The Truth About Angels

The Truth About Angels

This century has seen the rapid emergence of the start-up ecosystem and the passion for entrepreneurship as a key economic development strategy to address the plateau of growth in developed economies, or to embrace the opportunity in developing economies. All over the world governments and communities are promoting start-up ventures. Success in this space leads to real jobs growth, new wealth generation and a more equitable distribution of wealth.

However, to start the ball rolling on new ventures there must be a source of risk capital, investors ready, willing and able to provide the cash required to move new ventures into operation. These are the early-stage investors who come in various forms and invest at differing stages.

The most prominent source of this early-stage capital is private investors. Even there, not all private investors are the same. They differ by capacity, capability, investment philosophy and investment strategy.

A key subset of private investors are known as Angel investors, individuals investing their own money and time in what they believe will be high value-growth companies for capital returns. For the most part, Angels invest in businesses they understand well based on their own experience and expertise. To gain access to deeper financial resources, broader experience and superior expertise many Angels collaborate through Angel groups.

Angel investors are distinguished from the broader base of private investors by a number of key characteristics.

  • A proactive intent to build a sizeable portfolio of concurrent investments in early-stage ventures;
  • Proactive investors, who advise, guide, mentor and assist their portfolio companies to plan and navigate the challenging pathway to success and exit;
  • A philosophy that they will only invest their financial capital when they can also invest their intellectual capital (this is a key reason for groups, which deliver a deeper, broader pool of intellectual capital and more collective time to engage with portfolio companies);

With so many people throwing terms like Angel investor around in the burgeoning startup ecosystem it is worth addressing some popular misconceptions.

Myth #1: Angels are only seed investors

A common misconception is that Angels only invest in raw start-up companies, usually called seed or pre-seed investments. Yes, Angels often have a greater appetite for this type of risk than more conservative investors like venture capitalists, family offices, private equity firms and investment banks. A key reason is the greater flexibility an Angel has in acting for himself/herself rather than the arm’s length mandate of those other investors, who are investing other people’s money under a pre-agreed contract.

Usually, Angels invest for capital returns so their interest is in growth companies. However, every astute investor applies a portfolio approach to manage risk, whether investing in property, listed shares, or private enterprises. Often, Angels apply a portfolio strategy within their Angel portfolios by spreading their risk across business life-cycle stages and industries.

Angels invest in seed, start-up, expansion and mezzanine rounds using both equity and debt structures, as appropriate. Essentially, an Angel can and will invest in what he/she perceives as a good investment opportunity at any stage of the company life-cycle. The governing principals will most likely include:

  • The understanding the Angel has of the business, its industry, markets and path to exit;
  • The opportunity for the Angel to contribute his/her expertise, networks and advice to accelerate growth and reduce risk; and
  • The confidence the Angel has in the management team and their willingness to receive and respond to both the financial and non-financial investments the Angel is offering.

Pre-seed investments are for companies that are typically at the concept stage. This is the riskiest type of investment and very rare for most investors of all types. The pre-seed requirement is the one that most accelerators have been developed to address, i.e. how to move an idea from concept to an investable proposition. That usually means a working prototype of some sort but, it depends very much on the nature of the business.

Seed investments are very high risk too. Typically these are investments made in pre-revenue companies to support them through market validation into first revenues. Most Angels will balance the risk of their seed investments with follow-on rounds into existing portfolio companies and first investments into high-performing growth stage companies where the lower risk offers more likely returns. These days such companies are being called scale-ups.

Myth #2: You have to be rich to be an Angel

No question, it is easier to be an Angel investor if you are already a multimillionaire but, it is not an essential requirement.

Decades of experience in Angel investing in Australia, Europe, the USA Canada and New Zealand have demonstrated that Angel groups typically deliver better investment returns than an individual Angel. There are many reasons for this better performance. Most relevant to busting this myth is the greater financial depth a group affords each of its members and the deeper expertise available to evaluate, select and assist the portfolio companies.

The opportunity to invest as part of a group means even those of modest means can be active Angels. With the typical Angel group investment being $100K-$500K, a group of ten investors can easily accommodate those with $50K to invest and those with only $10K. Often the smaller investors are able to make valuable contributions of time and expertise. Those contributions significantly reduce the risk for the whole group and are highly valued by the larger investors who, effectively, enjoy a disproportionate benefit.

Myth #3: Angel investments become VC investments

Arm’s length investors like venture capitalists are constrained by a whole range of factors. Not the least of these is their need to put a large amount of someone else’s money to work and deliver the targeted cash returns within a well-defined period.

Prudent investors, Angels and venture capital firms alike, only invest in businesses for which they believe they have relevant expertise, experience and networks. However, the venture capital firm has defined that range and focus in the contract with its investors and may not stray far from that commitment. Even if the firm brings on board new talent with new areas of experience and expertise during the life of their fund, the contract has already been signed.

Angels, on the other hand, can choose to alter their focus for whatever reason makes sense to them. After all, it is their own money. An Angel group, for instance, may gain new members with new expertise, experience and networks that enable the group to broaden its focus and take advantage of opportunities previously beyond their comfort zone. This diversification of scope is a first order risk mitigation strategy in any investment portfolio.

There are structural aspects of the way venture firms invest that may discourage an Angel-backed company from taking venture capital. This is not because the venture firms are evil, nor unreasonable. Once again it is rooted in their role as the keepers of other people’s money and their obligation therefore to be aggressive in protecting the interests of their own investors.

Every new round of investment should only happen because the company is being successful. However, each new round brings new dilution to the founders and early investors while extending the time to achieve an investment return. The more capital invested, the larger the value of the exit required to deliver on the anticipated rates of return. So while new investment seems to increase the likelihood of further growth, it does not necessarily increase the likelihood of a high multiple exit. Most high value-growth start-ups are exploiting a niche in the market, a temporal or structural opportunity. The longer they take to realise a liquidity event the greater the risk that the opportunity evaporates, or that competitors overtake their advantage. In either scenario the likelihood of selling the company for the desired investment return starts to decrease rapidly.

For these and other reasons the majority of Angel-backed companies are unlikely to engage with venture capital investors. The Angel investors will continue to develop a company, increase its value and reduce the risk until the company is sufficiently attractive to achieve a liquid exit for the investors.

This brief insight into the world of Angel investing has sought to dispel some urban myths and demonstrate the very real opportunity for many Australians to find room for Angel investing in their own investment portfolios.

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