Investing: The Best Way to Buy

By Anne Field

Think Internet stocks are overvalued? Then don't buy them. Here's a better way to profit from the Net's explosive growth.

Stephen Coleman figured that finding a promising, IPO-bound Internet start-up would be a lot like his own specialty, laser eye surgery: To the novice observer, it looked like a quick, simple operation. Only when you stood there with equipment in hand did you realize how much experience and training was really necessary. It would take a lot more than just instinct and timing to find a good prospect and determine whether or not to go with it.

What Coleman did was piggyback on the experience of others. Three years ago, he joined the Gathering of Angels, a group of wealthy private investors who meet once a month in Santa Fe, New Mexico, to listen to entrepreneurs make their pitches and talk deals. Two years later, he invested about $10,000 in USA Talks.com, an Internet telephony company that seemed likely to go public. And it did. After a wild ride in the market, his stake rose to about $200,000 before plummeting again. Nevertheless, Coleman is eagerly waiting for his next opportunity. È Although cyber-stocks seem to many investors to be prohibitively overvalued, there are actually lots of ways to get in on an Internet company early -- before the IPO. Only not just any old wealthy investor can play. To become a successful Internet angel -- someone who invests anywhere from $25,000 to $1 million of his or her own money in a fledgling company -- you have to know where to find the deals and how to evaluate them.

Getting in on the ground floor of an Internet start-up is one of the riskier gambles you can make with your money. The standard rule of thumb applies: "Investors should only put in money they can truly walk away from the minute they write the check," says Bob Fitzwilson, a Menlo Park, California, investment counselor who has invested in about 25 companies in the past five years. There's no way to be sure a company will ever make money, much less be bought or go public. And while the company remains privately held, your investment will be highly illiquid. You need to think like a venture capitalist and invest in a portfolio of as many as ten companies. Like any self-respecting portfolio, yours should be diversified, representing different segments of the Internet market -- a few content providers, say, a few routers, a software security firm, and so on.

Then there's the time factor. You can expect a firm to take three to five years before it stages a successful IPO. And you may be expected to put in lots of time during that period working with the company as an adviser. That has a good side: Many companies require that you be an accredited investor, meaning, according to the Securities and Exchange Commission, that you have assets of $2 million and income of $300,000. But if you work so closely with a company that you can be deemed almost a part of it, then this rule doesn't apply.

Not every start-up will take your money, either. The hot ones, in fact, might be really picky, since the wrong angel can kill later venture- capital interest. "I've seen cases where venture investors stayed away because they didn't want to be encumbered by an unsophisticated angel," says David Gerhardt, president of the Capital Network, a group in Austin, Texas, that links angels and entrepreneurs. You'll be more likely to find a taker if you can bring more than just cash to the table -- say, expertise in an industry or a helpful Rolodex.

How to find deals? Start by contacting lawyers and accountants who handle start-ups (particularly Internet companies), tell them you want to make investments, and ask if they could show you their deal flow. You could also contact ultra-plugged-in financial insiders, like investment bankers, who are likely to know which clients are about to do an IPO. "This way, you get in on the upside of the market," says Kathy Lane, a San Francisco BayÐarea investor who bought shares of Vignette, a company in Austin, Texas, that makes Internet tools. It went public seven months ago, and Lane doubled her money on the first day. Other sources: business incubators associated with universities or firms like Technology Ventures in Albuquerque, which helps engineering whizzes turn their innovations into companies. Also, find out where the deal makers go to break bread and talk turkey. "In most communities, there's a spot the VCs go to eat," says Lane. In Silicon Valley, it's Buck's in Woodside. VC heavyweight John Doerr has been known to stop in for breakfast, and rumor has it that the founders of Netscape drew up the plans for the company on a napkin there. One easy way to get started is through matchmaking services. Often associated with universities or business incubators, they put angels and money-hungry entrepreneurs in touch. Angels register with a network, like the Capital Network in Austin or Technology Capital Network at MIT, and provide information on interests and investment criteria; entrepreneurs provide details on their companies. When organizers see a good fit, they send an executive summary to investors, who then decide whether to contact the company. Online services that do similar things have also sprung up. (See "Contact Sheet,")

For a more organized approach, try venture forums and fairs. Often run by chambers of commerce and universities, forums are monthly breakfasts and lunches for which members pay around $100 a year to chat, hear talks on appropriate subjects, and, most important, figure out who's doing what and who's worth hooking up with. At the Baltimore-Washington Venture Group's forum, company owners and private investors provide a 15-second sound bite explaining who they are and why they're there. Participants can also do more intensive networking, handing out business cards and arranging further meetings. Venture fairs provide an even more informative view of specific companies. Over a day or two, anywhere from 15 to 50 start-ups present their business plans in 15-minute snippets to an audience of interested investors; attendees pay anywhere from $300 to $1,200 to come.

