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occur in the cost associated with private placement: front-end fees and
back-end fees.
To avoid surprises, the cost for a private placement when handled by the
entrepreneurs and the principals of the venture themselves (e.g., preparing
and duplicating documents, binding, mailing, phone calls, follow-up meet-
ings) can be anywhere from 3 to 5 percent of the amount raised to a high of
12 to 25 percent depending on whether intermediaries (licensed broker-deal-
ers, investment bankers, and the like) are involved. So although a private
placement is less costly than a public offering and other types of offerings,
there are costs.
But the great advantage of a private placement comes with what the in-
vestor offers the entrepreneur beyond capital. Private investors bring much
more than money to the deal; whereas in the venture capital industry, many
of the venture capitalists have become money managers and are not spending
much time with the companies in which they have invested because those
companies are in later stages of development. Early-stage companies need a
lot of hand holding, and angel investors are motivated to nurture new ven-
tures as part of their hedging strategy to manage the downside risk in the
deal. Thus, it becomes incumbent on the entrepreneur to take advantage of
what angels bring to the enterprise.
Still another advantage of the private placements is its quick implemen-
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Alternative Sources of Capital


tation. Based on our experience, the time frame for private placements is, for
the shortest, 3 weeks, and for the longest, 12 months. The range of the time
frame is wide. But if a management team is ready to raise capital, has com-
mitted itself to the venture, has put aside some financial resources, and is
willing to commit the necessary time to the venture, things can happen
quickly. And if the venture meets the criteria we have outlined, has developed
the capitalization strategy, has been properly managed using the advice and
counsel we have provided”particularly with regard to efficiency in the pri-
vate placement process”a private placement can be concluded in a relatively
short period, reasonably in about nine months.
Finally, a significant difference between angel investors and insti-
tutional investors is that institutional investors”because of the larger size
of the funds under management”are gravitating to later-stage deals, which
means they are gravitating toward larger deals. Meanwhile, individual
angel investors are typically investing smaller amounts, and investing in
smaller rounds. This way an individual investing $25,000, $50,000, or
$100,000 becomes a significant player in the transaction. In this way,
the private placement accommodates the smaller transactions, which, in
fact, are the hardest transactions right now to get financed in the venture
capital industry.
In a study of 1,200 investors in its database, ICR found that 20 percent
invested less than $25,000 per deal; 40 percent invested $25,000 to $99,999;
and 25 percent invested $100,000 to $250,000. Angel investors by their pre-
ferred size of investment per deal will tend toward smaller transactions over-
all. Ninety percent of the time they participate in deals of less than $1
million, with a mean investment size of approximately $50,000.


PROFESSIONAL VENTURE CAPITAL AS A FUNDING
RESOURCE FOR EARLY-STAGE COMPANIES

The reasonable question for the entrepreneur to ask is this: “Are professional
venture capitalists a realistic option for me to pursue to finance my deal?” It
may be fair to say that these could be the worst of times for the venture cap-
ital industry. As the Money Tree Survey claims, valuations are down 50 per-
cent, often as low as one to three times revenues; the venture-backed IPO
market is soft, averaging eight venture capital“backed IPOs per quarter for
the past three years; 50 percent of venture capital firms are predicted to be
gone in five years, and 27 percent of venture capital firms formed in the past
six years will not raise a second fund; litigation with limited partners is in-
creasing; major write-downs are still to come in many venture capital port-
folios; syndication is in vogue to reduce or share risk, making a round more
96 UNDERSTANDING THE ANGEL INVESTOR


complex; early-stage investing has been effected more than has later-stage;
fund managers are refocusing on a few industry sectors; and hundreds of
firms are “walking dead” and will go away. The implications for entrepre-
neurs seem clear: don™t rely on venture capital funding; bootstrap while
keeping your burn rate low. For example, a win for a CEO may be $2 mil-
lion to $5 million in a venture capital“funded deal and “You may be work-
ing for a salary”but you just don™t know it!”
However, if you meet the industry™s criteria, the fact is that professional
venture capitalists are financing companies. While the majority of venture
capital firms focus primarily on expansion capital for venture in rapid
growth phases and with a high probability of exit through sale of the com-
pany or an initial public offering, a minority are willing to consider early-
stage investments.
The PricewaterhouseCoopers/Thomson Venture Economics/NVCA
Money Tree Survey reports that venture capitalists invested a total of $40.6
billion in 2001, $21.4 billion in 2002, and $18.2 billion in 2003. These in-
vestments went to 4,600, 3,035, and 2,715 companies, respectively. While
not a huge number of companies, it is an important contribution to address
the capital gap. While Silicon Valley, New England, New York metro, Texas,
the Southeast, and Los Angeles/Orange county account for a significant
amount of the investment, the fact is that the investments are spread out, al-
beit to a lesser degree across the country. It is also true that biotechnology,
software, medical devices and equipment, telecommunications, networking
equipment, and semiconductors also account for the majority of investments
by venture capital funds, that is, 66 percent in 2003.
The bottom line for entrepreneurs seeking capital is that if they don™t fall
into these geographic areas or industries, they™re most likely out of luck. And
if they do, the competition (especially with companies previously funded by
or with management known to the venture capital firms) will be stiff indeed.
According to the Money Tree Survey, in 2003, the entire venture capital
industry invested $354 million into 166 start-ups and seed-stage deals. First-
round financings were higher at $3.3 billion into 716 deals. Remember,
that™s $354 million into start-ups out of a total investment of $18.2 billion
invested in 2003. As you can see, chances of funding an early-stage deal (in
which early-stage is defined as seed/start-up) is slim to slight.
Another way to understand if your deal is appropriate for venture capi-
tal is to realistically ask yourself how much capital you need to raise at this
time (and at this valuation)! Then consider the typical deal size of venture
capital financings. The mean deal size for venture capital firms in 2001 was
$9.4 million; $7.4 million in 2002; and $7.1 million in 2003. Now ask your-
self, “Do I actually need that much capital, especially at my current pre-
money valuation?” This is important for entrepreneurs who seek to have
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Alternative Sources of Capital


