Total Loss	200
Large Loss	33
Small Loss	27
SUBTOTAL	260
0 to 25% Gain	29
26% to 49% Gain	25
50 to 100% Gain	18
100 to 300% Gain	33
> 300% Gain	49
SUBTOTAL	154

As a result of the broad spread of results and the sheer number of losses, angel investors need a whole portfolio, rather than making only two or three total investments. As the statistics show, the likelihood of failure is so great for any given investment, it’s better to take a wide range of relatively small risks than to put a large proportion of available funds into a small number of investments. Angels should also be diversifying through the stage of investments as well as industry.

Because of the early-stage nature of most angel investing, patience is key. The primary exit strategy is a merger or acquisition, providing the investors with cash or liquid stock, or both. Getting a young company to the point of being acquisition-ready takes maturation of products, market, and management; none of these happen overnight. Therefore, most angels anticipate a three-, five-, even seven-year holding period before they can recover their investment, let alone profit from it.

Investment Preferences

Angel investors typically invest in industries similar to the ones venture capitalists choose, which seems logical, since angels and venture capitalists alike are looking for high potential returns (which accompany large potential market caps) in growing, prosperous, and futureoriented fields. Figure 2.1 shows a compilation of survey results conducted by the Angel Capital Education Foundation (currently a program of the Ewing Marion Kauffman Foundation) with Angel Capital Association member groups (forty groups reporting).

Figure 2.1 Investment Preferences in Percentage for Angel Investors

If one compares these statistics with venture capital investment focus as reported in PricewaterhouseCoopers MoneyTree survey for the period from January 1 to March 31, 2006, shown in Figure 2.2, the similarity of investment preferences is obvious, with the major differ-ence being the flip in preference between medical devices and equipment and software, and more diverse investment interests by angels.

Figure 2.2 Investment Preferences in Percentage for Venture Capitalists

ANGEL DEALS

Many companies never need venture capital financing to achieve positive cash flow and eventual liquidity for investors. Software companies are often started in someone’s spare bedroom or the proverbial garage and grown organically. In such cases, the entrepreneur may need only minor amounts of cash in the early stages of building the product and launching an initial market push. If the young company has an interesting but limited market capitalization potential, or if the company can create an interesting market niche that generates strong margins, setting up as a limited liability company (LLC) may be preferable to a corporation or sole proprietorship. The LLC structure allows the business to provide investors a return on their investment through the sharing of profits, though they also share any losses. It can work particularly well for companies with low acquisition or merger potential and high cash flow opportunities.

Many deals are simply not appropriate for venture capitalists. Looking at informal statistics compiled and averaged from various sources, it is clear that few companies receive even angel investment dollars and far fewer venture capital dollars for myriad reasons:

• Less than 1 in 100 start-ups obtain angel financing.

• Less than 1 in 1,000 start-ups are venture capital financed.

• Less than 1 in 10,000 new companies go public.

• Less than 1 in 25 angel deals see venture capital money.

• Less than 1 in 100 angel-funded companies go public via IPO.

Because many companies never meet venture capital investment thresholds, angels are beginning to retain a calculated amount of their investment capital for an anticipated second round of financing, by way of “keeping their powder dry.” As well, angels often invest in traunches, deals in which an investor will agree to a designated amount in a particular financing, contingent on the company’s reaching certain milestones or meeting certain preset obligations. For instance, an angel investor may agree to invest $300,000 in a series A preferred stock round, but provides only $100,000 upon completion of the financial documents. The company’s receipt of the second $100,000 is dependent upon completion of the first product, and the third $100,000 dependent upon securing the first customer. These investment preconditions typically have other requirements such as timing or size of customer, and are agreed to by the parties as a condition to financing. In addition, these traunch requirements are usually taken from the company’s business plan as projected accomplishments with the funding—putting the angel’s money where the entrepreneur’s mouth is. Staged investment also protects the angel from throwing good money after bad when an entrepreneur cannot deliver on the initial promises, or when conditions arise outside the entrepreneur’s control, such as a market shift or a big player entering the market before the small entrepreneurial company gets off the ground, making the prospective investment no longer viable.

Angels’ Vital Role in Early-Stage Funding

To appreciate the vital and essential role that angel investors play in early-stage financing, you need only look at the current statistics on venture capital financing and compare those to angel investing.

