THE SYNERGY BETWEEN ANGEL NETWORKS AND CORPORATE VENTURING
TOUGH TIMES FOR STARTUPS
The growth of a seed or start-up company is heavily dependent on the availability of risk capital. In early-stage companies, traditional sources of financing come from personal savings, family and friends, and severance packages. This form of financing, sometimes called “love money,” is usually sufficient to finance market research and to explore a product concept, but is rarely enough to reach prototype development. At this stage, entrepreneurs must begin looking for new sources of financing. In most cases, venture financing is not appropriate, as venture capitalists are reluctant to examine opportunities where the total financing is less than $1 million. As a result, angel investors, who are typically successful entrepreneurs with seed capital and acumen, help to bridge this financing gap.
When love money has been expended, many start-ups will pursue grants and government funding. In Canada, examples of these funding sources include the Scientific Research and Experimental Development Program (SR&ED) and the National Research Council’s Industrial Research Assistance Program (IRAP). Some may choose debt financing in the form of low-interest loans or credit card advances, while others pursue supplier or angel capital. Despite these multiple sources, raising early-stage capital to fill the gap between love money (e.g., $150,000) and professional venture capital financing (e.g., $1 million) is still difficult.
ANGELS FILL THE FUNDING “GAP”
Angel financing is one of the few early-stage “smart money” sources that can fill the early-stage financing gap. As Carleton University professor Allan Riding remarked at the University of Toronto’s “Financing Innovative Continue reading ANGEL NETWORKS AND CORPORATE VENTURING
Angel investors address the gap between love money and venture capital or more sophisticated sources of downstream capital. Generally considered the weakest segment of the financing services spectrum, angel investors must address higher risk, uncertain liquidity, long investment horizons, management gaps and a wide range of other industry-specific issues. Historically, angel investing has been carried out primarily by individual private investors; disciplined investment managers rarely invest at the angel level.
Relatively little has been known about angel practices and how they might be improved. Indeed, relatively little has been known generally about the angel investing “sector.” It is unclear, for example, how many angels there actually are in Canada. Oddly, many angels do not even recognize themselves as angel investors; they might not even be familiar with the term. Yet, the reality is that angels invest more than five times in early stage businesses as the entire venture capital industry combined.
Angel investors often work in groups for three key reasons:
To access more and higher quality deal flow than can be found by working alone.
To reduce individual effort by dividing up the work.
To reduce risk by tapping into the group’s varied experience.
Group participation also allows individual investors to spread their capital across more deals, resulting in better diversification and reducing risk.
Less than 20 local angel groups have been formally established in Canada, compared with more than 300 in the U.S. While each network is uniquely designed to serve the interests of its members, these groups have many characteristics in common, such as the investment screening process, and many that vary, such as organizational structure. Four groups are Continue reading BUILDING AN ANGEL GROUP
“Down-rounds” have become a critical challenge for angel investors. These are the declining valuations that often accompany the entry of new investors into subsequent financing rounds. In some cases, down-rounds are substantial enough to severely diminish or eliminate entirely the equity stake held by angels and other early investors.
Angel investors are often quick to criticize venture capital investors (VCs) for down-rounds. However, angels who are careful about keeping their eye on the ball are much less likely to suffer heavily in down-rounds. VCs and angels may exhibit differences in approach and may be driven by different prerequisites. Nonetheless, the two have much in common. With better attention to detail and a better understanding of the VC process, angels can make early-stage investing a more congenial and rewarding experience.
How does the prudent angel avoid getting burned in down-rounds? The primary rule of an angel investment – as with any investment — is to plan for one’s eventual exit. Angel investors need to consider their exit strategy from the outset, and continue to do so through the entire investment process to payout. Only the naïve will expect later-stage investors to look after their interests
THE INVESTMENT CLIMATE
By the end of 2002 and into 2003, the environment for early-stage financing had become as discouraging as it has been for the past 25 years. Little money was being invested and fear tended to dominate investment decisions, making negotiations difficult and seriously reducing risktolerance.
This tough environment intensified the inherent conflicts between angels and VCs. While many angels pointed to VCs as the source of their problems, the truth is that both angels and VCs found the investment climate trying, albeit for somewhat different reasons. However, with a little perspective, angels can understand the venture capital process better and thereby improve their own positions.
