If you’re thinking of becoming a business angel which would you rather, wait for a windfall that may never arrive? Or see a return spread over the length of your commitment?
This is the dilemma facing business angels as they try to find a way to profit from their investments in start-ups.
A business angel group based in Scotland presumably using the conventional equity in exchange for investment route practically doubled their money via investment in a company that invented a “solution for womens’ pelvic health”.
Fantastic returns can be made in these less glamorous areas of business – apparently one in three US women will have a pelvic health problem by the age of 60. Unfortunately for most business angels the odds are stacked against them finding a business with this much potential. How often do we hear the headline ‘business angel syndicate fails to exit’? Trust me, this is the far more likely outcome using an exit dependent investment model.
Despite the overwhelming odds against a successful exit you will only hear about the small percentage that achieved a ‘home run’ as business angels in the US call it. The failure rate remains in the region of 80% and it is widely acknowledged that business angels will need to invest in 10 businesses and hope to achieve a home run in one of them to pay for all the failures and hopefully return the modest profit which makes all the pain worthwhile.
A climate of uncertainty still pervades as economies continue to emerge from recession, so even these gloomy statistics will be put to the test when results are gathered from 2010.
However business angels are unlikely to keep banging their heads against a brick wall in the hope of making money. There is a new, more sophisticated approach to angel investment emerging which could reduce the risk and tip the odds back in the favour of business angels.
This model is called royalty based financing. The concept might be new in angel investment circles but it has been around for a while and successfully used in sectors as diverse as mining and the film industry.
So what is royalty based financing?
It might sound complicated but the idea is simple. Rather than rely on a home run exit that might take many years or may never occur, business angels can agree to give up their equity stake and exchange it for royalty payments gained from the company’s income stream.
The amount and frequency of the payments made to the angel investor depends on how quickly the business starts generating returns and how long the business angel is prepared to wait for those returns to kick in. When they do, the entrepreneur can agree to begin paying back the investor monthly as they would with a standard business loan from the bank or quarterly.
These payments to the business angel can be capped at a rate agreed between the two parties prior to the commitment. They can even be put off for a year allowing the entrepreneur to do what he or she does best, sell their product. The entrepreneur can also feel in control of the business rather than looking ahead to a time where the business would need to be sold off to satisfy the needs of the investor.
Business angels adopting the royalty based investment model can either sit back or become actively involved in a business where everyone is aware of the need to be maximising profits from day one. The business might still fail of course as many do in the start-up phase, there are no guarantees in this risky business, but at least the business can begin generating returns for the business angel investor(s) while it remains afloat.
Is this model perfect? Bookmark ibusinessangel.com or sign up to our e-newsletter and find out the potential disadvantages of royalty based financing.