Answers to Common Business Angel Investor Questions

Assembled here are often-asked questions related to direct investment into early stage, private transactions.

1. What is angel investing?
2. What is a good working definition of venture capital?
3. Don't venture capital firms fund start-ups?
4. How much do entrepreneurs usually seek from angels?
5. Who is the typical angel and how would you characterize him or her?
6. Where is the line drawn between the function of a venture capitalist and that of a banker?
7. Is there anyone else other than the SBA, the banks, and the venture capitalists to fund ventures?
8. What do private investors find attractive in a company?
9. What are the three things an entrepreneur should ask before he or she seeks angel investment?
10. What is considered "significant participation" on the part of the investor?
11. What are some of the primary industries of interest to your ICR pool of private investors?
12. Why are these industries of interest to angels?
13. What do investors believe to be the best financing method or structure?
14. An investment suitable to entrepreneurs sometimes involves commingling of funds.
15. How is commingling organized by the entrepreneur?
16. Do guidelines exist on how to assess risk, or the risk-reward ratio?
17. What is a typical return on investment?
18. What is a typical time frame for return on investment?
19. It seems as if the average investor can do pretty well by investing money passively in highly liquid markets and have almost as good of a shot, maybe better, at a return without the degree of risk. So why not just avoid the risk?
20. What hedging strategies do these investors use to limit their downside risk?
21. Do private investors spend more time evaluating a deal before investing, or in adding value after the investment has been made?

Answers to Common Business angel Investor Questions

1. Q: What is angel investing?
   
   A: The angel investor market is very large, around $40 billion a year. Many individuals in start-ups have used up their own money, spent money from family and friends, and cannot qualify for bank loans or funds from venture capital. They need funding from private individuals—angels—to keep going.
   
   
2. Q: What is a good working definition of venture capital?
   
   A: A wide range of alternative asset investments is available to investors. One of those alternative asset classes is the private equity investment, or venture capital. Within the venture asset classes, a number of different types of investment opportunities open up to the investor, ranging from seed, R&D, and start-ups at the riskier end, through to bridge, acquisition/merger, and turnaround investments at the less risky end. Those at the less-risky end provide less return on investment since they involve more established companies.

   Definitions of these stages help: "Seed" means that a company is in the idea stage when the process is being organized; "R&D" is typical of the financing of product development for early stage or more developed companies; "start-up" designates a venture completing its product development and initial marketing. At the safer end, "bridge" designates a venture requiring short-term capital to reach stability; "acquisition/merger" refers to a company in need of capital to finance an acquisition or merger; "turnaround" denotes a venture in need of capital to change from unprofitability to profitability. Private investors invest approximately $40 billion into 700,000 companies and approximately $3 billion to $4 billion into early stage transactions, that is, seed, R&D, and start-up, each year
   
   So entrepreneurs have a substantially higher probability of being funded by private investors, particularly if their company is not one of the"darling" industries. These private investors are high-net-worth investors, typically possessing a net worth between $1 and $10 million; 90 percent are self-made, and own their own businesses. They represent a pool, together with the richest families in the United States, of about $8.2 trillion in net worth derived from approximately 3.4 million households. However, when we correct for only those who make these aggressive investments, the numbers drop significantly. Still, this is a major pool of capital, growing at a rate of about 14 percent to 20 percent per year. And when compared to pension fund growth, currently at about 8 percent per year, we see an immense source of capital.

3. Q: Don't venture capital firms fund start-ups?

   A: Venture capital firms have become more like money management firms. Fewer of them exist, and they tend to gather larger and larger pools of money. As a result, the size of their investments has increased, often into the double-digit range of millions of dollars. This tendency leaves seed-stage companies behind.

4. Q: How much do entrepreneurs usually seek from angels?

   A: Anywhere from $150,000 to $3 million, which is all they need when they start up. If an entrepreneur seeks early stage venture capital, he or she is going to raise more money than needed and will give up a bigger stake at a lower valuation. That's the attraction of dealing with angels: An entrepreneur raises less money but keeps more equity.
   
   A lot of entrepreneurs do not like to raise money. They like to write software code or work on a product but view raising money, selling themselves, as an undesirable activity. But the most significant difference between a successful start-up and a failure is that the successful company learned how to raise money.

