Angels and Pinheads

The previous few posts established the environment in which organized angel activities operate: a need for revenue to support increasingly professional operations and hired management, combined with limited means of assessing fees to participants in any transaction. The result today is that angel groups and events predominantly function on the basis of flat fees collected from investors, entrepreneurs, or sponsors. Charging each of these audiences has issues.

Investors are usually seen as the best source of fees to run angel activities: after all, they are the ones with the money and stand to make the most from the deal, right? Well… if you put yourself in their shoes, it’s not so simple: there is a limit to how much anyone will pay for what effectively boils down to a club membership or trade show attendance. For angel groups, I have heard investor memberships across the country ranging from $1000 to $5000 annually. Any less, and there isn’t enough income to support a manager; any more, and the investor expects the manager to provide a lot more service: such as screening deals independently, conducting due diligence, and negotiating terms. Those activities, of course, are viewed by the SEC as streng verboten, so most groups keep the amounts in line with value delivered. The same is true for events: investors are willing to pay a few hundred to a few thousand dollars, depending on the lavishness of the venue, headline acts, and extra-curricular activities.

Sponsors can be either public or private, though service providers like law and accounting firms, investment banks, valuation companies and the like are the most common targets. They make the big bucks, so they must have a lot of money to spread around, right? Well… as anyone who produces events can tell you, there are two problems with this assumption: there isn’t as much sponsorship money as there used to be, and sponsors have an annoying habit of expecting value for their contributions. Over time, sponsors start filling more of the seats in the audience, appearing in signage on every visible surface, and showing up on the agenda for “brief” welcomes, thank-yous, and overviews.

Finally, we come to the touchiest constituency: the companies seeking financing. There is enough debate in this topic for a separate – and upcoming – post, but suffice it to say this revenue channel has challenges. Whether couched as application fees, presentation fees, coaching fees, boot camps, or any combination, most entrepreneurs view these costs skeptically – often for good reason. Still, these fees persist, and aren’t necessarily indicative of some deep-seated class warfare against struggling entrepreneurs.

So, for better or worse, the organized angel sector today depends on these three revenue sources. Take away any one, and it becomes a balancing act to keep a group going. And more than likely, at some point you’ll lean back and land on your ass, wondering what the heck happened.

Growing up in California, I spent a lot of time in the High Sierra at a family cabin. One of the popular games the parents organized was “hunting snipes”: taking the kids out after dark armed with paper bags and flashlights, stomping around in the woods shouting “Here snipe!” while shining the lights into the bags hoping to catch one of the elusive bird/mammal/reptiles when it ran toward the light. At some point in affair, the kids would notice the parents were all gone, as were the flashlights. Alone in the dark, lost in the woods. Panic and crying. Huge laughs from behind the trees!

Trying to connect the right investors to the right deals feels a lot like that. If you are an investor, you’d probably like to collaborate with other investors with complementary skills and interests, and it’s hard enough to find a few of those.  Then you have to find deals that fit your profile, and do it as efficiently as possible.  Somewhere out there, just beyond the light, is an entrepreneur with exactly the kind of deal you are looking for, if only they’d make themselves known. 

For some investors and entrepreneurs, this is no big deal. If you’re well-established in the community, visible and accessible, and have a track record on the appropriate side of the transaction, you’re going to get deals done.  You’ll have great access and say or hear “no” a lot. But for the new investor or first-time entrepreneur, it’s a tougher hunt.  Perhaps somewhat obviously, this is why organized angel activities survive and evolve: to minimize the friction in the opportunity discovery process. All the rest is really secondary and more sociological than functional.

The most fundamental human organizing principle is a group. Big and small, formal and informal, groups help us navigate life… even when we’re reluctant members.  Not surprisingly, organized groups persist as the most common way for angels to engage entrepreneurs. These might be informally managed by a few members, or a large organization formally run by paid professionals, but the principles are pretty much the same: find deals; vet and screen them; discuss, vote, dig deeper.  Having groups focused on specific market sectors allows them to be smaller; larger groups allow for more pooling of skills and broader industry reach.

Events are another popular means of getting the party started.  Whether monthly dinners, quarterly breakfasts, or annual blowouts, events get entrepreneurs in front of more investors (hopefully), but there typicallyisn’t a structured follow-up process, so the entrepreneur is often left working with a bunch of individuals, individually.

Investor directories and match-making sites are becoming more popular, and provide a great way for investors to search out deals that fit their profile without enduring a lot of social activities.

