Angel Financing: How to Find and Invest in Private Equity / Edition 1

by Gerald A. Benjamin, Joel B. Margulis

Overview

Your guardian angel has arrived

Capital is the single most important factor to getting your venture off the ground, but finding it can be a challenge, particularly if you're running out of funding options. Suppose your venture is too small for institutional players. What do you do once you've exhausted your personal financial resources? Where do you go after banks, the leasing companies, the venture capital firms, have turned you down? What you need is an "angel"—a private investor with high net worth. Angel Financing—the only book of its kind—provides you with a road map to this valuable, little known, source of capital financing.

Explains the structure of the direct private capital market

• Covers everything from the valuation process to writing an investor-oriented business plan

Product Details

ISBN-13:	9780471350859
Publisher:	Wiley
Publication date:	11/02/1999
Series:	Wiley Investment , #75
Edition description:	Revised ed.
Pages:	336
Product dimensions:	37.72(w) x 11.62(h) x 1.15(d)

About the Author

Gerald A. Benjamin (Sausalito, CA) is a Senior Managing Partner of International Capital Resources (ICR), an investment banking, corporate finance, and capital sourcing firm. He is also publisher of the California Investment Review.

Joel Margulis (Mill Valley, CA) is a freelance writer who has published books and articles on a range of business and finance topics.

Table of Contents

THE CHALLENGE AND THE SOLUTION.

The Challenge.

The Private Placement Investment.

A Strategy That Works.

THE ANGEL INVESTOR.

Alternative Sources of Capital.

What Do Private Investors Look For in a Deal?

Types of Private Investors.

The Newest Breed of Angel: The Manager-Investor.

RESOURCES: FINDING ANGEL INVESTORS.

Alternative Funding Resources in Accessing Angel Capital.

Building Your Own Database of Angel Investors.

The Role of the Placement Agent in Raising Capital: A Marketing Partner for Your Deal.

THE INVESTOR PERSPECTIVE.

The Venture Process.

The Valuation Process in Private Transactions.

Due Diligence.

On-line Options: Entrepreneurs, Investors, and Web-Sites.

Conclusion.

Appendices.

Introduction

The Challenge

The grand impresario Florenz Ziegfeld had a backer-- an "angel," in Broadway parlance-- named Jim Donahue who at the time of the 1929 stock market crash was disastrously affected financially. Deeply despondent over his losses, Donahue took his own life by throwing himself out of his office window. When Ziegfeld heard the news, he immediately penned a note to Donahue's widow that read, "Just before your husband 'fell, ' he promised me $20,000." Needless to say, three days later the money arrived. And that's the kind of chutzpah it took then-- and takes now-- to raise capital for high-risk deals.

THE CHALLENGE

Make no mistake: Raising funds for an early-stage venture or a small-growing business is an arduous task.

Where do you turn once you have exhausted the founders' financial resources and those of family and friends, but are not yet able to access venture capital? What if you're worn out from struggling with venture capital firms, banks, factors, leasing companies, and the like? What if you lack the ability to fund growth from cash flow or retained earnings? What if you have not yet achieved financial strength and public reputation sufficient to support a small corporate offering registration (SCOR) or an initial public offering (IPO)? What if your venture is not defined by the venture capital community as a "darling" industry? What if your deal is too small for institutional players-- say, in the $100,000 to $300,000 range?

During the formative years of a start-up, entrepreneurs assume the responsibility for, and risk associated with, making their dream become a reality. Typically, a substantial portion of their net worth is committed to the venture. But by the first major round of funding, entrepreneurs often have exhausted their own financial resources and those of family, friends, associates, and business contacts. So entrepreneurs face a daunting challenge.

This challenge so often faced by entrepreneurs reveals only part of the task involved in early-stage capital formation. Even though these entrepreneurs create benefits-- jobs, advancement of technology, capital expenditures, asset growth, and contribution to tax revenues-- the supply of needed capital for early-stage ventures recently has been dwindling. There are three reasons for this: (1) start-ups need more money than in past years; (2) traditional capital and financing have diminished; and (3) more competition exists for start-up capital.

Taking each of these points in turn, first, a 1986 study by the National Venture Capital Association (NVCA) and Coopers & Lybrand (C& L) revealed that venture-backed companies founded between 1981 and 1985 needed an average of $7 million in capital during those five formative years. By contrast, repetition of this study in 1994 for the period 1988 to 1992 disclosed that required start-up financing-- enough to survive and thrive-- had increased to an average of more than $19 million in private equity. While it is true that the amount of seed capital required is correlated with the technology (the higher the technology, the higher the seed capital required), the NVCA/ C& L studies demonstrate a 173 percent increase in funding needs in only seven years! Moreover, as Forbes magazine reminded us at the end of 1998, traditional venture capitalists are agents of other people's money and seldom finance brand-new companies. Small companies are setting their sights well below the mean venture capital deal of between $3 million and $7 million. Small companies simply do not need that level of funding.

