Those mythical creatures, Angel Investors, are they Venture Capitalists?
There is perhaps a misperception that the likes of private equity funds, venture capitalists and angel investors are synonymous; they all provide a source of capital, right? Why are there angels and why have they become more prominent in the last 10 years? After all, doesn’t the definition of venture capital include all of the activities that angels perform?
Firstly, Private equity
Private equity consists of money from third-party investors that is pooled together and then invested into other businesses. They can commit large sums of money for long periods of time. Private equity companies usually seek to invest large sums of money into big businesses, but there are smaller private equity firms in South Africa that may be interested in making smaller investments. Be warned though, that securing private equity can be a time-consuming and difficult process.
Venture capital (VC), a type of private equity, is equity funding provided by outside investors into early-stage, high-potential, high-risk ventures in return for above-average returns. The VC capital fund makes money by owning equity in the companies it invests in, which usually have a new technology or business model in high-tech industries.
Venture capital is attractive for new companies with limited operating history (and a tried and tested concept) that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, they usually get significant control over company decisions, in addition to a significant portion of the company's shares and future value.
VC funds provide strategic direction to ultimately grow investments to a profitable exit. This includes experience and insights into international expansion, legal requirements regarding exchange control and intellectual property (IP) protection and an international contact base to open doors for entrepreneurs. Among the main advantages of VC is that investors only realise their investment if the business does well. If it fails, there is usually no obligation to repay the investment.
An angel investor or angel (also known as a business angel or informal investor or angel funder) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital, as well as to provide advice to their portfolio companies.
Unlike banks or other financial institutions, angel investors are willing to take a chance and invest smaller amounts of money in high-risk businesses, with the hopes of gaining high returns within a set period of time (usually five to ten years).
These wealthy individuals use their own funds to finance projects that they believe will be lucrative, or where they can use their talent and skill to mentor new entrepreneurs.
Angel capital fills the gap in start-up financing between friends and family and large venture capital investment - it is usually difficult to raise more than a few hundred thousand rand from friends and family, and most traditional venture capital funds usually only consider multi-million rand investments. Angel investment is therefore a common second round of financing for high-growth start-ups. Because it's extremely high risk, a very high return on investment is normally required.
The term "angel" originally comes from Broadway, where it was used to describe wealthy individuals who provided money for theatrical productions. In 1978, William Wetzel, then a professor at the University of New Hampshire and founder of its Centre for Venture Research, completed a pioneering study on how entrepreneurs raised seed capital in the USA, and he began using the term "angel" to describe the investors that supported them.
Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for reasons that go beyond pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less than full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts. Because there are no public exchanges listing their securities, private companies meet angel investors in several ways, including referrals from the investors' trusted sources and other business contacts; at investor conferences and symposia; and at meetings organized by groups of angels where companies pitch directly to investor in face-to-face meetings.
The past few years, particularly in North America, have seen the emergence of networks of angel groups, through which companies that apply for funding to one group are then brought before other groups to raise additional capital.
Angel investments bear extremely high risks and are usually subject to dilution from future investment rounds. As such, they require a very high return on investment. Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. Current 'best practices' suggest that angels might do better setting their sights even higher, looking for companies that will have at least the potential to provide a 20 to 30 times return over a five- to seven-year holding period. After taking into account the need to cover failed investments and the multi-year holding time for even the successful ones, however, the actual effective internal rate of return for a typical successful portfolio of angel investments is, in reality, typically as 'low' as 20–30%. While the investor's need for high rates of return on any given investment can thus make angel financing an expensive source of funds, cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures.
Angels vs. Venture Capitalists
In the early days (30 years ago) of technology venture capital, great firms like Arthur Rock and Kleiner Perkins funded companies like Digital Equipment Corporation (DEC) and Tandem. In those days, building the initial product required a great deal more than a high quality software team. Companies like Tandem had to manufacture their own products. As a result, getting into market with the first idea, meant, among other things, building a factory. Beyond that, almost all technology products required a direct sales force, field engineers, and professional services. A start-up might easily employ 50-100 people prior to signing their first customer.
Based on these challenges, start-ups developed specific requirements for venture capital partners:
- Access to large amounts of money to fund the many complex activities
- Access to very senior executives such as an experienced head of manufacturing
- Access to early adopter customers
- Intense, hands-on expert help from the very beginning of the company to avoid serious mistakes
In order to both meet these requirements and build profitable businesses themselves, venture capitalists developed an operating model which is still broadly used today:
- Raise a large amount of capital from institutional investors
- Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company
- Evaluate each deal very carefully with extensive due diligence and broad partner consensus
- Employ strong governance to protect the large amount of capital deployed in each deal. This includes requisite board seats and complex deal terms including the ability to control subsequent financings
- Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal
It turns out that building a company has changed quite a bit since the early days of venture-backed technology companies. Building a company like Twitter or Facebook is quite different from building Tandem. Specifically, the risk and cost of building the initial product is dramatically lower. The emphasis is on product to distinguish it from building the company. Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1M and did not entail hiring a head of manufacturing or building a factory.
As a result, for a modern start-up, funding the initial product can be incompatible with the traditional venture capital model in the following ways:
- Lengthy diligence process.
- Too much capital.
- Board seat.
As a result, a venture capitalist usually requires a serious commitment from the entrepreneur to pursue an idea that is highly experimental. If the product doesn’t stick, it might make sense for the entrepreneur to pursue a totally different idea or drop the business altogether.
As entrepreneurs needed someone to bridge the gap between building the initial product and building the company, angel investors stepped up. As they generally use their own money they come with none of the above VC constraints described above: they don’t go on boards, they don’t need to put in lots of capital (in fact, they usually don’t want to), they prefer dead simple terms (as they often don’t have legal support), they understand the experimental nature of the idea, and they can sometimes decide in a single meeting whether or not to invest.
On the other hand, angels do not manage huge pools of capital, so entrepreneurs need to find someone else to fund the building of the company (as opposed to the product) and most angels do not plan to spend a great deal of time helping entrepreneurs build the company.