The prudent angel investor knows and understands his competitors and his allies.
VCs AND ANGELS ARE BOTH EARLY-STAGE INVESTORS
The earliest investors frequently include the company’s founders, the management team, friends and family, and angel investors. Some venture capitalists may enter at this early stage, though this is unusual. It is often a mixed crowd that supports an early-stage venture, but what these investors share is a powerful interest in growing the company. These people are investing in the future, based on what they know about the talents of the management team and its ideas and products.
In contrast, later investors generally have a better sense of the business’ prospects, and are investing on the basis of visible results rather than personal knowledge, instinct or experience. These later investors, who are almost exclusively venture capitalists, are interested in making deals that will bring a good return within a specific time frame. While some VCs look at the bigger picture and are comfortable with long-term investments, many prefer to earn a healthy return with a quick turnaround. Liquidity is a key consideration, as venture capital funds must generate a steady return for their investors.
This need for relatively quick returns on investment often push VCs to sell an equity position sooner rather than later. In so doing, they may leave early investors and managers with nothing but bitter experience. Naturally, this is a key source of tension between angels and VCs. However, since this is a well-known element of
early-stage investing, it is sensible to plan for the eventual entry of secondary investors. The prudent angel will learn as much as possible about the role and motivations of VCs, and will also attend closely to the start-up’s stage of growth and need for new capital injections.
BEGIN WITH A REALISTIC APPRAISAL OF THE INVESTMENT
Entrepreneurs are enthusiasts by nature and will occasionally woo investors with grandiose predictions of how much revenue they can generate over a short period of time. It has not been unheard of for start-ups to boast expected revenues of $5 million or $10 million or more. And yet, a simple review of available statistics quickly reveals how inflated such projections can be. A recent survey ranking the top 100 independent software companies in Canada in 2001 (Branham 100, www.branham.com) noted the following:
Only 63 of the 100 had revenues of over $10 million a year.
The companies had, on average, been in business for 15 years.
The 100th ranked company on the list had revenues of only $2.8 million.
These figures illustrate how risky it is to place one’s trust in an entrepreneur’s earliest projections. As early-stage investors, angels often get swept up in management’s enthusiasm. Instead, they need to put their financing on a more cautious footing and ask themselves: “If these sunny projections don’t materialize, how am I going to protect myself when the company goes back to the market for more money?”
MONITOR THE INVESTMENT FROM THE OUTSET
The prudent angel investor will ask for best and worst-case projections at the outset and assiduously track results against them. Angels need to know when the company’s course deviates from expectations, and when it does, be prepared to take the necessary steps. These may include a further personal investment, joining the Board, helping with marketing, finding a purchaser for the investment, writing-off the investment, finding additional angel investors or providing stronger incentives for management to deliver.
THE ENTRY OF THE VENTURE CAPITAL INVESTOR
Let’s assume the angel investor has retained his investment. A few years have passed and the early, enthusiastic, hockeystick revenue projections are a distant memory. The company has built a solid foundation and is now attracting interest from venture capitalists. This is great for the company and may help it to realize its goals. However, angel investors must be aware that their situation changes with the entry of the VCs.
Once in, the VCs need to make a quick exit in order to provide a constant flow of income to their investors. They also need to leave some value in the company for managers to ensure the necessary incentives are in place to continue growing the business. However, as noted above, early-stage investors can easily get squeezed out.
Having provided the initial capital for growth, the prudent angel is alert to the ongoing need to protect and build his investment. Fortunately, there are several mechanisms available to help him. These include averaging down, the use of formal debt instruments of various sorts, guaranteed pay-outs, management fees, finders’ fees, shotgun clauses triggered by share dilution and representation in the form of directorships, among others.
In truth, new businesses rarely begin generating revenue momentum — or VC interest — until the third or fourth year of operation. This may be too long for many angel investors to wait, as the risk is simply too high. Consequently, there is often a gap between the time when angel investors should or must get out and venture capitalists are ready to come in. The result can be a stalemate in which all parties withdraw from the game — VCs because they can’t get the requisite returns within the requisite time frame, companies because they don’t like the terms of investment and angels because they don’t want to risk more money.
