Angel Investing 101 : Lesson One:
What defines “angel investor” or if this is private,
why is the government involved?
Table of Contents:
History of Angel Investors
Economic Contribution of Angels
Government Involvement
Why be an Angel
Definition and Types of Angels
Closing
History of Angels
Investors
The term "angel" comes from the practice in the early
1900's of wealthy businessmen investing in Broadway productions. Being the
"sponsor" of a show carried prestige and potentially big returns that could be
reinvested if the show was successful. That practice has evolved to
one where the very successful strive to continue their successful track record
by offering expertise, experience and contacts, in addition to money, to help
companies they relate to succeed and grow. Less is known about angel
investing than venture capital because of the individuality and privacy of the
investments. However, every success story can track its initial entry into
the market to an Angel or group of Angels that provided the needed knowledge and
capital to launch and grow that company.
For years, traditional angel investing involved one or
more forward thinking investors seeking to expand his or her economic base
through minority ownership in multiple companies, inviting their friends to
participate in a promising new deal. Rarely was the management team asked
to make a presentation to the prospective investors. Rather, it was the
strengths of the sponsors' reputation that the other investors relied upon in
joining in on the funding activity. As a result, the angel
investment process was often a secret process based exclusively on who you knew,
not how good your deal was. However, the last decade has
seen dramatic changes in the angel investing process, resulting in significant
growth in the amount of angel money in the market place. Key factors
driving this dramatic shift in the nature and volume of angel investing are:
- Dramatic increase in Venture Capital
firms. This was driven by the chicken/egg phenomena of growth in
capital markets which lead to the availability of institutional money to
invest in large Venture Capital funds for the private market. As the market makers
moved to investing in the private markets through Venture Capital funds,
individual money followed, initially in the same funds and then later directly
into the targeted accounts where returns had potential to be greater and
sooner than the exit for the institutional money. Angel investors had
the benefit of knowing that since institutional money was behind the influx of
capital into the private sector, it would follow that same investment as it
entered into the public market with the IPO, delivering the higher than
average returns to that early stage investor.
- Formation of Structured Angel Networks. In
the late 1990s we saw the dynamics of organization coming to Angel investors,
with the Band of Angels of Silicon Valley as the first. The development
of on-line registration and posting environments and investor consortiums that stretched across geographies enabled
and necessitated that investors look at materials and make decisions based on
information provided, not relationships already established. The
need to connect led to the emergence of capital conferences and incubators and
deal flow meetings that are common today.
The Angel market and the activity level of angels is tied
to the activity of the VC market place which in turn is tied to the activity of
the capital market. The last couple of years, 2002 and 2003, saw the
flushing out of deals that the VCs were nursing and a return to capital raises
for new funds. VC goals and objectives in the funding process differ
widely from that of Angels (to be covered in lesson 4 "What type of investment and at what stage,
and how are VCs different from Angels?"). Yet Angels learned the hard way
that their investments is most critically dependent on the second round funding
provided by VCs. If that does not exist, it is harder for them to move
forward on an investment, thus the movement to private lending (to be covered in
Lesson 5 'When is an Angel Investor really a bank?"). We see the
capital markets turning around and increased activity with the VCs, so the time
is right to develop the skills to enter into this next wave of prosperity.
Angel investors are individuals who have developed a
financial portfolio that is diversified with traditional investments,
potentially public markets, bonds, real estate, and either through proceeds from
that or simple accumulation of wealth now have "extra money" to invest back into
their community through providing capital to start up and early stage companies.
They typically invest in businesses and look for a higher return than they would
see from more traditional investments. Many are successful entrepreneurs who
want to help other entrepreneurs get their businesses off the ground.
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Economic
Contribution of Angels:
The U.S. Small Business Administration estimates that
there are at least 250,000 angels active in the country, 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. Angel investors typically will invest up to 5% of their
portfolio or net worth into early stage companies that would be, by its nature,
considered a high-risk, illiquid investment.
Angel investors fill the gap between the entrepreneur's
personal access to capital through savings, available credit and friends and
family, and the next source of funds that is dependent on some sort of
basis of measure. A bank requires assets, receivables, contracts, or
cash flow before providing working capital or line of credit. A VC
requires a proven product and customers already buying it or with a backlog of
firm commitments. According to Gerald Benjamin, author of Finding
Your Wings and founder of the Private Investor Network, the angel investor
market is around $30 billion a year and serves a critical role in the evolution
of a company from an idea to a going concern by providing capital that can't be
readily obtained elsewhere and practical experience to the start up
company. Research by Samuel S. Kortum of Boston University and Josh
Lerner of Harvard University, indicates that although venture capital has
accounted for less than 3 percent of corporate R&D in recent years, it has
generated as much as 15 percent of U.S. business innovations.
