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- Angel Investors - The Definition
- What does an Angel Investor Expect?
- An Overview of the Venture Capital Industry
- Private Equity Investing
- What is a Venture Capitalist?
- Investment Focus
- Length of Investment
- Types of Firms
- Commitments and Fund Raising
- Illiquidity
- Other Types of Funds
- Disbursements
- Exits
- IPO
- Mergers and Acquisitions
- Valuations
- Management Fees
1) Angel Investors - The Definition Back to Top
Angel investors are individuals who invest in businesses looking for a higher return than they would see from more traditional investments. Many are successful entrepreneurs who want to help other entrepreneurs get their business off the ground. Usually they are the bridge from the self-funded stage of the business to the point that the business needs the level of funding that a venture capitalist would offer. Funding estimates vary, but usually range from $150,000 to $1.5 million.
The term "angel" comes from the practice in the early 1900's of wealthy businessmen investing in Broadway productions. Today "angels" typically offer expertise, experience and contacts in addition to money. Less is known about angel investing than venture capital because of the individuality and privacy of the investments, but the Small Business Administration estimates that there are at least 250,000 angels active in the United States, funding about 30,000 small companies a year. The total investment from angels has been estimated at anywhere from $20 billion to $50 billion as compared to the $3 to $5 billion per year that the formal venture capital community invests. In fact, the potential pool of angel investors is substantially larger. There are about two million people in the United States with the discretionary net worth to make angel investments.
The Center for Venture Research at the University of New Hampshire which does research on angel investments has developed the following profile of angel investors:
- The "average" private investor is 47 years old with an annual income of $90,000, a net worth of $750,000, is college educated, has been self employed and invests $37,000 per venture.
- Most angels invest close to home and rarely put in more than a few hundred thousand dollars.
- Informal investment appears to be the largest source of external equity capital for small businesses. Nine out of 10 investments are devoted to small, mostly start-up firms with fewer than 20 employees.
- Nine out of 10 investors provide personal loans or loan guarantees to the firms they invest in. On average, this increase the available capital by 57%.
- Informal investors are older, have higher incomes, and are better educated than the average citizen, yet they are not often millionaires. They are a diverse group, displaying a wide range of personal characteristics and investment behavior.
- Seven out of 10 investments are made within 50 miles of the investor's home or office.
- Investors expect an average 26% annual return at the time they invest, and they believe that about one-third of their investments are likely to result in a substantial capital loss.
- Investors accept an average of 3 deals for every 10 considered. The most common reasons given for rejecting a deal are insufficient growth potential, overpriced equity, lack of sufficient talent of the management, or lack of information about the entrepreneur or key personnel.
- There appears to be no shortage of informal capital funds. Investors included in the study would have invested almost 35% more than they did if acceptable opportunities had been available.
- For the business seeking funding, the right angel investor can be the perfect first step in formal funding. It usually takes less time to meet with an angel and to receive funds, due diligence is less involved and angels usually expect a lower rate of return than a venture capitalist. The downside is finding the right balance of expert help without the angel totally taking charge of the business. Structuring the relationship carefully is an important step in the process.
2) What does an Angel Investors Expect? Back to Top
There are almost as many answers to what angels expect as there are angels. Each has their own criteria because they are individuals. Almost all want a board position and possibly a consulting role. All want good communication although for some that means quarterly reports, while for others that means weekly updates. Return objectives range from a projected internal rate of return of 30% over five years to sales projections of $20 million in the first five years to the potential return of five times investment in the first five years. Most are looking for anything from a five to 25 percent stake in the business. Some want securities - either common stock or preferred stock with certain rights and liquidation preferences over common stock. Some even ask for convertible debt, or redeemable preferred stock, which provides a clearer exit strategy for the investor, but also places the company at the risk of repaying the investment plus interest. Additionally, the repayment may imperil future financing since those sources will not likely want to use their investment to bail out prior investors.
Some angels ask for the right of first refusal to participate in the next round of financing. While this sounds eminently reasonable, some venture capitalists will want their own players only or certain investment minimums so this strategy may limit who future participants might be.
Future representation of the board of directors also needs to be clarified. When a new round of financing occurs, do they lose their board right? Or should that could be based on a percentage ownership - when their ownership level drops below a certain level, they no longer have board representation.
In order to protect their investment, angels often ask the business to agree to not take certain actions without the angel investors approval. These include selling all or substantially all of the company's assets, issuing additional stock to existing management, selling stock below prices paid by the investors or creating classes of stock with liquidation preferences or other rights senior to the angel's class of security. Angels also ask for price protection, that is anti-dilution provisions that will result in their receiving more stock should the business issue stock at a lower price than that paid by the angels.
