Angel Investing and Entrepreneurship
You've just finished writing your business plan and estimate it will cost $500,000 to launch your new company. You check your piggy bank and realize you only have $1.78. What's an entrepreneur to do?
After tapping friends and family, your potential pool of capital grows to $11.78. Because your brother-in-law wants 50% ownership of your new company for his $10 in equity, you decide to give him back his money and look elsewhere.
You immediately realize the need for venture capitalists to fund your venture. You start looking up venture capital firms on the Internet.
This is the usual sequence of funding sources many new entrepreneurs pursue. However, only one or two new companies in a thousand ever receives venture capital from professional venture capital firms. And, cold calling venture capital firms is seldom effective.
Like many entrepreneurs, you may have overlooked the greatest source of external financing of high-risk, start-up ventures—angel investors. Angel investors are usually wealthy individuals, often entrepreneurs, themselves, or business people, who make high-risk investments in small companies.
Mark Van Osnabrugge and Robert J. Robinson, authors of Angel Investing: Matching Start-Up Funds With Start-Up Companies—The Guide For Entrepreneurs, Individual Investors, And Venture Capitalists, estimate angel investors fund thirty to forty times more ventures than professional venture capitalists. Angels invest about $50 billion annually in small companies, Van Osnabrugge and Robinson estimate. In absolute dollars, angels invest three to five times more money than venture capital firms.
Further, Van Osnabrugge and Robinson point out that angel investors are essential in funding ventures which need $500,000 or less, because professional venture capitalists are seldom interested in making such small investments (and new entrepreneurs seldom have that much money in their piggy bank).
Some angel-backed companies go on to receive venture funding, becoming publicly traded companies and industry leaders. In this way, angel investing strongly complements the role of venture capital. Without angel investment, these companies might never have grown sufficiently to attract the interest of venture capital firms.
Because angel investors are instrumental in funding early-stage, fast-growth, entrepreneurial firms, which ultimately are responsible for nearly all job creation, Van Osnabrugge and Robinson conclude that the actions, behavior, and investments of angel investors play a significant and underappreciated role in the well-being of the economy.
"Venture capitalists get all the press, but the vast majority of entrepreneurial firms are actually funded by business angels, especially those firms in their earliest stages. A good analogy might be to equate this to looking at a forest of trees and—though we realize that only a small percentage of seedlings make it to maturity—acknowledge just those trees that are over six feet high and growing. This shows little concern for the seedlings and the germination process. In our real-life forest of entrepreneurial firms, it is the business angels who are the gardeners caring for the seedlings.…" write Van Osnabrugge and Robinson.
Yet, the habits of angel investors are relatively unknown to most entrepreneurs. This is partially because many angels are shy. Unlike their outgoing venture capital brethren, angels often keep a low profile to avoid being deluged with business plans and requests for capital. Most potential investments are introduced to angels by their business and personal contacts.
Angel Investing details and documents the way angel investors make investments. There are many valuable lessons for the entrepreneur seeking angel capital.
Lessons For The Entrepreneur From Angel Investing
Capital inflow is only one valuable function of angel investors. Many angels have considerable business experience and industry contacts to help the fledging firm. These angels often actively participate in the operation of the business. Three-quarters of entrepreneurs say an investor's active participation benefits the firm. Don't just seek to get the most money, but seek angel investors who can, overall, contribute the most to your firm.
Angels, like venture capitalists, put great emphasis upon selection of the entrepreneur they fund. The key factors angels focused upon for funded ventures were the entrepreneur's enthusiasm, trustworthiness, and experience. The angel liking and having a good impression of the entrepreneur played an important role. Similarly, the entrepreneur should choose an investor he or she feels comfortable working with.
Angels aren't interested in low-growth, lifestyle businesses. Typically, they want businesses which can grow at 40% or more. However, unlike venture capitalists, many angels don't calculate Internal Rates of Return (IRR) and other measures of investment performance. Angels often view such calculations as too speculative.
In addition to discussing valuation, exit strategy, and writing an effective business plan, one of my favorite chapters in Angel Investing was "Negotiating the Funding Agreement." When I started reading the chapter, I must admit I rolled my eyes when I read, "Negotiation is increasingly becoming a complex and theoretical academic field.…"
Reading about the theory of negotiation seems a bit like reading about the theory of golf. But, the book had been excellent so far, so I continued and found some valuable advice about negotiating your "interests" or what you care about:
"It is a naïve entrepreneur indeed who limits interests to the question of 'How much money can I get?' Some interests are tangible and objective, such as funding level, profit, timing, quality level, and specifications. However, and perhaps just as important, interests may also be intangible and subjective. These include the relationship, the character of the negotiating process, the precedent it sets, fairness to both parties and their constituencies, sustainability, the effect on reputation and self-image, whether trust is enhanced or eroded, and the like.…"
Van Osnabrugge and Robinson go on to explain how many new entrepreneurs negotiate aggressively on the "hard interests" to the extent of endangering the business relationship with the investor. Van Osnabrugge and Robinson also offer this as a possible explanation of why successful angels don't demand an excessive equity position. Skilled angel investors preserve the working relationship with the entrepreneur.
"  …Since agreement represents simultaneous solution of all sides' problems, solving their problem is part of solving your problem. This book has stressed again and again the issues facing investors, be they business angels or venture capitalists; the entrepreneur who focuses on those issues and tries to help the investor with these problems stands a far better chance of being funded…." write Van Osnabrugge and Robinson.
Angel Investing has many useful tidbits for building a business. For example, in the chapter about bootstrapping, the authors recommend forming business alliances. One quoted study showed that the success rate of U.S. software companies which formed a business alliance had an overall success rate of about 71% compared to a 46% success rate overall. This confirms the importance of business relationships to a new firm.
Lessons For The Angel Investor From Angel Investing
Van Osnabrugge and Robinson predict that the importance of angel investing will increase in the future partially due to the large number of people who have achieved wealth via entrepreneurship and the growth in the stock market. Many of the newly affluent want to invest in start-up firms. Partially, this is due to the popularized success of some angel investors. For example, the angel who invested in amazon.com turned a $100,000 investment into $26 million upon exit.
However, spectacular successes are rare, and it is important to only invest money you can afford to lose. Losing capital in about 40% to 50% of angel investments is typical. Further, many new angel investors do inadequate due diligence, which might have prevented capital loss. Van Osnabrugge and Robinson show that a lack of due diligence is by far the greatest regret angel investors have.
Anyone considering making an angel investment should read Angel Investing by Mark Van Osnabrugge and Robert J. Robinson.