NACO is proud to present NACO Academy Publication A Practical Guide to Angel Investing: How to Achieve Good Returns (Second Edition). This guidebook is a must-read for new angel investors, experienced angel investors, and entrepreneurs seeking angel financing.
A Practical Guide to Angel Investing How to Achieve Good Returns 2 nd Edition
Steven A. Gedeon, PhD
A Practical Guide to Angel Investing How to Achieve Good Returns – 2 nd Edition
This book was made possible with financial contributions from:
This book is produced by the National Angel Capital Organization 101 College Street, Suite 120G Toronto, ON, M5G 1L7
©2017 National Angel Capital Organization
ISBN: 978-0-9951968-5-8
Copyright Notice T he information in this publication shall not be reproduced, in part or in whole or by any means, without advance written permission from the National Angel Capital Organization. For permission, please email: legal@nacocanada.com.
A Practical Guide to Angel Investing How to Achieve Good Returns 2 nd Edition
Steven A. Gedeon, PhD
Dedication
To W. Daniel (Dan) Mothersill, who helped transform a nascent National Angel Organization into today’s vibrant organization with funding, employees, governance and a mission to transform the Canadian entrepreneurial ecosystem. As President of NACO and, for many years President of the organization now known as Angel Investors Ontario (AIO), he gave the organizations a home office, managed staff, raised funding, created Angel groups, lobbied government and inspired the current generation of Angels and entrepreneurs. Dan’s vision and drive, along with other early founders, such as Henry Vehovec, Ian Bandeen and Andy Wilkes, helped create Canada’s current world-class Angel investing environment that has great companies to invest in; government tax credits; annual research reporting; national and provincial Angel organizations; a stable funding base; thousands of Angel investors; and dozens of Angel groups, networks and funds throughout Canada. I was privileged to work with Dan in many capacities over the years: we co-authored Age of the Angel (Mothersill, et al.) sat on boards, coached entrepreneurs, started Angel groups and wrote government grants together. He hired dozens of my students, and I chaired NACO’s Education and Research Committees. He became a Distinguished Visiting Professor at Ryerson University, where we taught together, and, shortly before his death, he was named Chaplain at Ryerson University. Dan firmly believed in the power of education to improve lives. Education has always been a central mission of NACO, and the organization continues to focus on: • Educating Angels about being better investors, coaches, mentors and board members • Educating entrepreneurs about becoming “investor ready” • Educating Angel group managers about improving deal flow, streamlining decision-making, and adding value to their members • Educating government officials about the role of early-stage investors in improving our economy He didn’t just educate others. Dan had just completed his Master of Divinity and was about to be ordained when he passed away unexpectedly. And we always said we would someday live in a Scottish castle with our wives to work on PhDs…
I am proud to help Dan’s continuing legacy with the NACO Academy and this book.
2 A Practical Guide to Angel Investing
Preface
Since I co-authored Age of the Angel seven years ago in 2010, the Angel investment asset class has undergone tremendous professionalization and maturation. It was time to completely rewrite the book in order to incorporate the deep stream of NACO Academy modules, new research on successful Angel investment best practices, new entrepreneurship tools, the rise of early exits, and new government regulations and stimulation programs. The Angel ecosystem in Canada has blossomed over the last seven years to become a global leader in startup investing. In Canada, the Angel investment asset class now invests as much money as the venture capital industry, while investing in about 25 times as many new ventures! This book is designed to capture the insights and experiences of this vast ecosystem of Angels and experts to completely rewrite NACO’s guidebook on how to be (or get money from) an Angel investor. This book is designed for three audiences. It is primarily written for new and recent Angel investors – to introduce you to the world of Angel investing and provide guidance on where to find deals, what to look for in a good investment, how to structure your investments, when to exit (leave the deal), and who’s who in the ecosystem. There are lots of facts and figures, tips, stories and quotes throughout, and I have tried to achieve a casual tone. Secondarily, this book is intended to help current Angel investors by demonstrating the diversity of opinions, indicating trends, and pointing toward current practices. As Karen Grant, Executive Director, Angel One Investor Network points out: “There is no such static thing as a best practice. Because the economy changes, our practices must change with them. And that varies from one place and time and group to another.” Angels can use this book as a guidebook as you navigate the new world of Angel investing or skim it to find the bits you like, nod your head in agreement at certain quotes, laugh at jokes, and find something you didn’t know or hadn’t thought of before.
