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business plans) and more intensive negotiations about deal terms and valua-
tion, which have become more beneficial to investors. In a word, the days of
raising high-risk capital with an executive summary and a PowerPoint pre-
sentation are long gone!
Second, traditional sources of capital, for example, banks that offer cor-
porate lending, have failed to keep pace with demand from entrepreneurs for
financing. The last statistics available show that Small Business Administra-
tion estimates of start-ups fall well below actual numbers of business start-
ups in this country. In the early 1990s there were only five million small
businesses. Today, if you count home-based businesses, almost five million
businesses are begun each year. So demand far exceeds the financing possi-
ble from traditional sources, especially those sources requiring cash flow, as-
sets, collateral, or other financing criteria normally associated with more
developed operating companies.
The third reason why it is more challenging today to raise capital from
among those with impressive personal wealth”especially those interested in
investing in higher-risk deals”is that they are the target of everyone from
charitable fund-raisers to the most successful money managers. In a word,
there is simply more competition for the money that is out there than there
was 10 years ago. These investors are also completing more than 700,000 in-
vestment transactions each year, which benefit as many as 500,000 start-up
and small companies. These numbers remain constant, though locating in-
vestors since the dot-com bust has become more challenging.
In addition, the high-net-worth, affluent market is the target of multiple
solicitations, not just from entrepreneurs offering private equity deals.
According to Giving U.S.A., charitable donations in 2003 totaled $240 bil-
lion, the majority of which came from individuals. This amount is a 2.8 per-
cent increase over 2002, and 2.2 percent of the nation™s gross domestic
product (GDP). This money was raised largely by professional fund-raisers,
a major competitor with entrepreneurs for discretionary net worth dollars!
Such donations also offer significant tax breaks as well.
Ten years ago everyone had a resume tucked neatly away in the desk
drawer; today more than 10 million visionaries have an idea or plan for a
new business. And with the people, regardless of economic conditions, cur-
rently intent on starting their own businesses, regions such as Silicon Valley,
New England, Southeast Texas, New York Metro, and Orange County,
California, have become zones of entrepreneurial fervor. A proven way to
wealth can involve coming up with an idea, then raising the money to fund it
into a reality. Today, as much as in the late 1990s, highly successful individ-
uals are attempting to achieve their own success and enhance their personal
wealth through entrepreneurial ventures.
Raising money today is much harder than it was five years ago, prima-
6 THE CHALLENGE AND THE SOLTUIONS


rily because finding investors has become an “in” thing. Entrepreneurs have
not discarded their dreams, but those with impressive personal wealth”es-
pecially those inclined toward investing in high-risk/high-return deals”have
become the target of everyone, from charitable fund-raisers, to purveyors of
luxury consumer products, to the world™s most successful money managers.
Understandably, new money managers, foreign money managers, and
other advisers seeking to manage funds aggressively target higher-net-worth
individuals. In fact, with the failure of and disappearance through acquisi-
tion of so many investment banks, brokerage and money management firms,
a survival mentality has gripped those who remain and compete with pro-
fessional money managers for private capital. Besides, as the flow of deals re-
mains steady, private investors become more sophisticated in evaluating
what constitutes an attractive high-risk/high-reward opportunity. In short,
there is simply more competition for the same amount of money than there
was five years ago.
International Capital Resources of San Francisco (ICR) surveyed more
than 480 entrepreneurial ventures seeking capital. The entrepreneurs cited
an expanding array of financing methods they were relying on to accomplish
their financing goals. However, the majority identified one alternative
financing resource as a practicable and preferred option: private equity
investors.
Exhibit 1.1 presents the primary funding methods mentioned during
those interviews (no percentage is given for methods receiving only minimal
recognition).
ICR discovered that 61 percent of entrepreneurs who came to its firm in
their search for capital were relying on the direct participatory investment,
casting an eye primarily toward informal, high-risk venture investors as their
means of raising capital. Eighteen percent anticipated relying on their per-
sonal financial resources and those of family, friends, and business contacts.
Only 9 percent of these primarily earlier-stage and developmental-stage com-
panies were capable of relying on profits and working capital in order to
fund their growth plans. Only 7 percent turned to banks for debt financing,
and 3 percent chose joint ventures and alliances. Finally, only 2 percent of
the 480 companies queried showed interest in approaching professional ven-
ture capital firms to fund their venture.
These findings have been supported by a 2001 study that found that the
percentage of INC 500 CEOs who have raised start-up capital did so 88 per-
cent from personal assets, 39 percent of personal assets from other co-
founders, 30 percent from family and friends, and 3 percent from venture
capital. Seed capital for the same group in 2001 came from co-founders 39
percent of the time, family and friends 30 percent of the time, and strategic
partners and customers 11 percent of the time.
7
The Challenge