To prepare to solicit an angel, several critical factors will aid in making the approach successful. First, assemble an advisory board that includes a securities accountant and an attorney. Two important functions of the board are to recommend angels to contact and to work with the management team to develop a business plan to present to the angel. The business plan itself should define the reason for financing, how the capital will be spent and the timetable for going public or seeking venture capital funding. It should include: an executive summary (description of the business, opportunity and strategy, target market, projections and competitive advantages); the industry, the company and it's products and services (including entry and growth strategies); market research and analysis (customers, market size and trends, competition, estimated market share and sales); the economics of the business (including gross and operating margins and break-even analysis); marketing plan (overall strategy, pricing, advertising, promotion, and distribution); design and development plans (product/service improvement and new products/services); manufacturing and operations plans (geographic location, facilities and capacity improvements); management team (organization overview, biographies and compensation plans for key employees); financial plan (tax returns, profit and loss forecasts, pro forma cash flow analysis and balance sheets, 5-year projections); and proposed company offering (desired financing, securities offering, capitalization, timetable).
Most of all, take your time in forming a relationship with an angel. You are going to be spending a number of years together at a critical time in your business' life. Take the time to assure yourself that this is a person who you are comfortable with through both the ups and downs the future will bring.
3) An Overview of the Venture Capital Industry Back to Top
Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies.
Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves.
Venture capitalists generally:
- Finance new and rapidly growing companies
- Purchase equity securities
- Assist in the development of new products or services
- Add value to the company through active participation
- Take higher risks with the expectation of higher rewards
- Have a long-term orientation
When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. Going forward, they actively work with the company's management by contributing their experience and business savvy gained from helping other companies with similar growth challenges.
Venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Many times they will co-invest with other professional venture capital firms. In addition, many venture partnership will manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development.
4) Private Equity Investing Back to Top
Venture capital investing has grown from a small investment pool in the 1960s and early 1970s to a mainstream asset class that is a viable and significant part of the institutional and corporate investment portfolio. Recently, some investors have been referring to venture investing and buyout investing as "private equity investing." This term can be confusing because some in the investment industry use the term "private equity" to refer only to buyout fund investing. In any case, an institutional investor will allocate 2% to 3% of their institutional portfolio for investment in alternative assets such as private equity or venture capital as part of their overall asset allocation. Currently, over 50% of investments in venture capital/private equity comes from institutional public and private pension funds, with the balance coming from endowments, foundations, insurance companies, banks, individuals and other entities who seek to diversify their portfolio with this investment class.
5) What is a Venture Capitalist? Back to Top
The typical person-on-the-street depiction of a venture capitalist is that of a wealthy financier who wants to fund start-up companies. The perception is that a person who develops a brand new change-the-world invention needs capital; thus, if they can’t get capital from a bank or from their own pockets, they enlist the help of a venture capitalist.
In truth, venture capital and private equity firms are pools of capital, typically organized as a limited partnership, that invests in companies that represent the opportunity for a high rate of return within five to seven years. The venture capitalist may look at several hundred investment opportunities before investing in only a few selected companies with favorable investment opportunities. Far from being simply passive financiers, venture capitalists foster growth in companies through their involvement in the management, strategic marketing and planning of their investee companies. They are entrepreneurs first and financiers second.
Even individuals may be venture capitalists. In the early days of venture capital investment, in the 1950s and 1960s, individual investors were the archetypal venture investor. While this type of individual investment did not totally disappear, the modern venture firm emerged as the dominant venture investment vehicle. However, in the last few years, individuals have again become a potent and increasingly larger part of the early stage start-up venture life cycle. These "angel investors" will mentor a company and provide needed capital and expertise to help develop companies. Angel investors may either be wealthy people with management expertise or retired business men and women who seek the opportunity for first-hand business development.
6) Investment Focus Back to Top
Venture capitalists may be generalist or specialist investors depending on their investment strategy. Venture capitalists can be generalists, investing in various industry sectors, or various geographic locations, or various stages of a company’s life. Alternatively, they may be specialists in one or two industry sectors, or may seek to invest in only a localized geographic area.
