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is a gambler and a dreamer. You share dreams and common ground on
which to build a relationship.
It is difficult to reach high-net-worth, private investors. The competition
for the attention of those with impressive personal wealth is brisk. The key,
as with any marketing program, is to target qualified prospects and to use a
mix of sources and resources to find them.
After diligent targeting and sourcing, meeting high-net-worth, direct in-
vestors amounts to plain hard work, persistence, and attention to detail.
Moreover, your approach must entertain as well as incite interest. Consistent
application of the principles set forth in this chapter will serve to develop in-
vestor awareness of entrepreneurs and those ventures that merit such atten-
tion. Sooner or later the persistent entrepreneur will capture the interest and
investment of these high-risk investors when they are seeking new invest-
ments following a liquidation, or simply when, for whatever reason, they
have decided to diversify or add to their portfolio.
In conclusion, deals are the dependent”not the independent”variable.
That is why the product must fit the customer and why the dreamer must be
73
The Solution: A Strategy That Works


matched with the right dream maker. Investors come to a situation with a
portfolio, an asset allocation strategy, and an idiosyncratic tolerance level for
risk. Except in some cases”following a windfall, an inheritance, a transfer
of retirement pension assets, or a sale of a business or stocks”the investor
will deal only within the context of that investment strategy. Take a lesson
from this chapter: Focus on the customer, keeping in mind that in today™s
competitive fund-raising market, the customer is the investor.
PART
Two
Understanding the
Angel Investor
4
CHAPTER

Alternative Sources of Capital


THE IMPACT OF ECONOMIC TRENDS ON THE
ACCESSIBILITY OF CAPITAL
A number of macroeconomic trends are having significant impact on the en-
trepreneur™s ability to find investors and to raise capital. These trends include
a better understanding of undercapitalization™s effect on building sustainable
companies; declining interest rates and the desirability of traditional debt
and credit; government intervention through tax incentives; contraction of
the institutional venture capital market and negative impact on the desir-
ability of the alternative asset class; and a moribund IPO market.
Capital is the coal that stokes the fires of entrepreneurship in the United
States. No capital, no start-up. No capital, no expansion. This everyone
knows. Particularly for start-ups and small businesses, finance-related issues
appear to be the number one cause of failure, according to Festervand &
Forrest™s extensive research prepared for the SBA. Eighty percent of new
businesses fail because of undercapitalization. Major culprits include an in-
ability to secure adequate long-term financing, the high cost of financing,
highly leveraged financing, excessive debt, and cash flow problems. Also, in
their 1998 study of business bankruptcy, Sullivan, Warren, and Westbrook
reported that 28 percent of business owners who ended up in bankruptcy
court identified financing difficulties as the major reason for their failure.
Even though interest rates have declined steadily for the previous four years
for corporate borrowing, traditional debt has become a less workable alter-
native for raising capital. Moreover, despite all the lending programs within
the SBA, not enough is being done to bolster financing availability in our
capitalistic society and make funding more accessible for start-ups.
For the SBA program, for example, applicants must display more than
just good character and management skills; they must demonstrate a history
of earnings and a cash flow record. Moreover, without collateral, and gener-
ally without a one-third capital contribution to the total cost of the project,



