What Is An Angel? 

The people that support businesses at an early stage are called “Angels”. It’s a phrase that comes from the U.S., where the people who back Broadway plays came to be known as “Angels”. About 95% of the start-ups in Canada are funded by a combination of what is called “love money” and Angels. Love money is from the entrepreneur, relatives and very close friends. Angels are people who are not related but bring enthusiasm and support as well as money!        

 Profiles of Angels                                    

 The average age of angels in Canada is 47, mostly male, with average annual family income of  $177,000 and an average Net Worth of $1.36 million. 89% have previous entrepreneurial experience. This is a  most important characteristic. They reject 97% of the deals presented to them. .Their average investment is $110,000. They often, and increasingly, invest as part of a syndicate.

*** 95% of business start-ups under $1 million are 

*** funded by love money and Angels ****

 Survey research conducted by the Canadian Labour Market and Productivity Centre documents that twice as many businesses have relied on investments from angels at some point in their development as on any other form of external equity investment. It is mostly  to gain the expertise and contacts of a larger group. Of course, angels are not a homogeneous group of people, but there are several different types of informal investor as is described more fully later in this document.

 What Makes Angels "Tick"?

 A Psychological Profile Of Informal Investors

 Understanding psychological attributes of informal investors can be helpful in terms of designing business plans that attract angels' attention. When reading through this section, think about how you can use this knowledge to your advantage. How can you appeal better to an investor's social needs? How can you put your own situation and business opportunity to the investor, in terms that satisfy his or her needs for achievement, involvement, and recognition of ability?

 This information is more important with independent angels than with corporate investors. To an extent, the entrepreneur is appealing to personal taste and personality, not simply to a cor­porate policy or monetary "logic". In what follows, we outline a psychological profile of the prototypical angel investor. We use some psychological terms, but we explain these terms and how to interpret and use the information presented. It is important to remember that this is only a profile of a typical investor. 

Research on Canadian informal investors finds that:

·        Angels feel that they personally can influence outcomes through their own ability, skills, or effort. 

·        They have very high needs for achievement and dominance. That is, they seek to do things better or more efficiently, to solve prob­lems, or to master complex tasks. People high in need for achievement like to put their competencies to work and will take moderate risks in competitive situations. High need for domi­nance means that angels like to control other people and exter­nal events. They like to establish and maintain good relations with other people. Yet they also require autonomy and the desire to be able to work independently. 

·        They are motivated by subjective feelings that result from performing well hence, they are highly involved in their work and their investments. 

·        Finally, relative to other people, angels report high levels of perceived stress and they cope with this stress by working harder. 

Informal investments are attractive to investors because of the high expected returns, but also because such investments cater to their own psychological needs. Angels undertake invest­ment strategies that allow them to cope with risk by indulging their needs for dominance and autonomy The other side of this profile is that, unless an entrepreneur is willing to permit the investor partner this scope, there is less likelihood of a success­ful partnership. 

It is not just the financial aspects that spoil many deals. Rather, business owners may be unable to obtain sufficient capital because investors and entrepreneurs can not come to an accom­modation over control and independence. To obtain informal capital, then, entrepreneurs must appreciate investors' needs to reduce their risk exposure through personal involvement and personal control. This involvement is a double-edged sword for the business owners. Entrepreneurs may forego some control­; however, investors can contribute much more than capital to the business. They add personal energy, skills, experience, contacts, and they strive for success.  

Investments that offer angels the opportunity to satisfy these needs will be more attractive than those that do not. When own­ers and investors reach the point of negotiating an investment, it is essential to articulate clearly the respective levels of control of the contracting parties. A well articulated process for dispute management is also useful. This may involve input from your lawyer, banker, accountant, or from other financial professionals 

Investors' needs for affiliation and risk aversion also suggest that entrepreneurs should expect investors to syndicate their investments. Syndication involves a group of investors who come together to finance and otherwise support a particular opportunity, and also share with other investors the risk of the deal. Syndication can be useful to the business owner as it spreads exposure of the firm to future, perhaps larger, investors and also gives the entrepreneur the nucleus of a Board of Directors 

Angels invest in businesses because they like involvement, to be part of the action. Therefore, keep even passive informal investors engaged by advising them fully of developments on an ongoing basis. 

How Do You Find Angels?

 There is no organized group of angels in Canada.  So you are on your own. 

Look close to home. Angels will want to be actively involved in your business, which is great, because they'll contribute “know‑how” as well as capital. To facilitate that involvement, Angel investors usually want to have their home or office within a 50-mile radius of your headquarters. You may have to expand your horizons but definitely stick within a day's drive. 

