«Note on Angel Investing Introduction An angel investor is an individual that uses his or her own cash to invest in early stage companies. This note ...»
Revised Oct. 30, 2002
Note on Angel Investing
An angel investor is an individual that uses his or her own cash to invest in early stage
companies. This note describes the fundamentals of angel investing, compares angels
with venture capitalists, and offers suggestions for best practices among entrepreneurs
and angel investors.
Company founders have a plethora of choices when they want to raise capital, including:
• Personal savings
• Credit cards
• Lines of equity
• Second mortgages
• Friends and family
• Government grants
• Asset based loans
• Accounts receivable factoring
• Business loans from banks
• Institutional investors (arranged through investment banks)
• Equipment lease financing
• Corporate strategic investors
• Angel investors
• Venture capitalists
• IPOs Seedstage entrepreneurs, with very early stage concepts, products and companies, should weigh their options carefully in order to ensure the long term survival and optimal growth path of their startups. Founders can seek debt and/or equity investments. Debt-related capital most often requires monthly payments that can reduce the cash flow of a fast growing company. Some founders may ask for more equity capital than they really need and give up too much equity in exchange.
This document was developed by Professor Fred Wainwright and Professor Michael Horvath as a basis for class discussion rather than to illustrate either effective or ineffective management. The authors thank Frank Ruderman T’72 for his editorial comments.
Copyright 2002. All rights reserved.
Bill Gates, for example, still owns a substantial portion of Microsoft, whereas most founders see their percentage ownership diluted to less than 5% after numerous rounds of financing and public stock offerings. Fortunately, if the company has reached an IPO stage, the small slice of a very big pie allows those founders to achieve a multi-million dollar net worth.
Angel investors are so named because in the early 1900s wealthy individuals provided capital to help launch new theatrical productions. As patrons of the arts, these investors were considered by theater professionals as “angels.” Estimates of the number of active angel investors in the US vary widely. The SEC Rule 501 states that an “accredited investor” is a person with a net worth of at least $1 million or annual income of at least $200,000 or combined income with a spouse of $300,000. According to Forrester consulting, the number of households in the US that fit that profile is approximately 630,000.
Angels fill a critical capital gap, between “friends and family” and VCs. When a startup requires more than $25,000 but less than about $1.5 million, angels are a viable source of capital. This level of funding is below the radar screen of most venture capitalists, although some VCs will occasionally fund a seed round of as little as $500,000.
During the past few decades, VCs have raised larger and larger pools of capital and since the time and expense of reviewing and funding a company are the same, regardless of size, it is far more efficient for VCs to fund larger transactions. It is important that angels continue to be actively involved in investing because without seed stage financing, the country’s entrepreneurial force loses its energy.
Angels and VCs rarely compete for the same deals
Table 1 below compares and contrasts these two types of investors:
Table 1 – Angels vs. VCs
* For a description of basic valuation concepts, see the valuation section below.
Angels have a variety of individual and professional backgrounds Angels can add tremendous value to startups. On the other hand, angels are humans and are subject to their personal idiosyncracies. One or more of these characterizations may
apply to an angel:
Guardian angel This type of investor has relevant industry expertise and will be actively involved in helping the startup achieve success. He or she has a strong rolodex of contacts and has the experience to add substantial value as a board member.
Operational angel This angel has significant experience as a senior executive in major corporations. For an entrepreneur, this type of investor can add much value because he or she knows what the company needs to do in order to scale up operations.
Entrepreneur angel An investor that has “been there, done that” is very valuable to a novice entrepreneur. For example, an entrepreneur can add perspective to the founders on what to expect from investors and how to effectively negotiate financing terms.
Hands-off angel A wealthy doctor, attorney or similar professional must focus on his or her day-to-day career. This type of investor is willing to invest but usually does not have the time or specific expertise to be of much help to the startup.
Control freak Some investors either believe they have all the answers because they have achieved certain wealth or they have the personality to convince themselves they know “everything.” Caveat emptor.
Lemming Some angel investors will not make a decision unless an informal leader in the angel group invests or makes positive comments about a startup. Success breeds success - even a term sheet from one or two small investors can allow an entrepreneur to access larger investors, who usually become more interested when they find out that fellow investors have committed. Some lemming investors are particularly astute at leveraging the work of other investors whereas other lemmings simply trust blindly in the due diligence and term sheets of fellow investors.
Angels band together Angel investors increasingly join one or more informal or formal groups. There are
various advantages of working in groups:
• Social bonds and networking
• Access to prequalified deal flow
• Leverage intellectual capital and expertise of individual members
• Learn from each other regarding deal evaluation skills
• More extensive due diligence capability
• Alignment of members’ interests
Angel groups can be structured in various ways:
• Each member owns a portion of the legal entity representing the group
• Limited liability corporations are formed by individuals to invest in specific deals
• The group is a non-profit entity and individual angels invest independently Names and contact information, if available, of angel groups in the West Coast and northern New England are shown in Appendix 1.
Annual fees in angel groups are usually in the range of $100 to $1,000 per member.
These fees cover meals, conference rooms and administrative staff.