(cont’d)
How to Achieve Good Returns
3
Preface (cont’d)
Finally, I hope there will be something for everyone in the early-stage financing ecosystem. Entrepreneurs will better understand investors and the fundraising process. Those who support the early-stage sector, such as consultants, lawyers, accountants, bankers and government agencies, will better see how their roles fit into things from their clients’ perspective. Friends and family will have deeper insights into what you are going through if you are trying to raise money. The curious will learn more about the fascinating world of finance and entrepreneurship. I tried to quote each of the many people who generously shared their stories, opinions and thoughts with me. In a few cases, I use quotes without attribution when summarizing several comments into a shorter statement: think of these unattributed quotes as summarizing a point of view held by many people into a Zeitgeist quotation. In this second edition, which is also translated into French, I have updated the book based on new information, streamlined a few sections for easier reading, and added a lot more information about Angel funds and portfolio management. This book is also meant to highlight the many resources, programs and events that NACO offers: • NACO Academy – an integrated program of educational modules from beginner to advanced courses • NACO Website – a resource with a wide range of member services and NACO Online Sample Documents you can use to share your investment practices, including investor declarations, legal agreements, checklists, term sheets and other documents • NACO Reports – 2014 and 2016 Report on Angel Investing Activity in Canad a – research reports on Angel investing activity in Canada • NACO National Angel Summit – the annual networking and educational event • NACO Co-Investment Events – events designed to help your investee companies raise their next round of financing with large-scale deal syndications
– Steven A. Gedeon, PhD June 2017
4 A Practical Guide to Angel Investing
Helping Clients Thrive and Communities Prosper
RBC is proud to have been a founding partner in NACO’s inception back in 2002. Since that time, the critical role Angels play in the development, mentoring and funding of Canada’s next great innovators has only grown in its importance. So too has the significance of NACO’s role in ensuring our community of Angels has the tools, resources and connectivity required to bring great ideas into reality and help promising entrepreneurs reach their full potential. NACO has also been a powerful voice in advocating the merits of innovative programs and the needs of our Angel community at all levels of government. As part of RBC’s guiding purpose of helping clients thrive and communities prosper, we are proud to support the ongoing development of this Guide to Angel Investing. Our hope is that through the information and guidance contained in this document, those who are interested in acting as Angels can make an informed choice and benefit from best practices. The knowledge-based sectors of the economy have long been a focal point for Angel investment. For over 30 years, RBC has supported this sector through teams who specialize in assisting companies exhibiting high growth potential and the need to invest in research and development. It takes capital to be an investor, but being an Angel requires so much more. The impact of an Angel investment goes far beyond the typical economic measures tracked by governments and organizations. How does one measure the impact of mentorship? Of being the first group outside of friends and family to say “I believe in the vision”? Supporting entrepreneurs and often passing on lessons learned after successful careers in business is invaluable. These are just some of the qualities that separate Angels from investors. We recognize all the tremendous work NACO and its partners have devoted to this important community over the years and look forward to the continued evolution of Angel investing in Canada.
– Ann Bowman , Head, Canadian Private Banking – David Rozin , National Director, Client Strategy, Knowledge Based Industries
How to Achieve Good Returns
5
Guide to This Book
2 3 5
Dedication
Preface
Helping Clients Thrive and Communities Prosper
Welcome to the World of Angel Investing
8 9
Who Are Angels and Why? How Do Angels Invest?