something to show for their efforts at the end of their venture™s journey, that
is, at exit. Especially so since we have seen median premoney valuations
plummet in early-stage round classes to $3 million for seed and $9 million
for start-up/first round. At these premoney valuations, entrepreneurs would
have to be willing to “give away the farm” to attract venture capital dollars.
Another interesting dynamic at work in the venture capital industry is
the large funding goals, reflective of and largely because of the increasing
funding size of later-stage transactions. Yes, the industry is investing, but
mostly in larger, later-stage deals. This is a symptom of the penchant of fund
managers to reduce risk by focusing on more developed ventures, and to use
more capital per transaction, a function of the larger funds under manage-
ment. This situation occurs because of the shakeout in the industry, the fail-
ure of less successful funds, and the gravitation of limited partners™ capital to
more successful funds, thus engendering larger pools of capital under man-
agement. So although the statistics suggest that the industry is active, the vi-
tality is undercut by the small number of deals actually being made. And the
implication of smaller numbers of deals does not bode well for ventures that
do not fit the venture capital profile perfectly. A cynical entrepreneur shared
this concern when he said, “You™d have better luck getting the capital you
need playing lotto than trying to raise it from the venture capital industry.”
In 2003, 94 percent of institutional venture capital money went to com-
panies in stages of development beyond seed and start-up. It is no wonder,
then, that entrepreneurs are looking away from venture capital until later
stages of their developing companies. As an NVCA publication declares,
“Most of the venture capital funds invested across the country were received
by companies already through at least one round of financing.” It boils
down to this: Angel investment runs the critical first leg of the relay race,
passing the baton to venture capital only after a company has begun to find
its stride. As the numbers presented reveal, venture capitalists focus on ex-
pansion and later stages of development, when their contribution is most
effective. In this way venture capital investment complements rather than
conflicts with angel investment.


COMPARISON OF ANGEL INVESTORS WITH
PROFESSIONAL VENTURE CAPITALISTS

Entrepreneurs should realize that early-stage investing by professional ven-
ture capital will form only a small part of their investment strategy. Arthur
Rock, a founder of Intel, said in Fortune that venture capitalists are now
portfolio managers, “more interested in creating wealth than in creating
companies.” Another Silicon Valley veteran has dubbed venture capital an
98 UNDERSTANDING THE ANGEL INVESTOR


oxymoron. Still another CEO warned entrepreneurs not to look on invest-
ment bankers as their friends, calling them “gatekeepers” as they screen out
what to them is just another deal. For entrepreneurs to rely too heavily on
that particular resource is a mistake, when, in fact, there remains a larger re-
source willing to assume a greater risk. The angel investor”patient and in-
terested in adding value to smaller, higher-risk transactions”stands ready to
nurture a company through the early leg of the relay. Then the professional
venture capital community becomes a more suitable contributor by virtue of
its fiduciary responsibility to those institutional investors who have entrusted
their money to money managers.
But examining the people who constitute the private investment market
is difficult because of their penchant for privacy, the lack of sophisticated
measures for accumulating data, the lack of disclosure requirements by the
government about private placement investment, and the costly nature of
doing qualitative research. Even the job of compiling information through
interviews and surveys and then analyzing their content is work. Because of
these difficulties, discrepancies appear in estimates of the size and capability
of the angel market.
Any estimation of the size of the angel market must inevitably begin
with some understanding of the extent of wealth in the United States.
According to data obtained by the Environmental Research Foundation, the
richest 0.5 percent of Americans, that is, one out of every 200 families,
owned more than 45 percent of the nation™s privately held net worth. This
wealth was composed of 47 percent stock, 62 percent bonds, and 77 percent
of all trusts in the United States. Also, the top 10 percent of families owned
83 percent of all income-producing wealth. In Lisa Keister™s book Wealth in
America, she used stocks, bonds, bank accounts, and real estate holdings
rather than income in her national survey to conclude that Baby Boomers
have accumulated more wealth than their parents, and that their net worth
is continuing to increase. It is the Boomers who are at the prime age for
angel investment.
In Arthur Kennick™s study, “A Rolling Tide: Changes in Distribution of
Wealth in the U.S. 1989“2001,” he estimates total net worth in the United
States at $42.3 trillion. And he reports in “United for a Fair Economy 2001,”
a 2001 study on the “Distribution of Wealth Ownership,” that although the
top 1 percent of U.S. households hold 32.7 percent of the nation™s wealth, the
next 9 percent hold 37 percent of the wealth; the next 40 percent hold 27.4
percent, while the bottom 50 percent hold 2.8 percent of the wealth.
Edmund Wolff™s research supports Kennick™s findings. In his “Recent
Trends in Wealth Ownership 1983“98,” sponsored by the Levy Institute,
Wolff found that the top 1 percent held 42.2 percent of U.S. net worth; the
next 9 percent held 42.2 percent; the next 30 percent held 44.4 percent; the
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Alternative Sources of Capital