According to the PricewaterhouseCoopers MoneyTree survey of venture capital investments, venture capitalists invested $21.7 billion on 2,939 deals in 2005. This demonstrates a fairly flat trend line from 2004, when venture capitalists invested $21.6 billion in 2,966 deals. Figure 2.3 shows the recent trend in venture capital investments with the bubble aberration right in the middle (a trend we hope never to witness again, though history suggests we are doomed to repeat it).

While these trends are interesting, a more detailed analysis provides important insight for young entrepreneurs on the source for early-stage financing. The majority of 2005 venture capital dollars went into late-stage investments, 45 percent to be precise, which is the highest proportion in the eleven-year history of the PricewaterhouseCoopers MoneyTree report on venture capital trends. Contrast this percentage in late-stage investments with the venture capitalists’ investment in the seed/start-up stage in 2005 (only 3.3 percent), and it becomes clear where the vast majority of venture capitalists focus their investment activities. This reflects a consistent trend by venture capitalists to invest in more mature companies. Figure 2.4 illustrates this point (from PricewaterhouseCoopers MoneyTree).

Figure 2.3 Venture Capital Investments, 1995-2006

VENTURE CAPITAL STATISTICS

Here is a further overview of VC funding and where the money is going:

2005—invested $21.7 billion (2,939 deals)
Average post-money valuation: $81.9 million
2004—invested $21.6 billion (2,966 deals)
2003—invested $19.6 billion (2,865 deals)
Increase due largely to late-stage investments:

$9.7 billion in 2005
$7.2 billion in 2004
$4.9 billion in 2003

In 2005, later stage = 45% of dollars (highest proportion in eleven-year history of MoneyTree)

Only 3.3% in seed/start-up stage

First quarter 2006: $5.6 billion (761 deals)—if this trend continues, 2006 will finish with a higher total investment amount than 2005

First quarter 2006: $187 million in seed/start-up companies (53 deals)—still 3.3% of the dollars and representing 7% of venture capital deals

Figure 2.4 Venture Capital Investments by Stage of Development ($ Billion)

Figure 2.5 Average VC Deal Size per Financing Round ($ Million)

Further evidence of venture capital migration up the investment and financing chain includes the average venture capital investment amount (see Figure 2.5, from National Venture Capital Association) and the average post-investment valuation for early-stage companies, which was $14.06 million for the twelve months ending with the first quarter of 2006 and $59.16 million for expansion-stage venture capital rounds, according to the National Venture Capital Association. These statistics represent investing patterns well beyond investment needs of early-stage companies. These statistics bear out the need to identify, foster, and expand other sources of early-stage financing—that is, of angel financing.

Even looking at just venture capital seed/start-up round financing investment averages shows numbers above most entrepreneurs’ needs, with an average investment amount of $3.9 million in 2005 (in 204 deals), and trending the same in 2006 with $3.8 million in the first quarter (58 deals) and $3.9 million in the second (74 deals). These investment amounts represent the acquisition of a significant percentage ownership on the part of the venture capitalists. Likewise, the relatively small number of deals clearly indicates that traditional venture capitalists are not serving the vast needs of seed/start-up companies.

What investments venture capitalists are doing in seed/start-up companies is at a relatively conservative valuation reflective of the multiple unknowns and uncertainties for success accompanying any seed/start-up company. Figure 2.6 shows a trend between $2 and $4 million in the last decade for venture capital investments in seed/start-up companies. These valuations are likely high for the general population of seed/ start-up companies. Because of venture capitalists’ adversity to risk, seed/start-up companies they are willing to invest in are typically by seasoned, successful entrepreneurs whom they know; thus, this reduces the risk and comparatively slightly increases the valuation.

Figure 2.6 Valuations of U.S. Venture Capital Seed/ Start-Up Rounds ($ Million)

The picture for angel investors is very different from that for venture capitalists. For example, the GEM Report (the largest annual measure of entrepreneurial activity worldwide, compiled by more than 150 scholars from 35 countries, under the direction of Babson College and the London Business School) concludes that angels fund a hundred times as many high-tech seed-stage companies as venture capital firms do in the United States. This prevalence of angel investors is uniform throughout the countries the GEM Report analyzed. Figure 2.7 provides a global look at venture capital as a percentage of all investments. Clearly, informal investors, which includes angel investors, are the main source of capital for start-up companies.

In addition, venture capital fund size trends do not speak well for any reversal of the move toward larger investment amounts per deal. According to the National Venture Capital Association, far fewer VC funds exist today, but the average amount of financial resources per fund is steadily increasing, as illustrated in Table 2.1. With so much capital to invest, venture capitalists cannot afford to spend time on deals as small as $1 million or $2 million (frequent first-round funding needs), when these deals take as much time in due diligence as a $10 million investment; the latter is a more efficient use of human and financial capital for those who have it available.