5. Q: Who is the typical angel, and how would you characterize him or her?

   A: There is no typical angel. Right now there are about 300,000 active angel investors, but the potential pool is much larger. About 2 million individuals possess the discretionary net worth to make angel investments.

   The age of private investors is typically between 48 and 59 years. They have postgraduate education and extensive previous management experience. They probably owned their own companies. They are very interested in earlier-stage deals because they can aggressively negotiate strong discounts, and they find the potential for high returns through capital appreciation is best realized through these kinds of deals.

   Within the bimodal distribution we have already described–one between $10,000 and $50,000 and the other between $100,000 and about $250,000–private investors typically pool their money or invest with a syndicate of co-investors, the motivation for which concerns hedging strategies and managing risk. But there is a strong preference for technology ventures, particularly those that overlap with their previous experience and expertise. There is a myth that angel investors invest only close to home. The fact is, in our study, we found that about 50 to 55 percent do want to invest geographically proximate to home. But fully as much as 48 percent said location was not a major criterion.

6. Q: Where is the line drawn between the function of a venture capitalist and that of a banker?

   A: The difference between a venture capitalist and a banker is primarily in the stage of development of the venture. Banks are not investors; they are creditors. Therefore, bankers do not make investments, particularly in early stage deals that have no assets that could be offered as collateral, nor do they lend to companies without cash flow with which to service debt. So it is unreasonable to expect to find resources for earlier-stage or developmental-stage deals from bankers. Last year the SBA served as a very effective source of guaranteed funding for small businesses, about $15.8 billion invested through its 7(a) guaranteed loan program. But those funds went into operating businesses. When we deal with early-stage ventures that have no assets and no cash flow, we have no alternative but to turn to someone willing to put up money for an equity share of the business. These are risk-takers, investors looking for substantial growth in capital appreciation on their investments.

7. Q: Is there anyone else other than the SBA, the banks, and the venture capitalists?

   A: Actually, a range of players appears in the picture. If we look at the creativity of entrepreneurs finding capital in the tight, competitive capital markets, we see a diversity of options. We see many people trying initially to fund their deals through family and friends and on credit cards. And we see individuals looking beyond these immediate sources toward private placements with strangers who are themselves professional investors. We see individuals using banks, SBIC (small business investment corporations), or MESBICs (minority enterprise small business investment corporations). They turn to venture leasing firms, factoring firms, and asset-based lenders. They use such structures as partnering or strategic partnering with a corporate investor. So there are different financing sources out there. The issue becomes one of deciding which capital source is appropriate for your venture at its particular stage of development.

8. Q: What do private investors find attractive in a company?

   A: The entrepreneur needs to be aware of the things an investor is lloking for in considering an investment. A study of approximately 600 investors listed in our proprietary database of investors tells us that they are looking for something they can identify with. They are looking for something that provides fun. Everyone seems to imagine that these investors are looking only at a return on investment. Return on investment is important, but these investors are looking for much more. Having already displayed their ability to make money–which has positioned them to be able to invest again–they are looking for something they can get involved in, something that excites them, something they can embrace, understand, and identify with. And, as we have said, it is fun to make money.

   Real excitement occurs with what we call the pre-IPO (pre-initial public offering of stock). The only way to make $1 million to $5 million with $100,000 is to get involved in a pre-IPO. A lot of people do not because they worry about the risk, but there are ways to manage and hedge against the risk to about 25 percent. And if you hit a home run two out of ten times, the returns can be significant and more than enough to make up for those risks.

   In addition, investors are looking for deals that have a proprietary advantage or unique technology that positions that venture ahead of any competition. Investors are looking at recipients of capital who can articulate that competitive advantage in their documentation. The financial statements must spell out the potential and promise for ROI and must offer multiple scenarios supporting the figures. The argument and potential for return on investment must be strong. And where there is no history of profitability, entrepreneurs need to have a track record elsewhere in the industry.

   It is a truism that business plans do not get funded, people get funded. So entrepreneurs must demonstrate within the context of the venture that they can make money for investors; they need a track record of having made money and having been able to raise capital. Another thing investors look for is not a promotion or even an invention but a plan for a profitable business enterprise. They are looking for people with perseverance, people who can survive rigorous background checks, people who are competent and successful, who exude a burning desire to succeed. Finally, the people investors are scrutinizing must have made a personal financial commitment of a significant portion of their own net worth to the venture.