middle 20 percent held 10 percent of the wealth, and the bottom 40 percent
held negative net worth.
If we look at investment holdings of stocks, bonds, mutual funds, and
Individual Retirement Accounts, the top 1 percent holds 42.1 percent; the
next 9 percent hold 36.6 percent; and the bottom 90 percent hold 21.3 per-
cent. Wolff™s findings are invaluable to those of us interested in identifying
which segments of the high-net-worth market to approach with our venture
investment opportunities.
Finally, the Survey of Consumer Finances claims that households in the
top 20 percent in the United States saw their net worths rise between 1983
and 1995. Why are these macroeconomic statistics and trends important?
Simply because it is historically confirmed that those households with net
worths of $1 million to $10 million comprise the group most likely to take
on an angel role in investing. These studies confirm that substantial numbers
of U.S. households”approximately 2,000,000”meet the net worth criteria
for investing in early-stage transactions.
Studies of the business angel market confirm that a source of capital for
higher-risk financing for early-stage entrepreneurial ventures not only exists
but flourishes. While obtaining accuracy and agreement on the size of the ac-
tive component of the market is difficult, that this market is huge is beyond
dispute. Just keep in mind that all studies are in effect estimates, estimates
that all attempt to get at the actual size. Early studies by Gaston, Wetzel, the
MIT Venture Capital Network, and UC-Irvine suggested that 250,000 active
angels invest at least once a year. Studies by Wetzel and Freer (1994) sug-
gested the number was 300,000 angels investing $10 billion to $30 billion
annually. The NVCA has suggested that angels contribute upwards of $100
billion annually. More recently, studies by Friedman estimate that 300,000
angels invested $30 billion per year in 2003. More conservative are 1999
studies by Sohl that $10 billion to $20 billion per year was sunk into 30,000
deals. With three to five million businesses being started each year, and the
extent of net worth available (how much of net worth being liquid essentially
is the question), the estimates reported above are not only believable but
most likely conservative and understated.
Based on ICR™s estimates, upward of 400,000 to 500,000 companies are
attempting aggressively to raise capital at any given time, and ultimately
about $3.5 to $4 billion of the angel market is going into seed, R&D, and
start-up stage transactions, the riskiest stages. Approximately 30,000 to
40,000 very early-stage transactions are being concluded in this market at
minimum per year. Ninety percent of those transactions are typically for less
than $1 million, with a mean investment per investor of $30,000 to $50,000
and a mean investment share in the first round of the financing of approxi-
mately 20 percent of the equity.
100 UNDERSTANDING THE ANGEL INVESTOR


Venture capital firms, since they are listed publicly in directories, on
software, and in online databases, are inundated with requests for capital.
To private investors, however, public listings are anathema. If they list
anywhere, they list with confidential private networks; for example, one of
the 170 formal and informal organizations located throughout leading tech-
nology and business regions of the United States, including investment
clubs, informal networks, associations, pledge funds, limited partnership
and incubators.
Thus, angel investors receive less deal flow. This gives them more time
to peruse the deals that do come in, and since they do not have to invest, they
become more selective. Private investors, after all, seek a profit on every in-
vestment. Professional venture capitalists, on the other hand, accept that a
percentage of their deals will fail, some unable to recover even bank account
returns. The reason? The professional venture capitalist has to invest. For ex-
ample, in one study of venture capital returns, the fund experienced a total
loss 11.5 percent of the time, partial loss 23 percent of the time, and break
even 30 percent of the time, and generated multiples of two to ten times in-
vestment or more 35.5 percent of the time. In effect, “swinging for the fence”

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