Private placement with informal
venture investors:
61%




Self, family, friends,
and business
Other: includes contacts:
venture capital firms, 18%
Profits
corporate investors,
and
and IPOs:
working
2%
capital:
Joint ventures 9%
and alliances:
3%
Banks, commercial finance companies, and small
business investment corporations (SBICs):
7%

Exhibit 1.1 Primary Targeted Funding Sources


THE ANGEL INVESTOR
Although the concept designated by the term angel dates back to the Golden
Age of Greece, its modern coinage dates only as far back as the Broadway in-
siders to describe the well-heeled backers of Broadway shows who made
risky investments in order to produce shows. Angels frequently invested in
these shows for the privilege of rubbing shoulders with theater personalities
they admired as much as to earn a return on investment (ROI). As a review
of the biographies of the great impresarios attests, money for those shows
was raised as much by attitude, good preparation, and luck as by the quality
of the offerings.
Angels today”numbering about 400,000 active investors according
to Forbes”are in many ways the same: wealthy individuals and families
willing to invest in high-risk deals offered by people they admire and
with whom they seek to be associated. Angels are also financially sophisti-
cated private investors willing to provide seed and start-up capital for
higher-risk ventures. In essence, angels are private informal venture capi-
talists, although as we will discuss, as the angel market develops, more for-
8 THE CHALLENGE AND THE SOLTUIONS


mal structures will become inevitable to facilitate transactions and increase
market efficiencies.
Public equities are traditionally a long-term play, and investors appreci-
ate this. But many have come to realize that recovery from the Bear market,
as has been the case in the past, can take a long time. For example, follow-
ing the Great Depression, the Dow Jones Industrial Average didn™t recover
its 1929 highs until 1954”25 years later! By investing a percentage (e.g.,
one to five percent) of their equity portfolios into private transactions in
order to offset public equity performance, the investors increase predictabil-
ity in their portfolios and maximize chances for performance, and so can ac-
celerate recovery. Sophisticated investors recognize that venture capital as an
alternative asset class is an investment vehicle instrumental in accomplishing
this goal.
Active angel investors possess the discretionary income needed to invest
in such risky ventures. In fact, a portion of their private equity portfolio is
often set aside for this purpose. This discretionary income sets the angel in-
vestor apart, even from the merely affluent. An affluent individual may have
an annual income of $100,000 but annual expenses totaling $150,000.
Large incomes, we know, can carry even larger debts. For this reason, we
distinguish between those who are affluent and those who are wealthy. In
setting standards for targeting investors in these high-risk ventures, many
entrepreneurs mistakenly judge investors solely on their income; income
alone has little to do with what counts in these types of ventures. They do
this primarily because data on income of individuals is more readily avail-
able, whereas finding out an individual™s net worth involves asking them the
level of their net worth. What counts are the discretionary funds for
early-stage, high-risk transactions, funds possessed only by wealthy angel in-
vestors, not necessarily by the affluent, whose debts can exceed their con-
siderable annual incomes.
The reader ought not forget, however, that although they represent a po-
tentially limitless source of funding for entrepreneurs and small business
ventures, private investors are unfortunately just that”hard to reach, in-
tensely selective, and usually immune to cold, “over-the-transom” invest-
ment solicitations.


