Myths about Angel and Venture Capital Investors

Most entrepreneurs have been exposed to myths about angel investors and venture capital investors. Let me dispell some of these myths:

• Myth - Venture capital investors invest in technology, not the people. Wrong. Venture capital investors invest in the management team far ahead of the technology that is the basis for the company. Their experience is that a highly qualified management team will engage the market, react and change the product or service the company offers as needed to succeed. Since most companies don't succeed with the first version of its product or service, a management team that can assess the market and make changes will more likely succeed.
• Myth - Angel investor groups act quickly when presented with an investment opportunity. Wrong. There is a trend toward angels forming groups to evaluate investment opportunities, select from the many opportunities they see, negotiate the terms of investment and make the investment. However, in most groups, this takes an inordinate length of time, especially if the angel group does not have a paid managing director to keep things moving. Most angel groups don't have a paid managing director. The reasons for the slow moving process is that the group often only meets once per month, a single naysayer in the group often causes the process to stop until others in the group override the negative opinion and the group has a preferred set of terms that may not be acceptable to advanced entrepreneurs, slowing the process down to get the group to accept other terms. It's not unusual for a company to make a presentation to an angel group one month, come back the next month to answer questions, begin negotiations lasting 30 days, then waiting another 30 days for the legal documentation to be completed before a closing occurs. Is it any wonder advanced entrepreneurs don't want to deal with angel investor groups? On the other hand, early stage entrepreneurs often have no choice but to raise capital from angel groups and don't realize how long the process will take.
• Myth - Venture capital investors want to control your company from the start. Wrong. Professional venture capital firms do not want to take control of companies when they make their first investment. First, they aren't staffed to exercise that degree of control over the companies. Second, if they have to have control in order to make the investment, they have concluded the management team is incapable of running the company which should lead to the decision not to invest. On the other hand, there are individuals and groups out there who hold themselves out as venture capitalists, but who will only invest if they obtain control. These individuals and groups are not true venture capitalists and advanced entrepreneurs should usually avoid them.
• Myth - Angel investors invest to make money. Usually wrong. Most angel investors are successful entrepreneurs who have cashed out. They invest to "be in the hunt" or to join with other angels who they want to be associated with or to have the opportunity to watch an entrepreneurial company go through the growing pains and, hopefully, succeed. Since, by definition, angel investors are wealthy, they don't have to make highly risky investments to increase their net worth. But, they HATE to lose money. Yet, angels will lose their entire investment in most of the investments they make in young companies. How do angel investors reconcile the risk-taking with hating to lose money? It's a mystery.
• Myth - Angel investors bring good advice to the table for the entrepreneur in addition to money. Usually wrong. The best thing an angel investor can bring to the table other than money is relationships, i.e relationships with potential investors, relationships with investment bankers, relationships with potentially large customers, relationships with law firms, accounting firms and banks, etc.

I've run out of time today. I'll continue this another day.

Business Development Companies can fill the gap between angel funding and VC funding

A gap exists between angel funding and venture capital funding for qualified, second stage companies. Very few angel funded companies will ever obtain VC funding before being acquired. So, a second stage, angel funded company has no choice but to grow with internally generated capital after exhausting the angel funding. But, this results in a lower rate of growth than could otherwise be achieved if growth capital were available. Yes, a company at this stage will probably be able to obtain a line of credit from a bank secured by accounts receivable or an equipment line secured by equipment, but bank borrowing is insufficient to fund a high growth rate. Alternatively, companies in this stage may seek to be acquired earlier than they otherwise would if they had access to growth capital, partly at the insistence of the angel investors who want a liquidity event.

There is an opportunity for business development companies to fill this gap and achieve attractive gains for its investors while filling the need of second stage companies for growth capital. A business development company is a special animal under the securities and tax laws. Essentially, a business development company is a publicly held, closed-end mutual fund that must invest primarily in privately held companies. A BDC that makes equity investments is basically a publicly held venture capital firm. A BDC differs from a venture capital firm in that it has the ability to raise capital from time to time as it makes investments through public offerings. A typical venture capital fund has a finite life and once it is fully invested, it liquidates its investments and distributes the net proceeds to its investors. The principals who run the VC fund then form a new fund and start the process over.

Unlike a venture capital fund that is privately held (as almost all are), a BDC is transparent to its investors and the public due to being publicly held. While this can be a burden on the BDC, the transparency is what all investors want and deserve. The biggest problem a BDC has with transparency is how to value its investments in privately held companies. But, a VC firm has the same problem in reporting its status to its investors, but doesn't have the SEC looking over its shoulder.

There is only a handful of BDCs that make equity investments in second stage companies, but there are many BDCs that only make loans, usually secured loans, acting essentially as finance companies. Why don't more equity oriented BDCs get formed? Well, the dynamics of the market can make it unattractive for an investment banking firm to underwrite the initial public offering for a BDC and it is expensive to start a BDC. Let's start with the expense of starting a BDC.

A founding management team has to be formed to start and manage the BDC. This team must have sufficient capital to bear the substantial legal and accounting fees necessary to prepare, file and process the registration statement for the initial public offering and the other expenses associated with the offering. The team must find and convince an investment banker to manage and underwrite the IPO. This process can take as long as one year and the members of the team must have the resources to devote almost full time to this process for that period of time. The reward for the team is to have the opportunity to share in the gains made by the BDC in its investments, similar to the "carry" available to the management team of a VC firm.

If a team can obtain the resources to form a BDC, the challenge is to convince an investment banking firm that the price of the stock will increase over the IPO price and increase over time as the BDC makes investments. Historically, the price of the stock has declined after an IPO for closed-end mutual funds of this type because there is little after-market demand for the stock. No underwriter will knowingly underwrite an IPO if it believes this will happen. So, the challenge for the management team is make a convincing case that it has the opportunity to make very attractive investments and that the BDC can keep the interest of investors while it takes several years to invest the proceeds raised in the IPO.

I believe there is an opportunity for BDCs to form while the gap bewteen angel funding and VC funding exists. I also believe that potential investors in an IPO for a BDC can find this an attractive way to invest in growth companies where the capital invested by the BDC into second stage companies causes these companies to grow. Further, unlike an investment into a VC fund, an investor in a BDC has a highly liquid investment since there is a public market for the stock of the BDC.

A case can be made for a BDC to have a $30-40 million IPO. The BDC should be able to fully invest the proceeds in 3-4 years, then have a subsequent offering assuming its investment portfolio is showing an attractive increase in value.

A management team will probably need to have $1-1.5 million to start a BDC and, the underwriter will probably require the management team to obtain commitments from private investors to invest up to $6 million in the IPO before agreeing to manage and underwrite the IPO. Quite a challenge.