In 2001, the National Governor’s Association Center for
Best Practices convened a year-long initiative on entrepreneurship. According to
its research small, high-growth companies accounted for 70% of new jobs in the
last decade. Yet, it found that state support for entrepreneurship is mixed.
State funding for entrepreneurial development lags behind other economic
development programs. “There seems to be less focus on the needs of
entrepreneurs during the start-up stage. While access to capital, especially
equity investments in start-ups, remains a critical issue, the overwhelming
majority of state financial assistance programs focus on direct loans, loan
participations and loan guarantees. Only 10% have an equity component. According
to the U. S. SBA, 50% of small businesses fail in the first year and 95% fail
within the first five years. Reasons for this failure
rate are lack of experience, lack of capital, underestimating the difficulty of
starting a business, lack of sound management, low sales, competition, and
unexpected growth. Enter the Angel Investment community. You have
learned that Angel investors play a critical role in providing capital and
experience to these start up companies, and ultimately the growth of
the American economy.
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Government Involvement
As discussed, Angel investors provide a valuable and
approachable source of capital. Indeed the very term "angel" investor
gives the image of caring, generous soles eager to provide encouragement, advise
and capital. Even with this benign impression, as with other investments,
investments by Angel investors are subject to Federal and State securities law.
The news has been filled with stories of how the SEC has
held people of influence and authority accountable for their actions which
contributed to a fall in a publicly traded stock or a misrepresentation of a
company's performance that dramatically harmed the employees and share holders.
In much the same way, the laws regarding the sell of private equity are designed
to protect those who may not have the knowledge and experience.
When an entrepreneur offers an equity interest in his business to an investor,
whether common stock or any other portion of his company, he is offering to sell
a security. As such, securities must be registered for sale under federal
and state securities laws. In 1982, the SEC adopted Regulation D,
often referred to as "reg D exceptions". These legal exceptions set forth
the rules of exemptions from federal registration of the sale of securities by a
company. Offerings exempt under rules 504, 505, and 506 are a common
cost and time saving way for privately held companies to raise capital
from private investors. Although, these exemptions are from federal
laws, the individual state laws are different.
For now, simply understand that Regulation D provides
three specific exemptions from registration as a private offering. Rule 504
provides an exemption for the offer and sale of up to $1 million of securities
in a 12-month period. The securities issued are restricted, which means they may
not be sold without registration. There is no limit as to the number of
investors. However, they should meet the definition of accredited investors
(i.e., have income of $200,000 and net worth of $1 million). Rule 505 creates a
private offering exemption of up to $5 million of securities in a 12-month
period, and Rule 506 creates a private offering exemption of any amount in a
24-month period. Both permit 35 non-accredited investors with no limit on the
number of accredited investors. If the company seeking investment starts from
the very beginning, documenting founder money and friends and families, they can
establish a fixed stock price and thereby enabling the use of any of the three
exemptions through a direct private offerings. The company structures a
deal, prepares disclosure information, and furnishes it to all prospective
investors, who then decide to invest or not. This is distinctly different from
private offerings such as that which is structured under a Private Placement
Memorandum where the venture capitalists and angel investors often negotiate the
investment with the entrepreneur. In a direct private offering, the
entrepreneur seeks out many private individuals to purchase, instead of seeking
to broadly approach angel investor or venture capital firms through investment
banks or forums.
Securities issued under Regulation D, Rule 504 may become
public offerings without SEC registration. The offering must be registered in
one or more states that require a public registration statement. Further, the
securities may be sold in states under a state registration exemption, provided
that they are sold also in states that provide a public registration statement,
and the same disclosure information is provided to all investors in those states
where they are exempt. If securities are sold exclusively in states where they
are exempt, public solicitation is permitted provided sales are to accredited
investors only.
Why be an Angel
With all this additional governmental oversight to be
aware of, is it worth it to be an Angel Investor? If you are a
successful angel investor, the answer is a resounding YES! Robert Kiyosaki, best selling author of the
Rich Dad, Poor Dad series of books
regarding wealth accumulation, has brought to the marketplace a focus on
three types of income: earned, portfolio, and passive.
Briefly, earned income is what you generate from your labor or work.
Portfolio income comes from paper assets such as stocks, bonds and mutual funds.
