Business Angels Heaven-Sent Or The Devil To Deal With?

Venture capitalists are generally thought to be the main source of equity finance for new and young entrepreneurial businesses. However, the reality is that the vast majority of venture capital funds specialise in providing development finance to established businesses and financing management buy-outs and buy-ins. Entrepreneurs seeking less than 250,000 are likely to be wasting their time in approaching venture capital funds.

By far the main source of classic venture capital small amounts of high-risk, early-stage equity financing provided by patient investors who provide value-added advice is the so-called informal venture capital market.

This comprises high net-worth individuals, the majority self-made with substantial business and entrepreneurial experience, who are prepared to invest either on their own or with others directly in entrepreneurial businesses. They are often termed business angels (although many dislike this term).

 

Most are relatively infrequent investors making an average of one investment every 18 months, although a small minority of investors are considerably more active, making three or more investments a year.

Business angels tend to keep a low profile. They are not listed in any directories and there are no public records of their investments. It is therefore impossible to say how many there are or how much they invest in aggregate.

Best estimates of the scale of the informal venture capital market suggest there are about 250,000 business angels in the US who invest $10 to $20 billion every year in more than 30,000 ventures. This is at least five times the size of the institutional venture capital market in terms of dollars invested annually and is at least 20 times larger in terms of the number of ventures financed.

In the UK the informal venture capital market is estimated to have invested at least twice as much in the small and medium-sized (SME) sector as venture capital funds.

Business angels are a heterogeneous group and making generalisations about them and their investment activity is problematic. Nevertheless, research undertaken in the UK, Scandinavia and North America suggests angel investments have the following characteristics.

Size of investment. The majority of business angels invest less than 50,000 per investment although some will provide more than 100,000 per deal. However, around half of all business angel investments involve co-investors, usually other business angels (generally trusted friends and business associates) but occasionally venture capital funds, and thus deal sizes can be larger. The business angel, or syndicate, will sometimes provide additional follow-on finance. Because of the effect of the business angels investment on a companys balance sheet, many entrepreneurs are also able to negotiate additional loans from their banks.

Business characteristics. Business angels make investments in virtually all industrial sectors, but predominantly in start-ups and early-stage ventures (although they occur across all financing stages).

Investment structure. The majority of investments involve equity finance. However, business angel investments may also involve loans (generally unsecured), guarantees and debt-equity arrangements either alongside equity finance or on their own. Equity investments typically involve straightforward financing instruments (ordinary shares). More complex instruments (such as preference shares) are relatively unusual except in large investments (more than 100,000).

Business angels normally do not take a controlling interest. It is more common in larger deals, which typically involve more than one investor, for the investor(s) to take a majority shareholding. However, these deals are often structured in a way that allows the entrepreneurs to regain majority control if the business meets performance targets.

Value-added contribution. Informal venture capital is smart money. Business angels are value-added investors. They contribute their commercial skills, entrepreneurial experience, business know-how and contacts through hands-on roles to make a wide range of strategic, monitoring and supportive inputs.

Entrepreneurs who have raised finance from business angels say that their most valuable contribution is as a sounding board for the management team. Despite the obvious potential for this involvement to lead to inter-personal conflicts with the entrepreneur, the evidence suggests that in most cases relationships are consensual and productive.

Geographical distribution. Informal venture capital is a local marketplace. Business angels can be found in virtually every town and city. The majority of their investments are local, typically within 50-100 miles of where they live. This is because of the hands-on nature of their investing and consequent need for frequent contact. However, business angels who have highly specialist investment preferences (for example, a particular sector or technology) are likely to invest over longer distances.

Holding period. Business angels are fairly patient investors, with a majority willing to hold their investments for more than five years. Successful exits are normally achieved through a trade sale.

Motives

Most business angels are motivated first and foremost by the opportunity for capital gain. Thus they are only interested in investing in businesses that have the potential to achieve profitable growth, that will generate returns of 30 per cent or more a year (averaged over the life of an investment) on start-ups and at least 20 per cent for investments in established businesses.

However, there are investors who are also seeking income from their investment, either by working full-time in the business or else by being paid a regular fee for their value-added contribution.

Business angels are also motivated, in part, by non-financial considerations, notably the opportunity to play a role in the entrepreneurial process and the fun of making informal investments.

Some are also motivated by various hot buttons for example, an interest in a particular technology.