12 15 18 19 20 22 23 26 27 30 33 34 38 43 43 51 53 55
The Role of Angel Investing in the Economy
Our Investment Ecosystem
Chapter 1 – Set Good Targets
1.1 Personal Motivation for Angel Investing 1.2 Personal Capital Budget Available to Invest
1.3 Portfolio Targets
1.4 Value Investing vs Momentum Investing
1.5 Co-Investing With Other Angels and Angel Groups
1.6 Personal Education Goals
Chapter 2 – Find Good Companies
2.1 Sources of Deals
2.2 Screening Opportunities 2.3 Managing Deal Flow
2.4 Using an Angel Fund to Augment Your Individual Investment Portfolio
Chapter 3 – Pick Good Companies
3.1 The Due Diligence and Deal Negotiation Process
3.2 Hygiene vs Insight
3.3 Analysis Lenses for Gaining Insight 56 3.3.1 People – The Team: Human Capital, Intellectual Capital, and Social Capital 56 3.3.2 Lean Startup and Getting to Plan B 58 3.3.3 Business Model Canvas and Lean Canvas 60 3.3.4 Strategic Lenses 62
6 A Practical Guide to Angel Investing
Chapter 4 – Make Good Deals 4.1 Negotiation Fundamentals
65 68 69 71 76 77 78 81 83 84 85 88 89 94 95 97 98
4.2 Deal Structure
4.3 Valuation
4.4 Term Sheet Conditions
4.5 Deal Syndication
4.6 Signing the Deal – Legal Stuff
Chapter 5 – Grow Good Companies 5.1 Governance and Coaching/Mentoring
5.2 Metrics 5.3 Money
5.4 Networking
Chapter 6 – Create Good Exits
6.1 Early-Exit Acquisition
6.2 Large Acquisition or Successful IPO
6.3 Secondary Offering, Dividend, Royalty, or Buy-Back
6.4 Fast Fail, Expensive Fail, and Zombies
99
Concluding Thoughts
100
A Word From Our Partners
Appendix
101 102 106 122 124 125 126 127 127 128
References
Glossary of Terms
Experts Who Reviewed This Book and Contributed Content Angels and Angel Experts Who Were Interviewed for This Book
About NACO
NACO Academy Modules
NACO Online Sample Documents
Acknowledgements
Author’s Bio
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Welcome to the World of Angel Investing
Congratulations, you’ve “made it”!
As a potential Angel investor, you are a high net worth individual who is qualified to be an Accredited Investor. Kudos – you have made it to the stage in your life when you are permitted by the Canadian government to invest in opportunities outside of the public equity markets without the required use of a broker. These investments are typically higher-risk with higher potential for reward. The good news is that you are now allowed to make private Angel investments outside of the normal public stock markets. You don’t need to spend money on management expense ratios or brokerage fees. The bad news is that the government permits this because it thinks you are smart enough to do all the work yourself and wealthy enough to afford losing all your money in these investments! This book will help you manage this risk and improve your potential for a good return on investment (ROI). It will help you find good opportunities, structure good deals, grow good companies, determine good exit strategies, and manage an investment portfolio, to maximize your chances of gaining high investment returns on your Angel investments. If you do it right (and maybe get a bit lucky), your Angel investment portfolio can achieve significant returns. The average US Angel participating with an Angel group achieves 27% annual return on their portfolio of Angel investments. However, in order to achieve this return, the average Angel will have to wait four to eight years to get their money through an exit event, such as the company being acquired or going public. (Wiltbank & Boeker) Risk vs Return for Angels
Angel investing
Venture capital
Private equity
Small caps
Emerging markets
High-yield and emerging market debt Large-cap value Large-cap growth
Domestic government bonds Investment grade bonds Real estate
Short-term treasuries
Real Return = 0%
Cash in the mattress Cash at the bank
Risk
8 A Practical Guide to Angel Investing
Got What It Takes? An Accredited Investor in Canada is an individual who, either alone or with a spouse, owns financial assets (not including principal residence) having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1 million; or whose net income before taxes exceeded $200,000 in each of the two most recent calendar years; or whose net income before taxes combined with that of their spouse exceeded $300,000 in each of the two most recent calendar years; and who, in either case, reasonably expects to exceed that net income level in the current calendar year. (See National Instrument 45-106. ) An Angel investor , also referred to as a Business Angel , is an Accredited Investor who privately invests their own money in a business, usually in exchange for ownership equity, debt or other terms. (An “angel” is a spiritual being sent by the celestial powers to give money to entrepreneurs who need it. This imaginary creature has never been found in reality.)
This book will help distil the wisdom of hundreds of Angel investors who came before you. They will share their tips about things that worked and things that didn’t. I hope you’ll learn from their mistakes before going out there and making your own.
The Good, the Bad, and the Reality Good news – you are wealthy enough to make private investments! Bad news – most of your investments will be complete losses! The reality – you should invest in a portfolio of 20-plus companies in order to gain average investment returns of 27% per year.