77
78 UNDERSTANDING THE ANGEL INVESTOR


applicants simply will not get the loan. The White House Conference on
Small Business put it succinctly: “Small companies still face complicated
state and federal requirements.” What we have, then, is capitalism without
the capital.
Even as the government has increased appropriations for SBA loans with
the Small Business Guaranteed Credit Enhancement Act of 1993, even as it
has permitted a capital gains exclusion for certain small business stock in-
vestments with the Omnibus Budget Reconciliation Act of 1993 and the
2003 Tax Act, and even as it has eased the burden of financial institutions
lending to small business with the Capital Availability Program, capital con-
tinues to shrink. Adding to this shrinkage has been the increased investment
of financial institutions in government securities.
However, some economic trends will influence the future attractiveness
of higher-risk, early-stage investments. The government™s tax incentive bill,
for example, contains provisions that can stimulate investment growth. As
the top marginal income tax increased to 39.6 percent, the ceiling on the cap-
ital gains rate on all asset classes was retained at 28 percent, and the 2003
Tax Act reduced long-term capital gains to just 15 percent through 2008.
As we can see in Soja and Reyes Investment Benchmark research, the
American government has historically recognized that it needs to nurture
young companies. The strategy it has used to stimulate investment has been
to create tax incentives and to reduce restrictions on investment managers:
for example, the 1978 Revenue Act that has provided capital gains incen-
tives for equity investment; the 1979 Employee Retirement Income Security
Act™s (ERISA™s) “Prudent Man” rule that crested new guidelines allowing
pension investment into venture capital; the 1980 Small Business Invest-
ment Incentive Act that stimulated growth of small business development
companies; the 1980 ERISA™s “Safe Harbor” regulations that broadened
discretion of venture fund mangers; the 1981 Economic Recovery Act that
lowered the capital gains rate; the 1986 Tax Reform Act that reduced tax
on long-term capital gains; and the 2003 Tax Act that provided dividend
and capital gain relief.
Provisions in the Omnibus Budget Reconciliation Act of 1993 serve as a
case in point. This law placed a capital gains tax ceiling on investments in
risky start-ups when money is left for longer than five years. With the aver-
age “hold time” of eight years, this incentive offers tangible potential benefit
for investors. The Act, having squeaked by the House by only two votes”
and having needed the Vice President™s vote to break a 50-50 tie in the
Senate”drops the tax on capital gains from 28 percent to 14 percent upon
liquidating stock in small business holdings or selling the company. This de-
crease applies to stock issued after the date of the bill™s enactment, August
10, 1993.
79
Alternative Sources of Capital


More recently, federal law encourages the financing of new businesses in
the form of the tax rollover opportunity created in 1997. Created by
Congress to channel capital into “qualified small businesses,” the investor
can roll over a capital gain from the sale of qualified stock held for more than
six months if the investor buys the stock of a different “qualified small busi-
ness” within a 60-day period beginning on the date of the original sale. The
law provides for an indefinite tax deferral, so that, in effect, for those who
act within 60 days of making a profit on the sale of a prior venture invest-
ment can roll over that profit”tax free”into new ventures again and again.
Favorable tax treatment is an economic trend that has repeatedly stimulated
small business.
Our position is clear: reduced interest rates for borrowing has not made
debt a solution for financing earlier-stage ventures. And even with sub-
stantive tax incentives, we are not seeing a major shift in capital to the
higher-risk, alternative asset market. Why? Government intervention, while
responsive to the problem of the capital gap and capital availability, and
laudable, has been largely ineffective at helping you raise money. This is so
because it is the capital market that drives public policy”not public policy
that continuously drives the capital market.
In fact, a more plausible explanation of the reason why entrepreneurs
face such a daunting challenge in raising capital is better provided by close ex-
amination of the 1,700 venture capital firms. Perhaps, it may be said that as
goes the venture capitalists, to some extent, so goes the angel capital market.
According to the PricewaterhouseCoopers/Thomson Venture Economics
/NVCA Money Tree Survey, total investment in the venture capital industry
has declined from $105.9 billion in 2000 to $18.2 billion in 2003. The num-
ber of deals declined from 8,082 in 2000 to 2,715 in 2003. This retraction
following the dot-com bust suggests that the flood of venture capital is over.
Corporate venture capital investment has declined from $16.9 billion in
2000 to $1.1 billion in 2003. Although the percentage of investment into
medical devices and equipment, biotechnology, and life sciences has in-
creased, interest in software, telecom, and networking equipment has de-
clined. Most important to entrepreneurs is that early-stage investing was
affected most. For example, start-up and seed financing fell to $303 million
(148 deals) in 2002 and to $354 million (166) deals in 2003. The amount in-
vested into start-up and seed deals in 2002 represented a reduction of 62 per-
cent from 2001. In this contracting economic situation, entrepreneurs must
remember that thousands of venture-funded companies that previously had
received early-stage funding are now seeking second rounds. It is estimated
that fewer than 10 percent will be successful at further fund-raising.
Furthermore, as venture capital investment has pulled back, and capital
overhang is estimated at more than $50 billion, internal rates of return are
80 UNDERSTANDING THE ANGEL INVESTOR