Concentrate on successful individuals within your industry. Angels like to invest in companies whose business lines they know something about. Save yourself a lot of rejections by doing some pre-selection. 

Save yourself even more time by meeting one leader in your chosen field and ask them who are the known experts in your field. They can be an awful lot of help to guide you to Angels. 

Other people to talk to are local Economic Development Officers, members of local Chambers of Commerce, Rotary or Kiwanis, Business Associations, University Development Offices, IRAP officers. Remember one contact can lead to another! 

Give yourself time to carry out an effective search. It takes six months to one year just to locate the right prospective angel. Then he or she might spend another six months investigating your company and putting together the deal. Be prepared. 

Angels are patient investors. They expect to hold their invest­ments for six to seven years over which they expect to reap an after tax capital gain of $6 per dollar invested. It is not far wrong to say that investors operate on the basis of a "7 - 7 rule": they expect to make a seven fold after tax return over (almost) a seven year holding period. 

Finally, informal investors usually involve themselves actively in firms in which they invest. They bring to the deal their contacts, experience, and enthusiasm. They are looking for ways to use their considerable skills ... all to the benefit of the entrepreneurs with whom they work. Our work has shown us that, while venture capitalists are concerned about their clients, angels believe in them. 

Finding And Working With Angels 

Study Your Own Local Networks. Angel investors in your neighbourhood have varying interests and personalities. Your job is to meet as many as possible and get all the referrals you can so that you can locate those potential investors who will be compatible with you and comfortable with your business. Part of the search for capital is working your way through the network. 

Customize Your Pitch. Go to people in the angel community and learn about the investor before you approach him or her. Find out what motivates them most: working in a specific industry, helping others, personal chal­lenge, financial return, etc. Then personalize the business plan to empha­size how your business opportunity reflects the angel's goals. If your business is not consistent with the angel's goals, move on to other angels. 

Remember, most Angels do not actively solicit most deals. Rather, they wait for deals to come to them. The majority of deals arrive cold. 

Networks. The important thing is to go through one person to another. Your lawyer, your doctor, your uncle, your father, your aunt. Working the network is vital. 

Be warned!  The search is a grueling task. Someone said, "if you've been everywhere and found nothing so far and feel you are losing your mind……then you are doing about average!". 

Conclusion: 

There are two rules in Angel hunting: 

1)      They are called Angels because you require faith to find them.

2)      It’s those (you!) who can see and vision the invisible, that makes the impossible possible. 

Angels show up in the strangest places at the strangest times. Just ask any entrepreneur how they found their Angel and they will usually begin with….”well, it’s a funny story…” 

Strategic Angels 

One form of angel you might consider is either a potential customer or supplier. In other words, when you think of Angels, you think of “who do I know that’s rich?” but another legitimate question to ask is “who gets rich if I get rich?” and you may find a supplier or customer who might get you started! 

Know Your Angel 

When you have found your Angel, you should seek out references.  I call it "checking for horns under the halo". You might wish to speak to other people that the Angel has invested in to see how they feel about him or her. 

What do Angels Look for? 

Rule number one! Be honest and comprehensive. If an angel discovers an undisclosed wart, the deal is cooked! 

**A Summary of the Angel Decision Process **

Search  

Most angels do not actively solicit most deals. Rather, they wait for deals to come to them". The majority of deals arrive 'cold". 

Screening

Evaluation 

The evaluation stage begins with the first meeting with you and your team and involves extensive information gathering by the angel. This process is more focused than a bank loan review and is "deeper” as it more thoroughly investigates essential attributes of the concept. 

There has been considerable research that has attempted to identify the criteria that Angels use. These include:

Due Diligence  

If warranted, the second phase of the evaluation step is "due diligence". This step may include reference checks and consultation with third parties. At this stage, the angel attempts to identify and resolve any barriers to the deal. Basic contract terms are outlined and pricing is discussed.  

Negotiation and Closing 

Negotiations occur over the structure of the investment, the firm's financial structure, ownership sharing, etc.  

Post Investment Involvement 

Angels' emphasis is on growth and risk protection. This protection may include active involvement, creative deal structures, syndication among several angels, etc.  

To organize this process, we identify four steps by which investors make decisions

First Impressions: Rejection at First Sight 

There are two main reasons why informal investors reject almost three quarters of business opportunities at first sight. 

First, they do not perceive that the product or idea has market potential.  

Second, investors reach rejection decisions because they lack faith in the business owner’s managerial abilities. 

