Private Equity/Business Angel Investing

Summary remarks from Bruce Sommer

 

Investing in private companies, whether through equity or debt, takes many forms. Similarly, there exist a multitude of approaches to “angel investing”.  From a more outside or legal standpoint, a “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 a non-public organization, typically at the seed or early stages.  

 

However, angel investors seem to provide much more than financial capital; they bring intellectual capital, business acumen, past experience starting and growing businesses, management experience, a network of competent service providers and local contacts, leadership, direction, mentoring, board representation, and much more.  All of these attributes are both essential to and often missing in new start-up organizations.  Combining these invaluable resources with promising entrepreneurs and exciting business ideas increases both the probability and rate of success.  This is much of what angel investing is about. 

 

As a consequence of this relationship between the investors and the entrepreneurs, successful high-growth businesses are able to launch and grow fast enough to provide many returns:

·         extrinsic financial return to the investors through investment harvest events (e.g., dividends, mergers, buyouts, IPO);

·         intrinsic returns of giving back and being part of exciting new endeavors; and

·         positive economic returns to the local community through wealth creation, job creation, and possible social impact missions

 

In addition to providing capital beyond financial capital, business angels distinguish themselves from traditional “venture capital” (VC) investors primarily by making the actual investment decision and investing their own money directly in the private start-up.  In other words, business angels determine how much and in which companies they will personally, or as a group, invest.  Mangers of VC firms make these decisions for their investors.  Furthermore, business angels tend to make smaller investments—roughly between $20,000 and $2M (2004 average ~$250,000 per A round)—and during earlier development stages than VCs. 

 

It has been estimated that business angels invest in 35,000 to 50,000 companies per year, which is seven to ten percent of all the companies that are started in the US annually (ACA, 2004).  This compares to the 2,500 to 3,000 companies in which VCs invest annually (MoneyTree, 2004). 

 

Similarly, more than four percent of people in the US have made some sort of “informal” investment in a privately-held company (Bygraves, 2004).  However, the overwhelming majority of this group has held some relationship (i.e., friend, family member, colleague, etc.) to the entrepreneur with which they invested.  Angel investing tends to be conducted with a more professional approach where the investor-entrepreneurs relationship is maintained in a more “arms length” fashion.

 

Our research has estimated the number of business angel investors, as described above, to be less than four million and likely closer to two million.  While we have identified about 17,000 investor-members of angel organizations in the US, we are confident that there are many more investors participating in “angel” deals. 

Angel investing groups/organizations

 

Private equity Investors can achieve investing objectives on their own or as part of investing groups/organizations.  There are more than 200 known business angel organizations in the US today.  The number of angel organizations has ether significantly grown over the past five years (at a rate of ~60%) or these angel groups are becoming more conspicuous.  Traditionally, angel investors have operated beneath public radar.  Today, however, they are gaining more attention as media and public organizations recognize the positive economic and social impact business angels make on local communities and national economies.  Many feel that access to early-stage capital provided by angels may be a leading catalyst behind our entrepreneurial economy.  Recent success stories such as Microsoft, Amazon, eBay and Google have helped create much excitement in the private equity market.  However, angel financing stretches back to at least 1874 when banks wouldn’t fund Alexander Graham Bell because they didn’t think it would be of “any practical value to transmit voice over phone wires.”  Luckily, two angel investors—Hubbard and Sanders—found some value in it. 

 

There are many reasons to become a business angel investor:

1.       Portfolio diversification (private equity as an “alternative asset class”)

2.       Increase potential investment returns (while no good data exist here, angel investments historic returns have seemed to average between 20% and 35%)

3.       Active, rather than passive, form of investing

4.       Intrinsic rewards of watching investment/business grow

5.       Staying engaged with business community

6.       Giving back to community

 

We feel that being part of an angel group is often a good approach to private equity investing, especially for investors who have not previously participated in this market.  The following list supports our position and outlines the advantages of joining an angel group:

1. Increased and more efficient deal flow

a.       access to a greater number of entrepreneurial investment activities

b.       groups seem to provide more efficient deal screens

2. Exposure to deal flow without giving up privacy/anonymity
3. Access to more capital (both financial and intellectual capital of other investors)
4. Increased access to downstream funding and working with venture capital
5. Reduced risk

a.       spread systematic risk across pool of investors

b.       greater pool of capital allows reduction of diversification risk

-    (ability to invest in more, and more diverse, group of portfolio companies)

c.       adverse selection risk reduced by diverse/specialized background of investors

d.       agency risk reduced due to greater ability to monitor company/entrepreneur

e.       information asymmetry reduced due to better resources to perform due diligence

6. Access to more and sophisticated due diligence

a.       investors’ specialty/expertise (e.g., technology, legal advice, accounting, etc.)

b.       access to negotiation resources (e.g., term sheets, legal document, etc.)

7. Increased intellectual capital to direct business
8. Expanded network opportunities
9. Higher intrinsic returns for investors working with group rather than on their own

- socialize with other members

10. Greater overall impact on local community

 

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