Figure 2.7 Venture Capital as a Percentage of All Investments (2005 GEM Report)

Why Not Try for VC Financing?

You might look at the statistics demonstrating that venture capitalists need to dispense lots of money at a time and conclude that the best approach is to go for venture financing and obtain all the funding you may need up front and thus avoid the distraction of fundraising in the midst of the serious business of growing a company. Unfortunately, this approach is illogical and often fruitless for many reasons.

Table 2.1 Fewer Venture Capital Funds; More Money per Fund

Say your company is valued at $3 million; an investor who puts in $7 million will thereby gain a 70 percent ownership stake, leaving you as the founder with at best 30 percent. (At best, because most professional investors will require the establishment of an option plan before investing, further diluting your founder interest upon their investment.)

When you lose ownership percentage you lose control, and that’s far more than a matter of terminology. Even if you don’t mind having 30 percent of something great, you stand a good chance of getting forced all the way out if you accept loss of control.

And in any case, you won’t often find $7 million just lying on the table these days. The risk of loss is just too high for most venture capitalists at the seed/start-up stage. Remember, venture capitalists are investing someone else’s money (not their own like angels), so they have obligations to make the highest possible return on their investments, meaning large return multiples (billion-dollar projected market cap companies) and minimal risk of loss.

Thoughtful growth and creative financing make for better companies and better leaders. The dot-com bubble was a clear lesson that injecting lots of capital into a company at a very early stage does not increase its odds of success—and may, in fact, have the opposite effect.

COMPARISON OF ANGELS TO VENTURE CAPITALISTS

The most usual comparison to angel investors is venture capitalists. Because the two groups are involved in similar businesses and in similar ways, the comparison is natural, but they have some very large differences. It can be helpful for someone starting a new business and seeking funding to have a firm grasp on these similarities and differences.

SELECTIVE INVESTMENT. While historically called sources of “dumb money” for investing in ideas with little understanding or up-front analysis, angels are becoming increasingly sophisticated through trial and error, angel organizations, educational programs, and the like. As a result, most angels now go through investment due diligence processes very similar to those of venture capitalists. Therefore, just as venture capitalists are highly selective about investments fitting into their investment profile for maturation stage, industry focus, portfolio compatability, investment terms, and other criteria, angels will often have similarly individualized investment selection requirements. This tells you as the entrepreneur that knowing your audience’s interests, preferences, and investment criteria is important if you want to avoid wasting your time and that of the investors by promoting a deal that is ill-suited for your audience. As noted earlier, on average, less than one in a hundred start-ups receive angel investing—and less than one in a thousand receive venture capital financing.

REQUIREMENTS FOR AN INVESTABLE COMPANY. An investable company is not just one with a good idea. Investors must see numerous other attributes—a great management team, a realistic exit strategy for themselves, an attractive multiple on the investment, a simple, straightforward ownership structure, innovative technology, and clear intellectual property ownership for starters, and the list goes on.

EXPECTATION OF RETURN ON INVESTMENT. Investing is not a philanthropic activity (though the typical investor will see a strong multiple return on only three out of ten investments, so the effort may seem like charity). Investments by friends and family are often called “love money” because the basis for investment is apt to be affection for the entrepreneur rather than any sort of critical analysis. An angel or venture capitalist is a third-party, professional investor with no established affection for the would-be entrepreneur. Without a reasonable expectation of return on the investment, such an investor simply will not risk putting capital into a company.

PROFESSIONAL ATTRIBUTES. Regardless of size, professional investors should bring three attributes to a company, and only the third of which is money. The first is experience and knowledge in their particular field of expertise, which adds value to the company and entrepreneur, and the second consists of connections to potential customers, vendors, resources, and follow-on financing.

Differences

PERSONAL WEALTH INVESTMENT. One of the most significant differences between venture capitalists and angel investors is that the former are investing third-party money and the latter their own personal wealth. As a result, venture capitalists have a fiduciary obligation of maximizing investor returns, and the continued viability of any venture fund depends to a great extent on outperforming other venture funds. Therefore, venture capitalists tend to invest on the home-run theory—that is, they choose high market cap companies at a point in their maturation that minimizes the risk of loss. Because of the size of venture capital investments and the need to create a greater assurance of success, venture capitalists often insist on being more actively involved than angels do, frequently requiring one or more board seats to gain control of corporate decisions.