Ideally, the prudent angel identifies the need for more money early on, and works with the investee to pinpoint and attract a venture player whose terms are mutually agreeable. Unfortunately, the reality in today’s environment is often rather different and angel investors must be prepared for it.
THE RETURN OF REASONABLE VALUATION
Returns in almost every market, from equities to venture capital, have fallen during the past two years. In hindsight, the real question is not why the fall occurred, but why it did not happen sooner. Valuations between 1998 and 2000 were outrageously high and added to investors’ uncertainty about how to assess risk. Amid all the energy and excitement that surrounded the late 1990s, people began using bizarrely high multiples, overly optimistic forecasts, market share projections and other novel methods to estimate potential success. None of these novel methods lasted beyond the bubble.
Thankfully, the past two years have seen a return to the fundamentals. Investors of all kinds are looking at conventional valuations (based on actual earnings, revenue, cash flow, and other tangible indicators) and conservative valuation strategies using lower multiples and more realistic forecasts. Indeed, the pendulum has swung back with a vengeance.
Everybody has been affected. Early-stage companies, financed by angels at the height of the madness, are now being funded at reduced valuations. Of course, this puts a further financial squeeze on angel investors. The prudent angel is just as likely to have been swept up in the madness as everyone else – and just as likely to be looking at lower portfolio valuations.
The solution lies in formulating strong funding and defensive strategies. Angels must ensure that an investee company has a solid business plan outlining how and when it will deliver promised results. They should also be prepared to supplement this by providing hands-on management and marketing assistance, as required. In portfolio terms, the prudent angel will focus careful attention on the fundamentals, including value propositions, sales channels, competitive advantage, market size and product and service differentiation.
Moreover, angel investors must remain keenly aware of developments affecting their investments. If restructuring is required, then the investor should try and lead it – by contacting management and other stakeholders to arrange for financing. By being the initiator, the angel investor will retain a measure of control and reduce the risk of being squeezed.
PARTICIPATING IN LATER ROUNDS
At some point, there will be a later round of financing. For angels, this can be an opportunity – after all, a down-round is a good time to invest as businesses have reduced their valuations, the inflated sales figures are flapping like torn flags, and management is increasingly eager to negotiate. However, the decisive factor for further investment must be sustainable profitability. Clearly, bubble-type valuations have had a lasting negative impact and investors and managers have become more concerned with building profitability. The prudent angel will have also adopted profitability as the fundamental element in investment valuation.
PREPARE FOR THE FUTURE AND BE READY TO STAY IN THE GAME
Angels who have prepared for the next round of financing will have already determined their course of action. If not, they still have a choice. They can enter the next round, where a better deal is being offered (in essence, averaging down, but retaining some control over the dilution); they can hold tight and watch their investment be diluted (the classic squeeze); they can scramble for leverage and payback (management fees, fees for services, directorships, shot-guns); or they can pull out.
Clearly, early preparation works better than last-minute scrambling, and enables the angel to plan how best to participate in later rounds. For example, if an angel reduces his initial payout, this can leave funds in reserve to enable reinvestment at the next stage. This allows the investor to get in on the ground floor and help build the company, while participating in the terms and benefits that go along with later-round financing. It also gives the angel leverage in new rounds and keeps the door open between the angel and the VCs, which is key to cooperative investing and, in effect, bridges the gap between the first and later rounds.
To reiterate, the prudent angel must be prepared for the next round of financing and has already planned the route that is most workable.
CO-OPERATION CAN PROVIDE MUTUAL BENEFITS
There is great value to be had in today’s market. After a couple of years of blight, even big brokerages are beginning to take an interest in small, well-run companies. In one recent deal, management, a national brokerage, VCs and angel investors were all involved at the same time. The company had positive cash flow and money in the bank. The arrangement seems to be working even though the compound annual growth rate isn’t quite at 30 per cent, which is something of a concern for the VCs. But the pricing was simply too good for the players to resist.
In this case, all management needed for continued growth was funding. The investors are working together to make sure management has what it needs. None of the participants wanted this company to fall into the angel / VC gap, and took steps to ensure this didn’t happen.
The lesson from this example is that the prudent angel welcomes partners who can help the investee.
