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Riding on Angels' Wings
By Fred Wainwright
Financial Times
Copyright (c) 2003 The Financial Times. All Rights Reserved.

For any economy to thrive requires a healthy entrepreneurial culture in which innovation and capital are roughly matched. Venture capital is one way to match the two but it is shrouded in mystery: since venture capitalists invest in new ideas, they cloak their dealings in secrecy.

Another group is even more secretive, and has greater impact: informal venture capitalists, known as business angels, use their own cash to invest in early-stage companies. For entrepreneurs seeking capital and individuals considering becoming angel investors, it is important to understand the conventions of angel investing.

Business angels are investors in great ideas. They fill a capital gap between "friends and family" and VCs. Estimates of the number of angel investors in the US and Europe vary because there are no registration requirements. But the power of angels lies in the sheer number of companies they fund; some studies suggest angels invest in 10 to 20 times more companies than VCs.

Entrepreneurs usually raise money in discrete phases or "rounds" as a company grows. Angels individually invest between $25,000 ( 15,000) and $1.5m in a company; early-stage angel rounds with several investors typically start at $250,000—well below the radar screen of most VCs, who prefer rounds of $2m and above.

So what is the appeal for the investor? First, angels can diversify their investments away from publicly quoted stocks and bonds. If a start-up succeeds, within four to six years it is likely to receive an offer to be purchased or float its shares on the stock market. Through such "exits" investors reap their profit.

Angels usually invest using preferred stock, which offers the owner more rights than common stock. They typically acquire 20 to 30 per cent of a company in the first round of financing. The aim is to make a return of 5-10 times their initial investment to achieve a return on their whole portfolio of between three and five times their investment. The portfolio approach is central: estimates suggest angel investors lose their investment in a third or more of the companies they fund.

Why do angels not simply invest in VC funds? According to the European Private Equity and Venture Capital Association, in the past 10 years European VCs have produced a 14 per cent return to investors. In the same period, according to the National Venture Capital Association, VCs in the US have produced a return of 26 per cent. But angels are not just driven by returns. Many have a strong emotional stake in investing: they enjoy coaching others and the rush of fast-paced company growth.

Those who invest part-time must be efficient about evaluating and negotiating deals. Angels often join business angel networks to lessen the burden.

Working through networks can filter out the weaker business plans; there are opportunities for new partnerships and for exploiting intellectual capital; and the group offers due diligence during deals.

Entrepreneurs present their plans to angel groups.

After the presentation, angels discuss the opportunity among themselves; if there is interest, a "champion" takes the lead in due diligence and negotiations.

Too many entrepreneurs limit their opportunities by writing weak business plans. Great ideas are common; much rarer are businesses with the people and products to enter a market and take share or dominate. Only 1 to 2 per cent of all business plans presented to angels or VCs receive funding.

An angel investor in effect selects a management team. A great team may make even a mediocre company achieve reasonable success; a company with the best technology may never succeed with a weak team.

Managers should have relevant industry experience and be used to working with a similar business model. And they must be willing to be coached.

One thing is certain about any business plan: it will be wrong. Projections and teams will change. Competitors will surge forward or fade. Most successful companies make radical changes to their business plans in time.

The target market should be quantifiable and preferably fragmented and growing. Patents or licensing agreements are important, as the company must be able to create a strategically defensible position.

A famously unsuccessful entrepreneur once said: "There is no competition." In fact, the business plan should summarise direct and ancillary competitors as well as threats. Since investors think in terms of recognisable patterns, the business model should be similar to models used by well-known, successful companies.

For example, an innovative biotechnology software program might be positioned as "the Microsoft operating system for DNA analysis equipment". The plan should also demonstrate that customers have a real problem that the product or service solves; that the product is a "must-have", not a "nice-to-have". This should be backed up by research.

Financial projections should show conservative, expected and optimistic figures (with assumptions) and a focus on cash flow and profitability targets. A company can sometimes survive operational mistakes but running out of cash is fatal.

The capital structure of the company must be fully disclosed, showing ownership by founders and any investors. The plan must specify the uses for the desired funds and details of expected future rounds.

At the presentation stage the entrepreneur should indicate the expected valuation before the angels' investment. This is often hard, since valuation is more art than science, especially for companies with no revenues or profits. In theory, company value is based on ability to generate cash in the future. These future cash flows can be discounted to a present value.

For companies without positive cash flow but with revenues or net profit, comparisons can be made with publicly traded companies. An illiquidity discount of 10-40 per cent applies to private companies.

If a start-up has no revenues yet, valuation relies more on common practices. US angels typically value seed-stage companies at about $2m-$5m while VCs prefer companies valued at more than $10m.

Angel investors have had a hard time since the 2000 stock market debacle. Of the start-ups that survived, many had to reach out to VCs who reduced the ownership of previous investors, including founders and angels.

The VCs' underlying 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 known as "pay to play".

Some of the larger angel groups have since formed their own funds or joined with VCs to ensure funding for young companies in subsequent rounds. Many angel investors believe that private investing during economic downturns increases the probability of success once the economy improves.

Angels must monitor their investments carefully and help managers identify opportunities, avoid pitfalls and build value in the company. Ultimately, attack is the best form of defence.


  • Personal chemistry between angels and the management team is critical, as they are embarking on a long-term relationship.
  • If several investors are interested, it is better to invest as a limited liability company.
  • Get in at the right price. If the entrepreneur will not agree about the start-up's valuation relative to your assessment of comparable companies and of the entrepreneur's capabilities to grow the business, move on.
  • Angels who lead the due diligence process and sit on a board on behalf of other angels should be compensated with a small percentage of equity.
  • The best angel board members have relevant experience, not the deepest pockets.
  • Monthly or quarterly reports are essential and problems should be disclosed early.
  • Milestone financing is becoming more common. Investors set targets for the start-up that need to be met before another tranche of funding.
  • Diversify your risks by investing smaller amounts in more start-ups. Angel investments should be less than 10 per cent of your portfolio.

Fred Wainwright is the Executive Director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business, and an adjunct Assistant Professor of Business Administration. He is also an investor and board member in early-stage companies and an executive director of two angel investor groups. He can be reached at pecenter@dartmouth.edu.

This article originally appeared in the August 15, 2003 issue of the The Financial Times.

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    Copyright 2002 The Trustees of Dartmouth College. All rights reserved.