Inside Secrets to Angel Investing

108 Pages·2008·1.36 MB·English

by  Roxie Thomas

Table of Contents
Chapter 1: What Defines An Angel Investor…………………………………………….………4
History of Angel Investors……………………………………………………………………….4
Economic Contribution of Angel Investors……………………………………………..8
Government Involvement………………………………………………………………………..9
Why be an Angel Investor………………………………………………………………………13
Definition and Types of Angel Investors…………………………………………………16
Angel Investor Categories……………………………………………………………………….17
Closing……………………………………………………………………………………………………..20
Chapter 2: Investment Cycle…………………………………………………………………………….21
Introduction………………………………………………………………………………………………21
Referral Sources…………………………………………………………………………
Intermediaries……………………………………………………………………………
Finders……………………………………………………………………………………….

First Date…………………………………………………………………………………………………..32

Courtship……………………………………………………………………………………………………35

Marriage…………………………………………………………………………………………………….36

Closing…………………………………………………………………………………………………..….38

Chapter 3: Private Equity Glossary……………………………………………………………….…..39

Chapter 4: Type of Capital-Business Life Cycle…………………………………………….…..64

Type of Capital Needed at Various Stages of the Business Life Cycle.…..64

Graph: Supply and Demand……………………………………………………………………..65

Business Life Cycle Described & The Economic Impact………………….……….66

Business Life Cycle: Life Cycle Firms…………………………………………..…66
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Business Life Cycle: Entrepreneurial Endeavors…………………….…….69

Chart: Stages of Endeavors Business Life Cycle Development….72

Economic Impact………………………………………………………………………..….72

Funding Options of Different Types of Business at Different Stages..……75

Chart: Diagram of Capital Source According to Stage of Business….…80

Specific Value of Angel Investors at the Different Stages………………………83

Role of Venture Capitalists in the Lifecycle/Funding Process …………………84

Graph: WebVan Stock Market Performance………………………………….87

Conclusion…………………………………………………………………………………………………87
Chapter 5: Investor As a Bank………………………………………………………………….……….89
When Is An Angel Investor Really a Bank.……………………………………………..89

Balance Sheet Sample.………………………………………………………………….89

Why Not A Bank….........................................................................90

What is A Bank.............................................................................92

