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Thinking Like An Entrepreneur
Table of Contents

Chapter 3
Men Are Cheaper Than Guns

Chapter 4
Intellectual Capital And Bootstrapping

Thinking Like An Entrepreneur


Angel Financing

If you're an entrepreneur seeking capital, a retired businessperson wanting to make aggressive investments in start-up companies, or a semi-retired, affluent business manager searching for a position, you'll want to learn about the world of angel financing.

After creating a database of 8,200 active angel investors, Gerald Benjamin and Joel Margulis, authors of Angel Financing: How To Find And Invest In Private Equity, conclude that the average angel investor is between 48 and 59 years old, has a postgraduate degree, has experience in management and in building a company, and typically invests between $25,000 and $250,000 per deal in one to four deals per year.

Based upon the U.S. distribution of wealth, Benjamin and Margulis ague that nearly 2.6 million U.S. investors are financially capable of making high-risk investments. (1.7 million households have an estimated net worth above $500,000; 700,000 households have a net worth above $1 million; 160,000 households have a net worth above $5 million; and about 10,000 households have a net worth above $10 million.)

However, the active investor market is much smaller—maybe 100,000 to 300,000 investors. The bulk of these investors are self-made millionaires with a worth between $1 million and $10 million. Many of these investors participate in informal networks that share information and invest as a syndicate. This allows larger sums of money to be raised while spreading the cost of due diligence.

Many of the 'lower-class' affluent, who aren't business owners, are unlikely to become serious angel investors, so, possibly, under a million potential angel investors actually exist. Plus, as Benjamin and Margulis point out, seeking investors with a net worth below $1 million could lead to problems.

To help protect non-business-savvy individuals from predators who promote dubious investments, the SEC restricts and monitors the sale of securities. Full registration to sell securities publicly is a costly process. But, realizing the need for smaller companies to raise capital, the SEC offers various exceptions to full securities registration.

These private placements often restrict advertising and offerings to the general population. But, certain individuals are deemed not to need the protection provided by securities registration. These individuals are labeled 'accredited investors.'

Compliance with securities laws often hinges upon knowing certain investors are accredited. For example, exemption from registration under Rule 505 or Rule 506 requires certain disclosure documents be provided if sales are made to 'non-accredited investors.' But, sales to 'accredited investors' are allowed without the proscribed disclosure documents. And, providing these documents isn't cheap. It's not just a matter of running down to Kinkos.

While several characteristics may define an 'accredited investor,' most common is an individual with a net worth above $1 million. Of course, there are many wealthy athletes and entertainers who don't know one iota about business or investments, but who are considered 'accredited.'

Fortunately, many of the extremely affluent, those with a wealth above $10 million, have professional financial advisors who make their investment decisions for them. Benjamin and Margulis tell us that because these professional advisors tend to be extremely conservative and sensitive to risk, the few families with wealth above $10 million don't tend to make as large a percentage of angel investments as one might expect.

It's important to avoid 'deal breakers.' These are financial advisors who will nix every deal, even a good one. The client can congratulate the deal breaker for preventing a bad investment and pay the deal breaker a hefty fee. Unfortunately, some of the broken deals might have been quite good. It's just habit for the deal breaker to find some reason to kill the deal. That's just how they view their jobs.

Because angel investors often have a management or entrepreneurial background, they tend to value real-world business experience. Benjamin and Margulis emphasize that business plans don't get funded, rather people get funded—especially people with industry experience.

Benjamin and Margulis say the first question entrepreneurs seeking angel capital must ask is: "Am I fundable?"

When approaching angels, it's crucial to be honest about any negatives associated with you or your venture. Not only does being upfront show your integrity, but a serious angel investor will uncover any problems when he or she performs due diligence anyway. Hiring a private investigator to perform a full background check on the lead entrepreneur is common. Benjamin and Margulis say entrepreneurs should anticipate and prepare for a thorough due diligence process.

Because individual angels don't have to invest, they won't be beating down an entrepreneur's door offering capital. Highly illiquid private placements aren't sought out for purchase, rather they are sold. Benjamin and Margulis say funding is built one relationship at a time, and that it's the entrepreneur's responsibility to see things from the investor's perspective and sell the investor face-to-face on the investment. Show how the company solves a market need.

Benjamin and Margulis write: "One of the most important traits of a successful fund-raiser is having the vision to create, conceptualize, and communicate a workable solution to a problem."

Being sure the product or service works is important to most investors. While having a great growth market is nice, it doesn't do any good if the product doesn't work. For example, Mark Twain lost a bundle and was driven into bankruptcy partially because of making bad investments in ill-conceived typesetting machines. Yes, Twain saw that type wouldn't be set by hand in the future. No, just because Twain realized that didn't mean he'd profit from it.

A working prototype has value. A product that has established market demand is even better. When money can be spent to produce and market a product, that money is less at risk than money spent to create new, untested products. Early stage product development companies need to give investors quite a bit of equity to compensate for the risk associated with product uncertainty.

Angel investors tend to like proprietary products and non-capital-intensive businesses. When I think "capital intensive," I think of industries like shipbuilding. But, today, it's those darn proteins! With required FDA approval, Benjamin and Margulis tell us that it takes about $200 million and twelve years to bring the average protein to market. So just because the business fits in a test tube doesn't mean it isn't capital intensive!

Experienced angel investors know that growing a company often takes more capital than anticipated. They anticipate future rounds of financing and dilution of their equity when valuing a venture. They ask themselves, "How much money will we need to raise in the future and where will we get it? What happens to my investment if we can't get the future financing from other sources? What rate of return is likely given the necessary future dilution of my ownership?"

One savvy investor said he loves making investments when a deep-pocketed investor is already committed to the enterprise's success. If a deep-pocketed investor has already placed $1 million into the company, it's likely that investor will provide a bit more money to keep the company going if the company gets into trouble, assuming the future still looks good.

Entrepreneurs should choose their investors carefully and budget for the fund-raising process. Does the investor have the resources, the expectation, and the desire to make future rounds of financing? Benjamin and Margulis say that about 10% to 15% of the amount entrepreneurs desire to raise should be budgeted for the fund-raising process.

While it's clear entrepreneurs seeking capital and aggressive investors seeking to make investments in smaller companies will want to learn about angel financing, why might a semi-retired, affluent business manager seeking a position benefit from studying angel investing?

Benjamin and Margulis say that one of the growing areas of angel investing is the manager-investor. Typically, these are older business executives or displaced technical workers who have a relatively high-level of wealth but who aren't quite ready for retirement yet.

Benjamin and Margulis write: "...they want to get back into the fray, but they have too much dignity in their late 40's to late 50s to push their resume across a table, or they are too affluent to make such a move in terms of their net worth....What they're going to do is buy their next job."

These executives typically want to invest $100,000 to $200,000. But, unlike some 'investors' who want to take over a business, these managers don't want control of the company. They do want a significant day-to-day role and want to add value to their investment through their knowledge and experience.

The desired level of investor involvement should be discussed and mutually agreed upon by the entrepreneur and the investor. And, in all cases, the personal chemistry between the investor and the entrepreneur and his or her management team is important. Remember, angel investments aren't sales where the parties walk away immediately after completing the deal. Rather, agreeing to a deal is only the start of what will hopefully be a beautiful friendship.