Altruistic considerations also play a role: these include the opportunity to bring a socially useful product or service to market, assisting in the economic development of their community and supporting the free market system that enabled them to prosper by helping the next generation of entrepreneurs.

Approach to investing

Business angels approach to investing is influenced by three key considerations.

Since they are investing their own money they do not need to refer decisions to others for approval;

They typically allocate only a relatively small proportion of their wealth to their informal investments. Thus, it will not seriously affect their lifestyle if they lose their money. Equally, they are sufficiently wealthy not to need the returns from a successful investment;

The business experience and financial sophistication of most business angels means they can evaluate the merits and risks of prospective investments, especially those in industries in which they are experienced.

Investment criteria

Investors reject well over 90 per cent of the investment proposals at the initial screening stage at this stage a potential investor decides whether the opportunity is worth investigating in detail or is to be rejected out of hand.

The attitude of most business angels at this stage is suspicious and even cynical. They are looking for reasons not to invest. Although the identification of one or two perceived weaknesses in the proposal is unlikely to be sufficient to make the investor stop reading, the accumulation of several weaknesses will lead to a rejection.

The first question that an investor considers is whether the opportunity meets his or her, often idiosyncratic, personal investment criteria in terms of the industry/market, amount of finance required, location of the business and stage of business development. Having established that the proposal is a good fit, the investor will begin to consider the proposal in more detail.

Advantages and disadvantages

Informal venture capital has several attractions. Although business angels seek a financial return on their investments in the form of capital appreciation they are, nevertheless, often motivated in part by non-financial considerations, and so may be willing to accept lower returns.

Business angels are often prepared to invest in an opportunistic way, often without too much study or investigation, particularly if the business is in a market or technology area that they are familiar with.

Business angels are generally quick to make investment decision and to write the cheque. US studies indicate that time between first meeting and receipt of funds is less for private investors than venture capitalists (2.5 months, compared with 4.5 months).

There is limited involvement by fee-based professionals, thereby minimising the costs involved for the entrepreneur. Business angels are normally prepared to take a longer term view of the investment.

Most business angels play a hands on role in the companies in which they invest. Thus entrepreneurs are able to benefit from the substantial commercial skills, entrepreneurial experience, know how and contacts of their investors. In some cases they may even play an active management role.

But there are also some disadvantages that should not be ignored.

Business angels are less likely to become involved in later financing rounds.

Although most informal investors are happy with a minority stake they may nevertheless expect to be actively involved in the business and have a significant say in strategy. Some angels may be meddlesome. In some cases, business angels may turn out to be devils with ulterior motives for investing.

Finding a business angel

Most rely upon networks of trusted friends and business associates to identify investment opportunities and are more likely to invest in opportunities that come from these sources. Other referral sources include accountants and, less often, bankers, lawyers and stockbrokers. Some angels also identify investment opportunities through their own personal search.

Entrepreneurs can maximise their chances of finding business angels by using the following strategies: Search locally;

Look for successful entrepreneurs who are familiar with the industry or market;

Many business angels are active in charitable and civic affairs;

Participate in networking organisations such as business clubs, industry and professional associations, university alumni associations as well as social organisations such as golf and tennis clubs;

Use gatekeepers such as lawyers, accountants and venture capitalists.

Finally, consider joining a business angel network. These provide a channel of communication between informal investors and entrepreneurs seeking finance. They enable entrepreneurs to present their investment proposals to several private investors simultaneously.

In addition they provide investors with a convenient means of identifying and examining a range of investment proposals while retaining investor anonymity until the due diligence stage.

Most operate on a not-for-profit basis, with state or quasi-state bodies underwriting the gap between the revenue they derive from registration fees charged on investors and businesses and, in some cases, a success fee levied on the business plus their operating costs. There are others that operate on a commercial basis, either free-standing or as part of accountancy or corporate finance practices.

Business angel networks are still relatively minor participants in the informal venture capital market and many business angels are sceptical of the quality of the investment opportunities that come through such networks.

However, network staff are often able to help entrepreneurs improve the presentation of their opportunity (for example, by ensuring it contains the type of information business angels seek). Some networks claim that 15-20 per cent of opportunities they circulate to investors receive funding. The feedback entrepreneurs receive from network staff and from angels can also be helpful even if they do not persuade them to invest.

Colin Mason is reader in economic geography at the University of Southampton