What Kind of Debt Does an Angel Investor Provide………………………........95

Summary………………………………………………………………………………………..….……100

Sources………………………………………………………………………………………………………….……106
About The Author………………………………………………………………………………………..…....108
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Chapter 1:
What Defines “An Angel Investor,” or If This Is Private
Business, Why is the Government Involved?
History of Angel Investors
The term "Angel" comes from the early 1900's practice 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 track
record by offering expertise, experience and contacts, in addition to money, to help
companies succeed and grow. Less is known about Angel Investing than Venture
Capital (VC) because of the individuality and privacy of the investments. However,
almost every large company can track its initial entry into the market to an Angel
or group of Angels who 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 investment for
minority ownership in private companies. They would invite their friends to
participate in a promising new business project. Rarely was the management team
asked to make a presentation to the prospective investors. Rather, it was the
strengths of the sponsors' reputation upon which other investors relied to join the
funding activity. As a result, the Angel investment process was often a secret
process based exclusively on whom one knew, not how good the 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
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marketplace. Key factors driving this dramatic shift in the nature and volume of
Angel investing are:
• Dramatic increase in venture firms - In the early to mid ‘90s we saw the
beginning of the change to capital markets that would forever change how
companies connected with capital. For many, it is a chicken and egg
dilemma. Which came first, the capital seeking high tech companies to
invest in or companies seeking capital? With the growth of the economy,
the capital markets responded favorably, institutional money adopted a
greater risk tolerance and invested in venture funds. The market-makers
followed suit and moved to invest in the private markets through Venture
Capital funds.
Individual money followed, initially in the same funds and then later directly
into the private companies 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 likely follow that same investment as
a next phase investor, leading to a march into the public market with the
IPO, delivering the higher than average returns to that Early-Stage investor.
The path to liquidity was pre-defined, so just as the egg and chicken are
intertwined, so were “capital” and “private equity opportunities”. Capital
increased dramatically and sought investment opportunities, even companies
that ordinarily may not have qualified, because the capital market for the sell
of the private companies’ securities was pre-defined. When the bubble burst,
there was a natural re-balancing of the opportunities and the capital.
The market of late has seen a massive movement of capital into Hedge
Funds and Private Equity Funds. Private Equity Funds are most often
associated with the acquisition and roll up of private companies into a larger
portfolio of companies managed by the Fund management. However, many
of the Private Equity Funds are structured in such a way as to acquire a
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minority share of the company and to operate in a passive manner, similarly
to Venture Capital Funds. Unlike Venture Capital Funds, these types of
Private Equity Funds tend to target traditional, non-tech sectors with long
term steady growth potential. This is good news to early stage angel
investors who like to invest in “meat & potatoes” businesses involved in
retail, manufacturing, and distribution. Money is attracted to money and the
potential for higher returns. With the collapse of the technology sector after
the dot-bomb period, investment portfolios sought a less risky, more
predictable target. With the heat turned onto merger & acquisitions, and
leveraged buy-outs as the alternative to IPOs, capital shifted after 2000 so
that so that by the end of 2004, 4% of the total investments assets in the
United States, totaling almost US$900bn, was held in private equity oriented
funds (including Venture Capital funds), according a Freeman & Co. report.
And according to a survey conducted by Russell Investment Group, on
average, private equity accounted for 7% of the asset allocation of 176
leading US and Canadian investment funds under management. Buy-outs
by funds or corporation’s in house equity funds are the new alternative to a
traditional IPO. Based on our economic analysis, we believe this trend has
been caused by the Market-Maker’s sensitivity to the volatility of the high-
tech markets and limited options for liquidity for those sectors caused them
to seek high growth opportunities in sectors with more predictable business
models and whose companies tend to have tangible assets in inventory,
manufacturing, equipment, and facilities in which to include in the valuation
and investment process.

• Formation of Structured Angel Networks - In the late 1990’s 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
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established. The need to connect led to the emergence of capital
conferences, incubators and deal flow meetings that are common today.
As a result, decision factors for Angel Investors become much more
objective.
The Angel market and the activity level of Angels are tied to the activity of the VC
marketplace 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 (covered in depth in Chapter 4:
"The Business Lifecycle…and the Capital Plan"). Yet Angels learned the hard way
that their investments are 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 Chapter 5:
“When Is an Angel Investor Like 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; likely public markets, bonds, real estate;
and either through proceeds from those investments, simple accumulation of
wealth, wealth from the sell of a company or IPO, and now have "extra money" to
invest back into their community by providing experience and 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
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successful entrepreneurs who want to help other entrepreneurs get their businesses
off the ground.
Economic Contribution of Angel Investors
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 to be between $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 their nature, considered a high-risk, illiquid investment.
Angel Investors fill the gap between the entrepreneur's personal access to capital
through savings, available credit, friends and family, and the next source of funds
that is dependent on some 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. It serves a critical role in the evolution of a company by providing
capital that cannot be readily obtained elsewhere, and practical experience needed
by you entrepreneurs. Research by Samuel S. Kortum of Boston University and
Josh Lerner of Harvard University indicates that although Venture Capital has
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accounted for less than 3% of corporate R&D in recent years, it has generated as
much as 15% of U.S. business innovations.
In 2001, the National Governors 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. Small Business Association (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.
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
souls eager to provide encouragement, advice and capital. Even with this benign
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impression, as with other investments, those by Angel Investors are subject to
federal and state securities laws.
The news has been filled with stories of how the Securities and Exchange
Commission (SEC) has held people of influence and authority accountable for their
actions which contributed to a decline in a publicly traded stock, or a
misrepresentation of a company's performance that dramatically harmed the
employees and shareholders. In much the same way, the laws regarding the sale of
private equity are designed to protect those who may not have the appropriate
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
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