Be an Angel

Do we know what a Business Angel is anymore?

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The conventional definition of a Business Angel has been:

“an individual investing their own capital in an unquoted business with which they have no prior (especially family) connection and to which they make a value-added contribution through active involvement in the business”.

The Global Entrepreneurship Monitor (GEM) survey has blurred the distinction between the ‘classic’ disinterested business Angel investment and kinship and affinity-based ‘family and friends’ money to the extent that no more than 10% of informal investment reported in GEM may meet the definition of classic Business Angel investment.

Local culture also plays a part, with Angels in some countries much more likely to form syndicates with family members, and to invest in business they have a family connection to.

The growth of Angel syndicates and equity crowdfunding has also thrown doubt on the continuing relevance of this definition.  Within European Angel networks, groups and syndicates (and those of other countries outwith the USA) a large proportion of members seem in practice to be relatively passive in terms of both the investment process and post investment support of investee companies. Most of the “work” is done by a small number of “Lead Angel” investors. This, at least in part, reflects the nature of many of the European Angels, who are often still in some form of full time employment and do not have the time to take on the lead investor role. It also reflects the growing number of individual Angels that are now likely to syndicate in any one deal. Too many for all of them to be particularly active in the process[1].

Angel investing is very much a personal activity. An individual voluntarily choses to invest their own money in companies they select.  It is extremely rare to find an individual who is a full time Angel investor (some individuals are full time Angel group / network managers), so the activity is typical practiced on a (very) part time basis, and could be likened to a “hobby”. Angel investing is often also referred to as “informal” investing, and this combination of self-motivation and determination within an informal framework is often a key attraction to individuals to become involved.

Angel investors also have varying motivations. Many Angels do not have profit maximisation as their principal motivation. They may simply like being involved in the process, or being part of the Angel club. As a result, it would be inappropriate to suggest that there is one “correct way” to be an Angel investor, and attempt to enforce a rigid training structure on all. Just because an investor does not adopt a particular technique or strategy does not mean that they are a “bad investor”.  For example, while many would recommend Angel investors mitigate their high risk by having a large portfolio of investments (and this advice is likely to form part of an Angel training program), if the investor is investing for largely non-pecuniary reasons they likely, and to them rationally, don’t care about optimal portfolio sizing. If investors are not trying to maximize their financial returns, then there is no reason for them to have large portfolios. Some may specifically want smaller, concentrated portfolios because they enjoy working closely with the entrepreneurs or just want to invest locally so that they can give back to their community.

The traditional, “western” definition of an Angel is increasingly being diluted – and this is a good thing. It allows more individuals to be comfortable bringing increased amounts of capital to fund new and expanding ventures.

[1] Bridget Unsworth who manages the New Zealand Angel Co-investment Fund estimates that as few as 5-7% of Angels in groups are truly active Angels.

How Do Angels Deal with High Risk Investing?

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Angel investors make decisions to invest under conditions of extreme uncertainty. Angel investors face cases in which uncertainty is so extreme that it qualifies as unknowable: they decide on investments in ideas for markets that often do not yet exist, and they propose new products and services without knowing whether they will work. For experienced Angel investors rather than being undesirable, unknowable risks are deliberately sought, on the basis that it is by investing in companies with unknowable risks that they can find the most attractive, most profitable investments.

Experienced Angels do not seek to maximize each decision but instead seek potentially extraordinarily profitable opportunities and accept a high failure rate. They rely on building a large portfolio to spread risk and accept that the overall failure rate, by number of investments, may be as high as 70%, even in the most developed capital markets[1], with 85% of all returns coming from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

A key role for “training” therefore needs to be providing nascent Angels with an understanding of the characteristics of the Angel market, tactics to deal with the high risk, and thus confidence to join with others in making their first investments.

Experienced Angel educators suggest that individuals new to Angel investing tend to seek out training on subjects such as valuation, looking for the “correct” valuation method or formula, reflecting a desire to reduce uncertainty (and perceived risk). In practical terms valuation training will likely highlight that there is no “right” answer, instead presenting a number of different methodologies, and suggesting that several should be used in each case and the results compared, but that local comparatives are likely to be the most significant influencer. Many of those new to investment struggle with this lack of a definitive answer but gain confidence when they see that all Angels face the same issues.

[1] 2016 Angel Returns Study, Angel Resource Institute, 2016.

Angel Decision Making – How do they get to Yes?

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Reading the available  academic research and discussions with experienced Angel investors suggest that “technical” subjects (valuation, financial modelling, technical due diligence) play a relatively limited role in the overall decision-making process, significantly due to the lack of “hard facts” in so many aspects of an Angel type investment. It is not a formalistic driven process. There is no proven formula for success, and no hard data to put into a formula should one exist.

