Introduction

Whether an established business looking for an injection of capital to expand or a start-up with an idea needing that first injection of funding, finding an appropriate and willing source of funds can be a daunting business in itself. What happens if you have exhausted your own financial resources and those of friends and family? What happens if your venture is not defined by venture capitalists as within a favoured industry? What if your deal is too small for institutional players - say in the £50,000 to £1m range?

Many entrepreneurs find themselves in this sort of situation. However, all is not lost as there is another potential source of funding, namely the low profile, yet influential business angel.

Who are Business Angels?

The term angel was coined in theatre land in the USA in reference to wealthy backers who make risky investments on Broadway in order to produce shows. This definition has now broadened and business angels are characterized as private individuals who invest venture capital, and often time and expertise, in smaller unquoted companies. They play an important part in the venture capital market by supplying smaller amounts of capital to companies that cannot be economically funded by the established venture capital market, helping fill what is commonly referred to as the "equity gap". Research has suggested that business angels will invest anywhere between £10,000 and £150,000 in a single venture and occasionally much larger sums (although these are usually as part of a syndicate, either with other angels or venture capitalists).

There probably is no such thing as a 'typical' business angel although, very loosely, they are characterized as being male, between 20 and 40, who have generally been successful in the 'traditional' market sectors. However, all this is changing as the much talked about generation of 'net millionaires', perhaps initially funded by business angels, become angels investors themselves.

Unsurprisingly angel investors want to make a good return out of what they invest in but, perhaps equally as important, they will often wish to take an active on role, whether in an executive or non-exec role, to assist the entrepreneur grow and develop the business. In this capacity the angels can act as an invaluable source of knowledge, and possibly contacts, that may prevent simple and yet costly errors being made.

How important are Business Angels in providing Venture Capital?

Although some investment activity is carried out through business angel networks, the size of this market in both the UK and US market is hard to determine as a large proportion of angel investments is done through personal recommendations and referrals and without official record. The UK business angel network is held to be the most highly developed in Europe, with estimates of the size of this market in the UK ranging from 20,000 to 40,000 angels investing anywhere between £0.6bn to £1.2bn in 3750 to 7500 companies per year. This is a favourable comparison to the UK venture capital industry that makes around 1,000 investments per annum, although the individual investments are generally much larger in size.

An increase in venture capital being raised in the UK, (from £14.34bn in 1997 to £24.34bn in 1998: Venture Economics Information Service) combined with a shortage of expertise to run these funds, has meant that investing larger amounts of equity in a smaller number of companies has become the new modus operandi for many venture capital firms. This helps to absorb excess funds not currently invested by the VC market and, at the same time, minimizing the administrative burden that many smaller deals would create. Consequently business angels are becoming more important in the funding of new ventures requiring smaller amounts of capital as the equity gap at the bottom end of the market has increased.

How do they differ from Venture Capitalists?

Business Angels differ from venture capital firms not only in the size of their stakes but also their willingness to take risks and are often willing to come in at a much earlier stage in a company's development than considered by a venture capitalist. Often angels are used to provide the initial seed funding for a company although it is unusual for a company to be 100% angel funded through to an initial public offering (IPO). An advantage of using experienced angels is that they often have strong links with venture capital firms who may be able to provide further funding as required by a growing enterprise.

Conversely, however, many of these entrepreneurs have been successful in the 'traditional' industries and, until recently, have been relatively reluctant to invest in advanced technologies, such as the internet or biotechnology, unlike venture capitalists.

What do Business Angels look for?

It would be impossible to cover, without writing a thesis, every point that a business angel would look for in a proposed venture, not least because every business angel is looking for different factors. There are, however, a number of areas that are important in investment appraisal and should be covered in any business plan.

Management

Ask any venture capitalist and most will say that the acid test of any deal is its management. However good an idea looks on paper, it requires strong management in order to bring it to fruition. Even a weaker venture can be moderately successful if it has the management expertise to support it.