KEEP YOUR EYE ON TOMORROW
There are two key questions for every early-stage company: “How do we attract money today to build the business now?” and “How do we make this business grow into the future?” Angels need to focus on the same questions on behalf of their investees and keep in mind that the past is history. The world has changed, valuations have changed and priorities have changed. An angel cannot change what has already happened. If VCs have already bitten into the investment, the challenge is to find a way to make the most of the flesh that remains.
The prudent angel investor stays focused on today and tomorrow and leaves yesterday behind.
TAKE ADVANTAGE OF TODAY’S PRICING
Angel investors are better off than they were two years ago, though they may not realize it. The reason is that investees are generally better managed today and more focused on revenues and profitability than ever before. Many of them are showing they can survive with a delayed or even evaporated second round. Also, as noted above, there is a small resurgence of investor interest in early-stage companies. While not definitive enough to constitute a trend, dollars are slightly more accessible, which will help to close the angel / VC gap, at least for some lucky companies.
The involvement of venture capitalists could hurt if there is a big down-round. However, valuations today are such that many angels will want to stay involved with their companies and participate with later-round investors. They can, in fact, help to reduce VCs’ anxiety about valuation by maintaining or building both their presence and their investment in the target company.
The prudent angel investor talks with VCs about valuations and how to realize intrinsic worth in their investees.
BUILD RELATIONSHIPS BASED ON TRUST
VCs are looking for quality deal flows. For this they need good relationships with those in the business community – including angel investors. Angels can provide access to a world of deals that VCs wouldn’t otherwise know about. This change in philosophy has been noticeable in the term sheets turning up recently.
There is no question that some VCs – driven by fear and the need for quick returns – squeezed some early investors unconscionably. There were more than a few very ugly deals. But the good faith required for successful business dealings cannot grow when one side is taking untoward advantage of the other. The ridiculously lopsided terms that were common in the recent past have begun to give way.
The prudent angel investor will look for mutually rewarding relationships and will not judge all VCs by the actions of a few.
BE PREPARED TO COMPROMISE
The key to a new relationship between angels and VCs is compromise. Relationships take time and both sides have to learn to trust one another and to support one another’s objectives. Even when the goals of the parties no longer align, if the relationship is strong, it is possible to get through with grace and dignity.
The benefits of compromise also apply to investment targets. Given the current environment, investors should aim for smaller profits on more deals and greater diversity in their portfolio to spread risk and enhance income. This goes for angels and VCs both.
BUT ARE VCs WILLING TO TAKE LESS INTERNAL RATE OF RETURN?
VCs are beginning to look at things in the longer term. The late 1990s saw an unbalanced market and a very demanding and somewhat unrealistic set of investors. Today, many VCs have learned that, as an early-stage investor, a short-term approach to making money just doesn’t work. Many are beginning to realize that the tough provisions inserted in term sheets when valuations were unrealistically high need to be altered now that valuations are more reasonable.
Slowly, the market is changing. At a recent venture fair, several major VCs made it clear that they were not interested in seeing companies project revenues of $100 million within five or seven years of start-up. They even suggested that their earlier demands had resulted in a whole generation of managers making unrealistic projections just to get on the radar screen. Another venture fair conversation featured a VC who had left the industry because he felt that the VC model resulted in too much money coming out of early-stage companies too soon.
The prudent angel investor encourages companies to provide realistic valuations and projections.
PICK YOUR PARTNERS, BUT….
There are good and bad VCs, and most angels would rather deal with VCs who never participated in the scurrilous squeezes. However, in this changing market, angels must be willing to look past VCs’ recent behaviour, because, realistically, there isn’t much choice. In tough times, any VC who is willing to get involved in a project and who has money is a good candidate for later round financing.
That being said, however, angels need to look to themselves. Based on their years of experience, relative freedom, and closeness to the investees, it is their responsibility to behave like the professional investors they are. That means building on their knowledge and experience to establish workable term sheets that provide reasonable protection. It means structuring various types of investment arrangements, creating measurable and monitored goals for investments and holding themselves accountable for the performance of their money.
Prudent angel investors cannot sit back and blame management, the VCs, the investment climate, commodity pricing or the telecom upheaval. Instead, they must realize that they have at their fingertips the resources to make good and profitable investments.
