When you order a martini at the Angel’s Share bar, a white-gloved waiter brings the shaker right to your table. The alcohol that evaporates while your drink is poured, so the thinking goes, is the angels’ share.
Like the cherubs who hang around that Manhattan bar, angel investors were left with fumes in the wake of the dot-com crash. Many first-generation Internet entrepreneurs saw their instant wealth evaporate. The business-cycle hangover left many investors vowing “never again.”
But for every downturn, there is an upturn, and angels are once again flying high. They’re pouring more money than ever into more startups and finding new ways to work with one another and venture capitalists to close the growing gap between seed financing and a first institutional round. The game is now not just about finding and seeding the next Google. It’s also about ensuring the angels’ share isn’t blown away by cash-laden VCs who are writing increasingly large checks.
Turn around again
“It’s back,” angel investor M.R. Rangaswami says of the seed stage market. He should know. As one of the co-founders of the SandHill Group, a software consultancy agency, Rangaswami sees some of the most promising deals before anyone else does. He made two investments last year, up from one the year before and zero between 2001 and 2004.
“Because of off-shoring of software development and open-source, you can get products done with much less money,” Rangaswami says. “If you raise a million bucks, you can get a product out the door, where in the old days it was a stepping stone to a venture round. This has been a very positive trend for us [angel investors].”
His experience isn’t unique. Angel investment rose sharply in 2006, according to a report by the Center for Venture Research at the University of New Hampshire. Total angel funding reached $25.6 billion last year, an increase of 11% from 2005, according to the report. The number of deals also increased, with angels investing in 51,000 ventures, up 3% from the prior year.
The number of angel groups is rising, too. Few people are as close to the explosion of interest in angel funds than Brian Johnson. He’s the executive vice president of RAIN Source Capital, which helps angel groups get off the ground in Minnesota and its surrounding states in exchange for a stake in their nascent funds.
If you raise a million bucks, you can get a product out the door, where in the old days it was a stepping stone to a venture round. This has been a very positive trend for us.”
M.R. Rangaswami, angel investor
“We’re getting calls from states across the country that want to duplicate a local program,” Johnson says. Since its inception in 1998, RAIN has launched 20 angel funds, 13 of them in the last two years alone, Johnson says.
But angels aren’t only popping up like toadstools. They’re also investing larger amounts in rounds, syndicating with each other for the first time, and pursuing new ways of doing business.
The Angel Capital Association—a 3-year-old organization that tracks trends in angel investment and helps disparate groups connect—estimates that each of its members committed an average of $1.78 million in 2006, up from $1.45 million in 2005. The average ACA member group did more deals, too, backing 7.4 companies during 2006, up from 5.5 in 2005.
Strength in numbers
Perhaps more telling is what the 3,000 ACA members said they want to do this year. The No. 1 goal: work with other angel groups. “That came through loud and clear,” says ACA Executive Director Marianne Hudson. The groups want to share due diligence efforts or split risk among groups, she says. Newer groups see syndication as an opportunity to learn from other, more experienced angel groups.
The most pressing reason to syndicate comes from the need to bridge the capital gap between what a single group, or investor, can offer a startup and what that startup might be able to get from an early stage venture capitalist. An angel might be able to write a check for up to $1 million, but anything over that amount requires serious money and a willingness to risk it.
Yet it has gotten harder for VCs—even those who focus on early stage opportunities—to write checks for less than $3 million. It is a conundrum. “A lot of entrepreneurs need more than one angel can provide, but less money than a VC can provide,” says Hudson.
Bridging that gap can be a big problem for angels. Jim Swallow, an angel with Monterey Investors, an informal group based in Monterey, Calif., says one of his companies is frustrated because it needs to raise a Series B round, but would have to give up a share of equity to VCs.
Angel investments totaled $25.6 billion in 2006, up 11% from 2005, while the the number of angel deals grew 3% to 51,000 in that same period.
Center for Venture Research, University of New Hampshire
“It’s hard for me to recommend that the company go to a VC firm because I would experience significant dilution,” Swallow says. “But still, they’re a good company and we need to be sure they have enough cash flow to bridge the gap until the cash comes in from customers. Most of the funds we’re talking to would want to take a bigger position for a bigger percentage. We don’t want to do that, so what’s our alternative?”
It’s a perfect opportunity to syndicate with another angel group, Swallow says.
But syndication among angels has been difficult. Groups are often geographically spread out and many are relatively anonymous. They each followed their own procedures for valuing deals, controlling their investments and setting timetables for entrepreneurs. That has given rise to organizations such as RAIN and ACA, which hope to make it easier for angel groups to work together through the use of standards. Hudson predicts that “there will be several models of angel groups, but there won’t be 57. There will be six to 10.”
Some angels are trying to bridge the funding gap for seed stage companies by pursuing new strategies and structures with venture capital firms. Take Sid Mohasseb. He’s raising a $2.5 million fund that’s part incubator, part angel investment vehicle and part VC fund. His Irvine, Calif.-based firm, called VentureFarm, expects to seed six startups with its inaugural fund.
Mohasseb, the firm’s only general partner, says that VentureFarm has raised just over $1 million and he is looking to add investors who could potentially join as general partners in the next fund. He also wants to add investors who can double as industry experts or facilitate relations with venture firms. He expects to be back out in the market for a second fund within 18 months.
Mohasseb, a former management consultant who is also an investor with Irvine, Calif.-based Tech Coast Angels, has invested in one startup through VentureFarm so far: TrendPoint Systems, a San Ramon, Calif.-based company that makes a device to monitor power consumption at the circuit level.
Mohasseb focuses on startups at the $1 million valuation level. When those companies reach valuations of $3 million, Mohasseb hopes to have a partial exit by bringing in a venture investor. He set up VentureFarm to sell half of its stake to any VC firm that funds a startup’s first institutional round.
We’re getting calls from states across the country [for help with organizing angel funds].”
Brian Johnson, Executive Vice President, RAIN Source Capital
Liquidating half of the fund’s holding in a portfolio company as early as the first round helps mitigate some of the risk for an angel investor and gives seed backers a little short-term gratification that they wouldn’t normally receive, Mohasseb explains. “I saw this dynamic of how angels work where you have to be in 25 deals for seven to eight years before you recognize any reward,” he says.
Other angels don’t like the idea of cashing out early to mitigate risk. “It would be a bummer if you had to sell half your seed investment in a Google to a Kleiner Perkins at the Series B price of $20 million instead of at the $100 billion pre-IPO valuation,” says Ian Sobieski, managing director of the Band of Angels of Menlo Park, Calif. “Sophisticated angels know it takes time to build companies.”
Sobieski says the Band of Angels’ IRR is driven by companies that typically take up to six years from their initial investment to go public or get acquired. The group has achieved a 55% return since its inception in 1994, he says.
Steve Stephansen, president of Sand Hill Angels in Menlo Park, believes most VCs would be opposed to the VentureFarm strategy. “It’s a model the VC firms would resist because it allows the seed investor to make money at a very early stage in the company,” he says.
Mohasseb acknowledges that holding 25% of a startup when it is looking for venture financing may not be the optimum strategy for maximizing returns. If an angel fund holds a substantial equity stake in a company, a VC may be tempted to over-value the startup to justify getting its own cut of the equity pie, Mohasseb says. “But what VentureFarm aims to do is to give VCs more of what they like without forcing them to overvalue the company or disincentivize the entrepreneurs,” he says.
Whether the VentureFarm model works or not, it illustrates that angels are at least trying to find ways to better work with venture firms. VCs would do well to make the same effort, since angels are playing an increasingly important role in the venture capital ecosystem. It seems only fair that angels should get a share.