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xxv
Introduction


It is a part of probability that many improbable things will
happen.
”Aristotle, Poetics




n writing this book, we intend to make probable many of the improbables
Ithat every entrepreneur faces in raising capital for his or her venture.
In spite of a recessionary economy, slow economic recovery, and a per-
sistent bear stock market since the tech meltdown over three years ago, a
number of trends suggest that the fundamentals of the private equity market
prevail. These trends include the continued fervor of individuals to start busi-
nesses in America, a pool of investors investing a portion of their portfolio in
private equities to offset poor public equity returns, improved portfolio per-
formance and recovery of their wealth, improved survival rates for start-ups,
and reduced costs of starting up a business.
According to the Panel Study of Entrepreneurial Dynamics sponsored by
the Kaufman Foundation, entrepreneurship remains strong in the United
States. About 6 in every 100 adults are engaged in trying to start new firms.
That means approximately 10 million adults are attempting to begin start-
up companies. New business creation is a fundamental indicator of entre-
preneurial activity in the U.S. economy, according to the study authors.
These 10 million adults represent more than 10 percent of all nonagricultural
workers in the country, estimates the Small Business Administration (SBA).
Regardless of recessionary times, investors face no shortage of deals for
investors to review. In 2001, 3.5 million businesses were started in the United
States. Only 950,000 of these were purchased or inherited. The rest were
new start-up companies.
What we see here is a major trend in our society toward entrepreneurial
behavior. Instead of having a resume handy, many seem to have a business
plan in his or her top desk drawer, creating a diverse array of investment
possibilities. Little wonder that one in three American households includes
someone who has started, tried to start, or helped fund a small business.
Entrepreneurial behavior is a major trend in our society.

xxvii
xxviii INTRODUCTION


Along with this growth trend in dreaming, potential dream makers are
growing in numbers and shifting their investment orientation as well.
Despite the volatile markets (a stock market loss in 2001 of $1.3 trillion) and
economic downturn, the combined wealth of high-net-worth Americans in-
creased 3 percent last year to $26.2 trillion. These are individuals with fi-
nancial assets of at least $1 million, excluding real estate. Substantial wealth
exists and is available for investment regardless of public stock market
losses. In addition, in 2002, 3.3 million U.S. households with a net worth of
$1 million to $10 million”excluding real estate and representing those
households most likely to provide early-stage angel investment”have in-
vested approximately 83 percent of their investable assets in equity-related
transactions, rather than putting them into mortgages or equivalents. One
billion dollars per week was being invested into equity by the first quarter of
2004. While there are five times more offerings than investment, the equity
market remains strong. According to the IRS, 1 taxpayer in 15 now has a
six-figure income. In 2000, 8.3 million households met this criterion, up 15
percent over the previous year. There is no shortage of risk capital.
Where are they coming from? Whether it™s the transfer of wealth from
the old to the young, technology entrepreneurs, loyal employees who have
cashed out tradable stock, or middle-aged casualties of corporate down-
sizing with large severance payments, a significant number of individuals
with the requisite financial capability do engage in direct investing. While the
number of qualifying households may seem large, correcting the number to
identify those willing to assume the risks associated with venture investing
results in approximately one million households having the discretionary net
worth to invest directly in early-stage deals. Many of these investors have al-
ready realized significant profits from other early-stage, private equity in-
vestments”and need no prodding! What we must not forget is that 90
percent of all U.S. millionaires are self-made, not inheritors of wealth; there-
fore, they know innately that they can derive profits and returns from suc-
cessful start-up ventures.
Sophisticated investors understand that to ensure adequate returns for
retirement or other objectives, a diversified portfolio is necessary, incorpo-
rating alternative asset classes in addition to public stocks, bonds, and cash
investments. Furthermore, investors plotting a recovery strategy to get their
portfolios back on track understand that they will benefit from the histori-
cally strong performance in private equities to offset disappointing returns in
public equities. They are aware of a well-documented low correlation be-
tween venture capital and large public stocks. It has not escaped these in-
vestors that companies such as General Electric, Ford, Hewlett-Packard,
Intel, and Microsoft were all founded during recessionary or depressed eco-
nomic times, as reported in USA Today.
xxix
Introduction