Finally, angel funds are a small but very interesting means of pooling investor resources and using the skills in the network.  There is a fair amount of management complexity to be discussed, but this may provide the best means of getting more potential investors into the mix. I’m going to consider incubators with a co-investment strategy a special case of funds.

With these options, it’s no surprise that investors and entrepreneurs have trouble figuring out where to invest their time.  But there’s another wrinkle: almost all of these activities costs money, and figuring out who pays for them is the source of a lot of angst.  Before I dig more into that, let’s look at the unnamed participant in the whole ecosystem: the regulatory environment.  Queue spooky music…

One wrinkle that has really impacted the angel investment sector is the VC trend toward later-stage investing.  This has been documented in many places, but the VC industry has effectively stopped investing in seed stage ($500K and less) and startup-stage ($2M and less) opportunities. [Note: Predictions abound that 2010 may see a return to smaller funds that participate in earlier stages, which will be good for everyone.]

Drawing on another slide from the 2007 ACEF presentation already referenced, there is a resulting condition that has developed — large rounds left unfilled by either individual angels or venture firms:

This gap has been increasingly filled by organized syndicates of angel investors, either through managed groups, angel funds, formal and informal networks.  When it works, this syndication has been credited with a number of positive outcomes:

• more professional deal screening and due diligence efforts;
• less reliance on institutional (venture) investors for businesses that aren’t attractive to VCs;
• better preparation of those businesses that do chose to pursue venture investment;
• faster closing of rounds, with more consistent and reasonable terms;
• better returns to angels (see the excellent study by Rob Wiltbank and Warren Boeker for the Kauffman Foundation, which I’ll be referencing later)

It’s this condition — inefficiency, desperation, and large amounts of money in flux — that has led to a lot of innovation in the angel investing sector, as well as a lot of questionable behaviour.  But as we’ll see in an upcoming installment, it’s a no-win situation.

Knowing the number of angel investors who are in the game, and believing that most of them have not been duped by someone, one has to wonder what are some of the reasons why they do it. There’s undoubtedly some psychometric research out there that outlines the personality traits and life experiences that make for an active angel investor, but just through observation over the years I have noticed the following:

• they are generally successful business people with an entrepreneurial streak;
• they may be retired or recently exited from another gig, so they have some time on their hands;
• they are still excited about the energy of the business (esp. startup) world;
• they are reasonably patient, but have human lifespans;
• they want to put some cash to work outside the public markets.

In terms of what they hope to get out of the experience, the rank looks something like:

1. Financial return
2. Opportunity to help grow a business (get their hands dirty; use their brains, skills and contacts)
3. Giving back to their community (call it for-profit philanthropy: a recognition that they were helped along the way and want to do the same for someone else)
4. Financial return

The last isn’t a typo — it’s just a reminder that in the end, if an angel loses money in a deal or it takes forever to pay off, s/he’ll probably be disappointed by the experience no matter how well the other bits went.

Angels tend to invest in things they understand as a by-product of their business and life experiences. While highly technical angels might be willing to invest in deeply technical startups, in my experience most look for opportunities they can understand at a “visceral” level: a better mousetrap, a tastier soft drink, a new service, a better way to deliver old services, etc.  Taking the “magic” out of the business proposal means they can focus on fundamentals like the team, market, channel, and so on.

Angels have also learned over the years to avoid capital-intensive markets, where their meagre investments will be stepped on repeatedly by much bigger feet just to get a product to market.  This is why only the most intrepid and knowledgeable angels (and a few hapless gamblers) participate in startups in the pharmaceuticals, biofuels, solar cell, semiconductor and other research-intensive or infrastructure-centric sectors. While the upside potential is impressive, the long durations and high expenditures are enough to keep most checkbooks unopened.

In most of these ways, angel investors differ from their VC counterparts.  As professional investors with funds whose horizons may extend ten years or more, VCs can play more of a bet-and-hold game, re-upping their bets as needed down the road.  Once VCs enter the deal, angels rarely have the staying power to remain “whole” for long.  VCs can also play more of an opportunity matrix strategy, scattering a few investments around several major sectors and riding the big waves.  For these reasons and others, angels and VCs aren’t inherently symbiotic: they may interact occasionally on certain deals, but the success of each is not dependent on the other.

With four million (more or less) potential angel investors in the US, but only ten thousand or so organized in any notable way, we can’t be talking about much money being invested, right? Yes… that was a rhetorical question. In fact, the same 2007 ACEF presentation mentioned previously includes a great slide comparing the relative investment volume by angels compared to venture capital firms:

In 2007, it’s estimated that angels invested $26B into 27,000 deals — for an average of $456K per deal.  During the same period, VCs invested $29.4B in 3,813 deals – averaging $7.7M per deal, and based on the VC industry trend toward later stage investing, one can assume the median investment is much higher.  So the overall scale of angel investment is very close to that of VCs, but the number of deals is vastly different. Not surprisingly, angels invest less per deal on average, and almost always less per investor. 