But what is management? Perhaps the easiest to measure is management experience. Although skills are transferable between industries, a business angel is more likely to favour an entrepreneur who has relevant industry experience because, not least of which, the entrepreneur should have a better understanding of the potential risks and difficulties.

However, management experience is not the only criteria that can be looked at. Psychologists have also attempted to formulate the characteristics that make up the ideal entrepreneur. It is difficult to measure these characteristic and rare for an entrepreneur to possess all of these skills. This is why the formation of a strong management team is often so important.

Compatibility

Linked to management is also the issue of compatibility. A business angel will often become actively involved in the entrepreneur's business, even if not on a day-to-day basis. As with all business relationships, complimentary (but not necessarily similar) personalities and like-minded attitudes as to how to run and grow a business can be of infinite more help that legal documentation, especially when the going gets tough. An important question for business angel and entrepreneur alike is therefore; "can I see myself working with this person?"

The Unique Selling Point (USP)

With big businesses dominating many markets, what is it about this business that is going to make thrive in the market, let alone survive? What is its USP? These can vary enormously from patents/intellectual property, processes or place and will be looked for by a business angel to ensure the ongoing success of the business. "Me-too" products are launched on a regular basis, but it is rare for them to have as great a market impact as if they were first to market.

A word of caution, however, as the entrepreneur should not become so involved with the uniqueness of the product offering that market needs are ignored. The market will not buy what the market does not want and an entrepreneur who promises to change the market is probably being over optimistic. Business Angels will therefore be looking for market research that proves the validity, size and appropriateness of the enterprise's market place.

Risks and Return

There is no getting away from it, but business angels will want to receive healthy returns from their investments because of the risks involved, and the risks are high. Research done by Southampton University found that a third of business angels who put their money into start-ups loose it all, whilst 40% do not make any profit. Entrepreneurs can be surprised as to the level of return expected by some investors, sometimes a 50-100% (and higher) internal rate of return (IRR) from their initial investments, but this should be viewed in the light of the risks involved.

Once a business has established cash flows and trading history, then the risk to investors is likely to lessen and the returns available decrease accordingly. In this market, which is dominated by venture capitalists, an internal rate of return (IRR) on the investment is expected to be anywhere between 20-30%. Of course, as with all investment decisions, however, the exact rate is determined by the particulars of the investment opportunity.

Naturally, a business angel must be able to recover the investment in the business and will look to how the money will come back. By its nature, equity financing of private companies makes investment exit difficult as there is generally a limited market for the shares. There are three main ways in which to exit an investment:

1) The company can go public through an IPO - This is often the favoured route of venture capitalists, particularly with investments in high-technology enterprises.
2) Trade sale - Where another business group decides to buy the entire business and give its shareholders a return over and above its net asset value.
3) Buy-back - Where the company can simply buy out the venture capitalist by refinancing the company out of cash flow. This mechanism may be built into the initial investment contract.

What should I expect from a Business Angel?

Money is the initial aim of many entrepreneurs when they approach a business angel, but you should be clear if there are any other elements that you are expecting. For example, if you want a business angel to play a hands-on role, be sure they have the time and willingness to perform this task. Similarly, is the business angel going to be able to introduce you to potential contacts useful for your enterprise? Listed in Table 1 are some questions that may help qualify suitable angel investors

TABLE 1

Key questions to ask the business angel investor

· What business angel investing experience do they have?
· What experience do they have in the market concerned?
· Why do they want to invest in the opportunity?
· How much capital is available?
· Does the business angel co-invest with others?
· How long is the business angel prepared to wait until exit?
· How extensive is the business angel's due diligence process?
· How much information does the business angel need to know about the opportunity?
· What is their ideal investment?
· Does the business angel have any comments/questions on the business plan?

How do I tap into the Business Angel Network?

For a listing of business angel networks in the UK, see UK Business Angels Network.