Start-Up Growth Often Relies on the Work of Angels

by Robert W. Fesnak, CPA, CMA, CVA | Sep 04, 2018

For the rising entrepreneur, obtaining access to capital is a major hurdle. There is a large capital gap between friend and family funding and institutional venture capital funding. This is partly due to the success of venture capital funds and their focus on larger, more developed investment opportunities. In addition, venture capital funds tend to favor more conservative investments in companies past the start-up stage. Angel investors are critical to filling funding gaps, particularly for start-ups and early-stage companies.

Who Are the Angels?

Business angel investors tend to be high-net-worth individuals (also known as accredited investors) who are interested in investing in start-up and early-stage companies. Angel investors may be individuals who invest solely on their own, or they may make investments through either formal or informal angel groups. Angel groups often offer access to investment opportunities; share deal costs, such as those for due diligence and the development of standard investment documents; and provide a diversified set of skills and expertise.

Angels invest primarily in companies at the early seed or start-up stages, but about 25 percent of angel investing will be in expansion-stage companies.1 A growing percentage of angel investors are technology and life science entrepreneurs who have had a successful exit from their previous companies. These investors recycle some of their proceeds back into the system as a new source of capital for early-stage companies and a critical boost to their communities.

Tom Petro, managing partner of 1867 Capital Partners and an angel investor in eight companies, claims that his investments have created 227 jobs over the past three years – a considerable number given the small size of the start-ups. According to the small-business lending firm Fundivo, 3.6 jobs are created in the United States per angel investment.

Profiles in Investment

A company receiving angel investment typically has a number of the following:

  • A business plan and business model
  • A prototype product
  • Initial research (and perhaps some development)
  • A management team being built
  • Some understanding of the marketplace for their product and how to price it
  • Some family and friend funding, including some degree of funding from the founder
  • Intellectual property protection
According to Fundivo, the top three industries funded by angels in the United States are technology and software, health care, and life science.2 These industries have experienced significant growth and seen opportunities for value creation.

Many angel investors are not product specialists, so they tend to focus more on assessing the company’s ability to penetrate the market, manage operations, and execute the business model. Petro notes that, in his evaluation of a potential opportunity, he tries to decide if the investment is a product or a company. He wants to invest in companies. Angel investors want to believe they are investing in what will be a long-term going concern.

To demonstrate to potential angel investors that a company is viable, management must first prove the following:

  • The product works.
  • The marketplace wants or needs it.
  • The product is priced correctly.
If a company does not have all three elements, then it most likely will not be sustainable.

Investors want to invest in a company that can be leveraged, one that is scalable and viable. An inability to clearly communicate how the business will be able to sustain rapid growth in the near term would be an impediment. A lack of experienced advisers who have been through the process and can provide constructive criticism is also a concern.

Here are several observations from angel investors regarding what they look for in a start-up.

Management – Don’t be focused more on the product than the company. The founders need to be able to execute the business model. At this early stage, without any revenues to help gauge the viability of the product, investors will be trying to understand the probability of management being able to execute. In addition, don’t let the valuation of the company be a problem at this stage.

Investment – The entrepreneur should have “skin in the game” (funds at risk) to show investors that they are personally committed to the success of the company. The entrepreneur also must understand that all parties need to make money.

Culture – The entrepreneur must be able to listen to investors and be flexible enough to change course if needed. Good chemistry among the entrepreneur, investors, and board members is critical.

Types of Investing

Early seed and start-up companies present considerable risks for angel investors due to these factors:

  • The research and development nature of the product
  • The lack of empirical data regarding the market
  • Insufficient experience of the founders
  • The absence of access to capital
  • Uncertainty regarding management’s ability to execute the business plan and business model
To compensate for the number and magnitude of these risks, angel investors usually require a rate of return on their investment that is greater than that required by venture capital firms.

Between 2008 and 2016, the median-size round of financing from angels was $400,000.3 Typically, initial angel rounds are between $50,000 and $200,000 per investor, providing start-ups with an early kick-start of capital. Follow-up rounds vary, depending on the progression, or lack thereof, of the company and whether certain milestones were met.

It’s always better to build a business around a technology or product with the assistance of investors who have been through the process before and can anticipate potential issues. Angel investors often offer the services of executives who are familiar with the company’s industry – a nonfinancial contribution that makes the fiscal investments all the more effective. This type of investment – also known as “smart money” – brings the executive’s skills, industry expertise, business experience, professional reputation, network contacts, and connections to potential future funding sources. It is often the case where an initial angel, having previously gone through the funding process, is able to assist management with introductions to, and negotiations with, other funding sources.