9. Q: What are the three things an entrepreneur should ask before he or she seeks angel investment?

   A: first, ask whether your company is financeable in terms of its business plan, its valuation, its competition, and a host of other factors. Second, ask yourself if you are financeable. That is, do you have a history of legal problems or other issues capable of raising red flags? Do you have the skills to make the company work? And third, is the risk financeable? If the deal is too risky, an angel will not want it. Investors have told us that they lost money when they got caught up in the entrepreneur's enthusiasm without really evaluating the investment.

10. Q: What is considered "significant participation" on the part of the investor?

    A: These investors separate basically into two categories. Within our database of over 7,500 investors, for example, a bimodal distribution occurs concerning preferred investment size. One segment of the database invests between $10,000 and $50,000. A second segment invests from $50,000 or $100,000 through $250,000. A small percentage invests more than $250,000 or less than $10,000 in each transaction; individuals are always looking for an opportunity to put a few thousand dollars in, just as there are individuals able to invest from $500,000 to $1.5 million directly in a venture. But these two extremes comprise less than 10 percent of our database. The two central distributions encompass the vast majority of individuals.

11. Q: What are some of the primary industries of interest to your ICR pool of private investors?

    A: High technology commands the greatest interest. The industries of major interest are: Biotech, computer hardware and software, health care, Internet, consumer and commercial product manufacturing, medical devices, telecommunications and wireless, and technology-related services.

12. Q: Why are these industries of interest to angels?

A: Many of the successful individuals involved in this kind of investing have backgrounds in the manufacturing and industrial areas. Investors stay close to what they know. These investors do not invest just money; they invest knowledge and experience, two assets central to hedging strategies and managing the risk associated with this kind of investing. Secondarily, however, computers remain highly interesting, particularly in networking hardware, multimedia and database development software, and the Internet. These areas foment a great deal of excitement. Information technologies, telecommunications, wireless technologies–these, too, stir interest. And, despite the FDA's turtle-paced approval process, medical devices–particularly those that will command a substantial market–remain very appealing to more astute, technical investors, as well as to some of the professional classes.

Other tantalizing areas include any kind of health care ventures that assist in cost containment, automation, assistance in interfacing with the insurance industry or managing paperwork, such as billing. These are always big pulls with private investors. Electronic equipment, analysis equipment, measuring equipment, sophisticated, subtle, highly sensitive measuring equipment–these are emerging areas of investment interest. Two businesses in the entertainment field were also coming on strong: casino gaming and, secondarily, new Age amusements; that is, either the virtual-reality amusements or amusements combining hydraulics, electronics, and computers–all designed to entertain individuals and create simulations. As one highly successful businessman puts it, "Entertainment is where America is going." These are the areas in our database that generate the most interest.

13. Q: What do investors believe to be the best financing method or structure?
    
    A: Investors report no single best method or structure, because a range of appropriate methods or structures exists. A deal structure becomes appropriate when the entrepreneur properly targets the investor. Too often entrepreneurs, convinced that they have an extraordinary deal–the next Apple Computer, for instance–approach venture capitalists, failing to grasp how slim the possibility is that they will be interested. Venture capitalists need to invest in national companies, companies with the potential to be very large businesses that will eventually go public. Professional venture capitalists are essentially portfolio managers, with a unique set of pressures. They have to raise their next fund; they have to invest the money under their management; they are responsible to overseers. None of this operates with the private investor.
    
    However, once the entrepreneur is on target, the private placement–the placement of treasury securities with a small number of private investors–has certainly become the preferred investment vehicle. The private placement is important to understand. It allows for different structures: debt, equity, or a combination of the two. It is a more flexible vehicle because a private placement is anything that is not a public offering. The main advantage of a private placement is its flexibility.
    
    In looking at the structures used most, three predominate, and underlying each is equity. First is preferred or common stock. The second is convertible subordinated debt, which is much more common to the institutional transactions, involving as it does some type of an interest payment arrangement. Third comes some kind of long-term debt with warrants. Long-term debt applies only to later-stage ventures. In almost all cases, the only way that these investors can really benefit from the risk they have taken is to share in the upside potential if the venture becomes successful. And the only way that they can do that is through equity. So, at bottom, all structures relate to equity.
    