Second, while the need for capital has been increasing, the supply of traditional capital has been decreasing. According to statistics taken from Reviving the American Dream by Alice Rivlin, net private saving shrank from 8.7 percent of national income in the years 1947 to 1973 to 4.9 percent in the years 1986 to 1990. Since 1980, net domestic investment-- private and public-- has declined from 7 percent of national income to 4.7 percent.

The third reason why it is more challenging today to raise capital among those with impressive personal wealth-- especially those interested in investing in higher-risk deals-- is that they are the target of everyone from charitable fundraisers to the most successful money managers. In a word, there is simply more competition for the money that is out there than there was ten years ago.

Ten years ago everyone had a resume tucked neatly away in the desk drawer; today everyone has a business plan. And with the people currently intent on starting their own businesses, cities such as Boulder, Nashville, Tampa, Miami, and San Francisco have become zones of entrepreneurial fervor. A Radical new way to wealth can involve coming up with an idea, then raising the money to fund it into a reality. Today, more than ever before, highly successful individuals are attempting to achieve their own success and enhance their personal wealth through entrepreneurial ventures.

Understandably, new money managers, foreign money managers, and other advisers seeking to manage funds aggressively target higher-net-worth individuals. In fact, a survival mentality has gripped those who compete with professional money managers for private capital. Besides, as the flow of deals surges, private investors become more sophisticated in evaluating what constitutes an attractive high-risk/ high-reward opportunity.

International Capital Resources of San Francisco (ICR) recently conducted a survey of more than 480 entrepreneurial ventures seeking capital. The entrepreneurs cited an expanding array of financing methods they were relying on to accomplish their financing goals. However, the majority identified one alternative financing resource as a practicable and preferred option: private equity and debt investors.

Exhibit 1.1 presents the primary funding methods mentioned during those interviews (no percentage is given for methods receiving only minimal recognition).

ICR discovered that 61 percent of entrepreneurs who came to its investment banking firm in their search for capital were relying on the direct participatory investment, casting an eye primarily toward informal, high-risk venture investors as their means of raising capital. Eighteen percent anticipated relying on their personal financial resources and those of family, friends, and business contacts. Only 9 percent of these primarily earlier-stage and developmental-stage companies were capable of relying on profits and working capital in order to fund their growth plans. Only 7 percent turned to banks for debt financing, and 3 percent chose joint ventures and alliances. Finally, only 2 percent of the 480 companies queried showed interest in approaching professional venture capital firms to fund their venture.

THE DIRECT, PRIVATE INVESTOR

The term angel was coined by Broadway insiders to describe the well-heeled backers of Broadway shows who made risky investments in order to produce shows. Angels invested in these shows for the privilege of rubbing shoulders with theater personalities they admired. As a review of the biographies of the great impresarios attests, money for those shows was raised as much by attitude, good preparation, and luck, as by the quality of the offerings.

Angels today-- numbering about 300,000, according to Forbes-- are in many ways the same: wealthy individuals and families willing to invest in high-risk deals offered by people they admire and with whom they seek to be associated. Angels are also financially sophisticated private investors willing to provide seed and start-up capital for the higher-risk ventures. In essence, angels are private informal venture capitalists.

Angel investors possess the discretionary income needed for such risky ventures. In fact, a portion of their private equity portfolio is often set aside for this purpose. This discretionary income sets the angel investor apart-- even from the merely affluent. An affluent individual may have an annual income of $100,000 but annual expenses totaling $150,000. Large incomes, we know, can carry even larger debts. For this reason, we distinguish between those who are affluent and those who are wealthy. In setting standards for targeting investors in these high-risk ventures, many entrepreneurs mistakenly judge investors solely on their income; income alone has little to do with what counts in these types of ventures. What counts are the discretionary funds for early-stage, high-risk transactions, funds possessed, again, only by wealthy angel investors, not by the affluent, whose debts can exceed their considerable annual incomes.

