Why don't angels invest in early stage or seed venture capital funds?

The vast majority of angel investors make investments on their own or follow other angels into deals. Few angel investors conduct due diligence on their own. Why? Because they don't have time and most don't have the needed expertise unless the investment opportunity is in the field of the angel's experience. Further, most angel investors don't have expertise in negotiating early stage investments. So, why do angels invest in early stage deals in such a haphazard way?

I'm not aware of any studies on why angels invest in this way, but I've represented many companies in their capital raising efforts at the early stage and have observed how angel investors typically behave. Most angel investors base their decisions to invest in early stage companies on the charisma of the founders, not on a thorough analysis of the products, markets and management skills of the founders. Yet. some early stage investments by angels pay off handsomely. How can this be? Frankly, I believe it is mostly luck.

I have a rule of thumb for seed stage investing - invest in 10 companies because 8 will fail (or you will lose all of your investment when later investors squeeze you out), one will make a 2-3 times return and, if you're lucky, one will make a 5 - 10 times return (maybe higher). Of course, the losses will occur in the first few years and the winners will take 5-7 years to achieve success for their investors. Most angels lose patience after five years.

In my experience, most angel investors do not invest in at least 10 early stage deals because they do not have sources for qualified deal flow. As a result, most angel investors get discouraged after investing in deals for three to four years and stop investing, almost assuring a loss on their investments.

If angel investors knew this pattern, why would they invest in a 3-4 deals expecting each one of them to be a 10X winner? In my experience, investors who are new to angel investing don't know about these odds or about the probability they will be wiped out by later investors when their companies have to have "down-rounds" with more sophisticated investors to stay alive.

I've blogged before about why angel invest (based on my experience). They invest for the "fun-of-it," not because they need to increase their net worth. Yet, they hate to lose money. If this is the motivation of most angel investors, it's understandable why they don't do due diligence, don't structure deals smartly and don't cultivate quality deal flow. It also explains why they don't invest in early stage or seed venture capital funds. A fund like this results in little or no contact by the investors with the investment opportunities and with other investors in the fund. In other words, the "fun" is taken out of the hunt for seed investment opportunities.

If angel investors wanted professionals to find the early stage investment opportunities, do thorough due diligence, negotiate favorable deals and offer guidance to each company after the investments are made, early stage/seed venture capital funds would spring up to meet the demand by angel investors to invest in these funds.

As an alternative, angels might band together to form angel investor groups hoping the group could engage a professional to do the due diligence and deal making for them with an approval process that would involve the angels in the decision making. These groups have been formed and some are purportedly successful in their investing missions, but my observation is that most angel groups fall apart after short periods of time due to the need for volunteers to do most of the work.

If angel investors were primarily motivated to invest in early stage companies based on potential returns, they should invest in early stage/seed venture capital funds. Commentators have recently been reporting that the smaller, early stage venture capital funds have provided greater returns to the investors. But, if an angel investor is primarily motivated to invest in early stage deals for the fun-of-it, that angel won't be interested in an early stage/seed venture capital fund because the fun is taken out of the equation and the investor will basically be a passive investor.

If a new, early stage/seed venture capital fund could offer some way to make it fun for angel investors to invest, that fund should succeed in raising capital from angels. Otherwise, a new, early stage fund will have to raise capital from institutional investors who are not into having fun, but into achieving the highest possible returns.

The key to attracting angel investors

As a corporate and securities lawyer for 35 years, now as a professor of entrepreneurship and negotiation, I've worked with many young, technology companies in their efforts to raise capital from angel investors. Almost all of these companies initially thought they could simply present a good business plan to several potential angel investor who they've never met before and get a commitment from each of them to invest several hundred thousand dollars. Those that ultimately raised capital learned the hard way that they had to establish a relationship with potential angel investors before they would invest.

A few of my clients followed my advice and the advice of others and started a year in advance to establish relationships with potential angel investors before attempting to raise capital from them. This took planning and perseverance since most young companies can't wait for a year to raise capital unless they can bootstrap for that period of time.

