Angel investing – The rest of the story

Editor’s note: “The Angel Connection” is a regular feature in WRAL Local Tech Wire. LTW asked consultant Bill Warner to share advice for entrepreneurs seeking angel investors and/or venture capital investment. He is chairman of the Triangle Accredited Capital Forum, an angel investor network with over 100 members throughout the Southeast.

RESEARCH TRIANGLE PARK, N.C. - In his book, “Fool’s Gold: The Truth Behind Angel Investing in America,” Scott Shane brings a much broader view of the state of angel investing in America than has ever been seen before.

We have all heard the glowing stories about how angel investors have struck it rich by investing in high growth start-up companies like Google, Yahoo, Amazon and others. Although true, these stories paint a very limited picture of what angel investing is all about. Scott tries to clear it all up. (An angel investor with the North Coast Angel Fund, and a professor of entrepreneurship at Case Western Reserve University, he also is the author of “Illusions of Entrepreneurship.”)

His approach is truly an articulate piece of research and analysis, written with the precision of a brain surgeon to eke out as much accuracy as possible, showing 37 pages of references to prove how right he is. Although written in quite a condescending tone, as if he wants to point out how inept angels really are, the reader has to slog through a verbose 230 pages to learn a few dozen interesting facts.

His contribution is a thorough characterization of the entire population of angel investors, offering a precise definition for them: Angel investors are people who provide capital, in the form of debt or equity, from their own funds, to a private business owned and operated by someone who is neither a friend nor family member. Within this definition are investors who are accredited and unaccredited, active and passive, individuals and group members, astute and naïve, experienced and inexperienced, invest a wide range of amounts of money, invest in many different stages of company maturity and have a wide range of industry interests. He is not counting friends and family investors and entrepreneurs who invest in their own companies. He is trying to dispel the myth that angels are sophisticated and brilliant wealthy people who pick winning start-up companies, thus establishing the overstated public image of what an angel is.

Looking across the entire population of informal investors, only eight percent are angels. The rest are friends, family and business associates. Scott points out how small this is to warrant all the hype that angels get. This is not new news, but does put angels in perspective with the whole.

Of some questionable value is his attempt to define the size of the angel investor market, pointing out how small a piece of the overall investment market it is. He cites $162B as the amount invested annually by informal investors and narrows it down to a mere $23B per year, being invested by angels, in over 50,000 companies, $12.4 of which comes from accredited angels. While I understand this perspective, this is a pretty sizeable chunk of money going into small businesses in America. He later points out that this is probably enough to cover the needs of companies that need angel capital financing. So, it’s a small amount, but there’s enough to go around. So, why is his point about the size of the angel market so significant? This is not new news either and is no more insightful than saying that the Earth is a small planet in a vast solar system.

He provides an interesting perspective of what angel investments look like. The public image of angel deals is created by the most sophisticated of angel investor organizations in America. However, when you include all the less sophisticated angels in the mix, he points out how diverse angel deals are with respect to the investment terms, size of investments, investment instrument, investor preferences, valuations and ownership shares to name a few. The deals from sophisticated angel groups look more like venture capital deals, while a large portion of all angel deals look wildly informal by comparison.

Another media myth he tries to dispel is that angel deals are all about high growth technology and life science companies. Although mostly true for venture capital deals, when you look across the spectrum of all angel investments you find a wide diversity of industries led by the likes of retail and personal services. Although this observation is kind of intuitive, he puts real data to work to stick this point in the eye of the media mythologists.

Scott puts a stake in the heart of the myth that angels are financial geniuses who have sophisticated approaches to evaluating business plans and making investment decisions. He does a nice job of showing how sloppy most angels are in due diligence and financial analysis. Given the definition of angels he poses, this is understandable, and later in the book he points out how successful angel groups are who put discipline into the evaluation process and into due diligence on the company. So, maybe there are some smart angels after all.

We all know how risky angel investments are. Scott points out much of what we already know about it. Less that 0.2 percent of angel investments end up in an IPO and about 1 percent end up in an acquisition. Only 41 companies of the 50,000 started annually reach $50M in sales. Only 1.7X returns are achieved. Over half of the angel investments are a bust, and the observations go on and on. But, the angel groups achieve a rate of return of 27 percent. Scott discounts this to 19.2 percent, to account for opportunity lost, which nobody else in the world does to an IRR calculation. I guess he needed a way to make it look worse. So, maybe that myth about angels has some truth to it, but only for those angels in sophisticated angel groups.

After 162 pages of excruciating detail, the reader gets to read about where the myth really comes from. It’s the rapidly growing group of angels that are within angel groups throughout the US. He observes that this is the place where the accredited investors hang out and pool their money and knowledge of industries that they know well. These very high net worth people and skillful business men and women have well thought out processes for evaluating companies and performing due diligence. They syndicate with one another to come up with investments ranging from a few hundred thousand dollars to well over a million each. As a result, they pick some great deals. Then, voila, they get better results than other angel investors. These are the people that the media mythologists are talking about. Why would they want to talk about the rest who lose their shirts?

For the reader who would like to get a perspective of the full range of angel investing, Fools Gold paints the best picture you will find. You would have to suffer through the wordiness to read it, but if you only read the conclusion and data chart at the end of each chapter, you could go through this book in less than an hour and learn a lot.

About the author: Bill Warner is the managing partner of Paladin and Associates, a business consulting firm in the Research Triangle Park area of central North Carolina, and is the chairman of the Triangle Accredited Capital Forum, an angel investor network with over one hundred members throughout the southeast.