Angel investors-- or the nonpoor, as we choose to refer to them-- also possess a healthy appetite for self-arranged private deals. Such direct investment serves to maintain the self-confidence of these high-net-worth investors and demonstrates their continuing ability to make money. These investors have amassed wealth precisely because they know how to invest. Further, it is reasonable to assume that they will remain active investors. Many want to enjoy the small percentage of their capital allocated for private equity. After all, even the most conservative investment adviser will leave a client some money to play with. It is this "play money" that ought to become the target of entrepreneurs seeking funding for high-risk, relatively illiquid, direct investment securities. These deals, in turn, offer the possibility of capital appreciation.

Angel investors include such high-net-worth individuals as the retired officers of corporations and private companies with $1 million to $5 million in pension assets to invest; the recipients of the estimated $20 billion in windfall transfers projected for the 1990s; the high-net-worth casualties of corporate downsizing; and the thirty-something and forty-something chief executive officers (CEOs) of small capital companies. These investors have saved money, are financially astute, and possess engaging, challenging intellects.

Further, these angel investors are concerned with after-tax returns and return after expenses-- the expenses, for example, of due diligence, intermediaries, and investment banking fees. They represent "patient" money, remaining comfortable with a long-term, buy-hold strategy, money not designed, as the Atlanta, Georgia, G& W Premium Finance Gazette puts it, "for high current income," but instead money that "often won't be available for some time." (The Gazette cites some examples: $25,000 invested in 1956 in Warren Buffett's Berkshire Hathaway has a 1995 estimated value of $90,000,000; the same amount invested in 1989 in Home Depot reached an estimated value of $3,500,000.) Last, angel investors define risk idiosyncratically, for example, the nature of potential loss-- irrecoverable or affordable-- the need for liquidity, and the need for control.

STRUCTURE OF THE PRIVATE INVESTOR MARKET

The structure of the high-net-worth private investor market (Exhibit 1.2) can be segmented into four categories: first, investors with a net worth of about a minimum of $500,000, comprising a little more than 1.7 million U. S. households; second, a group of investors with a net worth of $1 million to $5 million (about 672,000 households); a third group worth $5 million to $10 million (about 158,000 households); and last, a segment with a net worth of more than $10 million (roughly 9,000 households).

This market includes the target group that offers the entrepreneur or inventor maximum possibility for finding investors. Growing at an annual rate of 14 to 20 percent, this high-net-worth market compares favorably, for example, with the current 8 percent growth rate in pension funds. Furthermore, each of these segments is adding about 1,000 households a year.

While we de-emphasize the use of income as a primary demographic in targeting the high-net-worth group, Exhibit 1.2 shows a similarity between the structure of affluence, or income, and net worth. Notwithstanding our earlier distinction between income and net worth, some correlation naturally exists between net worth and income. But do not be swayed by the numbers.

In the United States, people with incomes between $200,000 and $500,000 a year submitted about 676,000 returns to the Internal Revenue Service (IRS) in 1991, accounting for 0.5 percent of the house- holds. Those with incomes between $500,000 and $1 million submitted about 118,000 returns, or 0.1 percent of the total. While no direct correlation exists, those with higher incomes-- say $200,000 to $1 million-- overlap with those having a high net worth of $1 million to $10 million. So when we compare the numbers in two sections of Exhibit 1.2 we see similarities.

We see that there are about 672,000 households with a net worth of $1 million to $5 million and 158,000 households worth between $5 million and $10 million. Also note that 0.7 percent have a net worth of $1 million to $5 million. Less than 0.2 percent have a net worth of $5 million to $10 million. So the percentages of households correlate closely to those percentages of returns. Those with incomes of $200,000 to $500,000 equal 0.5 percent of returns; those with incomes of $500,000 to $1 million filed 0.1 percent of the returns. Thus, the numerical similarities point to a similarity between the structure of income and net worth. Still, the fact remains: Discretionary net worth forms the true measure of our target market.

The majority of investors represented in the categories of net worth ranging from $1 million to $10 million are self-made. Most rich Americans have earned their money; theirs is not inherited money, reveals the 1995 RAND study by the Santa Monica nonprofit research group. These individuals have built and own their own companies and have generated their personal fortunes through hard work and through understanding an industry or a business.

However, while these numbers seem large-- a $4.5-trillion market and approximately 2.6 million U. S. households that might be appropriately targeted-- the market for higher-risk, developmental, or expansion deals is substantially less than that. A portion of these investors is not composed of accumulators, or people investing in growth investments with possible capital appreciation; instead, they represent savers and those looking for income from their investments-- circumstances incompatible with earlier-stage investments.

Other circumstances also lessen the pool of investment dollars. The dollars diminish when you correct statistics for geographical locale and proximity of the company seeking the direct investment. The dollars also diminish when you scan such items as net worth (exclusive of house and car), previous investment history, current holdings, status and role in the business community, and interests in specific industries.