These two reasons relate to each other. The investor wants to earn a substantial return on investment. Business plans that are unprofessional or incomplete speak volumes about the inability of management to commercialize successfully the idea or product. Investors do not even bother to read such business plans, and in the eyes of many investors, too many business plans are simply not well prepared. 

An additional factor at this step relates to how the business plan came to the investor's attention in the first place. Some business owners send proposals directly to angels in the hope of finding investment capital. In other cases, business associates and friends refer business opportunities from the owner(s) to the potential investors.

 Opportunities that business associates or friends refer to investors stand a far higher chance of surviving beyond the first impressions stage than others. This makes sense. To the extent that the investor respects the intermediary, they also respect business opportunities referred by them. 

Reviewing the Business Plan: Initial Screening 

Investors reject 60% of the opportunities that survived their initial impressions. By the end of the first two steps in the decision process ‑ first impressions and initial screening - investors will have rejected nine out of 10 proposals! Again, the professional­ism connoted by the business plan is paramount. From that plan, the investor makes an evaluation of the principals of the firm. A negative impression leads to almost certain rejection. 

Seeking informal capital, then, can be discouraging. To run this gauntlet, business owners must accomplish two tasks by means of the business plan.  

First, they must capture the attention of the investor. Presenting the investor with a challenge that appeals to the investors' motivation is helpful. We will examine patterns of investors' demands as well as investors' motives later, however, catching the investor's attention may mean that the business plan needs to be tailored specifically to each investor!  

Secondly, and perhaps most importantly, business owners must convince the investor of their management abilities. The angel investor is considering entrusting thousands of dollars of personal funds to a business in its early stages. To do so, the investor must perceive that the owners of the enterprise will not only treat the investment with fiscal responsibility but that they are able to transform the product or idea into a successful busi­ness. This takes management skills that do not necessarily come with either technical competence or engineering brilliance. 

Meeting the Business Owners: The Principles of the Principals 

For the 10% of opportunities that survive the first two stages of review, in the third stage of the decision process the investor meets with the business' principals. Investors reject half the remaining proposals at this step, usually because investors have doubts about one or more of these three factors: 

·        investors will try to confirm their initial impressions about the capabilities of the owners, especially the management capabilities; 

·        investors will form impressions about the integrity of the owners; and 

·        investors will test for the compatibility that a close long-term rela­tionship entails. 

·        investors demand integrity. Any sense that the ownership of the firm is not forthright, is attempting to conceal relevant infor­mation, or is being less than honest ends the decision process. 

·         In addition, investors want to test that they will be able to work closely with the principals and that the principals of the business understand the values, needs, and motives of the investors. 

The Presentation 

The building block for any deal is the business plan, including the firm's financial statements, anticipated return on investment, descrip­tion of the management team, and product offering. Additional information will vary depending on risk, level of need, negotiating position, etc. 

The presentation is all-important. For the first meeting it should not be too long, but the first page should spell out how much you are looking for, what you are going to use the money for, and how much of your company you are prepared to give up for the money. This places a value on the company and is a very important negotiating issue between you and the Angel. You should also state early how much you have invested, even if it is “sweat equity” and what is the current state of your company…startup, minimal revenues or whatever. This will help in discussing the valuation. 

This presentation includes calculations leading up to valuations with five-year projections. Everyone knows that it is difficult to project that far ahead, but those kinds of numbers give the Angels some idea of the ambition of the entrepreneur, and therefore are important.  

The plan should give some idea of how much more money may have to be injected into the business to execute the plan. 

Many Canadian early stage companies are undercapitalized compared with the U.S., and there is also reluctance on the part of the entrepreneur to give up more of the pie to get bigger.  In addition to the financial aspects of the business, the Plan should also address the issue as to why this particular opportunity is so special. What is the uniqueness of the business idea? This is the part that will intrigue the Angel. 

What is the niche that the business will fill? How is it different from others? Is it in a new field? If so, the Angel will want some third party research to convince him or her that this is a good idea.  

All too often, entrepreneurs have an excellent idea, but do not spend enough time researching the potential market, how it should be targeted, likely competition to emerge, etc. A well researched and presented Business Plan gives an indication of how successful a new venture is likely to be. 

Remember two rules! 

·        Keep it short, at least for the first presentation.

·        Do not get too technical!

(Many IT proposals suffer from the obsession of the entrepreneur with the product.)

 When Angels look at entrepreneurs, they are interested in two things: 

a)      integrity

b)  hard work and dedication. 

Tips On Securing Informal Risk Capital 

Expect investor partners to take active roles in the organization. The business will likely benefit from angels' high levels of confidence in their own abilities to succeed and from their high need to equate successes with their own efforts. 