Rather, decision making is based on a mix of technical analysis and intuitive assessment (what Angels frequently refer to as their “gut feeling”), with recent research suggesting that intuitive assessment is favoured over technical analysis[1].

The typical Angel decision making process begins with a subjective assessment as to whether the investment is likely to ‘fit’ with their personal investment criteria rather than a technical analysis. This may include location, amount sought, knowledge of and interest in the sector, and their own ability to add value.

Experienced investors rely heavily on their prior experience and previous investments to inform their present decision making and typically prioritize their intuitions about the entrepreneur over process and “hard fact” (e.g. business viability data).  Finance, in terms of the financial structure of and projections for the venture, is the most important criterion for both nascent and novice Angels but ranks only fourth for experienced investors[2].

The Learning Process

Investors who may now be classified as experienced consistently said that initially investing with other, and then more experienced, Angels had been their most valuable source of learning.  A number added that they had learnt more from failed investments than successful ones!

This suggests that the most effective way to improve the skills of new Angels is through engaging with experienced Angels in actual real investments. How do they get that engagement? Join an existing, active local Angel group, attend their meetings, help with the due diligence and join in a few syndicated deals.

 

[1] Managing the Unknowable: The Effectiveness of Early- stage Investor Gut Feel in Entrepreneurial Investment Decisions, Laura Huang and Jone L. Pearce, Johnson Cornell University, 2017.

[2] Heuristics, learning and the business Angel investment  decision-making process, Richard T. Harrison, Colin Mason & Donald Smith, 2015.

The Myth of the VC Series A for Angel Funded Companies (or any others)

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Very few Angel investments receive follow on funding from venture capital firms.

According to the University of New Hampshire, Centre for Venture Research there were around 75,000 Angel investments in the USA last year. Yet the PWC Moneytree report recorded just 5,004 VC deals (of which 33% were in the San Francisco area). So even if every VC deal had previously had Angel funding, that would still be a tiny fraction of Angel backed companies going on to secure any form of VC funding.

CB insights reported that 68% of USA and European successful technology company exits had received no VC funding before the exit.

These numbers are supported by the research in Scott A. Shane book “Fools Gold? The Truth Behind Angel Investing In America”, (Oxford University Press, 2009). “Fools Gold? is possibly the first book to bring together hard data on angel investing within the USA from multiple governmental and academic sources, including the Internal Revenue Service, the US Census Bureau, the Federal Reserve, the Kauffman foundation and many others. The book so encourages Angels to invest as part of an Angel group, and encourages policy makers to invest in supporting the creating of angel groups. This to facilitate a portfolio style of investing and the pooling of investment funds to provide larger amounts of funding over a longer period than would be possible as a solo investor.

Fundamentally Angel investors need to plan for the Whole Life funding of their companies. They cannot just assume that future funding will be provided by some as yet unidentified VC. They must therefore crowd in as many investors as they can into the first and other early rounds, even where this means each individual investor investing less into each deal than they could, or would like to. Only in that way will there be sufficient future reserves of capital to fund the likely 4 or 5 rounds typically necessary to get to a successful exit.

Angel Investing – Not Just for the Supper Wealthy (who are usually not very good at it anyway).

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The Best way to be an Angel Investor? Become a member of an established Angel Group of Network and join in lots of deals with other members, investing just a little initially in each one. Let’s say a company was looking to secure £250,000. That should be provided not by one of two really rich individuals, but by 10 or more individuals each investing between £10,000 and £40,000. Why? Because Angel investing is very risky – as many as 70% of the Angel backed companies in the USA fail to provide a return to the investor – so the reality is, however good that pitch looked, no one, however experienced they are, can pick the winners.

Angel investing can be highly profitable, with organised angels with a portfolio investing strategy achieving IRR returns of 25% (and one Angel friend showing a 101% IRR!). But you must do a lot of deals. Less than 6, and the probability is you will not get any return. You need to be planning to do 15 to 20 new investments over say a 5 year period, recognising that many will not manage to develop as planned. Then be prepared to provide follow on funding only to those that do show real development and in particular customer traction. Don’t keep funding the ones that don’t perform (and they will likely be the majority!). It’s only after the company has been actually operating for a few years that you will have any chance of starting to see which ones are likely to be the real winners.

And the only practical way to be able to invest the necessary cash, and time, across such a large number of investments is to do it as a “team sport”, investing with as many other Angels as you can, providing small amounts of initial funding each, and then building on the successes with more capital. A good rule of thumb is that for every £1 you provide as an initial investment, you need to plan on providing another £3 for follow on into the “good” ones.

Being part of a group has many other advantages.  Usually better access to deal flow as the Group will be better known than individuals, certainly more people and brain power to do screening and due diligence and access to much more post investment support.

And why are the Supper Wealthy usually not very good at it? They don’t share the deals, and put too much money into too few companies, and don’t have the time to provide adequate post investment support into a properly sized portfolio. Better to be a team player.