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Angel Investing: Matching Start-Up Funds with Start-Up Companies: The Guide for Entrepreneurs, Individual Investors, and Venture Capitalists

"Delivering more funding to more entrepreneurs than any other source, business angels are some of the most important (though least understood) players in our entrepreneurial landscape today," write Mark Van Osnabrugge and HBS professor Robert Robinson in Angel Investing. In this excerpt, they look at pros and cons of a kind of funding critical to the survival and growth of young firms.

Angel Investing

Business angels are individual investors with varied backgrounds, so generalizing about them as a whole is overly simplistic; nevertheless, they do have unique characteristics and advantages that are noteworthy (Figure 4.1).

We suggest that angels enjoy at least ten advantages:

1. Business angels prefer smaller-size investments than venture capitalists. The funding amounts fall within the equity gap—the range of funding sought below $100,000-500,000 that is normally too small to entice institutional investors to participate, primarily because of those investors' sizable due diligence and monitoring costs (Mason and Harrison, 1993a; Freear, Sohl, and Wetzel, 1996; Harrison and Mason, 1992a). However, few firms can raise $5 million until they have raised up to $500,000 for their early growth and development. This presents a sort of catch-22 for entrepreneurial firms and makes the advent of business angels, and their preference for small investments (often less than $100,000 per angel), a necessary blessing.

2. Business angels usually invest in start-ups and early-stage ventures, the ones having the most difficulty obtaining outside funds (Mason and Harrison, 1993a, 1995; Freear, Sohl, and Wetzel, 1996). Even Stanley E. Pratt, the former publisher of Pratt's Guide to Venture Capital Sources, the bible for the venture capital community, admitted to the suitability of business angels in his advice for entrepreneurs: "Unless you're highly unusual, I wouldn't waste my time with venture capitalists . . . I'd look for individual [investors]" (Posner, 1993, p. 55). Studies show that business angels make up a whopping 44 percent of all external equity investors supporting firms with revenues less than $3 million, 26 percent of those funding firms with revenues of $3-10 million, and only 4 percent of all external investors funding ventures with revenues above $10 million (Posner, 1993).

3. Business angels make investments in virtually all industry sectors (Mason and Harrison, 1995). The range of investments they fund is unlimited. We have come across angels who have funded bathing suit companies, prototypes of sailboats, and even a syndicate in Nebraska that funded a new hockey arena for a semiprofessional hockey team. Sector aside, however, it should be noted that what most attracts angels to an investment is high growth potential (as opposed to lifestyle or mom-and-pop operations).

4. Business angels are more flexible in their financial decisions than venture capitalists and tend to have different investment criteria, longer investment horizons ("patient money"), shorter investment processes, and lower targeted rates of return (Freear, Sohl, and Wetzel, 1996; Harrison and Mason, 1991a, 1992a; Deakins, 1996).

5. Raising funds from business angels does not involve the high fees incurred when raising funding from financial institutions (Harrison and Mason, 1991a).

6. Most business angels are value-added investors in that they contribute their personal business skills to furthering young businesses (Mason and Harrison, 1996b) and therefore may elect to invest locally to facilitate involvement (Wetzel, 1983; Mason, Harrison, and Allen, 1995). This free assistance and advice from an investor who, quite often, is a seasoned veteran of the business world is priceless for young entrepreneurs starting out and would not normally be affordable by other means. Since angels prefer to invest locally, their sector experiences and preferences often align strongly with many of the new firms in the area. An obvious example are the many wealthy high-tech entrepreneurs in Silicon Valley who are now investing their own funds in the next generation of local high-tech firms.

7. The business angel financing market is more geographically dispersed than the formal venture capital market; business angels can be found everywhere, not just in major financial centers. This is particularly important for regional development since many angels elect to invest in a firm within a few hours' drive of their homes, thereby helping to retain and recirculate wealth within geographic areas (Mason and Harrison, 1995, 1996b). Indeed, angel investing tends to be very regional in nature. Angel funds are particularly plentiful in areas such as California and Massachusetts, but other places emerging as particularly influential areas are North Carolina, Colorado, the Pacific Northwest, Austin (Texas), and central Utah (Sohl, 1999). In certain other regions, the supply of finance is slightly scarcer, leading some states to set up high-tech venture funds with state money to seed early-stage firms. These funds are capitalized annually to the tune of $50 million in Pennsylvania, $50 million in Virginia, and $87 million in North Carolina and $19 million in Illinois, but they have only limited effect ("Helping High-Tech Firms . . . ," 1999). Angels now already provide substantial sums in these areas, and with proper incentives their funding power could be vastly increased. One such interesting initiative has been undertaken by the government of Singapore to boost local entrepreneurship ("15 High-Tech Startups . . . ," 1999). A $10 million Business Angel Fund (BAF) has been set up to stimulate investments by angels (including foreign angels) in start-up firms in Singapore, matching investments made by these or institutional investors in high-tech start-ups. The success of such schemes remains to be seen.

8. Obtaining money from a business angel has a leveraging effect in that it makes the investee firm more attractive to other sources of possible finance (Mason and Harrison, 1996b; Mason, Harrison, and Allen, 1995). Angel investments certainly heighten venture capital interest in such ventures.

9. Business angels are also instrumental thanks to the loan guarantees they offer their investee firms, in addition to the money they personally invest. The angel who helped Apple Computer get off the ground in 1977 invested $91,000 and guaranteed another $250,000 in credit lines.

10. Angels are not averse to funding technology companies, which inherently come with high risks. In fact, U.S. angels fund 60 percent of all young technology firms looking for $1 million or less in start-up funds (Chan, 1999). In Silicon Valley alone, business angels bankrolled 786 start-up companies in 1998, investing a combined $4.55 billion (Talton, 1999). We found that 64 percent of U.S. matching services believe that their angels prefer high-tech investments, 21 percent claim their investors are indifferent, and only 15 percent believe high-tech opportunities are not preferred.

Business angels also have a few disadvantages, and we call attention to four in particular:

1. Business angels are less likely to make follow-on investments in the same firm (Mason and Harrison, 1995). Conversely, venture capitalists spend around two-thirds of their funds on expansion funding of their existing portfolio firms.

2. Business angels prefer to have a say in the running of the firm, which may force the entrepreneur to give up some degree of control (Mason and Harrison, 1995). Some business angels may have limited expertise in running the particular type of investee firm they fund, making their contribution less value-added and more meddlesome.

3. A small minority of business angels may turn out to be "devils" who have self-serving motives for investment (Mason and Harrison, 1995), rather than promoting the good of the firm.

4. Unlike many venture capital firms, business angels do not have the national reputation and prestige of a big-name institution, which can be crucial if the firm is successful enough to seek assistance from an investment bank for a private placement or IPO (Spragins, 1991).

Fortunately, it is widely agreed that the advantages of business angels generally outweigh their disadvantages; this has prompted some to conclude that an active informal venture capital market is a prerequisite for a vigorous enterprise economy (Mason, 1996a).

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Excerpted from Angel Investing: Matching Start-Up Funds with Start-Up Companies: The Guide for Entrepreneurs, Individual Investors, and Venture Capitalists, Jossey-Bass, 2000.

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Figure 4.1