Not all venture capitalists invest in "start-ups." While venture firms will invest in companies that are in their initial start-up modes, venture capitalists will also invest in companies at various stages of the business life cycle. A venture capitalist may invest before there is a real product or company organized (so called "seed investing"), or may provide capital to start up a company in its first or second stages of development known as "early stage investing." Also, the venture capitalist may provide needed financing to help a company grow beyond a critical mass to become more successful ("expansion stage financing").
The venture capitalist may invest in a company throughout the company’s life cycle and therefore some funds focus on later stage investing by providing financing to help the company grow to a critical mass to attract public financing through a stock offering. Alternatively, the venture capitalist may help the company attract a merger or acquisition with another company by providing liquidity and exit for the company’s founders.
At the other end of the spectrum, some venture funds specialize in the acquisition, turnaround or recapitalization of public and private companies that represent favorable investment opportunities.
There are venture funds that will be broadly diversified and will invest in companies in various industry sectors as diverse as semiconductors, software, retailing and restaurants and others that may be specialists in only one technology.
While high technology investment makes up most of the venture investing in the U.S., and the venture industry gets a lot of attention for its high technology investments, venture capitalists also invest in companies such as construction, industrial products, business services, etc. There are several firms that have specialized in retail company investment and others that have a focus in investing only in "socially responsible" start-up endeavors.
Venture firms come in various sizes from small seed specialist firms of only a few million dollars under management to firms with over a billion dollars in invested capital around the world. The common denominator in all of these types of venture investing is that the venture capitalist is not a passive investor, but has an active and vested interest in guiding, leading and growing the companies they have invested in. They seek to add value through their experience in investing in tens and hundreds of companies.
Some venture firms are successful by creating synergies between the various companies they have invested in; for example one company that has a great software product, but does not have adequate distribution technology may be paired with another company or its management in the venture portfolio that has better distribution technology.
7) Length of Investment Back to Top
Venture capitalists will help companies grow, but they eventually seek to exit the investment in three to seven years. An early stage investment make take seven to ten years to mature, while a later stage investment many only take a few years, so the appetite for the investment life cycle must be congruent with the limited partnerships’ appetite for liquidity. The venture investment is neither a short term nor a liquid investment, but an investment that must be made with careful diligence and expertise.
8) Types of Firms Back to Top
There are several types of venture capital firms, but most mainstream firms invest their capital through funds organized as limited partnerships in which the venture capital firm serves as the general partner. The most common type of venture firm is an independent venture firm that has no affiliations with any other financial institution. These are called "private independent firms". Venture firms may also be affiliates or subsidiaries of a commercial bank, investment bank or insurance company and make investments on behalf of outside investors or the parent firm’s clients. Still other firms may be subsidiaries of non-financial, industrial corporations making investments on behalf of the parent itself. These latter firms are typically called "direct investors" or "corporate venture investors."
Other organizations may include government affiliated investment programs that help start up companies either through state, local or federal programs. One common vehicle is the Small Business Investment Company or SBIC program administered by the Small Business Administration, in which a venture capital firm may augment its own funds with federal funds and leverage its investment in qualified investee companies.
While the predominant form of organization is the limited partnership, in recent years the tax code has allowed the formation of either Limited Liability Partnerships, ("LLPs"), or Limited Liability Companies ("LLCs"), as alternative forms of organization. However, the limited partnership is still the predominant organizational form. The advantages and disadvantages of each has to do with liability, taxation issues and management responsibility.
The venture capital firm will organize its partnership as a pooled fund; that is, a fund made up of the general partner and the investors or limited partners. These funds are typically organized as fixed life partnerships, usually having a life of ten years. Each fund is capitalized by commitments of capital from the limited partners. Once the partnership has reached its target size, the partnership is closed to further investment from new investors or even existing investors so the fund has a fixed capital pool from which to make its investments.
Like a mutual fund company, a venture capital firm may have more than one fund in existence. A venture firm may raise another fund a few years after closing the first fund in order to continue to invest in companies and to provide more opportunities for existing and new investors. It is not uncommon to see a successful firm raise six or seven funds consecutively over the span of ten to fifteen years. Each fund is managed separately and has its own investors or limited partners and its own general partner. These funds’ investment strategy may be similar to other funds in the firm. However, the firm may have one fund with a specific focus and another with a different focus and yet another with a broadly diversified portfolio. This depends on the strategy and focus of the venture firm itself.