Entrepreneurs tend to underestimate the amount of capital they need to get to the next round. This may be due to overconfidence on the part of the entrepreneur regarding the funds needed, or it may be a valuation issue. The goal is not just to survive to the next funding round, but to do so while significantly increasing the company’s value. While start-ups don’t want to take in excess funding and further dilute the entrepreneur’s equity, they must be aware of the amount needed to get to the next inflection point where value has been created.

Angel investing requires patience and flexibility regarding a business’s path to success. Patience is needed because the holding period for angel investments is generally between four and six years; for some investments, especially highly successful ones, the holding period can be upward of 10 years. Time is needed to complete the product research and development, commercialize the product, negotiate and close on institutional rounds of financing, grow the business and, ultimately, execute the investor’s exit plan. Additional rounds of financing will mean that the angel investors’ equity interest will be diluted if they do not continue to invest at each round. Flexibility is required to be able to adjust quickly to changes in the external factors that directly affect the business, such as regulations, technology changes, market needs, and competition. A business plan or model is not a long-term document.

Investors and entrepreneurs generally connect through personal contacts, business professionals, and early-stage events where companies present their products and business plans to an audience of angel investors and early-stage venture capital. Events include Angel Venture Fair, the annual Philadelphia Alliance for Capital and Technologies (PACT) Capital Conference, Delaware Crossing Investor Group, university business plan presentations, and other less formal events. An example of the benefits of these events is the Lion’s Den presented by PACT at its annual Capital Conference. According to Dean E. Miller, president and CEO of PACT, “Through the first three editions of the Lion’s Den, five of the nine companies have collectively raised over $3 million.”

Investing in start-ups and early-stage companies is a high-risk proposition. According to the 2016 Angel Returns Study by the Angel Resource Institute, the cash-on-cash multiple on their investment portfolio averaged 2.5 times the original investment, which worked out to be an internal rate of return of about 22 percent in the 2016 study,4 down from 27 percent in 2007. The investment portfolio may average 22 percent, but individual investment returns are extremely volatile. The 2016 distribution of these results were such that 70 percent of exits resulted in losses; only 7 percent experienced returns greater than 10 times the original investment.5

Types of Investors

Active investor Jeff Fox observes, “The increase in the number of angel investments made in recent years is because angel investors are seeing more deals and better-prepared entrepreneurs. This is because of the congruence of business schools focusing on entrepreneurial studies and improved training of students to better understand what is required to start a business.” Graduate students may also have a different mind-set: They want to be independent, be their own boss, and use innovation to change the world.

The median angel and seed round over the past eight years has been about $400,000. The average amount was $1.15 million, which is skewed by several large rounds that are not representative of a typical round.6 However, as Miller recently stated, “There are more super angels and super angel groups that play like an institution as to deal size, number of deals, and sophistication.” These super angels are capable of investing larger amounts and are able to provide additional capital after the initial investment. This defers the need for venture capital funding until a later time when the company has a higher valuation.

Companies are also doing more bootstrapping to defer the raising of the initial angel round. U.S. start-ups are waiting 2.4 years (median) to raise their initial angel round. This is a year longer than 10 years ago.7

Types of Financial Instruments

Financial instruments that can be used for investing in early-stage companies are common stock, preferred stock, and convertible debt. The use of common or preferred stock requires both parties to agree on a pre-money valuation. Valuation, however, is difficult because these companies often lack the following:

  • Hard assets
  • Historical financial data
  • Revenues (or have minimal revenues)
In addition, early-stage companies likely have more uncertainty in their financial projections, more volatility in their cash flows, a product that is still being developed, and a management team that is still being built.

The stage of the company, the lag time to revenues, and the quality of management can help to set a range for the pre-money valuation. However, many early-stage companies use convertible debt with a discount from the next round of financing in these situations. It is probably the fairest way to handle the valuation issue, basically deferring it until a later round. The typical discount is about 20 percent, so an angel investor gets credit for investing early at a riskier time in the life of the company.

A Need for Angels

The increase in the number of deals funded by angels over the past 10 years is exciting, but more is needed. The number of serial entrepreneurs doing angel investing continues to grow, providing some of the needed capital to fuel a robust entrepreneurial system. But they can only do so much. There is no lack of start-up and early-stage companies that have great ideas and products. What they need are angel investors who will help grow their ideas to fruition and enable them to compete and succeed.

1 Angel Investment Statistics, Fundivo.
2 Ibid.
3 PACT
2017 Philadelphia Venture Report, data provided by Pitchbook.
4 2016 Angel Returns Study, Angel Resource Institute.
5 Ibid.
6 PACT
2017 Philadelphia Venture Report, data provided by Pitchbook.
7 Ibid.


Robert W. Fesnak, CPA, CMA, CVA, is a partner with RSM US LLP in Blue Bell. He can be reached at robert.fesnak@rsmus.com.

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