    What you see is a reliance on preferred stock for a couple of reasons. One, it is senior to common; it provides leverage to influence management when things go sideways. It requires the entrepreneur to remain in contact with the investor. The provisions can create warning mechanisms that permit the investor to make changes in management or establish time frames and conditions for making changes. Preferred stock structures can provide some income through dividends, although such an action, especially in the early stage deals, is not exercised. Also, preferred stock is redeemable by the corporation.
    
    The corporation can set up a sinking fund and establish compulsory containment. In addition, preferred stock is convertible to common stock, so if, in fact, the company is purchased or does go public or otherwise liquidates, there is the option for the holder to share in that.
    
    
14. Q: An investment suitable to entrepreneurs sometimes involves commingling of funds. How do these commingling deals usually work?
    
    A: Each participant is an individual investor. Those individual investors will interact with the entrepreneurs, and each investor will be supplied equity in the venture proportional to the money each invested. The investors do not invest as a pool, as a venture capital partnership does. They do conduct individual transactions. But each investor's share of equity has to be measured against the venture's valuation. Of consequence is the share of equity each receives among all the parties, because any instance of inequality could spell trouble later on.
    
    
15. Q: How is commingling organized by the entrepreneur?
    
    A: The establishing of co-investors can go either way. It is our experience that when someone finds a deal attractive, he or she will bring it to the attention of associates and colleagues and will grandfather-in other individuals to look it over. However, it is not uncommon for an entrepreneur to foment excitement in a deal. So it runs both ways.
    
    
16. Q: Do guidelines exist on how to assess risk, or the risk-reward ratio?
    
    A: There are a couple of things you can do to assess risk. Risk in these ventures takes different forms. This kind of risk differs from quantifying the risk in an investment in the public market. A private placement is more qualitative in nature. First of al, you have management risk. Can the management carry out the plan they are so passionately presenting? Do they have the ability, the experience, the background, and the track record to accomplish the forecasted sales and/or manage the internal operations? More importantly, are they going to be able to form a team within the ranks, or will they succumb to resentment as a result of negotiating founder stock shares? Has discord been struck among the members?
    
    Another type of risk you have to evaluate is product and technology risk. If this is a technology that has not yet been developed, significant risk emerges. If the assembly of existing, well-tested technologies have been molded into a new technology, the risk is substantially less. So you have to assess product and technology risk.
    
    Market risk is another consideration. The need for missionary selling creates a horrible situation. It becomes expensive to grab the minds of the American public. If no market exists, will the market accept that product? And if the market has not demonstrated its desire to purchase the product through purchase orders or through sales in terms of the company's performance, substantial risk arises in having to market the product. You then have operations risks that emerge regarding the company's ability to produce in the volume and quality the company has projected. Unanticipated problems, such as those experienced with Pentium in 1995, can strike a company at any time. If such a problem arises, can the company deliver the product in such a way that it will achieve its projections?
    
    There also exists financial risk if–more likely when–the company will need more money than it has claimed, or if your investment is a very small percentage of the amount claimed to be needed. You're investing $25,000 in this round, but the next round asks for $25 million. So you have a very substantial risk that the company will not be able to raise the rest of the money. Suddenly, your small investment does not amount to anything. Ways to quantify risk come through the pro forma financial statements. But remember: Most investments fail to return targeted multiples. Talk to any investor; rarely have deals returned the multiple that entrepreneurs had claimed.
    
    
17. Q: What is a typical return on investment?
    
    A: From the point of view of private investors–not from the institutional venture capital perspective–angels seek a number of nonfinancial returns. Angel investors have a broader palette of motivations than just return on investment. However, that is not to deny a strong interest in return on investment. First of all, we have seen a great interest in job creation and urban revitalization. So we see a number of organizations trying to pool investors and make the market more efficient for investing in ventures that will create jobs within a proximate geographic locale. Also, a major increase has occurred in the number of organizations facilitating investor and entrepreneur introductions for socially responsible investments.
    
    Although more inherited wealth participates in technology for medicine or for energy, many angel investors also are interested in investing in these useful areas. In addition, we see some entrepreneurs funding women and minority entrepreneurs. So a different dimension drives these investors over and above making money, a dimension that includes the personal satisfaction they derive from assisting entrepreneurs to build successful ventures.
    