Typically an entrepreneur must complete a questionnaire and submit an executive summary or a full business plan. A proactive entrepreneur will understand the angel investing process. A reading list is enclosed in Appendix 2 and a sample angel group questionnaire is shown in Appendix 3. Some groups require that a member meet with the entrepreneur and determine if the plan is viable before allowing the entrepreneur to present to the group. Other groups allow the administrative staff and managing director to review the plan and invite the entrepreneur to present without a “champion.” Once the presentation is made (usually in 10 to 45 minutes, including a question and answer period) the entrepreneur is asked to leave the room. The angels discuss the opportunity and, if one or more angels are interested then, depending on the group, either the entrepreneur is invited back at a later date for a more thorough review of the plan or an initial term sheet is developed within a week and presented to the entrepreneur.
Sometimes, if an entrepreneur presentation is weak but the idea has merits, the entrepreneur will be coached on what to do in order to be able to present in a future meeting. Occasionally, the entrepreneur is matched with an angel that is willing to coach the entrepreneur (informally or for a fee) in order to raise the quality of the business to fundable status. Some angels specialize in helping entrepreneurs write business plans and develop their strategy.
Angel groups occasionally band together with other angel groups to share due diligence and invest sufficient capital to complete a round of financing.
Evaluation of business plans uses several parameters Companies don’t build themselves. People build companies. Ultimately, an angel investor is selecting a management team. A great team can make even a mediocre company achieve reasonable success, whereas a company with the best technology will not be successful with a mediocre management team.
Some of the key factors of a business plan that improve the success potential of a startup are shown below.
Table 2 – Success Factors
One thing is certain about any business plan: it will be wrong. Projections will change.
Teams will change. Competitors will surge or fade. Most successful companies make radical changes to their business plans as managers discover the reality of their situation versus their original expectations. Thus the experience of a management team is critical in order to handle sudden changes in strategy. Angel investors play a critical role in helping management teams make adjustments and prepare for venture funding.
Valuation is highly negotiable in early stage investing Valuation is much more of an art than a science, especially for companies with no revenues or profits. In theory, a company is valued based on its ability to generate cash in the future. These future cash flows can be discounted using basic financial formulas in order to estimate the sum total of value today of all future cash flows.
For companies without positive cash flow but with revenues or net income, comparisons can be made with publicly traded companies in similar industries. For example, if ABC startup is in the medical software business, and publicly traded companies in the same industry trade for approximately 2 times annual sales, then it is reasonable to estimate the value of ABC as somewhat less than 2 times its annual sales. Usually a discount of 10% to 40% is made for private companies due to the fact that their stock is not publicly traded and the likelihood of matching willing sellers and buyers of private stock is fairly low.
Investors refer to the valuation of a company prior to receiving a round of investment as “pre-money.” Once funding occurs, at that instant, the value of the company rises by the amount of funding and the “post-money” value is determined. For example, a company valued at $1 million “pre-money” will be worth $1.2 million “post-money” after receiving a round of $200,000 in funding. The investor in that round owns one sixth of the company ($200,000 is one sixth of $1.2 million).
If a startup has no revenues, then valuation is subject to much negotiation and relies more on common practices of angel and venture capital investors. A “hot” company with patents or competitive advantages and potential for hundreds of millions of dollars in sales will certainly command a larger value than one with tens of millions in potential sales, but hard rules are difficult to establish in the investing industry. Angels commonly value seed-stage, concept-type firms at around $4 million while venture capitalists prefer to invest in early stage companies that they value at $10 million and higher.
Latest developments in angel financing
Angel investor groups have had a difficult time since the stock market debacle in early
2000. Many early stage companies lost customers or ran out of cash. Of those startups that survived, many had to reach out to venture capitalists who insisted on significantly reducing the ownership percentage of previous investors, including founders and angels.
During times of major decreases in startup valuations from one financing round to the next, the VCs’ basic message to earlier investors was “if you can’t invest in the company in this new round of financing to keep it alive, then you don’t deserve to own much of it.” This is similar to a poker game; those players who are unwilling to up the ante lose everything they placed in the pot in previous betting rounds. Tough, but fair.
Some of the larger angel groups have either formed their own funds or joint ventured with venture capital funds in order to ensure that young companies have the necessary funding in subsequent rounds to grow rapidly. Thus the angels are better able to monitor their investments as the startups achieve greater growth.
Tenex Greenhouse, for example, is an angel group in California that has launched a $20 million (target) venture fund using angel and institutional capital to support successful angel-funded startups. Tenex Greenhouse also offers intellectual capital, leveraging its members’ functional specialties and industry experience to provide support to funded startups.
The well known Band of Angels, started in 1995 in Silicon Valley, now has a $50 million VC fund with capital from institutional investors. From another perspective, VIMAC is a VC fund in Boston that has a network of over 200 angels who can co-invest on select deals, especially ones that require more advisory work.
One of the results of cross-fertilization of ideas and organizational structures among angels and VCs has been the emergence of typical financing terms. Exhibit 4 describes common financing terms offered by investors to entrepreneurs.
Milestone financing is becoming more common. Investors mitigate their risk by setting operational targets for the startup that need to be met before another portion of funding is made. The pricing and terms of the milestone funding is pre-set to avoid excessive legal costs.
Suggested best practices for angels