Passive income generates wealth without your direct involvement, such as real
estate investments or for our purposes, private equity investments. Kiyosaki further develops the concept of the
Cashflow Quadrant in which the rich
get richer because they learn how to effectively function on the right side of
the quadrant, which includes business owners and investors. By
definition these two types of people make money without a direct exchange of fee
for service or hour for dollar. If they went away for 6 months,
their income would continue and potentially grow. In the last lesson of
this course, you will learn how to build your investment model for passive
income through private equity business ownership. Similar to real estate,
you will determine the type of asset you want to acquire and the return you desire,
either as an ongoing revenue stream, a predictable short term gain, or a riskier
long term yet larger ROI, and build your evaluation criteria based on those
inputs.
You can think about the difference between buying public
stocks and private equity as the difference in wholesale and retail.
If you can choose the right wholesale product to buy that is sure to have a
valued retail price on it, you get the profit of the difference between
the wholesale price and the retail price. If the company performs,
reaches milestones and makes a profit, it will either be acquired at a
significant profit to the original investors or will go "public" in the retail
"over the counter" market and the market will dictate your profit.
Regardless of your exit, the profit will have been made in the transaction from
wholesale to retail. We have all heard about the "dot bombs"
and people losing their life savings. Those stories rarely apply to
serious investors who conducted proper due diligence and did not let emotion get
in the way of a business decision. For example, $25,000 invested in
Intel in its early stage investment rounds, would be worth more than $40 million
depending on the ups and downs of the market. The point is that the
rich, affluent investor....the "millionaire next door"...has already made his or
her money before the public knows the company exists to put the order into their
stock broker.
According to Brian Hill in Attracting Capital from
Angels, angel investors can achieve greater results than venture capitalists if
they approach their portfolio of private equity investments in a thoughtful and
thorough approach. They need to be able to diversify their portfolio
and as with public stock purchases, anticipate that there will be some losses.
In their example, an angel investor makes four investments:
1 write off at 0% return
1 limps along at a 15% return
1 meets its target at a 40% return
1 is a superstar at 125% return
A weighted average return here is an impressive 45%.
Much better than any stock portfolio. But if they don't have that
superstar, the average changes dramatically and the net return would only be
14%. According to the U.S. Private Equity Performance Index as
of 9/30/2003:
| Investment |
1 yr |
3 Yr |
5 Yr |
10 Yr |
20 Yr |
| Early/Seed |
- 18.3% |
- 26.3% |
54.1% |
35.7% |
19.9% |
| NASDAQ |
52.5% |
-21.3% |
1.1% |
8.9% |
11.5% |
| S&P 500 |
22.2% |
-11.5% |
-0.4% |
8.1% |
12.3% |
This clearly shows that, with the exception
of the last 3 years, the private equity market for early and seed stage
investment, historically, has outperformed the public markets--even before there
was a "dot.com". As discussed earlier, the movement of
capital from private to public impacts the "retail" market for the "wholesale"
private equity. We are seeing the market correction, so the timing
to ramp up with wise angel investments is ideal. The early
stage investment is significantly riskier than the public equity investment,
and the reward is understandably greater as a result. Through this
e-course you will learn strategies to mitigate your risk as an angel investor in
early stage companies.
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of contents
Definition and
Types of Angels
You have heard the term "accredited" investor.
You have seen that definition of at least $1 Million in net worth or $250
thousand individual or $350 thousand with spouse in earned income.
But what if you don't quite have that type of wealth accumulated or currently do
not have that type of income? In reality, most angel investors are
not accredited investors. They are "sophisticated investors".
The distinction between accredited investors and non-accredited investors is
significant under the federal and state private placement exemptions (Government
Involvement) discussed earlier. If only accredited investors are
involved, no special disclosure is needed. The assumption is that if
they have accumulated that kind of wealth, then they are experienced enough to
know what to look for in the due diligence process to make a wise decision.
If non-accredited investors are involved, the private placement rules require
the disclosure of information regarding financials and risks, in much the same
way a company discloses for a registered non-exempt offering. Also
keep in mind the limits the Reg D exemptions place on the number of
un-accredited investors in each offering, whether using the 504, 505, or
506, exemption. The seller of the equity would need to have a
reasonable basis to conclude that the potential investor, that was not
accredited, had the sophistication to make an investment decision, either
because of specific experiences, education or certifications.
Investment Bankers and registered Dealer / Brokers will require the investor to
sign a statement that they testify to their status as an accredited investor.
An entrepreneur selling stock directly may not and no actual check will be done
to confirm you are accredited. The expectation is that you know you may
lose that investment, and you are responsible for the decision to invest.
Angel Investors can be categorized into one of 5 types:
Super Angel: The Super Angel typically has a
net worth of greater than $5 million. They will invest in the Venture
Capital funds, and for the "star" business, $250 thousand or
more in a single investment and also join in the later rounds.