What resources? At the very least, they have each other in Canada’s increasingly active and organized angel network. And they have the experience of working with their fellow investors – the VCs and the brokerages. They need term sheets. They need regular meetings with management. They need to be kept in the loop and to keep themselves informed. They need metrics. They need to track investments against stated and communicated goals. They need to know how to say “no”. They need an understanding of business models, business management techniques and valuation criteria. Because, let’s face it — if they had invested as professionals in the first place, it would have been much harder to squeeze them.
The prudent angel investor treats his or her investments as a business.
As they develop national expertise, angels need to focus on ensuring a better and more business-like working relationship with both investees and other investors. This will go a long way to helping bridge the gap between angel investors and venture capitalists.
Angel Investment Incubators were created originally as a way of making use of abandoned industrial space. However, recent events have encouraged incubators to focus on providing true value-added services. According to the National Incubator Association:
“A business incubator is an economic development tool designed to accelerate the growth and success of entrepreneurial companies through an array of business support resources and services. A business incubator’s main goal is to produce successful firms that will leave the program financially viable and freestanding.
These incubator “graduates” create jobs, revitalize neighborhoods, commercialize critical new technologies and strengthen local and national economies.
Critical to the definition of an incubator is on-site management, which develops and orchestrates business, marketing and management resources tailored to a company’s needs. Incubators usually also provide clients access to appropriate rental space and flexible leases, shared basic office services and equipment, technology support services and assistance in obtaining the financing necessary for company growth.”
Business incubators have experienced a tremendous surge in growth over the last two decades, swelling from just 12 in the United States in 1980 to over 900 by 2000, with 3000 in existence around the world. Much of this growth was fueled by a desire to find an active way for companies, government and the financial community to stimulate innovation and new business creation. Over 80 per cent of the incubators created in North America were “not for profit,” created as a tool of government economic development or linked to research organizations eager to see the benefit of their research work applied to the marketplace.
In the late 1990s, the dot-com boom created what appeared to be a major opportunity for a new generation of incubators in the private sector. Many saw this approach as providing a superior route to business success, as compared to traditional venture capital funding. Unfortunately, this business model was based on the false premise that money ploughed into start-ups in the first 12 months could be returned within 12 months, due to the high valuations that the stock market and acquisitions were placing on these companies. The collapse of market capitalizations for such companies resulted in a reappraisal of this model, not to mention the spectacular collapse of some incubators, such as NRG and Itemus in Toronto. Incubators created by large corporations, such as Nortel or OnX, which were seeking to capitalize on innovation from within their companies, have met similar fates. It has become obvious that current market conditions will not support such enterprises in the private sector.
Given this experience, universities and governments have begun experimenting with new “not for profit” models. These approaches are based on links between a community and a mixed-use incubator, and between a strong research organization, such as a university, and a technology incubator. Each of the new incubators has a different agenda, with different models achieving varying levels of success and sustainability. Today’s incubator manager needs to build on the most successful practices of other incubators, while fully engaging the local business community in fostering
new enterprises. Angels, too, are making an important contribution to creating regional wealth and, under certain circumstances, facilitating the growth of technology hubs.
The fundamental needs of new businesses remain the same – access to resources and support to help them survive the critical first phase of development. Indeed, the importance of business fundamentals and strong early stage development are being re-emphasized in the post-dot.com world. Incubators can play a critical role, not just as providers of space and equipment, but as a real axis of business advice and services and an environment of mentoring and encouragement.
Angel Investment Incubators can also fulfill four important functions for angel investors:
Supporting and developing angel investments in early stage companies.
Providing a source of high-potential, qualified deal flow.
Facilitating the creation of win-win relationships between angels and entrepreneurs.
Accessing a large community of interested parties who can provide networking opportunities for the new company.
Each of these roles is examined below.
SUPPORTING AND DEVELOPING AN ANGEL INVESTMENT IN
EARLY STAGE COMPANIES
The traditional model of incubators is changing. In addition to offering inexpensive and flexible space, as well as technology infrastructure and support equipment, incubators are also providing start-up companies with many value-added services and a much more comprehensive development process. This includes such help as refining the USP, active mentoring, providing the start-up with training, expertise and new businesses tools, and facilitating access to the financial community and to a range of business services, such as accounting, legal, public relations and recruitment.