Entrepreneurs might believe that a litany of reasons is responsible for
high-net-worth individuals to be disillusioned and perhaps ignore this real-
ity: September 11, the “dot-bomb” fiasco and tech stock bubble burst, stock
market volatility, low interest rates, a stagnant initial public offering (IPO)
market, the return to government deficit spending, overpaid CEOs running
public corporations like casinos, electronic speculators, predatory hedge
funds, fraudulent public stock values and financial statements, deceptive in-
vestment bank shenanigans, faithless analysts, collusive accountants and fi-
nancing of the securities market through brokers, and creation of speculative
vehicles to securitize loans and income streams. While your suspicion of fi-
nancial and regulatory integrity is clearly justified, these events didn™t just
happen overnight and are not likely to quickly fade away. There is, however,
a more positive side.
The impact of innovative technology on our lives is axiomatic. Our lives
will remain intertwined by technological developments in education, com-
puter hardware and software, telecommunications, medical science, and
media entertainment. The U.S. economy remains larger than the combined
economies of Japan, Germany, Britain, France, and Italy, and the U.S. con-
tinues to develop and export technology and knowledge in support of these
major industrialized economies. Sixty-six percent of all technological inno-
vation comes from small, private companies, start-ups not spin-offs, 99 per-
cent of which are financed by founders, family and friends, and, of course,
angel investors. Angels are early- and expansion-stage private equity in-
vestors who invest their own money directly into sustainable ventures in in-
dustries they know and understand to earn capital appreciation for their loss
of use of capital.
As cited in the Kauffman Foundation study, “The National Commission
on Entrepreneurship documented the entrepreneurial beginnings of 197 of
the Fortune 200 corporations and found the formation of new industries and
the development of most new technologies highly dependent on the creation
of new firms.” Private investors, particularly angels, understand the poten-
tial in this finding.
Another factor influencing the creation of investment opportunities is
the tremendous improvement in survival rates among small companies in the
United States. Major studies support the statistic that approximately 65 per-
cent of all start-ups initiated over the past five years will survive six to ten
years. Given that the mean hold time for angel investments range from five to
eight years (depending on the particular industry), the chances of investors
getting their investment back and seeing a return on investment has, com-
pared with ten years ago, significantly improved.
Another study of those companies that have grown to $5 million to $10
million in annual sales indicates that 30 percent grew from start-ups, not
xxx INTRODUCTION


from companies that were purchased or inherited, or through ownership
transfer. In addition, of those companies that closed or discontinued, only 47
percent closed because they were losing money. Fifty-two percent of those
companies that closed or discontinued did so while breaking even or show-
ing a profit and were closed for other economic reasons.
The last economic trend influencing entrepreneurialism is that the cost
of starting a company is decreasing. In a recent study of Inc.™s 500 fastest-
growing companies, 78 percent surveyed reported that the seed capital to
launch their venture was $100,000 or less. Only 22 percent required more
than that to get off the ground. ICR research discloses that to start a com-
pany that successfully grows to $2 million to $5 million a year in sales will
require an angel round after cradle equity from family, friends, and founders
of only $500,000. To start a company that will grow to $5 million to $10
million in sales, the preinstitutional Series A rounds are averaging $700,000.
In spite of burgeoning entrepreneurship and ample numbers of promis-
ing ventures, an available pool of capital, and a relatively high probability of
venture success, there still exists a capital gap. A number of surveys of start-
up and small businesses confirm that financing the venture is a major chal-
lenge and that many are struggling to meet their growth capital needs.
Entrepreneurs may be confused by the different studies published that es-
timate the number of angel investors in the United States. But we have to re-
member that all studies are estimates and extrapolations from available data
pried from a group that prizes its privacy, a group that is not legally required
to publicly disclose its activity. Still, research from Off-Road Capital in 2001
reveals that more than a quarter of a million high-net-worth individuals in-
vested an estimated $65 billion into at least 30,000 private companies, a
number that hugely eclipsed the venture capital firms™ investment in the same
year, both in terms of quantity of capital and number of investments.
A study published by Josh Friedman estimated the number of active an-
gels in 2002 at 300,000. Jeffrey Sohl of the Center for Venture Research has
estimated angel investing to be $10 billion to $20 billion per year in as many
as 30,000 deals. We estimate the number of sophisticated active angel in-
vestors at more than 400,000 in the United States, plus many more who take
on a passive role. Active investors are those who have acquired the proper
tools and skills through training and experience to develop deal flow, man-
age due diligence, negotiate and structure deals, value early-stage companies,
oversee and advise companies postinvestment, and harvest returns by guid-
ing their investee companies to liquidity. Of course, passive investors partic-
ipate in more formal structures, such as investment clubs or funds, but still
others are present as lead investors ready to take on a more active role.
An angel is a private, nonrelated investor, investing their own money,
typically $25,000 to $ 250,000 per investment, alone or in syndication with
PART
One
The Challenge and
the Solutions
1
CHAPTER