INVESTMENT FOR REASONABLE RETURN. Many angels do not invest on the home-run theory at all. Instead, they look for more modest returns over their entire portfolio. Because angels are investing their own wealth, they don’t face time constraints on showing a handsome profit; the resulting patience allows for the early-stage investing strategy. The social or community involvement aspects of angel investing also provide for involvement in a company at less than a controlling level.

CONTROL UPON INVESTMENT. Unlike venture capitalists, angels are unlikely to take a board position and more likely to play an advisory role for the founder and management team. Many angels refuse board positions because of the potential liability, an unfortunate consequence of the litigious current environment and new laws such as Sarbanes-Oxley. Many angels invest for the enjoyment of being part of a company, being part of the entrepreneurial process.

TIME OF INVESTMENT. As noted, for the most part, angels and venture capitalists invest at different times in a company’s maturity. Angels invest at an early stage in a company’s growth, taking a very high risk on the entrepreneur, management team, and innovative technology. In contrast, venture capitalists have continuously moved up the investment food chain for the multiplicity of reasons previously articulated, and now invest primarily in later-stage companies with market-proven technology, established sales, and a complete management team.

TIME TO INVESTMENT. While negotiation time varies greatly among investors, on average, angels progress more rapidly to investment than venture capitalists. This does not reflect any less care on the part of angels. Instead, because angels typically invest individually and use their own money, they have the freedom to choose their level of due diligence as well as comfort with sixth-sense feelings about a founder, management team, and company. Venture capitalists have limited partners to whom they owe a fiduciary duty of maximizing investment return and minimizing risk.

A WHOLE WORLD OF ANGEL INVESTORS

If angel investors are high-net-worth individuals (HNWIs) who invest their personal wealth primarily in early-stage companies, are there really enough of them to make a difference? How many individuals are both willing and able to be angel investors? No definitive study has been done on the actual number of angel investors in the United States and elsewhere, but the Center for Venture Research estimates the number of angel investors in the United States at around 126,000 (for the first half of 2005). The number of individuals with sufficient wealth to qualify at an “accredited investor” level under Regulation D of the Securities Act is known, and this forms the pool of potential angel investors. (See Appendix 3 for the full text of Regulation D.) Some estimate the ratio of active to potential angel investors in the United States to be as high as 1:10.

According to the 2006 World Wealth Report (WWR) by Capgemini and Merrill Lynch, the population of HNWIs has grown steadily in the last ten years, nearly doubling in sheer numbers worldwide from 4.5 million in 1996 to 8.7 million in 2005. HNWIs are defined in the WWR as those having financial assets in excess of $1 million. The aggregate wealth of HNWIs doubled during the same period, from $16.6 trillion in 1996 to $33.3 trillion in 2005. The Ultra-HNWI population—those with individual financial assets in excess of $30 million—continued to grow in 2005 with a 10.2 percent increase to 85,400 individuals, with North America having the highest overall percentage of Ultra-HNWIs, undoubtedly fueled by soaring gas prices and the high profit return of Canadian oil sand fields. What may surprise many is that South Korea, India, Russia, and South Africa witnessed the most growth in HNWIs. The United States still has the greatest overall population of HNWIs and the greatest distribution of wealth, but the aggressive, entrepreneurial nature of foreign markets such as China and India (and Eastern Europe to some extent) are making the distribution of HNWIs a truly global phenomenon. The WWR shows that emerging markets continued to outperform other parts of the world, adding wealth in those countries. Figure 2.8 from the WWR shows comparative HNWI population growth for selected markets from 2004 to 2005.

Figure 2.8 Percentage Growth in High Net-Worth Individuals Globally, Selected Countries

Savvy entrepreneurs understand the global nature of business today and also understand that an aspiring young business does not compete for investment dollars only with other U.S. companies, it now competes with most of the rest of the world. Part of this broader thinking is also understanding that wealth generation is driven by growth in GDP and robust public markets; in other words, when the public markets are positive and corporate earnings are up, HNWIs have greater earnings and therefore more disposable income with which to invest in risky ventures such as seed/start-up companies. The inverse also applies. In 2005 and early 2006 the U.S. Federal Reserve kept increasing the overnight lending rate in an attempt to keep inflation in check, ultimately slowing (though not entirely stopping) GDP growth. Interest rate increases, coupled with devastation caused by Hurricanes Katrina and Rita, and with soaring oil prices, all reduced investor and consumer confidence and undercut the willingness and interest of HNWIs, or angel investors, to take greater risk with their investment capital. Therefore, as an entrepreneur, you must understand that even though your company is just taking off, domestic and global factors will influence your access to capital, markets, and talent.

