March - 2000 - issue > VC Talk

As noted in Qualification of an Angel (siliconindia, December ’99, www.siliconindia.com/magazine), angel investing is a phenomenon on the venture capital scene. It is estimated that each year over 250,000 angels invest $10 billion to $20 billion in 30,000 firms in the US. The previous article focused on the “invisible” quality of these private investors, but there is also another aspect to angel investing: the growth of “bands of angels” roaming the high-tech corridors seeking to avoid the pitfalls associated with individual angel investing, and pooling their resources for more investing and negotiating power.
What are those problems? We can think of four that have led to the formation of quiet angel groups, giving Regulation D qualified investors the opportunity to target their own seed capital.

First, individual angels have a hard time finding appropriate ventures, and the process to unearth them is inefficient. Second, individual angels have little or no support staff and limited time and resources. Each step of the angel investing process benefits from the efforts and skills of members. These steps include sourcing and screening of deals, due diligence, term negotiation, post-investment involvement and follow-on financing, as well as exit.

Two other reasons why angels form bands are: the visibility as a group and the opportunity to network with other angels for learning and fun.

Our research shows that individual investors who are motivated to invest at the seed and start-up stages gain much from the “networks of trust” they establish with other private investors, both socially and intellectually. In fact, it is these networks that have allowed angel investing to grow and prosper in the past five years.

In our interviews with individual angel investors in Silicon Valley and the 128 Beltway in Boston, we learned of four basic types of angel groups:

* Seed financing businesses (e.g., Furneaux & Co. and BRM)

* Member-organized angel clubs (e.g., Band of Angels on the West Coast and Walnut Venture Associates on the East Coast)

* For-profit matching and investment organizations (e.g., Garage.com and VIMAC)

* Third-party matching services (e.g., Investors’ Circle and ACEnet)

Angels and angel groups in other parts of the US can be located through local universities, small business development agencies, venture law firms, venture-related accountants, investment bankers, and Internet searches.

What are the characteristics of each of these types of angel groups? Let’s look at them one by one.

Seed Financing Businesses

Seed financing businesses are full-time businesses that provide seed and follow-on financing. The firm’s principals supply the capital. They also provide emerging companies with “company growing” expertise on a full-time basis. They help recruit executives and sometimes take an interim operating role to jump-start the operations of a new venture. These groups typically make a few relatively large investments per year. The chart accompanying this article shows both the size and the levels of investing of each one of these angel group types.

Seed financing businesses have fairly formal operating structures. They are incorporated as limited liability corporations (LLCs) or S-corporations and have full-time paid administrative assistance. The principals are likely to meet on a weekly basis to address the issues of the portfolio companies and to leverage their combined network of contacts for deal flow. The business will also pay for expert opinions as needed for patent searches, market assessments, and background checks of the entrepreneurs they are interested in. The due diligence process is quite extensive.

Furneaux and Co.’s process, for example, has several levels. The levels are: the 5-minute screening for location, industry, and market potential; the 1-hour screening to read the business plan and assess the competition; the 5-6 hour screening to meet with the management team; and an extensive assessment of personal references, the technology and customer base. All these screenings are followed by several weeks or months of due diligence investigation, if the deal passes the screening test.

Groups of this type seek to negotiate terms similar to those sought by venture capitalists. These work intensively with the entrepreneur to bring products to market and build management teams. For example, BRM supplies comprehensive assistance, including programmers, human resources personnel, product managers, and so on, to shorten time to market. It also takes responsibility for leading the next financing rounds for the company and finding appropriate investors, such as venture capitalists.

Member-Organized Angel Groups

Member-organized angel groups typically operate as clubs, where admission is by invitation and members bring different skills to the group and different value to the entrepreneurs they are investing in. Members value the social aspect of investing alongside others they like and respect. Each member decides whether or not to invest in a particular deal on a per-deal basis. Typically, one member sponsors a deal and engages a team of 5-7 interested members to conduct due diligence. The angels are not paid for their work, although they can receive warrants in consideration for extra work.

Member-organized angel groups or angel clubs can fund many early-stage ventures. In 1998, for example, the Band of Angels, which consists of 120 members, invested $17 million in 30 companies at an average pre-financing valuation of $4.8 million and an average equity stake of 15 percent.