They typically will not take an active day to day role in the company, unless
they are the actual founder of the company. They prefer a Board of
Director's seat and will make a commitment to open doors and facilitate access
to key companies as potential customers or alliance partners, and to other
investors. They bring name recognition to the company and become a
very positive factor as the company moves forward to later rounds with Venture
Capital firms.
Super Active Angel: The Super Active Angel
typically has a net worth between $1 million and $3 million and came by their
money through a liquidity event with another company. They will invest
between $100K and $400K and take a strategic role in the company, potentially
deferring their first year income to put their investment to work rather than to
take a pay check. They will take additional stock options or shares
in exchange for this additional financial sacrifice. Because of
their track record they bring very specific experience and success to the new
venture and desire to "step into" a company rather than start from scratch.
They can facilitate follow on investment of $300k to $1M from both Active and
Passive Angels in their personal network. They typically do not want
to spend 10 years building the company. They invest and work with a
specific intent to build the company to a liquidity event in 3-5 years so they
can exit and replace themselves with an executive that can take the company
through its expansion and mature phases.
Active Angel: The Active Angel invests
in multiple companies in amounts between $20K and $250K, but with a total
portfolio of about $500 thousand to $2 million at risk in private equity
ownership. They have accumulated their wealth through successful
private equity investments, other investments, "golden parachutes", inherited
wealth, or in some cases, liquidity events from selling their own company.
They typically have personal community and family interests and want flexibility
in their work schedule. They want to share their experience and
associations as part of their managing their investment and helping to ensure
its success. They will commit to some level of involvement in
operations and/or marketing for a specific number of hours or days per week.
They like to "roll up their sleeves" and complete a task or a part of the
strategic plan or for that matter, develop the strategic plan. They
may take a Board Seat and they may be able to bring additional investors to the
table.
Passive Angel: The Passive Angel typically
will invest in an angel network or follow on in an investment where another
angel investor they know and trust is taking an active role. Their
investment range from $20K to $100K with at total portfolio in the $500K to $1M
range. They look for a focal point within the fund or the consortium of
angels that participated in the round to convey the information and monitor the
progress. They want to be kept abreast of all developments, and will
become active as a board member or to lend specific advice and counsel as the
need arises.
Professional Angel: The Professional Angel is
typically a "sophisticated investor" rather than an accredited investor.
They typically provide specific professional services, legal, financial, or
consulting, as their vocation and prefer to invest services in the company in
exchange for equity. If they are very compelled with the company, they may
invest small amounts of money, $10K to $50K. The Professional Angel can be
a real asset to a start up company that needs work done but does not have the
capital to hire professionals to complete the work for them. Time is
money, particularly for a professional such as this who is paid on an hourly
basis, so this type of investment needs to defined measured and documented
just as a cash investor would be documented. As a Professional
Angel, you need to complete due diligence and make decisions also as to whether
or not you can afford to invest time into a company to ensure you too get a
return on that investment.
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Closing
Thank you. This concludes your first lesson.
Your homework, upon reading this material, is to determine your net worth and to
start to decide what your level of involvement will be in the companies you will
eventually invest in.
Next week you will learn about "The Investment Cycle…the first date, courtship and the
marriage". You'll get insight into the process of how an Angel
learns about an investment opportunity and works through the evaluation process,
leading to a decision.
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We are committed to your success in this learning cycle.
If there is more information we can provide to you, please let us know.
Karen Rands
President, Kugarand Holdings, LLC
Founder, Angel Investor 101
About The
Author
 Karen
Rands is the founder of Kugarand Holdings. She has lived in the
Atlanta area for 20 years. She received her Economics Degree
from Emory University and her MBA from University of Florida.
She has spent the last 3 years, in the tough economic market,
figuring out what works for the investors and the entrepreneur and
developing the curriculum necessary to create a new generation of
Angel Investors. You get to be a part of that wave. |
Disclaimer: Every effort has been made to accurately
represent our products, their sources and their potential when applied by
the student. Any information offered regarding actual
earnings or examples of actual results can be verified upon request or the
source can be made available. Purchasing equity in private companies is an
extremely risky business. The information provided during the
online orientation to angel investing is drawn from personal experience
with angel investors and companies seeking funding, and from recognized
authors, columnists, and is not intended to represent or guarantee that
anyone will achieve the same or similar results. Each individual's success
depends on his or her background, dedication, desire and motivation. As
with any business endeavor, there is an inherent risk of loss of capital
and there is no guarantee that you will earn any
money.