So what does this tell us?  Obviously, angel investment is a powerful component of the startup business funding ecosystem.  Does it tell us much about the interactions between angels and VCs?  Not really.  While conventional wisdom might say that a typical funding path for a high-tech start-up is: founders/family/friends, then angels, then VCs, in reality the investment profiles of the two groups keeps them separate much of the time.  I’ll explore the reasons why in a couple of posts: Profiles in Courage and Mind the Gap.

One origin of the dispute around how angel investors “ought” to behave stems from a lack of clarity around what exactly makes one an angel investor.  One definition of early stage sources of start-up funding calls out the four “Fs”: the Founders, their Friends, their Family, and other Fools.  Thus an angel is someone initially not associated with the business in which they are investing.  The “fool” attribute is perhaps not flattering, but as we’ll see it can be all too appropriate and has some historical context.  According to tradition, the term “angel” was originally applied to backers of early Broadway shows by their producers, and the sobriquet was more flattering than others considered (“sucker”, “mark”, “rube”, “chump”, etc.).  It’s a mistake even today to believe the term applies to any heavenly characteristics or conduct.

The Securities Act of 1933 attempted to corral a lot of bad fundraising behavior by requiring registration of many types of security offerings, with the exception of offerings limited to certain entities and individuals — including accredited investors, which loosely defined are “wealthy and presumably sophisticated suckers, marks, rubes, and so on.”  OK, it doesn’t really read that way in Regulation D, but I’m sure it was in an early draft.  Either way, this began the modern age of angel investing: if companies restricted their fundraising to certain types of individuals and organizations, they could significantly cut down on their paperwork.  Of course, the majority of that “paperwork” was mandated financial and other disclosures, so it essentially put the responsibility back on the investor to ask the right questions and hope for the right answers.

Note: The ’33 Act was followed up the next year with the Securities Exchange Act of 1934, which went on to establish governance over securities trading, corporate reporting, insider trading and one other significant development for we angels: the regulation of transaction agents.  More on that later.

In the most general terms, then, angel investors possess a minimum threshold of wealth; are expected to have the ability to sort out business details; are willing to take enormous chances on early-stage businesses; and are pretty much on their own.  Thus it’s no surprise that most invest infrequently (if ever repeatedly), and many look for ways to organize in order to minimize their risk.   It’s also clear that not every potential angel bothers to be one.  A 2007 report by the Angel Capital Education Foundation shows that of the 4.2M millionaires in the US (a good proxy for total accredited investors), only 225K are “active” angels, and 10K are active in formal groups.  There’s a lot of opportunity to get more investors involved, if the process can be improved.

Every blog has to have a first post, and this is it.  I suppose I should elaborate on why blog this exists at all: after being active in the so-called angel investment sector for five years, I think I’ve learned a few things worth sharing.  Some of it is good news, some not so good.  Lately there has been a lot of focus in the press on some of the not-so-good, so I’d like to start with a few posts on the wide-ranging nature of angel investment which should paint the landscape, and then we can tackle some of the more controversial and timely issues.

Note that I don’t want to recreate all the great material already available from groups like the Kauffman Foundation, Angel Capital Association, Angel Capital Education Foundation in the US, the Canadian National Angel Capital Organization and the European Business Angel Network.  In fact, I’ll be referencing it liberally, and for the most part focusing on US-centric issues as they are closer to home.

But to give everyone a little preview, I’m not rabidly for or against any existing models of angel organization and investing.  I do believe that the next few years are going to see some radical shakeup in the marketplace, though; but that’s because it is time for new thinking, not because of any inherent inequity in the current systems.  However, as the title of this blog suggests, there are early-stage investors who really are angels, and some who are real pinheads.  We’ll try to sort out the best and worst practices.

All that said, here’s a few fundamental tenets underlying what I’ll cover:

• Direct investment from private individuals (i.e., angels) is a necessary – and significant – component of the startup ecosystem
• Those individuals have many different goals and investment profiles, and there is no “one right way” for them to find and participate in deals
• The securities regulatory environment is a fundamental contributor to the problems we see in organized angel activity
• Caveat emptor
• TANSTAAFL

If you disagree with any of these, I don’t suppose the rest will be very enlightening.  Just the same, thanks for stopping by.