Business Angels What Do We Know, What Do We Not Know, and What Should We Know?

Business Angels What Do We Know, What Do We Not Know, and What Should We Know? Although business angels have existed in one form or another for centuries, thorough academic research on them wasn t conducted until Seymour and Wetzel s seminal study in 1981. Since then, researchers have been busy filling what became apparent was a serious gap in the knowledge of business angels backgrounds, investment interests, and behavioral patterns. This essay will first examine what is commonly known about angel investors, before proceeding to identify knowledge gaps in the literature. By appreciating what we know and what we don t know about angel investors, it will then be possible to explore what it is that entrepreneurs seeking financing should know. Before undertaking a review of the literature, however, it is first important to clearly define business angels. Different authors have proposed a wide variety of definitions, yet most share certain characteristics. What is clear is that angel investors are high net worth individuals (Wilson, 2011) who have no family connection to their investments (Mason and Harrison, 2008) and who differ from venture capitalists in that they invest their own funds (De Clercq, 2006; Lerner and Kortum, 2000). Other definitions highlight that most angel investors have previous experience investing (Wilson, 2011), are, or used to be, entrepreneurs themselves (ACA website), and that they typically invest in the seed or start-up stage of the business. Most definitions also include the fact that angel investors typically take a more hands-on approach to their investments than venture capitalists although the extent to which they are involved is debated and will be further discussed later in the essay. Let us now undertake a review of the available literature and understand what it is we do know about angel investors. There are a plethora of studies examining what characteristics are generally shared by typical angel investors, and analyzing those characteristics provides an excellent platform from which to begin. Freear et al. (1994) found that angel investors are typically well educated, middle-aged, and have considerable business experience. However, in terms of their experience in venture investing, they can range from hugely successful entrepreneurs to individuals with no previous experience investing at all. Other studies have shown that an overwhelming majority of them prefer to invest close to their home base (McKaskill, 2009; Freear et al., 1994), and that they rarely invest more than a few hundred thousand dollars total (McKaskill, 2009). Perhaps surprisingly, a large number of them are not millionaires (McKaskill, 2009). Other studies have found that most invest alone (not as part of a network, although networks have been growing), and usually diversify their risk with a portfolio, knowing that many companies will not perform well (Wilson, 2011); in fact, they 1

expect that up to one third of their investments will fail and reject seven out of ten deals (McKaskill, 2009). Although the overall amount of angel investments is roughly equal to that of venture capital investments, the significantly smaller individual investment size means that angel investors contribute to eight times as many businesses (Mason and Harrison, 2000). However, due to their apparent invisibility and issues of asymmetric information, most business angels are unable to find sufficient ventures in which to invest, and there are considerable funds left uncommitted (Mason and Harrison, 1995). Another defining characteristic of angel investment is that it is a transformational, valueadded, active investment strategy, in which the investor expects to have a hands on approach (McKaskill, 2009). Angels are sought not only for their funding, but also for their industry experience, networks, and access to venture capital firms (Freear et al., 1994). They also play a key role in providing strategic and operational expertise for new ventures, as well as contacts and introductions many studies have shown that for the entrepreneur these are just as important as funding (Harrison and Mason, 2010). Typically, they acquire between 10% and 20% of the company and expect a certain degree of involvement in the running of the business (Harrison and Mason, 2010). The transactions of business angels are characterized by a high degree of information asymmetry, as entrepreneurs possess information about themselves and their opportunities that potential financiers do not (Shane and Cable, 2002); this is often cited as one of the greatest limitations to a increasing the amount of angel investment. Due to the high degree of information asymmetry when selecting entrepreneurs, investors face high risks as entrepreneurs have strong incentives to act opportunistically and overstate their ability to identify and exploit opportunities (Shane and Cable, 2002). It is largely to address this concern that the number of angel investment syndicates, groups, and networks have been growing since the mid 1990s in the UK and the US (Wilson, 2011). Networks allow investors to choose from a much wider array of companies, increasing their deal flow and addressing the information gap in the early stage financing market (Wilson, 2011). Although amongst their motivations for investing many business angels cite helping others, fun, an addiction to high risks, and improving self-image and recognition (McKaskill, 2009), their principal objective remains a successful exit. The majority of positive exits are either trade sales, IPOs, or MBOs (Mason and Harrison, 2002), and studies show that the average time to exit is four years (Freear et al., 1994). However, it is important to note that the majority of exits are negative, ending in either failure or bankruptcy (Wilson, 2011). 2