The Challenge


INTRODUCTION

The grand impresario Florenz Ziegfeld had a backer”an angel, in Broadway
parlance”named Jim Donahue who at the time of the 1929 stock market
crash was disastrously affected financially. Deeply despondent over his
losses, Donahue took his own life by throwing himself out of his office win-
dow. When Ziegfeld heard the news, he immediately penned a note to
Donahue™s widow that read, “Just before your husband ˜fell,™ he promised
me $20,000.” Needless to say, three days later the money arrived. And that™s
the kind of chutzpah it took then”and takes now”to raise capital for
high-risk deals.


THE CHALLENGE
Make no mistake: Raising funds for an early-stage venture or a small, but
rapidly growing business is an arduous task.
Where do you turn once you have exhausted the founders™ financial re-
sources and those of family and friends, but are not yet able to access venture
capital? What if you™re worn out from simultaneously running your com-
pany while struggling with venture capital firms, banks, factors, leasing com-
panies, and the like? What if you lack the ability to bootstrap and to fund
growth from cash flow or retained earnings? What if you have not yet
achieved financial strength and public reputation sufficient to support a
small corporate offering registration (SCOR) or a direct public offering?
What if your venture is not defined by the venture capital community as a
“darling” industry? What if your deal is too small for institutional players,
say, less than $3 million?
During the formative years of a start-up, entrepreneurs assume the re-
sponsibility for, and risk associated with, making their dream become a real-



3
4 THE CHALLENGE AND THE SOLTUIONS


ity. Typically, a substantial portion of their net worth is committed to the
venture. But by the first major round of funding, entrepreneurs often have
exhausted their own financial resources and those of family, friends, asso-
ciates, and business contacts. So entrepreneurs face a daunting challenge.
Although it is correct that cradle-equity from family and friends is a form of
angel investing, it is neither the primary nor the only funding source for start-
ups or for most small companies.
This challenge so often faced by entrepreneurs reveals only part of the
task involved in early-stage capital formation. Even though these entrepre-
neurs create benefits”jobs, advancement of technology, capital expendi-
tures, asset growth, and contribution to tax revenues”the supply of needed
capital for early-stage ventures recently has contracted, and entrepreneurs
face a much more difficult environment, as some sources of capital have been
reduced or eliminated. There are three reasons for this: (1) start-ups need
more money than in past years; (2) traditional capital and financing have di-
minished; and (3) more competition exists for start-up capital. There are a
few reasons for this: first, a reduction of newly affluent angel investors in the
market; second, traditional capital sources failing to keep pace with the level
of entrepreneurial activity in the United States; and third, more competi-
tion”direct and indirect”for start-up capital sources.
Many of the young entrepreneurs successful in the 1970s, 1980s, and
1990s have, in their industries, morphed into the active investors of today.
But the dot-com bubble bust has clipped the wings of many of those newly
affluent investors who before the shakeout seemed to possess insatiable ap-
petites for promising venture opportunities in high tech. Many entrepreneurs
without extensive knowledge of alternative capital resources may have in-
ferred that all angels had disappeared for a while. It is true that some angels
have had their net worth shrunk by public market losses estimated for the
U.S. at more than $7 trillion over the past three years, and, as a result, lost
their accredited legal status or lost discretional net worth liquidity for higher-
risk private deals. Still, solid angel players merely regrouped and assumed
more realistic and cautious approaches to finding and making new invest-
ments, sticking particularly “closer to the knitting,” that is, investing in areas
they fully understand.
More accurately, angels are available, but those remaining in the game,
as we have pointed out, are making fewer investments, investing fewer dol-
lars per deal, and providing reserves to shore up their positions later, should
it be necessary, and are perhaps taking longer to make investment decisions
because of the increased time frames for due diligence. Due diligence, after
all, has become much more rigorous. We commonly find entrepreneurs tak-
ing six to nine months to raise rounds less than $1 million. Other implica-
tions for entrepreneurs are more intense demands for documentation (e.g.,
5
The Challenge


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