Two examples of the training programs available to new business owners are the Ventures Innovation Incubator at the TIME Centre (Simon Fraser University), and the Exceler@tor (University of Toronto). Both programs offer workshops and training sessions for start-ups located in the incubator and for new technology businesses in the wider community. The TIME Centre has also held a one-day workshop focused on board governance for start-ups, designed to forge links between start-ups and the investment community.
One of the ways in which incubators help start-ups is by bringing them in contact with one another and with the wider business community. It is important for new businesses to have face-to-face contact and opportunities to network and share experiences. The Harvard Business Review, in an article entitled Networked Incubators, talked about the importance of these interactions in distinguishing successful incubation models3. Incubators, whether housing the start-ups in a collective space, or reaching them more remotely, are creating opportunities for new businesses to meet and interact. These interactions help to generate new ideas and encourage business owners to drive their enterprises forward.
The provision of shared physical space and equipment is still a core part of most incubation programs. This is especially critical for specific business sectors, such as biotechnology, which have a protracted pre-revenue development phase and where labs and equipment are very expensive. Incubators providing such facilities include the Laval Biotechnology Incubator, which provides inexpensive space and pools costly equipment so that the start-ups can focus on testing and building their businesses, rather than covering significant capital and operating costs. This is also true in IT incubators such as the Exceler@tor, where sophisticated IT technology infrastructure can be shared by the 25 companies housed in this Toronto facility.
As incubators evolve from sympathetic landlords to a source of significant knowledge and resources, they will dramatically increase the chances that a new company will succeed and grow and that an angel’s investment will be rewarded. The incubator will reduce the company’s burn rate, both by reducing its operating costs and helping it to secure more flexible financing terms. It will improve access to technology infrastructure and partners. It will allow start-ups to become better prepared to present themselves to the investment community. And it will provide a tightly formed network of colleagues and mentors, while helping enterprises to develop the necessary skills to thrive.
PROVIDING A SOURCE OF HIGH QUALITY DEAL FLOW
Angel Investment Incubators have traditionally set three major requirements for admission: technological innovation, willingness to learn and significant market opportunity. This makes them an ideal source of high quality deal flow for angel investors. In addition to helping turn technology innovations into businesses that are investor-ready, incubators can also prepare the start-up for negotiating a specific deal. The ability of an incubator to facilitate this marriage between new companies and angel investors will greatly increase the deal conversion rates and lead to higher levels of investment success.
Incubators, especially those run on or by universities, have unique access to research talent. This opportunity to build relationships with faculty and to raise the profile of business creation on campus often encourages researchers in the lab to create new businesses. This synergy is illustrated by the number of large and successful incubators located adjacent to campuses in Boston, North Carolina, California and elsewhere. Simply being close to the source of the discoveries, and connected with the research community, encourages the creation of new businesses and investment opportunities.
The second way that Angel Investment Incubatorsdevelop a strong pool of investments is by providing training and resources to make the new businesses “investor ready.” Incubators assist start-ups in developing a coherent business plan and offer presentation training, which can transform a lab researcher into an articulate businessperson. In some cases, they will find the right person, other than the inventor, to lead a technology company. Some angel investors say that this preparedness means that they pay more for investments coming out of incubators, as the business owners are more savvy and have thought through the value they bring more clearly. But this training is also reflective of their overall management skills and development, which makes them better deal partners than the average new business owner.
FACILITATING THE CREATION OF WIN-WIN RELATIONSHIPS BETWEEN ANGELS AND ENTREPRENEURS
Incubators serve investors by bringing them together with a hub of pre-screened investments. The creation of this unique “marketplace” facilitates deal flow and allows angel investors to identify investment opportunities that have received and will continue to receive training and support.
The incubator can also provide guidance on technology or market development to angels with limited experience. Many incubators even offer customized presentations, which introduce the angel to a set of potential investments that meet the angel’s criteria. This pre-selection allows the angel to achieve a higher deal conversion rate per presentation and makes the deal-making process more efficient. Such synergistic relationships between incubators and angels are just beginning to develop. Both sides can do a lot more to encourage this natural partnership.