Angel clubs might not be incorporated, and their funds are not syndicated. They’re likely to meet monthly at dinner or breakfast meetings, where a few pre-screened companies present their business plans in 30 minutes or less. Only companies that are sponsored by a member receive the opportunity make presentations at this meeting. If members express interest in a deal, a company visit is organized and more detail is sought. The company visit is the first step in the due diligence process, which could include personal reference checks, competitive analysis, potential customer presentations and technology analysis, among other things.

Most of these groups have modeled their term sheets on venture capital deals that include demand rights, voting rights/board representation, registration rights, piggyback rights, anti-dilution provisions and information rights.

After investing in the deal, an angel from the group is likely to take a seat on the company’s board. Members’ involvement after investment can be up to 3-4 days a month, although typically the angel board member spends one day per month advising the company. The group can help the company recruit other board members, recruit and coach management, build customer alliances, define the financial strategy, recruit other investors and help with business, marketing and technology plans.

For-Profit Matching Services

Third-party for-profit matching services provide screening, due diligence, and investment services for member angels. They usually have another fund that invests in emerging companies. Our two models for this type of angel group are Garage.com and VIMAC. Our information is drawn from interviews with them and published materials. Both companies are financial intermediaries that make money by charging startup companies and/or angel investors for their services, by investing their own funds, and by carrying interest.

Garage.com is an Internet service that closed its first deal in January 1999. It identifies and screens opportunities, grooms startup companies and posts investment opportunities in technology companies on its password-protected online database called “Heaven.” The seed funds needed are in the range of $500,000 to $2.5 million.

This group invests money from its own investment fund, along with funds from angels. It has relationships with venture capitalists and corporate venture programs to fund subsequent rounds for start-ups. Member angels and /or the startup venture pay a placement fee. Typically, angels pay 5 percent to 15 percent of all investments made and pay an annual membership fee or an upfront one-time initiation fee. Start-up ventures seeking funding may pay cash fees, or in the form of equity share at founder’s price and warrants.

For example, VIMAC allows individual investors to invest on a deal-by-deal basis or by investing in their side fund called Vintage Trust, allowing angels the opportunity to diversify their investments across multiple ventures. In the deal-by-deal approach, VIMAC puts together a term sheet and creates a limited partnership memorandum, passing this to prospective angels who can then meet the entrepreneur.

VIMAC charges angel investors a one-time 11 percent fee for investing in the limited partnership; it also receives 20 percent of partnership capital gains after the principal has been repaid to the angels, who are limited partners.

The partners at VIMAC have operating and venture experience; they provide support to their start-up companies similar to that provided by venture capitalists. In many cases, they hire independent investment managers to manage transactions through the life of the investment. They seek to invest with other venture capital companies and to retain a board seat.

Angel investing groups of this type look for companies with working prototypes, proprietary technology and lead customers. To provide an indication of their deal flow, we can look at Garage.com’s fourth quarter in 1998. The angel group looked at 1,900 deals, conducted limited due diligence on 100-200 deals and significant due diligence on 75 companies, finally taking on 12 companies as clients. Garage.com says it considers the quality of the deal, the source of it, and the educational background of the entrepreneur in its screening process. After due diligence, opportunities are posted in “Heaven” and sent to select investors based on preferences they have indicated. Typically, individual investors take a 20 percent to 30 percent stake in the company. Garage.com expects valuations to be in the range of $2-$5 million.

Non-Profit Third-Party Matching Services

In this type of angel group, the non-profit matching service, little or no screening is conducted by the organization. The angels themselves are responsible for due diligence, negotiation, and investing.

The group brings angels and entrepreneurs together through conferences, workshops, informal meetings and distribution lists. According to a 1998 article by Paul Gompers for a Harvard Business School case study, the largest and most far-reaching non-profit matching service is ACE-Net, or the Angel Capital Electronic Network, launched by the US Small Business Administration’s Office of Advocacy.

Entrepreneurs who desire exposure on the ACE-Net fill out an application, file financial statements and pay a $450 fee to appear on the network for six months. To facilitate matches, company listings are organized by region, industry and type of investment sought, typically in the $250,000 to $2 million range.

Another well-known group of this type is Investors’ Circle. Its primary focus is identifying socially responsible venture opportunities for members. Founded in 1991, its members (currently 150) have invested over $40 million in 60 companies since then.

As one can see from these descriptions of the variety of angel groups, the investment climate in the US has expanded considerably for companies requiring seed and start-up financing. If the rise of the venture capital groups is viewed as the first wave of individual, but organized, investing, angel investing can be called the second wave.