STRUCTURE OF THE PRIVATE INVESTOR MARKET
Angel investors also possess a healthy appetite for self-arranged private
deals. Such direct investment serves to maintain the self-confidence of these
high-net-worth investors and demonstrates their continuing ability to make
money. These investors have amassed wealth precisely because they know
9
The Challenge


how to invest. Furthermore, it is reasonable to assume that they will remain
active investors. Many want to enjoy the small percentage of their capital al-
located for private equity. After all, even the most conservative investment
adviser will leave a client some money to play with. It is this “play money”
that ought to become the target of entrepreneurs seeking funding for
high-risk, relatively illiquid, direct investment securities. These deals, in turn,
offer the possibility of exceptional capital appreciation.
Investing to earn the potentially extraordinary returns of a new business
is extremely risky. The angel has the opportunity to earn above-average re-
turns and enjoy the challenge of helping younger visionaries grow a business,
but even after meticulous due diligence, investors lose their investment capi-
tal 33 percent of the time. However, these risks do not frighten away sophis-
ticated angel investors. These investors love the action, manage the risk, and
search for the “big hit” in pitting their skills against the market. And, at the
same time, they continue to contribute to an economic system that has done
well by them and that they are devoted to.
Angel investors include such high-net-worth individuals as the retired,
wealthy officers of corporations and private companies with $1 million to $5
million in pension assets to invest; the recipients of the estimated $20 billion
in windfall transfers in the late 1990s; the high-net-worth casualties of cor-
porate downsizing; and the thirty-something and forty-something chief ex-
ecutive officers (CEOs) of small capital companies that made their fortunes
through stock offerings, or sale of their companies in the 1990s. These in-
vestors have saved money, are financially astute, and possess engaging, chal-
lenging intellects.
Furthermore, these angel investors are concerned with after-tax returns
and return after expenses”the expenses, for example, of due diligence. They
represent “patient” money, remaining comfortable with a long-term,
buy-hold strategy, money not designed, as the Atlanta, Georgia, G&W
Premium Finance Gazette puts it, “for high current income,” but instead
money that “often won™t be available for some time.” (The Gazette cites
some examples: $25,000 invested in 1956 in Warren Buffett™s Berkshire
Hathaway has a 1995 estimated value of $90,000,000; the same amount in-
vested in 1989 in Home Depot reached an estimated value of $3,500,000.)
Last, angel investors define risk idiosyncratically, for example, the nature of
potential loss (irrecoverable or affordable), the need for liquidity, and the
need for control.
Less dramatic examples abound, such as the New York pediatrician who
invested $50,000 in a medical instrument start-up. Five years later, after an
initial public offering (IPO), the doctor cashed out for $2 million. Or take the
six New Jersey physicians who, along with several other private investors,
each put up $13,000 to start a facility to treat kidney stones. In ten years,
10 THE CHALLENGE AND THE SOLTUIONS


they earned seven times their investment, and the venture remains profitable
and pays investors impressive gains, demonstrating that sustainable compa-
nies need not be sold or taken public to provide return of investment and re-
turn on investment.
Angel investors are different from their venture capitalist counterparts,
who are more conservative, collect substantially more dollars from pension
funds and the like, and put the bulk of the capital to work in later-stage
deals. The angels have more time to spend with fledgling companies, helping
them to build sustainable companies rather than ventures solely for exit. This
hands-on guidance is invaluable to entrepreneurs who are the recipients of
more than capital but wisdom, knowledge, experience, and expertise of pre-
viously successful entrepreneurs in the investors.


MAKING SENSE OF THE HIGH-NET-WORTH MARKET

The classification model for targeting the most appropriate financial demo-
graphic segments of the high-net-worth market”so entrepreneurs have the
best possibility of locating angel investors”has not varied since our first
book (1996) and is not subject to changes, changes that have occurred in
economic conditions. The structure of the high-net-worth private investor
market (see Exhibit 1.2) can be segmented into four categories: first, in-
vestors with a net worth of a minimum of $500,000, comprising a little
more than 1.7 million U.S. households; second, a group of investors with a
net worth of $1 million to $5 million (about 672,000 households); a third
group worth $5 million to $10 million (about 158,000 households); and
last, a segment with a net worth of more than $10 million (roughly 9,000
households).
This market includes the target group that offers the entrepreneur or in-
ventor maximum possibility for finding investors. Growing at an annual rate
of 14 to 20 percent, this high-net-worth market compares favorably, for ex-
ample, with the current 8 percent growth rate in pension funds. Further-
more, each of these segments is adding about 1,000 households a year.
While we de-emphasize the use of income as a primary demographic in
targeting the high-net-worth group, Exhibit 1.2 shows a similarity between
the structure of affluence, or income, and net worth. Notwithstanding our
earlier distinction between income and net worth, some correlation naturally
exists between net worth and income. But do not be swayed by the numbers.
We see that there are about 672,000 households with a net worth of $1

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