Investor(s) and owner(s) now engage in negotiations about the investment and the structure of the deal. The proportion of ownership the founders are willing to cede in exchange for the needed capital is very often a stumbling block at this point. Again, investors reject half the investment opportunities that survived the three earlier decision stages, usu­ally because the two sides simply cannot reach a mutually acceptable agreement. 

What Is A Reasonable Return On Investment? 

In the final analysis, it is usually the company's earnings that will be of most interest to future buyers. For example, if it earns $1 million in the fifth year and, if investors can make 8% on bonds or other 'safe' invest­ments, then they might be willing to risk money on this venture for 12% or 15%. This means that they might be willing to pay 7 or 8 times earn­ings. However, investors will also be looking at the prospects of future growth in earnings and therefore future appreciation in the value of their investment.  

In fact, the investors who buy out the original investors (even if it is the public through a public offering) are usually not interested in an income stream either, but in further capital appreciation. Nevertheless, it is the earnings potential of the company that is very important to determine its value at some future time.  This means that it is very impor­tant for a new company to demonstrate its ability to produce earnings with some kind of regularity. 

While it is possible to do a mathematical analysis of the value of a com­pany based on earnings, growth rates and alternative rates of return, it would be a fruitless exercise because, in the final analysis, rules of thumb are used to place a value on different types of companies. The first thing that the original risk investors will look at is the prospect of a public offering within a reasonable period of time, say, five years. If this is not possible, they will try to visualize other potential buyers such as the employees, a larger company or another investor who might want to develop the company further and then sell it. As a last resort, they will look at the prospects of a payback in the form of dividends. 

However, what they will not agree on quite so readily is the present value of that selling price. This is a function of their required rate of return and the risk involved. Entrepreneurs will find that they must be prepared to discuss the question of risk frankly and openly with their potential investors. That is why they should familiarize themselves with risk analysis tools of the type described later. 

Negotiating A Deal With Investors. 

Angels' investments are about the most risky investments around. In most cases, the firms are at very early stages of development, with unproved products or services and an incomplete management team. Investors could, alternatively, invest in the stock market and get, on the average, a 10‑15% rate of return. Institutional venture capitalists invest at later stages of development of the firm, stages that are less risky, and still expect rates of return in excess of a 30% annualized rate. Angels expect compensation to reflect their risk, but they are patient investors. On the average, for each dollar invested, informal investors expect to take seven dollars out of the firm six to seven years later. 

The first step in the negotiations between the investor and the entrepre­neur has to be an agreement on the business plan. If one party is aiming at sales of $10 million in the fifth year and the other is aiming at $30 million, there is no basis for any negotiation. Reaching agreement on the business plan will be easier if both parties recognize that it will be updat­ed at the end of each year and that the entrepreneur will always be working against a business plan and a budget that are reasonable and attainable. However, the busi­ness plan that they both start out with must be regarded as a contract between them. 

The entrepreneur will particularly want to know how much of the comp­any's equity he or she will have to give to the investor for whatever amount of risk capital is invested.  

For purposes of illustration, let us assume that a business plan has been agreed to which calls for sales of $5 million in the fifth year and after‑tax profits of $500,000. It also calls for the company to become profitable in the third quarter of the second year and remain profitable every quarter thereafter. The total risk capital requirement is $400,000..

The investor will establish a rate of return on the investment that is com­mensurate with the risk and with alternative rates of return. When the prime rate of interest is in the 10% range, the risk investor may ask for 25% to 30% if the risk is low (e.g. the product is at the pre-production stage) and 40% to 50% if the risk is high (e.g. at the idea stage).  

If the investor is disappointed with this figure, one option is to delay the raising of the capital while the product is taken to a higher level of devel­opment. Additional retained equity will be possible because both the $400,000 investment figure and the 50% rate‑of‑return figure will be reduced. Such additional equity is usually referred to in the trade as “sweat equity” and it is seldom worth the effort. An early association with an investor will give the entrepreneur some guidance as well as assurance about the availability of working capital can be more advanta­geous in the long run than a few extra percentage points of equity. 

Whatever approach the entrepreneur wishes to take, an understanding of the impacts of the different variables will prove useful.                 

Because of the very heavy impact that the risk factor has on the attrac­tion of venture capital, every entrepreneur should strive to minimize the risk (or at least the perceived risk) to the investor. While this can be done by developing the product further, the same thing can often be achieved by doing good market research and risk analysis. Investors should feet very comfortable with the data leading up to the financial projections. They must be convinced that the initial products can be developed and sold, that the product migration strategy is sound, and that the market research has been well done. 