Who Are Angels and Why? Most mortals are restricted from Angel investing and must invest exclusively in highly regulated financial asset classes, such as public stocks, bonds, GICs, T-Bills, money markets, mutual funds and insurance. Most countries’ securities regulations allow exemptions for certain high net worth individuals to be accredited investors and make private Angel investments. Angels are expected to sign a formal document declaring their eligibility to make Angel investments. Canadian securities regulation National Instrument 45-106 requires an Angel to earn over $200,000 per year ($300,000 as a couple) or have over $1 million in assets, not including their principal residence. (See NACO Online Sample Documents: Investor Declaration .) Most recently, Angels with less than $5 million are also required to sign a Risk Acknowledgement Form #45-106F12 (RAF). (Volker)
How to Achieve Good Returns
9
Most Angels enjoyed a successful business career and want to share their expertise and experience with younger entrepreneurs. Of course, they want and expect to gain above-market rates of return on their investments, but often they also want to “pay it forward,” help others, and give back to their communities. Angels are often retired executives or other professionals or, in many cases, they are “cashed-out” former entrepreneurs who ran and then sold their own companies. Most of their money goes into stable investments in real estate, public stock markets, and bonds and other investment asset categories managed by professional financial advisors. Some gets spent on their bucket lists – sports cars, cottages, dream homes, yachts, or nice long vacations to a tropical paradise. But then what? What Will You Do With the Next 20-Plus Years of Your Life? For most Angels, the answer is “I want to continue to do what I love but without the daily stress of running a company. I want to be involved in strategy, important deals and major decisions. I want to lend my expertise but I don’t want a job,” or, “I want to help other entrepreneurs learn from my mistakes but I want a share in the upside for my time.” If you are looking for the stories of individual Angels, Josh Maher’s book, Startup Wealth , provides interviews with 23 US Angels who give their personal reasons for becoming an Angel, and what they have learned about Angel investing over the years.
The term “angel” was initially coined for wealthy people who donated, loaned or invested in Broadway theatre productions. They were often thought of as patrons of the arts who invested because of their love of the theatre. Similarly, Business Angels invest because of their love of business.
Angels invest for many reasons, including: • Potential for significant financial returns • Excitement of being involved in an interesting company or industry • Mentorship with the entrepreneur • “Paying it forward” by sharing their expertise with those who need it • Contributing to the economic growth of their region or country • Giving back to the community • Enjoying the social aspects of networking with other Angels
10 A Practical Guide to Angel Investing
Hopes and Dreams Being an Angel is like being a grandparent. You get all the joys of being a parent/entrepreneur but you don’t have the stress of changing diapers, paying for university, firing employees or meeting payroll.
Aside from personal reasons for investing, we know, for example, that the median US Angel is 57 years old and has 14.5 years of entrepreneurial experience founding 2.7 ventures. He (86% are male) invests no more than 10% of his net worth and has made 10 investments over nine years with two exits or closures. 99% have college degrees and over half have graduate degrees. (Wiltbank & Boeker) As an investment asset class, we know that Angel returns can average 2.6X the investment in 3.5 years – an internal rate of return (IRR) of about 27%. This compares very well with other asset classes (Wiltbank). However, looking only at averages can be very misleading!
Distribution of Returns by Venture Investment
60
10% of Investments Produce 90% of Cash
50
UK: Overall Multiple: 2.2X
40
Holding Period: 3.6 years; Approx.: 22% IRR
30
US: Overall Multiple: 2.6X
20
Holding Period: 3.5 years; Approx.: 27% IRR
10
10–20X
30X
< 1X
1–5X
5–10X
Exit Multiple
Orange Bar: UK % of exits in that category Source: Wiltbank , Returns to Angels in Groups . Angel Capital Association
Blue Bar: US % of exits in that category
The distribution of returns shows that over half of all investments never return their original capital or fail completely (less than 1X, or the first bar in the graph above). In contrast, 10% of exits produce 90% of total returns (the last bar in the graph). Since only one in ten investments will account for almost all returns, successful Angels must use a portfolio approach. (This need for a portfolio to reduce risk is the same as the reasoning behind mutual funds or index funds.) Investing in only a couple of deals over several years (i.e., dabbling at being an Angel) is a weak investment strategy.