For more efficient access to deals, angel clubs are a better bet -- particularly for experienced investors. These alliances provide a systematic way to listen to brief presentations from companies and to pick the brains of other angels. Members usually meet once a month and hear pitches from two or three entrepreneurs; there's a question-and-answer period and the chance to meet privately afterward. That's if you can get in. Perhaps the best-known club, the Band of Angels, a 140-member Silicon Valley group started in 1995, has fairly stringent requirements: You have to be accredited and sponsored by a current member -- and you're required to make investments. Smaller groups, like the 20-member Walnut Venture Associates in Wellesley, Massachusetts, have similar restrictions.

Not all groups are so picky. The Gathering of Angels in New Mexico, for example, has a mailing list of 1,500 investors and does not require that they be accredited or even that they make an investment. Based in Santa Fe, it's opening affiliates in Atlanta and Scottsdale, Arizona, next year. One angel club, Seraph Capital Forum in Seattle, runs what it calls a boot camp for new investors, a half-day workshop on such topics as how to find a deal and how to value a company. Recently, some angel clubs have fine-tuned their approach by forming funds -- groups of 60 or so investors who pool their money and vote on which companies to invest in.

Perhaps the biggest advantage of these clubs is their access to expertise. Four Internet experts are carefully positioned at each meeting of the Gathering of Angels, so they can ask the tough questions that other, less cyber-savvy investors might not think of. That's really helpful during the due-diligence stage, when members can divide up the work. More frequently, however, one person will become the lead, doing most of the research and taking responsibility for the validity of the deal. Stephen Coleman, for one, makes investments purely on the recommendations of well-respected colleagues, like the Gathering's founder and a few others. "I decided I'm not going to business school," he says. "I'm going to trust one or two people and follow their judgments."

If what you want is someone with a lot of experience to act as a screen for you, two new Internet outfits may also help. OffRoad Capital acts as a matchmaker for later-stage investments, finding and selecting companies and conducting due diligence. Then it lists firms and their plans online for subscribers; the minimum investment is $25,000. Some deals have as many as 200 participants. Typical of the backers is Richard Dreskin, a principal at a broker-dealer in Roseland, New Jersey, who recently put $47,000 in OffRoad's first completed transaction, a $4.5 million financing for a company called PNBC, which does online trade shows. "I relied on OffRoad's expertise completely," he says. Similarly, Garage.com targets entrepreneurs seeking $1 million to $4 million in early-stage funding and puts them through an equally rigorous evaluation process. Those that pass muster are presented to investors in an area called Heaven, which member-investors can regularly review. If you're interested in a company, you notify Garage.com, which sends along your profile. The entrepreneur looks over your vital statistics and decides whether to talk further.

If becoming an angel sounds too risky, there are public companies that make Net investments, most prominently CMGI, based in Andover, Massachusetts. CMGI has a majority stake in ten Internet businesses, including AltaVista, and a minority stake in dozens of others. Recently, it introduced a program that lets investors with at least 100 shares of CMGI buy into an IPO of one of its majority holdings at the offering price. Its first offering, in July, was Engage, an online marketing company. Similarly, Safeguard Scientifics, a company in Wayne, Pennsylvania, with 30 Net companies in its nest, sets aside 20 to 25 percent of the equity of the firms it has a stake in so that Safeguard investors can participate in IPOs.

If you're able to provide services to fledgling companies, you might even be able to arrange a trade. And that doesn't just mean providing accounting help. Late last year, Soi Tee Lee, then the owner of a restaurant in Burlingame, California, offered a couple of starving entrepreneurs free food in return for stock options in ZipLip.com, their fledgling Internet company, which sells E-mail security systems. Lee got 10,000 shares worth $800. Since then, the company has raised $1 million, and its valuation is $6 million. His shares are now worth $12,000, and he's poised to make a lot more if ZipLip goes public. Who knows: Perhaps their janitor might also be interested in making a deal.

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