iBusinessAngel

Where Business Angels Fear to Tread?

Investors in early stage and start-up businesses are known as angel investors. The tag ‘angel’ coming from their tendency to operate in the margins where venture capitalists, banks and other backers choose not to go.

They also help plug a major funding gap to get such ventures off the ground and they happen to be the kind of investors who are prepared to take a risk, rely on their instincts and invest large sums without too many hard questions asked.

At least this is the accepted view.

But we may well be seeing a new breed of business angel emerge, one that takes a more conservative approach in these risk averse times.

Times, as Bob Dylan once sang, are a-changing as we see a trend emerging both in the UK and the US for a more cautious approach to investing in embryonic stage businesses. With many investors’ fingers burnt by the financial crisis it is hardly surprising that the appetite for risk remains limited – which in turn is making it increasingly harder for start-up businesses to attract funding.

According to the latest NESTA report on business angel activity in the UK, 83 per cent of angel investments were made with co-investors and a significant proportion (28 per cent) were made within just 50 kilometres of home. Working close to home and in the company of fellow investors shows that most business angels need security like anyone else and are careful where they put their money. The figures debunk any myths suggesting otherwise.

This is further borne out by statistics released in the US where an article this month in BusinessWeek suggests angel investors are getting pickier based on their analysis of data supplied by Angelsoft, an internet based company supplying online tools to angel investors.

The study looks at the share of companies seeking angel funds passing through each stage of the ‘deal funnel’ between 2007-2009. Not surprisingly, given the economic climate in the past two years, a glance at the chart reveals a dramatic decline in the number of businesses getting even as far as the screening process between 2007 and 2009. The statistics make worrying reading for anyone hoping for an easy ride when they approach potential investors for their start-up if the pattern is repeated her in the UK. .

More worrying still, just 2.8% of businesses made it as far as the due diligence stage, a fall of more than 50% on 2007/08 figures. This would indicate that angel investors in the US have become, as the article suggests, more ‘picky’.

But is it simply a case of angel investors becoming more picky? The figures reveal that just under half of businesses make it through screening to the due diligence phase, which is a pattern that has been broadly repeated since 2007.

However even though there were around 50% less businesses making it through the deal funnel, when we reach the end of the funnel and to what those business are striving to achieve i.e. investment, the proportion of those businesses making it through the final stages, is shown to be higher in 2009 than in 2007 or 2008, with 2.8% making it to due diligence and 2.1% securing investment.

Herein lies the good news for those businesses who sought funding. The proportion of businesses receiving funding in 2009 compared to 2008 suggests that if a business made it to the due diligence stage, there was a significantly better chance of securing investment.

The small percentage of businesses that made it through screening and the presentation phase also stood a greater chance of making it to the end of the deal funnel. This may suggest that angel investors are indeed becoming more choosy, but it could well be more a case of less money in the angel investor’s pot making it tougher to get past this initial screening process.

We know that more than half of investments fail; therefore it doesn’t take a great leap of the imagination to conclude that angel investors are willing to take fewer risks than they once were. This will be bad news for many start-ups and there will be many innovative businesses that fail to get a vital injection of capital. The number of businesses that have slipped through the net since 2007 is anyone’s guess.

It isn’t all bad news, according to the figures in the US business angels are choosing to invest in a greater proportion of those businesses that make it through screening. But we may be seeing that even business angels have their limits.

Pounds and Pence

In the first recession investors wanted business plans that offered new simplified services or goods that make things work better (ie. increase efficiency – such as self-service on the web for better prices) or that reduce costs (such as better conferencing or collaboration on the web allowing businesses to cut corporate travel).

However, as opinions strengthen that stocks have rebounded too fast and property assets have not fallen far enough, entrepreneurs and investors need to start thinking about how to handle the second recession.

Now, this is not to say that a second recession is guaranteed, simply to say that the risk of a second recession is sufficient for it to be a part of your plan.

And this is where it gets difficult…

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“Venture Capital funds available for start-up and growth businesses has dropped 70% since 2000″, said Anne Glover chief executive of Amadeus Capital Partners at the BBAA Annual Awards Dinner.