Considering the circumstances, our own calculations indicate that for higher-risk, early-stage, manufacturing-related deals, the true market contracts to about 300,000 investors. This range exists because investors who engage in direct investing in early-stage deals typically surface only a few times a year, and only when seeking new investments that follow a liquidation or windfall event-- or simply when they are in the mood for a change.

INVESTOR ACTIVITY IN EARLY-STAGE DEALS

While it is true that private investors prize their privacy and that obtaining information about private transactions in this highly secretive market is difficult, International Capital Resources' proprietary research, plus other important studies, can help us understand the extent of the activity of the high-net-worth investor's direct investment in early-stage deals.

In his landmark study funded by the Small Business Administration, Dr. Robert J. Gaston suggests, as we noted in the preface, that approximately $55 to $56 billion a year is being placed into as many as 720,000 companies. Dr. William Wetzel, Jr., at the University of New Hampshire Whittemore School of Business has suggested that approximately $15 billion of this $55 to $56 billion was being placed into approximately 60,000 very-high-risk, early-stage, seed, research and development (R& D), or start-ups per year. And in one of his speeches, Robert Pavey, a general partner at Morganthaler Ventures in Cleveland, also suggested the $55 to $56 billion figure, with as many as 500,000 companies receiving the disbursement of capital from the private investor market per year. Meanwhile, the Small Business Development Center at the University of California, Irvine, has suggested that in California alone approximately $30 billion is being invested in about 240,000 transactions per year.

Although these estimates vary, the amount of capital and number of transactions involved signal a vast market. In contrast, the venture capital industry in 1994 invested a total of $4.9 billion, of which approximately $1.09 billion went into about 314 seed and first-round transactions. By comparison, then, we see that the private investor market fairly glitters as a major source of capital for the higher-risk, early-stage investment.

Simply put, private investors, or business angel investors, are a primary, if not the primary, source of capital for early-stage and growing companies.

ANGELS, A GOLDEN CAPITAL SOURCE

So we see that angels are investors worth accessing. Cass Apple, former president of Sierra Designs and founder of Digital Records Corporation, thinks so. He felt motivated to turn to an angel instead of an institutional investor because of the willingness of angels to commit large stakes in individual companies based on the understanding that angels, in turn, want a voice in management. Speaking to the San Francisco Business Times, Apple put it this way: "The typical venture capital firm wants to get involved only when you are further along-- and for more money than you need. The primary advantage of going with individuals is that it is much quicker and you can tailor the details of the deal to the individual investor."

Apple also valued early funding from someone who added brain power, plus the perspective of an experienced partner. Such an early investor, he concluded, could help develop a marketing strategy as the company prepared to bring its product to market.

He surmised still another advantage: Despite the healthy return for the angel from a successful start-up, the angel would exercise less control at the beginning than would a venture capitalist. The ability of the investor to deal with the entrepreneur was, for Cass Apple, where "the rubber hit the road"-- and with a lot less friction.

INVESTORS WORTH ACCESSING

So, as Cass Apple found out, these investors are worth accessing.

Still, there exists the old problem of meeting these investors. In his book Giant in the West, Julian Dara writes that for 19 years Joseph Strauss attempted to get funding to build the Golden Gate Bridge! Nineteen years before he found A. P. Giannini, who ultimately financed the $6 million necessary for construction. Although contemporary entrepreneurs have been creative in identifying and accessing alternative sources of capital for their growing ventures, we have to be realistic: How many of us have the patience of a Joseph Strauss?

For many entrepreneurs, finding, attracting, building relationships with, and closing with private business angel investors remains inefficient. The reason is simple: Angels prize their privacy. These individuals are hard to find; moreover, a fair review of the literature will indicate that there is little formal guidance in identifying their whereabouts. Currently, most angel investors are located primarily by word-of-mouth contacts from other investors or by reliance on professional intermediaries with a book of investors in related fields.

Angels are hard to locate for the simple reason that they are secretive about their investment interests, since everyone eagerly solicits them to access their wealth. Is it any wonder they cling to their privacy? Because of these circumstances, you could make hundreds of presentations, spend countless hours, and waste thousands of dollars searching for private investors. Largely, labor lost. Lost, that is, unless you learn to use proven strategies that make the search more efficient. This means not only identifying these people but also establishing contact and managing relationships with them throughout the funding process.

The challenge, then, lies in efficiently accessing these investors. How do you find them? Chapter 3 will tell you how. But before tracing a strategy that works, you need the information in Chapter 2 on direct, private investment to determine whether your deal-- and you-- are, in fact, financeable.