But, think about it, doesn't common sense tell you that angel investors are not stupid and won't invest unless they have direct or indirect relationships with the companies they will invest in? Every angel investor has many, many investment opportunities. The smart angel investor invests in companies the angel investor knows more about than he or she learns from a business plan. Or, he or she has a friend (usually another angel investor) who has a relationship with the company and intends to make an investment. This is what I mean by a direct or an indirect relationship.

I can't remember a client who raised capital from angel investors who were total strangers. Usually, one of the angel investors had a relationship with the company for a period of time. This investor acted as a lead investor and brought in friends to the deal. The friends trusted the lead investor's judgment because of the relationship he or she had with the company.

So, the key to raising capital from angel investors is to establish a relationship with one or more angel investors so the angel investor can become a champion with other angel investors he or she knows. I know this is easy for me to say and very hard to do when a young company is trying to survive for up to a year while establishing these relationships. But, those who are able to do this, who have dynamite business opportunities, management with experience and business plans that are believable can raise capital from angel investors.

Are advanced entrepreneurs good negotiators?

Not ususally. But, they don't realize they are poor negotiators. So what?

In order to capture the attention of advanced entrepreneurs, I often point out that entrepreneurial businesses make life or death decisions several times per year (sometimes per month), while a large company may make a life and death decision once every five years. Therefore, the liklihood of making a mistake that leads to the entrepreneurial business feeling compelled to be acquired or worse, going out of business, is very high.

Many of the mistakes result from a failure to successfuly negotiate a strategically important transaction or relationship. Why is this? First, most entrepreneurs, like most executives, believe the ability to negotiate effectively is a natural talent (which is not true). As a result, they fail to take courses to develop negotiating skills. Second, the entrepreneur fails to follow the number one rule in negotiation - be better prepared than the other side!

Every entrepreneur will be involved in heavy duty negotiations with people on the other side who are more skilled at negotiating than the entrepreneur. Yet, the entrepreneur believes his or her common sense will be enough to do well in the negotiation. Not even close!

Hiring a lawyer or other expert to negotiate for you is expensive and, often, not very helpful since the lawyer or other expert probably does not fully understand the context in which the negotiation is taking place. Only you have a keen appreciation of the trade offs you may make to get the deal or transaction done. It is easier for you to learn how to negotiate than it is to bring the lawyer or expert up to speed about your business.

Every entrepreneur should take a mini-course in negotiation from the local university or one of the firms that advertise in the airline magazines offering weekend programs on negotiation. This will be one of the best investments of time and money an entrepreneur can make.

Economic gardening is a good thing, but ......

Many state and local governments are promoting "economic gardening" as a means of stimulating growth in their economies and employment. This is a good thing. But, a key ingredient is missing - access to capital for growing entrepreneurial companies. Capital is in short supply by definition. Only those businesses that can convince investors and lenders that they can produce increased value for investors or meet their debt obligations for lenders deserve to obtain capital. The programs for economic gardening seem to focus on helping the growth stage companies deal with growth issues in order to make them more attractive to investors and lenders. This is a good thing also, but needs to have an added dimension.

How can governmental entities make capital more available to deserving growth companies in their geographic areas? Not by promoting venture capital firms to focus on a their geographic areas and not by trying to educate angel investors on investing in entrepreneurial companies. I urge all governmental decision makers to read a new book by Josh Lerner, a Harvard professor, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed--and What to Do About It, The Kauffman Foundation.

So, what can be done? Can angel investors be induced to make more investments in these companies? Probably not. Can growth companies be educated on how to raise capital from angel investors, resulting in more capital being invested in these companies? Perhaps. Can founding entrepreneurs of growth companies be convinced they need to make changes in order to be much more attractive to angel investors? This is the biggest impediment to attracting capital from angel investors. Yet, most entrepreneurs running growth companies cannot accept the realities of valuations of their companies, management changes needed, giving the investors some degree of control (through veto powers, not the power to force the company to take certain actions) and having boards of directors that are not rubber stamps for the entrepreneurs.

Entrepreneurs who have the courage to accept these realities have a much better chance to raise capital from angel investors. Those companies that raise capital from angel investors and make significant progress in developing their companies can become candidates for venture capital financing. Creating the environment where companies can raise more capital from angel investors is the best way to promote investments by venture capital firms in the future. My conclusion - economic gardening can make a difference if the economic gardening programs can help the entrepreneurs running these companies deal psychologically with these realities .