ACCESSING A LARGE COMMUNITY OF INTERESTED PARTIES WHO CAN PROVIDE NETWORKING OPPORTUNITIES FOR THE NEW COMPANY
Angel Investment Incubators, given their role as a hub and their linkages to universities and research facilities, are in an excellent position to elicit partnerships with many organizations. For example, the Exceler@tor has strategic partnerships with Microsoft and HP, which enable it to provide more sophisticated technology solutions and a ready partner for early stage commercialization. Such partnerships also allow incubators to help their tenants by arranging for technology evaluations and collaborations and by putting these new companies in touch with prospective partners and even acquirers.
These relationships bring considerable value to the early-stage company, as do the interactions that incubators facilitate with the investment community, potential employees and the academic community. Start-ups operating outside incubators are unlikely to have the same level and number of relationships available to them.
AN EVOLVING MODEL
While Angel Investment Incubators have undergone tremendous evolution, there are still important developments underway to better align the interests of incubators, investors and innovative businesses.
In the original, rent-driven business model, incubators had little incentive to push start-ups to develop and outgrow the incubator, as this would truncate revenues. Today’s incubator is more likely to incorporate a model that allows for a return of value to the incubator at a subsequent stage, thus providing an incentive to encourage the new company’s growth. The Exceler@tor, for example, uses a warrants model to achieve this.
Angel Investment Incubators are also looking at new business models that allow them to generate revenues by providing training and continued access to services for their alumni. This could be done by taking a further equity or royalty position in the new business. Such an approach provides the incubator with much greater incentive to push the start-up to develop, leverage training and resources and grow the business, which in turn aligns the start-ups more closely with the interests of investors.
To attract investors, start-ups should be seen as ready to take on the challenges and realities of the business world. VCs sometimes consider incubators as negative selectors because the comfort of the incubator could prevent the aggressive growth of the business. If start-ups feel that their welcome at the incubator is never-ending, with cheap access to resources, they may become complacent and not push their businesses forward. To this end, incubators must set and enforce ongoing performance expectations and strict exit policies. They should also ensure that start-ups are paying appropriately for the resources they consume and meeting regular payment schedules. In some cases, substantial increases in monthly rent or service charges are advisable.
A specific challenge in university-run incubators is ensuring that decisions are based on business considerations. It is not unusual for a founder to maintain an academic mindset, instead of a competitive, commercial frame of mind. This will inevitably inhibit growth and commercial success. The incubator must ensure this issue is dealt with firmly, otherwise it will create problems for investors trying to instill a returns-driven approach to these businesses.
The mission of most “not for profit” technology-based incubators is to increase the survival rate of graduates and foster their acceleration in the commercial market space. Angels with limited technology knowledge and networks can significantly benefit by working with incubator management to:
take full benefit of the resources and networking opportunities available through this special resource.
By forging strong partnerships with incubators and by sharing common goals, angels can identify superior opportunities among incubated companies and enjoy higher returns than they would otherwise receive by investing in individual opportunities alone.
In response to current market conditions, angel investors are looking for ways to minimize risk while contributing to the development of new ventures. Clustering or investing in groups has been identified as one means for angel investors to reduce transaction costs while increasing opportunities and returns.
By pooling assets, angel investors can share the risks and leverage the expertise of partners. They can also participate in offerings with high-quality private growth companies, which may not be available to the individual angel investor. This approach also gives investors more negotiating power with respect to the terms of the financing and the direction of the business. And by pooling their money, angel investors can present an attractive value proposition to growth companies that readily competes with formal venture capital dollars.
While there is no “ideal” angel structure, this paper will address two specific types of structures that facilitate group investing: limited partnerships and the Capital Pool CompanyTM (CPCTM)program of TSX Venture ExchangeTM. It also outlines two other structures, which are currently unavailable, but are worth considering for the future.
Angels have used limited partnerships for many years as a way to bring together capital and expertise for specific investments. Syndication allows for greater leverage of funds than individual investors can achieve on their own.
There are five key elements that angels should consider before investing in a particular enterprise. These are the legal, financial, technology, marketing and human resources aspects of the company. Each of these areas presents the investor with several fundamental issues, which should be examined and addressed before embarking on an investment. The experience of many investors is that a failure in just a few items can easily result in failure overall. Thus a major challenge for investors is to distinguish between those items that are deficiencies, and can be remedied, and those items which are fundamental flaws.
