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
Why be an Angel
Definition and Types of Angels
History of Angels
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:
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.
back to table of contents
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.
back to table of contents
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.
Companies selling securities must comply with both federal and state laws and regulation. Exemption from federal law does not create an exemption from state laws. To facilitate small business formation, the North American Securities Administrators Association (i.e., the state regulators) created SCOR, the Small Company Offering Registration. It is a simplified registration form that companies can use to register offerings and as a disclosure document for investors under Rule 504. The use of this uniform filing and disclosure form, called Form U-7, adopted by over 45 states, simplifies the process for the direct private offering. This enables client entrepreneurs to offer Rule 504 securities in a public offering in multiple states. Because these are public offerings, there is no limit on the number of investors or promotional activities. In some instances, an offering amount may exceed $1 million. Regulation A, which permits up to $5 million, can be used in conjunction with SCOR Form U-7 to create a multi-state public offering. (For more information, go to http://www.sec.gov/info/smallbus/qasbsec.htm#eod6 for a SBA Q&A document)
Sounds complicated? On the surface, yes. But as you dig deeper, it becomes very black and white and a decision tree can be created with an if / then process flow. The determining factor on the use of these exemptions and choosing a direct private offering or a private offering through memorandum, is who and how much has been invested before you and what type of investment will be needed in the following rounds, if any. The direct private offering approach is an ideal way to properly document the very early money that gets a company to the point of being financed by VC money.
Your take away is this: as you work through the funding process with a prospective company, you need to understand what investment has been made prior to your introduction, and what follow on investment will be needed. You do not want to get into a situation where the founder and early investor money has not be properly documented, and your investment is put at risk because the later stage investors won't touch it because there are either too many unaccredited investors, varied share prices and/or incomplete documentation. In some cases the early errors made by entrepreneurs in accepting friends and family money can be "cleaned up" through legal and accounting documents. Being aware of these issues makes you more equipped to determine what intangible expenses will be associated with the investment you are about to make.
back to table of contents
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%|
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.
back to table 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.
back to table of contents
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.
Please give us feedback so we know how to continue to meet your needs:
Was this information useful?
To refer this program to a friend or colleague please click here __________________
Other information you would like to see or learn about _________________________
We are committed to your success in this learning cycle. If there is more information we can provide to you, please let us know.
President, Kugarand Holdings, LLC
Founder, Angel Investor 101
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.