The above process is about the only way of evaluating a startup company. In the case of companies that have some history of sales and earn­ings, most investors will want to evaluate them on their very recent per­formance. A rule of thumb followed by venture capital companies is that an investee company is typically worth between one and two times its current annual sales. This would be a 'pre-money' valuation, that is, the value of the company before the money goes in.

What Angels Look For:  

Control, (even with less than 50% of the voting shares) 

The Form Of The Investment. 

 There are two issues to be considered once you have agreed on the amount. How does the Angel make the investment and how does the Angel get out? 

One way to do it is to structure the investment by way of convertible preferred shares or debentures. The choice between these depends on the tax position of both investor and investee. Obviously, if the business will be losing money for a few years, then dividends to the Angel, which carry a dividend tax credit, will work. On the other hand, if the company is in a taxable position, dividends are payable after tax but interest payments are deductible by the company, so this may be the better route to go. Obviously, this is a matter of negotiation, depending on the relative tax positions of the two parties. The result of these negotiations is to arrive at a coupon rate which will give the same after tax return to the Angel, whether the investment be by way of preferred shares or debenture, and yet be most tax-efficient to the business. 

Both instruments should be convertible, so that if the business doesn't measure up, the preferred shareholders convert, become strong common shareholders and take over the company. If, however, the company goes well, the Angel can get a coupon rate and the entrepreneur can redeem the instrument over time, to give the Angel the agreed upon return. They may or may not pay a coupon; if they do, it should be cumulative, but payment will depend on the cash flow of the proposed investment. The preferred will have terms which suit the cash generation shown by the projections, and they will be redeemed out at a premium over book value, which together with the coupon rate, (if any), will yield to the investor an internal rate of return appropriate to that kind of investment. 

Let's talk about redemption. There is a great amount of controversy about rates of return and many entrepreneurs complain that venture capitalists want a 30% to 40% rate of return. What they forget is that this is pretax. The Bank of Montreal makes 18% on its equity post tax, which pretax, is equivalent to approximately a 30% rate of return. So you should be looking to give the Angel more than that kind of pretax return and you should set redemption rates on the investment instrument plus the coupon rate after tax to give the Angel something in that range. 

After all, the Angel cannot pick up the phone and ask his or her broker to sell your stock! And I think you would agree that your venture is a little more risky than the Bank of Montreal! 

You can set a fairly low coupon if you like, 8% or 9%. As the instrument gets redeemed out over time, they should carry a substantial premium, but the entrepreneur can end up owning the company 100%. The Angel has helped the business get going and has received a good return, everybody wins! 

Another feature is to make the instrument convertible on an IPO which is, of course, the preferred exit strategy! 

The Shareholder’s Agreement 

The terms of the Shareholders’ Agreement often come as a surprise to the entrepreneur who may have been relying on a spouse for advice, but generally is self reliant in decision making. Now there is this person who may own 40% of the Company, and is looking at things like controls over Capital Expenditures, changes in salaries (including that of the Entrepreneur), what kind of car does the company own and so on and so on. These items have to be clarified beforehand as are things like shotgun buy-sell arrangements, drag along rights and any other matters that are deemed to be important. These should be negotiated openly and in good faith between the Angel and the Entrepreneur and not left to lawyers!   

The Shareholder’s Agreement is the most critical document in a venture capital investment since it (rather than the votes attached to the shares) is usually the vehicle through which the corporation is controlled. A shareholders' agreement sets out the rights that the Angel has against the company, as well as the rights between the VC and the other shareholders. 

Typical rights against the Company include: 

Rights against other shareholders may include: 

·        Rights of first refusal and "piggyback" or "tag-along" rights in the event of a sale by other shareholders;

·        "Drag-along" rights to force other shareholders to tender to an offer for 100% of the company;

·        An obligation on other shareholders to vote their shares to elect the Angels or its nominee to the board of directors. 

Whatever the provisions of the shareholders agreement, it should terminate automatically just prior to an IPO. 

Corporate Governance. 

One of the advantages of having more than one Angel is that it forms the nucleus of a Board of Directors. You should have an indemnity clause in your Corporate By-Laws, but also you should buy D & O Insurance. You should set up a Compensation Committee, chaired by an outside director (but could be an Angel) and an Audit Committee. An Angel will doubtless want to chair that committee! You should keep the Board small…five is a good number. 

You should have regular meetings with agendas and other material distributed beforehand, so that they can be professionally run meetings and give the Angels a good impression about how you are building the Company.