and it’s a soft measure that’s important to us.
What are the first questions you ask before you get into due diligence?
Jim: We need the entrepreneur to show us the idea is plausible.
We’ll look at the entrepreneur’s background in the industry and running a small business. We’ll want to know if there’s any associated intellectual property. We’re looking for governance structures — having a voice on the board of directors, for example.
Failing to check off any of these factors is often a “deal-killer.” These answers are what make or break a pitch in the first 30 minutes.
Your first interaction with capital is critical. Don’t come to an investor if you’re not prepared. And if you don’t know how to prepare, ask someone.
So, you need to get your house in order — your business plan, your financial records, your pro forma projections. Be ready to answer the questions thoroughly. Being unprepared is the number one reason you’ll miss out on an opportunity.
What does preparedness look like for entrepreneurs in their first investor meeting?
Jim: I want to see that your financial documents tell the same story as your business plan. If I see an inconsistency in what you say you want to do and numerically how you’re going to get there, that tells me that you’re not prepared.
Don: Also, the entrepreneur needs to be able to tell a concise story. I need the entrepreneur to tell me what advantages — I often refer to as “edges” — they hold that will allow them to take this idea and grow it.
Convince us — why do we want to invest in your company, put money at risk, and further your idea? If they can’t hit those points and be consistent between the deck and the numbers under the hood, it’s an almost immediate deal killer. It’s about trust, and now you can’t trust what you’ve just been told.
Jim: Another deal killer, and we see this a lot — is the entrepreneur’s character. We call it the “employee entrepreneur.” They come into a pitch and ask us to give them money to do what they want to do, the way they want to do it.
But that’s not the deal we want as investors. We don’t want to come in to be a “silent partner” and essentially hire you to execute the vision while we don’t have a say in management.
We expect to be active, so if you give us a pitch that suggests you’re looking just for transactional funding, we won’t be very receptive. On the other hand, we’re not interested in being brought in to work in your business, either.
Should entrepreneurs call in expert legal help to develop their governance structure?
Jim: You have to spell out to investors what rights they have. What you learn as an early-stage investor is that “money is temporary, control is forever,” especially in an equity investment.
Most companies have a legal team drafting their corporate documents. During the process, I’d challenge entrepreneurs to ask themselves: if I bring investors into this company, what rights do they have? You need to make it clear what their role will be, which will be more appealing once it’s time to develop those terms of engagement.
Don: Most of our companies need guidance in terms of structure. Some don’t know where to turn to or aren’t willing to pay for that help. Many of these entrepreneurs reach a point where they need to up their available expertise to move forward with investments.
In terms of tax designations, do you have recommendations for entrepreneurs?
Jim: Here’s an example in the weeds: Suppose a company is very successful, and the entrepreneur is a 50% owner. What happens with an LLC is 50% of that profit passes through to the owner.
But the problem is, if you’re in a growth phase, you can’t take that cash out of the business to pay the founder’s tax liability. So, the founder will have to pay that tax bill out of pocket. It could put the company out of business if they take the money out, so what do you do?
That’s why the proper corporate structure is so crucial for growing businesses: C-Corp versus LLC versus S-Corp, etc. And that comes down to getting the right advice from the start.
As an early-stage company, it might be hard for the business plan and financial statements to line up right away without this help.
As investors, how can you identify the ‘diamond in the rough’ cases?
Jim: There are very different metrics you look at between industries, SaaS (software as a service) vs. product companies, etc.
So, let’s talk about what we don’t want to see. Don’t tell us you’re going to use our money to grow your way out of poor margins and poor EBITDA (earnings before interest, taxes, depreciation, and amortization).
Investors want to see a model that throws off strong margins, EBITDA, or both. When we don’t see that, we immediately become skeptical.
There’s a higher bar in this region due to the amount of resources available. If we see that your business starts off with insufficient gross and operating margins, we won’t believe that you’ll be able to “scale” your way to success.
Here’s an ideal scenario: The entrepreneur asks us to invest in their idea. The customers are essentially paying for the selling, general and administrative expenses (SG&A). Sure, you might be using the funding to grow sales, and part of that will go into SG&A for a time. But we’re not interested in just funding you to hire people. You have to demonstrate that there’s a growth opportunity on the top line, not just covering expenses.
Don: We’re less likely to put money into SaaS and apps like investors do on the coasts versus an established business that needs some working capital to grow 20%. We also look to invest in startups that already have some form of debt financing in place, but need additional unsecured capital to complete their capital stack.
We’re starting to see the results where we’re getting returns on our projects more often than not.
And if we implemented this model in other areas in Appalachia, I think we could really make a difference towards increasing economic development.
Conclusion: Start your business and apply for funding
Keep up the momentum for your entrepreneurship journey.
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If you’re interested in contacting an angel investment group and need help getting prepared, reach out to SOAR today.