There are several factors to consider with technology. For instance, is there a demonstrated demand for the product? Creating a superior rat-trap – or even a wholly new product or technology for which there is little consumer need – will rarely result in a well-trod path to the company’s door. A product’s success is directly related to its utility.
Secondly, will the technology function reliably under the real-world conditions proposed? To what extent has it been effectively tested?
Does the technology offer benefits that are not available from competing products – such as added functions or features or lower costs – or does it simply duplicate offerings currently available?
Is the technology protected? Are patents in place? To the extent that there is no proprietary technology, what evidence is there of an ability to create a competitive business?
Efforts should also be made to check the employment history of management and to determine whether or not the technology or any part of it was engendered in the course of prior employment. Former employers Continue reading Angel Investing Due Diligence
Angel investing has long been an important source of financial support and mentoring for new and growing businesses bridging the gap between individual (friends and family) and institutional venture capital rounds of financing. Over the past several years, this sector of the private capital market has been formalizing in response to both growing demands and complexity.
According to research conducted by Jeffrey E. Sohl at the University of New Hampshire’s Center for Venture Research, there were approximately 50 formal business angel investing groups in the United States five years ago. He now estimates that there may be as many as 170 formal and informal organizations located throughout leading technology and business regions in the US and Canada. These groups have several characteristics: loosely to well-defined legal structures; part-time or full-time management; standardized investment processes; a public face usually with a Web site and public relations activities; and, occasionally a traditionally structured venture capital/angel investing fund.
The number of organized groups has grown in response to several factors:
A desire to attract better deals and generate higher returns than angels acting alone;
The growth of venture capital funds and the attraction of venture investing;
A widening “capital gap” between individual and institutional venture capital investors that has created a need and an opportunity for pooled investments;
The legal and economic complexity of these investments;
A large increase in the number of self-made, high net worth individuals who want to be more involved in their alternative asset management;
The volume of deal flow; and,
Social camaraderie among investors.
As a result, investment screening is fairly consistent across groups. Specific organizational and legal structures, however, remain varied. Most groups developed their own organizational structures and processes independently and have recently begun to discuss and debate best practices, some of which are discussed in this paper.
For entrepreneurs and other investors, the net results of this change are mostly positive. Although the models of business angel investing groups continue to evolve, these groups are generally better financed than ad hoc groups of individual investors. These groups provide an extended network that benefits both funded companies and co-investors by providing greater due diligence, operational support and domain expertise. Business angel groups can also provide a key source of qualified deal flow for venture firms; as well as provide intermediate capital for companies with financing requirement levels between individual investors and institutional venture capital.
This paper is the product of the first summit of organized angel investing groups, an April 2002 meeting focused on the best practices of angel investing. Thirty representatives from 18 groups across North America attended the meeting at the Massachusetts Institute of Technology. The Ewing Marion Kauffman Foundation coordinated the summit, working with a committee of angel organization leaders. The summit was initiated by the leader of CommonAngels, of Boston, who noted that organized angels need and are interested in opportunities to share information in order to enhance their practices. The participating angel organizations expressed a strong interest in continued sharing of information and best practices, and will hold additional summits in the future.
What Is An Angel?
From a purely legal standpoint, an “angel investor” (or “business angel investor”) is a “high net worth individual,” usually an accredited investor (as the term is defined in Regulation D under the Securities Act of 1933 or SEC Rule 501) who invests his or her own funds in private companies, typically at the seed and early
stages. To most companies, though, angel investors are much more: they often bring expertise or affinity for that company’s product, market or management team, in addition to taking additional financial risks. Many serve as active advisors or mentors for entrepreneurs, provide additional relationships to aid the business’ growth, and supply industry and entrepreneurial experience.
Broadly, these individuals fall into four categories as defined by a study on angel investors by MIT’s Entrepreneurship Center:
Guardian Angels, who bring both entrepreneurial and industry expertise. Many have been successful entrepreneurs in the same sector as the new companies they back.
Entrepreneur Angels, who have experience starting companies but come from different industry sectors.
Operational Angels, who bring industry experience and expertise, but generally from large, established companies, and may lack first-hand experience with the travails of a startup.
Financial Angels, who typically invest purely for the financial return.