9) Commitments and Fund Raising Back to Top
The process that venture firms go through in seeking investment commitments from investors is typically called "fund raising." This should not be confused with the actual investment in investee or "portfolio" companies by the venture capital firms, which is also sometimes called "fund raising" in some circles. The commitments of capital are raised from the investors during the formation of the fund. A venture firm will set out prospecting for investors with a target fund size. It will distribute a prospectus to potential investors and may take from several weeks to several months to raise the requisite capital. The fund will seek commitments of capital from institutional investors, endowments, foundations and individuals who seek to invest part of their portfolio in opportunities with a higher risk factor and commensurate opportunity for higher returns.
Because of the risk, length of investment and illiquidity involved in venture investing, and because the minimum commitment requirements are so high, venture capital fund investing is generally out of reach for the average individual. The venture fund will have from a few to almost 100 limited partners depending on the target size of the fund. Once the firm has raised enough commitments, it will start making investments in portfolio companies.
10) Illiquidity Back to Top
Limited partners make these investments in venture funds knowing that the investment will be long-term. It may take several years before the first investments starts to return proceeds; in many cases the invested capital may be tied up in an investment for seven to ten years. Limited partners understand that this illiquidity must be factored into their investment decision.
11) Other Types of Funds Back to Top
Since venture firms are private firms, there is typically no way to exit before the partnership totally matures or expires. In recent years, a new form of venture firm has evolved: so-called "secondary" partnerships that specialize in purchasing the portfolios of investee company investments of an existing venture firm. This type of partnership provides some liquidity for the original investors. These secondary partnerships, expecting a large return, invest in what they consider to be undervalued companies.
12) Disbursements Back to Top
The investment by venture funds into investee portfolio companies is called "disbursements". A company will receive capital in one or more rounds of financing. A venture firm may make these disbursements by itself or in many cases will co-invest in a company with other venture firms ("co-investment" or "syndication"). This syndication provides more capital resources for the investee company. Firms co-invest because the company investment is congruent with the investment strategies of various venture firms and each firm will bring some competitive advantage to the investment.
The venture firm will provide capital and management expertise and will usually also take a seat on the board of the company to ensure that the investment has the best chance of being successful. A portfolio company may receive one round, or in many cases, several rounds of venture financing in its life as needed. A venture firm may not invest all of its committed capital, but will reserve some capital for later investment in some of its successful companies with additional capital needs.
13) Exits Back to Top
Depending on the investment focus and strategy of the venture firm, it will seek to exit the investment in the portfolio company within three to five years of the initial investment. While the initial public offering may be the most glamourous and heralded type of exit for the venture capitalist and owners of the company, most successful exits of venture investments occur through a merger or acquisition of the company by either the original founders or another company. Again, the expertise of the venture firm in successfully exiting its investment will dictate the success of the exit for themselves and the owner of the company.
14) IPO Back to Top
The initial public offering is the most glamourous and visible type of exit for a venture investment. In recent years technology IPOs have been in the limelight during the IPO boom of the last six years. At public offering, the venture firm is considered an insider and will receive stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years. Once this stock is freely tradable, usually after about two years, the venture fund will distribute this stock or cash to its limited partner investor who may then manage the public stock as a regular stock holding or may liquidate it upon receipt. Over the last twenty-five years, almost 3000 companies financed by venture funds have gone public.
15) Mergers and Acquisitions Back to Top
Mergers and acquisitions represent the most common type of successful exit for venture investments. In the case of a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the venture investor will distribute the proceeds from the sale to its limited partners.
16) Valuations Back to Top
Like a mutual fund, each venture fund has a net asset value, or the value of an investor’s holdings in that fund at any given time. However, unlike a mutual fund, this value is not determined through a public market transaction, but through a valuation of the underlying portfolio. Remember, the investment is illiquid and at any point, the partnership may have both private companies and the stock of public companies in its portfolio. These public stocks are usually subject to restrictions for a holding period and are thus subject to a liquidity discount in the portfolio valuation.
Each company is valued at an agreed-upon value between the venture firms when invested in by the venture fund or funds. In subsequent quarters, the venture investor will usually keep this valuation intact until a material event occurs to change the value. Venture investors try to conservatively value their investments using guidelines or standard industry practices and by terms outlined in the prospectus of the fund. The venture investor is usually conservative in the valuation of companies, but it is common to find that early stage funds may have an even more conservative valuation of their companies due to the long lives of their investments when compared to other funds with shorter investment cycles.
17) Management Fees Back to Top
As an investment manager, the general partner will typically charge a management fee to cover the costs of managing the committed capital. The management fee will usually be paid quarterly for the life of the fund or it may be tapered or curtailed in the later stages of a fund’s life. This is most often negotiated with investors upon formation of the fund in the terms and conditions of the investment.
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