Entrepreneurial Finance is not about capital raising

I'm teaching Entrepreneurial Finance in the Rollins College MBA program this term. The obvious approach to this class is to focus on different means of obtaining capital. But that is not what Entrepreneurial Finance is about. Let's refer to Entrepreneurial Finance as EntFin to shorten this blog. EntFin is about mobilizing resources to take advantage of an opportunity identified by an entrepreneurial company.

For a product, the basic resources to take advantage of the opportunity are marketing and sales resources, working capital and capital equipment. One way to obtain these resources is to raise capital and buy them. But, there are many other ways to mobilize these resources. Since it is usually very hard to raise capital, entrepreneurial companies must be very creative in getting others to provide these resources.

As an example, a start-up company making widgets that use a new technology that has been patented can license others to use the technology to make the widgets relying on the licensees to find the marketing and sales resources, the working capital needed and the capital equipment necessary. Or, the company could make only the component of the widget that uses the company's proprietary technology and sell the component to OEMs who make the widget. The OEMs have to find the marketing and sales resources, the working capital and the major capital equipment to make the widgets (the company may have to purchase some capital equipment to make the components and must acquire the working capital to fund a small inventory and accounts receivable from the OEM).

Or, the company could joint venture with a large company interested in making the widgets by contributing the company's technology to the venture for a share of the profits. The joint venture partner would provide the marketing and sales resources, the working capital and the capital equipment to make the widgets. There are other ways to use other peoples money to provide the necessary resources to take advantage of the opportunity.

So, EntFin is the study of ways to mobilize resources, not just ways of raising capital. Each of these ways have advantages and disadvantages and some of the ways may not be doable. My goal in teaching EntFin is to open the eyes of the students to ways of mobilizing resources that includes, but is not limited to, raising capital.

Is an entrepreneur who failed an "advanced entrepreneur?"

We all know the saying, "We learn from our mistakes." Most people claim they learn more from mistakes than they do from successes. I don't believe this is true. Instead, I believe this is usually a way for a person to "psych" him or herself up after making a mistake that is very costly. Too often, an entrepreneur who started a business that failed blames the failure on outside circumstances or forces, not on mistakes made by the entrepreneur.

On the other hand, most entrepreneurs who have a successful business can readily state the decisions or actions taken by the entrepreneur that caused the success. An entrepreneur who has the courage to face up to mistakes made that caused a failure is likely to be a success the next time around.

For this reason, knowledgeable investors appreciate an entrepreneur who admits mistakes he or she made in the past and states clearly what was learned from these mistakes. Further, an entrepreneur who suffered through a business failure and has the courage to try again is my kind of entrepreneur. This entrepreneur is an "advanced entrepreneur" just as much as one who succeeded the first time.

Are entrepreneurs really risk takers?

I've often said that, in my experience, entrepreneurs are not risk takers. Instead, they don't know most of the risks they are taking. There is a disconnect between the risks that experienced entrepreneurs, looking back on their careers, realize they took versus the risks that new entrepreneurs think they are taking. Why is this?

First, newbie entrepreneurs don't know what they don't know. When I ask a new entrepreneur to list the risks he or she is taking while in the start-up mode, the entrepreneur is often hard pressed to list more than two or three risks. This list is not even close to the kind and number of risks the entrepreneur is taking. This explains the frequent comment experienced entrepreneurs make that, "If I really knew what I was getting into, I probably would not have started my company."

Even when I or others point out risks that the entrepreneur is taking, the entrepreneur usually denies the existence of the risks or assumes the risks can be easily managed. It takes courage to admit that there are major risks that are being taken and that some of the risks, if they come true, may cause the business to fail.

I often remind my students that no one "knows what they don't know." If an entrepreneur knows what he or she doesn't know, then the entrepreneur can research the matters and come up with answers. But, when they don't know what they don't know, they are operating blindly and will usually be surprised by challenges that jump up and threaten the survival of their businesses.

Most entrepreneurs don't know the risks they are taking. The best way to know is to ask questions of those who have "been there, done that."