Most of the gaps in our knowledge of angel investors originate from the fact that the informal venture capital market is virtually invisible and often misunderstood (Wetzel, 1987). It is interesting that many of the issues that make the market for informal investments somewhat inefficient are also the reasons that many studies have significant limitations: unfortunately, information about investors and investment opportunities is quite limited (Wetzel, 1987). It is difficult to establish with certainty the size of the angel investment market; while Mason and Harrison (2000) found that angel investment and venture capital investment in seed and early stage start ups were roughly equal to each other, Maula (2005) found that angel investment was five times greater. What is clear is that the numbers vary greatly across different countries and depending on the research methods used. The significant differences between the two studies might also be explained by how the authors chose to define seed and early stage financing: how they define the limits between early and not early could have a serious impact on the proportion of investment attributed to business angels. Another important gap, identified by Freear et al. (1994), is that most studies do not take into account high net worth individuals who never become angels. Therefore, we do not know what makes certain high net worth individuals predisposed to become angel investors. Freear et al. (1994) attempted to address this gap and found that the biggest detriments to becoming an angel investor are related to lacking assistance in monitoring the performance of the investment and assistance in pricing and structuring which, importantly, are both related to the technical aspects of investing. However, theirs is one of the few studies that explicitly addressed the issue, and data was collected from only 184 respondents to their survey. Furthermore, 146 said they had already made angel investments in the past, suggesting that perhaps those who had already invested were more likely to respond to the surveys in the first place, skewing the data. Even if their methods and conclusions were flawless, it remains clear that further research into what exactly separates angels from non-angels is necessary. One area in which a large number of studies have been conducted but in which there is little consensus on the conclusions to be drawn is that of the role that typical angel investors like to play in their investments. Wilson (2011), argues that most angel investors prefer to remain minority shareholders, do not usually ask for a board seat, and are happy to let the entrepreneur remain fully in control of their business. McKaskill (2009), however, found that typical conditions attached to their funding are a position on the board of directors, veto power over key issues, approval rights over other issues, the right to put the business up for sale or replace the CEO if certain milestones are not achieved, and often expect and enjoy 3

being involved in the management of the business. De Clercq (2006) addresses the issue by proposing that there are two types of angel investors: those whose primary interest is simply to generate a profit and those who want to be part of an exciting opportunity to be involved with an entrepreneur. The first type will resemble venture capital finance in many ways, the second, while possibly helpful, could also become an issue for the entrepreneur due to meddling. The differing conclusions drawn by different studies is likely due to the fact that angel investors are a widely diverse group of people and cannot therefore be neatly categorized, and demonstrates the possible pitfalls of applying definitions to largely unpredictable groups of people. Another knowledge gap is that of the role and impact of informal institutions on angel investment. Ding et al. (2014) examined the effect of social trust on the number of angel investments, and their study found that countries with higher levels of trust also have higher levels of angel investment. Social trust affects investor decisions by improving the transference of information, promoting cooperation, and enforcing sanctions. While these findings should not be surprising considering that angel investment involves informal procedures and generally relies more on trust and empathy than many other transactions, correlation does not necessarily imply causation and additional studies should be conducted to further investigate the effects of informal institutions on angel investment. After undertaking a thorough review of the literature and fully understanding what it is we know and don t know about angel investors, it is now possible to determine what it is that aspiring entrepreneurs should know about obtaining finance. Most importantly, entrepreneurs should recognize that reluctance to invest usually stems from problems of asymmetric information (Shane and Cable, 2002), and take measures to increase the information at the disposal of the investor. Such measures could include, for example, agreeing to contractual rights that allows the investor to provide capital in stages, allowing the investor to abandon the investment if negative information is eventually revealed (Sahlman, 1990). Other contractual rights could establish forfeiture provisions, loss of shares, or punitive dilution rates if achieving below-target-performance (Hoffman and Blakely, 1987). Furthermore, entrepreneurs seeking financing can agree to assume as much of the risk as possible and pledge large amounts of whatever collateral they have available in order to demonstrate their commitment to and confidence in the success of the venture. However, entrepreneurs should also know that their over-optimism is well documented and understood (Cooper et al., 1988), and that therefore many investors will not necessarily be swayed simply by a demonstration of confidence after all, the vast majority of entrepreneurs 4

are confident that their ventures will succeed; yet a very large proportion fail. Furthermore, it is unlikely that aspiring entrepreneurs will possess the amount of collateral necessary to shoulder any significant proportion of risk. Understanding those issues, Shane and Cable (2002) argue that rather than attempting to personally correct information asymmetry, entrepreneurs should rely on the importance of social trust, cooperation, and norms. Specifically, they found that most proposals that obtained funding had been referred to the investor by a third party. Their study is certainly reinforced by Ding et al. s (2014), which clearly demonstrated that countries with higher degrees of social trust have higher levels of angel investment. What entrepreneurs should draw from this is that they should make every effort to find reliable third parties that can refer them to either angel investors or angel investor networks, as doing so will increase their chances of obtaining financing at least as much as increasing the amount of information they make available. Finally, entrepreneurs should make sure that they know angel investors motivations for investing in the first place: generally, to make high returns on their investment in a time span of about four years (McKaskill, 2009). Because for most angel investments this means a trade sale, entrepreneurs need to be well aware that the contract they sign with the angel investor will most likely include provisions necessitating a trade sale at one point, and therefore need to understand that if they seek angel financing they will likely need to part with their business within a few years. While this may seem like a minor point, entrepreneurs will often become emotionally attached to their businesses, and demonstrating a reluctance to sell in the future will likely make it harder to obtain financing. By first analyzing what it is we do know about angel investment from the available literature and then identifying knowledge gaps in that literature, this essay illustrated some of the dynamics of angel investment. Drawing from both the literature and its limitations, we were able to understand what entrepreneurs who are considering seeking angel financing should know in order to increase their chances of obtaining the crucial investment necessary for them to start or grow their businesses. 5

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