    To answer the question in terms of venture capital returns, let us be realistic about what someone can expect. On the average, 60 to 65 percent of these investments break even, do not break even, or represent a partial or total loss. So a substantial portion–six out of ten–even after meticulous due diligence, result in no financial return or in returns below that of a bank deposit account. Approximately 20 percent of these investments, based on our research, provide a two-to-five times multiple on the investment. About 8 to 9 percent provide between five and ten times the investment, and about 7 times out of 100–about 6.9 percent–we see a return of ten times or more the investment made. As venture capitalist Lucien Ruby shrewdly notes, venture capital investors do not have to get their desired return. In fact, they usually do not. But they want to see the desired return as a possibility. Now, when we calculate the targeted rates of return for a typical direct investment, the multiple is a major consideration, but so is the time within which the investor wants to receive that multiple.
    
    
18. Q: What is a typical time frame for return on investment?
    
    A: What we see is a range in the acceptable time frame. If we look at the activities from the 1970s and 1980s, we see the time for holding investments ranging from five to ten years. Although for the institutional investor the goal is always to liquidate within three to five years, reality sets in, making the wait much longer before achieving fruition and creating a substantial liquidation event. On average, the holding time to liquidation for successful direct, private investments reaches eight years.
    
    
19. Q: It seems as if the average investor can do pretty well by investing money passively in highly liquid markets and have almost as good of a shot, maybe better, at a return without the degree of risk. So why not just avoid the risk?
    
    A: We cannot underestimate how astute many of these investors are. They are multimillionaires. Over and above their house and car, they have net worth between one and ten million dollars. They have been successful investors. They are banking on their sound judgment to once again select a venture like the one that put them where they are today.
    
    We find it sobering to examine the targeted rates of return that these individuals bring to these ventures. With a seed and start-up, we see individuals seeking strong indications that they will realize an annualized international rate of return between 60 and 100 percent. In expansion, the company is generating revenues, but might not yet be profitable or in the black. Here we see targeted returns of around 40 to 50 percent. In a profitable situation–the company is making a profit but is cash poor–we think 30 percent to 40 percent is the typical target. In mezzanine, a company is bridging to cash out. Here we commonly see a targeted internal rate of return of 20 percent per year. So, although very substantial returns are targeted for early stage deals, within the private equity class called venture capital, more developed situations offer much more security and provide the potential for lesser rates of return, for example, a 20, 25, or 30 percent return, such as in a mezzanine transaction.
    
    
20. Q: What hedging strategies do these investors use to limit their downside risk?
    
    A: hedging strategies begin by conducting thorough due diligence and by being thorough in all investigation related to due diligence. It is much more important to avoid a bad investment than to try to hit a home run. After all, these investors are making an average of between one and three investments per year. So their ability to diversify risk becomes limited. They can manage only so many value-added investments, which take huge chunks of time to administer.
    
    Hedging strategies begin with due diligence, but they continue by negotiating steep discounts very early on in the negotiating process for the risk being taken by these early stage investors. These investors rarely invest at the price valuation suggested by the entrepreneur.
    
    Another way to hedge is by syndicating as early as possible. Bring other investors into the deal, backing off what you might have planned as your investment amount. Say an investor plans to put in $250,000. The investor backs off to $125,000 and attracts other investors who come in and do a couple of things. One, they carry on due diligence. Two, they confirm–or fail to confirm–the original investor's opinion. And three, if the additional investors do confirm, they share the financial risk.
    
    Another strategy involves individuals using other people's money as soon as possible in the transaction. For example, rather than investing in the venture directly, an individual may provide a guaranteed line of credit as a part of the transaction. This saves the investor from touching current cash flow but guarantees his or her participation while using other financial capabilities that he or she possesses.
    
    Also, rather than waiting until the venture goes "south," or discovering that milestones have been missed, many investors hedge on the risk associated with these highly illiquid investments not only by taking a seat on the board by looking for increased involvement. whether as an informal consultant, counselor, or adviser, or as a part-time individual or full-time manager in the firm, their involvement keeps them close to the action.
    
    
21. Q: Do private investors spend more time evaluating a deal before investing, or in adding value after the investment has been made?
    
    A: The answer is both. Remember that the essence of venture investing is value added. So each investment is time consuming. These investors bring their own contact network. They provide technical and marketing guidance and expertise to less-experienced entrepreneurs. They provide recruitment support and assistance in developing strategy and business plans. They also provide introductions to customers and vendors. They assist in joint venturing, identifying joint-venture partners, and so forth. Venture capital investing and value-added investing involve a commitment over and above the capital that is committed to the deal.

© Benjamin and Margulis 2000