This means that businesses seeking new capital that are unable to raise bank finance (and who is able at present?) will need to increasingly turn to Business Angels.

In the view of Anne Glover, this represents a huge opportunity for Business Angels as the Venture Capital businesses will not be able to take all the best deals and leave the angel investors with the left-overs.

In fact, a theme that developed during the recent BBAA event was that Venture Capital firms want to work with Business Angels.

A number of VC firms, such as Catapult, look to invest alongside Business Angels.  Rob Carroll, managing director of Catapult said “investing alongside experienced entrepreneurs and angel investors increases our chance of success.”

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Business Angels need training - that was the overwhelming message coming from the British Business Angels Association annual conference held at the Belfry in early July.

Quoting new research from Nesta, Mogwenna Rees-Mogg stated that a ‘56% failure rate for Business Angel investing is not good enough’.

This means that for every £1 invested by UK Business Angels, 56p will be lost out right and the remaining 44p will have to grow considerably to make up for the loss and return the business angel with a sufficient return to justify both the money and the time invested.

Discussing the Nesta research in more detail, the panel members expressed the view that it is likely that perhaps 10 or 20% of Business Angels do considerably better than the remaining 80 to 90% and therefore, in order for angel investing sector to grow, more investors need more support, training and help to make better investments.

John Huston, Chairman of the US equivalent to BBAA, Angel Capital Association, confirmed that the results of the Nesta survey into UK business angel success rates mirrors the experience in the USA.

The BBAA (British Business Angels Association) trade body is today organising its annual awards ceremony and conference at the Belfry.

The event is sponsored by Advantage West Midlands, the redevelopment agency for the West Midlands.

It will include both an opportunity to recognise key contributions made to this growth sector during the year at the annual awards dinner as well as create a platform for discussion about how this new sector should grow during the conference session on Thursday.

Many business angel networks and agencies have seen an increase in activity in 2009 as a result of high net worths looking for greater influence over how their money is invested as well as more business start-ups turning to business angels to provide initial funding.

However, converting interest into actual funds invested; and, funds invested into business success is where the industry still needs to prove its mettle.

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The FT neatly describes the difference between Debt and Equity when it argues today, that the tax treatment should be the same for both.

Of course, the fact that it is not has led investors to structure their deals to take advantage of the difference.

And, flavour of the month is convertible debt. But more of that in a minute…

Firstly, why debt rather than equity? Well, because the interest payments that a business makes on debt are tax deductible for the company. Similar returns going to equity investors (in the form of dividends) are not!

Therefore, companies make bigger profits if they leverage up with debt rather than seek equity investment.

And, in this current environment where banks have either withdrawn funding or increased the cost, more start up businesses need to depend on Business Angels for a greater part of the initial investment.

This gives the Business Angels greater power to negotiate convertible debt. That is, a cash sum which earns a particular level of interest each year (and the company can off-set this interest cost against profits) with the magic ability to convert into equity at a pre-defined ratio, should the investor so desire.

However,  it isn’t just for tax reasons that convertable debt is popular. It is also because business plans are less clear and timing of exits are less certain that a debt investment structure means that the investor still gets a return on his money whilst waiting for the market to pick up and the company to be sold for a profit.

Hence, it is tax efficient for the company and great for the investors. Now that the business owners have fewer options, it seems that business angels are able to negotiate and agree these structures more easily.

Small businesses and start up ventures can no longer access easy investment from banks and therefore need to turn to private individuals – or business angels.

These business angels also often bring a degree of industry experience and knowledge that can be invaluable for small or start-up companies.

The UK has the highest number of angels in Europe, nearly 5,000 active investors in 2007. They invested €73m in 388 deals in England and Wales and a further €41m in 61 deals in Scotland. The average amount raised per deal is €327K and with many investments starting at or around €20k per stake.

The number of wealthy investors in the UK looking for an alternative to investing in stock markets and property is growing rapidly, we believe, and they are looking at the Direct Business Investment option with greater interest than ever before.

In response to a surge in interest in this sector and to serve this growing community of business angel investors we will launch www.iBusinessAngel.com in the early autumn of 2009.