continuing to slide and further act to drive away capital investment into ven-
ture capital funds.
Another economic trend that has an impact on the availability of capital
is the moribund IPO market. As Bill Davidow has said, “When everyone is
running for the door, the only measure of success becomes how wide you can
build the door.” Investors are facing the lightest new offering market in
years. Since venture capital returns are closely a function of IPO exit, entre-
preneurs can appreciate that absence of this high-return exit can dampen en-
thusiasm for high-risk, long-term investments.
According to the research firm Equidesk, 5,000 companies went public
during the 1990s at IPOs of typically between $25 million and $35 million.
The number of IPOs has declined steadily since 1999 to the lowest level in
many years. There were 510 IPOs in 1999, 373 in 2000, 108 in 2001, 97 in
2002, and only 88 in 2003, according to Bloomberg Financial Markets.
Although recently there seems to be a burst of investor interest in IPOs, the
average deal size has ballooned to close to $340 million. Also, as more than
6,000 companies owned by venture capital portfolios await exit, it could be
a very long time to liquidate so many companies. Some experts are estimat-
ing both an IPO and merger and acquisition downdraft for up to five years,
with merger and acquisition eight times more likely for deals in the range of
$100 million to $300 million.


ALTERNATIVE SOURCES OF CAPITAL AND HOW
THEY AFFECT EARLY-STAGE INVESTMENT
As Exhibit 4.1 illustrates, the array of alternative sources of financing offers
many choices to the inventor, start-up entrepreneur, and fast-growing small
business owner. In this section, we provide a comprehensive overview of
these alternative sources of capital.


Corporate Investment and Strategic Alliances
These methods involve entering into a contract to do business with a much
stronger and better-known business partner. The shared prestige can boost
the start-up™s credibility. When properly structured, this strategic relation-
ship benefits suppliers, customers, vendors, and distribution sources. It is a
venture with complementary customers or technology. Corporate alliances
involve long-term relationships, synergy with an existing product line, re-
lated products to feed into distribution, shared risk, and industry contacts”
all aspects encompassing resources beyond the funding itself. Moreover,
corporate investment is more affordable than venture or institutional capi-
81
Alternative Sources of Capital


EXHIBIT 4.1 Main, Alternative, and New Early-Stage Financial Sources

• Business angels”private placements • Transaction financing
• Academic institutional research • Strategic alliances
financing
• Venture capital (industry specific) • Corporate investments (one new
fund/week)
• Bootstrap financing • Private equity funds
• Self-finance: savings, loans, credit • Direct investing by financial institutions
cards
• Licensing technology • International financing”immigration
investment
• Royalty
• Joint venture • Direct private offering
• Venture leasing • Incubator-based financing
• Family, friends, colleagues, and • Community loan development funds
associates
• Barter investment • Economic development programs

Source: International Capital Resources


tal, resulting in a higher valuation and more equity than what comes from
traditional or early-stage funding. Corporate investors, however, may not ac-
commodate an exit strategy. U.S. companies are completing approximately
5,960 joint ventures or strategic alliances per year with foreign and other
U.S. companies; the majority of these transactions involve only two compa-
nies and are joint ventures. Strategic alliances, however, take a long time to
formulate.


Lease Financing
Lease financing possesses an inherent edge in raising funds because you use
the equipment you lease as collateral. Advantages to leasing include avoid-
ing a down payment. Leasing is an installment purchase that, at the expira-
tion date, offers a few options: The lease may be extended; the leased items
may be bought at par to their market value; or the lease ends.

Licensing
This method of financing involves entering into a contract to provide tech-
nology or a product or some other commodity to the licensee. The licensee,
82 UNDERSTANDING THE ANGEL INVESTOR


in turn, will provide a fee and/or a royalty based on revenues for specific ben-
efits (e.g., rights to distribute within a defined territory for a specified time).
The second party is granted the right by the owner of a product to manufac-
ture, sell, or use it in some way.

Franchising
Similar to licensing, franchising requires the franchisee to pay for the right to
sell the service or product of a franchiser in exchange for a fee and portion
of the income from sales or profits. The franchiser may supply expertise, as
in the case of McDonald University. Franchises involve virtually every kind
of business. The franchiser may sell a single franchise or franchise a geo-
graphical territory. This alternative capital resource requires no debt service
or loss of equity in the company. One start-up company sold 10 franchises
for $25,000 each, raising $250,000 to fund further growth. Also, the fran-
chisees assume all costs for opening, staffing, and running new outlets as well
as assuming all contingent liability. Franchises are responsible for 50 percent

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