Angel Organizations

Over the last ten years, according to the Center for Venture Research at the University of New Hampshire, the number of angel organizations has grown exponentially. Several factors have been responsible, including the Internet bubble—as evidenced by the large jump in 1999 shown in Figure 2.9. A natural fall-off occurred with the 2001 bust, but the trend for establishing angel groups continued in following years.

Figure 2.9 Growth of Angel Organizations in the United States

Why this proliferation of organizations? One of the key reasons is quality deal flow. Entrepreneurs would much rather present to a room full of accredited investors than make individual presentations to each investor. The best deals want the most efficient course to financing. Presenting to fifty potential investors at one time is far more effective than making fifty individual presentations. Additionally, nearly all angel groups have screening committees or other mechanisms for selecting the best candidates for presenting at angel group meetings. Additionally, we know that individual angels have limitations on investment funds, which can restrict an angel’s ability to negotiate certain investment terms. With angel groups, several angels may decide to invest, or pooled funds may be invested, increasing the total investment dollars and increasing the angels’ collective ability to negotiate terms. Through this collective investment, angel groups help partially meet the ever-increasing funding gap between individual angels and venture capitalists. Equally important, many angel groups can provide a subsequent round of financing, which is necessary for many companies with capital needs under the venture fund radar.

Due diligence (discussed in more detail in Chapter Eight) is not a process to be entered into lightly. Proper and thorough due diligence often requires industry and technical knowledge, as well as comfort with financial documents, legal documents, marketing strategies, and the like. The old saying about two heads being better than one certainly applies to due diligence. Few people have the depth and breadth of knowledge and background to conduct effective and comprehensive due diligence. Therefore, angel groups provide a real solution through collective due diligence, conducted by the group or a subset of group members.

Another great benefit of an angel group is the ability to learn from other angel investors through formal training programs or sessions, as well as through listening to discussions at group meetings, committee meetings, and at other times. Good information and wide experience on the part of the investor make the investment experience richer and more valuable for the entrepreneur as well as safer for the angel investor. Finally, groups provide the social benefits of sharing similar interests. That common interest exists for the potential benefit of the entrepreneur. Most angel investors still invest as lone rangers—by themselves rather than through a group—but the number of investors in angel groups along with the actual number of angel groups is growing because of these obvious benefits.

Because of the real value angel groups present as a source of investors, this book provides an extensive list of angel groups in the United States and Canada, and in Europe, in Appendix 4 and Appendix 5. The source of much of the information on U.S. and Canadian angel groups is the Angel Capital Association www.angelcapitalassociation.org and Angel Capital Education Foundation www.angelcapitaleducation.org, two leading North American organizations related to angel groups, along with the National Angel Organization (NAO) www.angelinvestor.ca in Canada. NAO has traditionally placed a greater focus through its membership and services on individual angel investors, but also certainly promotes the establishment of angel groups. For Europe, information was obtained from the European Business Angel Network (EBAN; www.eban.org).

Angel groups are organized into a number of different legal, organizational, and administrative structures. As a result, angel groups invest in a number of different ways. Most angel groups still leave the investment decision up to each group member. Though the members may conduct due diligence as a group or in subgroups, individual investment decisions are still the typical path. As angel groups are becoming more popular, more angels are forming funds, either as an adjunct to an existing group, called side-car funds, or funds from the initial organizational stage. Angel funds are similar to venture capital funds from the standpoint of having members who agree or commit to contribute an agreed amount to the fund for investment. In a venture capital fund, the limited partners (investors) have no say in investment decisions. In contrast, angel fund members participate in the investment decision at some level—deal screening, due diligence, investment decision, post-investment relationships, and so on.

Seed Stage Investing

No statistics exist for Return on Investments for angels. Nonetheless, it is clear that angel investing in start-up/seed stage companies does have the potential for handsome returns. Statistics from early-stage/seed venture capital funds can be used for estimation purposes, as shown in Table 2.2 and Figure 2.10. (All from Thomson Financial/National Venture Capital Association.) Of course, creating these types of returns does require many factors such as diversification of investment portfolio, educated and selective investments, follow-on support for the young companies—and a bit of luck.