How to Achieve Good Returns
11
How Do Angels Invest? Visible Angels are Angels who participate in an Angel group and/or who want to be found by entrepreneurs who are looking for investment. Because we know who they are, they are counted in annual reports, and governments can track the important role they play in stimulating the economy. It is estimated that, in Canada, there are 10 times more invisible Angels who do not want to be found. We know this from company tax returns and because of comparisons with the number of US Angels, who tend to be far more visible than Canadian Angels. NACO estimates that there are 20,000 to 50,000 individuals who make Angel investments each year in Canada. (NACO National Angel Summit, 2015) According to the Angel Resource Institute (ARI), for most Angels in Angel groups, it appears that a general guideline for an individual is to invest around $25,000 in a first round of investment. This will vary from group to group. For example, the average for the Golden Triangle Angel Network (GTAN) or VANTEC is closer to $45,000 per deal. In addition to this first round of investment, most Angels also reserve some money to invest in the next (usually larger) round, if the company needs and deserves it. This use of “dry powder,” or the real options approach, is explained in section 1.3. NACO’s 2016 Report on Angel Investing Activity in Canada (Mason and Tjahjakartana) provides an array of statistics about Angel investing, and it is well worth the time to review its contents. You can benefit from knowing which sectors are popular, which Angel groups are performing well, and what deal structures they are using. Many of the infographics throughout this guidebook show highlights of the report.
Average Deal Size
2013 $945K
2014 $1.229M
2015 $1.160M
2016 $1.731M
12 A Practical Guide to Angel Investing
Average Angel investment deal size has grown over the last few years to $1.7 million in 2016. However, since the median deal was only $400,000, there are a large number of much smaller deals. Overall, Angels do a large number of smaller investments and then, as these companies grow, provide an ongoing source of fewer, but much larger funding rounds. In many cases, successful companies achieve significant exits without any venture capital (VC) or other investors.
Calculating ROI Most Angels calculate their ROI in terms of their multiple returned:
if a $10,000 investment pays back $15,000 that’s a 1.5X multiple. However, this simple reporting metric fails to account for the time value of money. A 1.5X multiple over a short time is far better than the same 1.5X paid out over a long time. An alternative way to state your ROI is using internal rate of return (IRR). The IRR is the interest rate you would have required over the same period to achieve the same final lump sum payment (i.e., exit event). You can convert the multiple to IRR using the following:
Money received upon exit / Money invested = (1+R) t
where R is the IRR and t is the number of years to exit. Unless you happen to have an old HP15C kicking around, it is easier to use an online calculator (see http://www.calkoo. com/?lang=3&page=26 for a good one). Below is a table to illustrate how IRR compares to multiples over different time periods.
Calculating ROI: Comparison of IRR to Multiples Over Time
Investment
Exit $15K
Multiple
Years to Exit
IRR 50%
$10K
1.5X
1 2 5
22.47% 8.45%
10
4.14%
$10K
$300K
30X
1 2 5
2,900% 447.72% 97.44% 40.51%
10
Getting a 1.5X return in just one year is a better IRR than a 30X return paid in 10 years. However, a 1.5X return after 10 years is less than 5% IRR.
How to Achieve Good Returns
13
Company Valuations
20
20
18
15
10
8
7
5
5
2
0
< $2M
$4–6M
$6–8M $8–10M
> $10M
$2–4M
Valuation (millions of $)
Source: Mason & Tjahjakartana , 2016 Report on Angel Investing Activity in Canada
How many companies do you need in your portfolio? The general suggestion among Canadian Angels is 20 companies. Dr. Wade Brooks estimated that you need 40 companies to have a 95% chance of getting the average IRR of 27%. A portfolio of 20 companies would give you a 60–70% chance of hitting the average. (NACO National Angel Summit, 2015) Of course, success takes more than just luck and a large portfolio. Angel experience, length of due diligence, and post-investment participation in company coaching and governance also significantly increase the rate of return and the chances of successful exits. (Wiltbank & Boeker) Again, these numbers can be misleading. Angel investment practices across Canada vary tremendously, and we will explore this diversity in more detail as we go through the six chapters of this book. To start, you must know yourself and Set Good Targets , so that’s explored in Chapter 1. How much time and money do you want to put into each investment? How many investments will be in your portfolio? How active do you want to be in the management of your investees? Do you want to be a Lone Wolf or a member of an Angel group? Do you want to just dabble or devote significant time to this over many years? The answers to these questions may vary over the years or from deal to deal.
Pop Quiz With a pre-money valuation of $5 million, how much of the company does a $1 million investment buy?
14 A Practical Guide to Angel Investing
The better your deal flow – finding lots of high-quality companies that ask you for funding – the better your chances of picking good ones to invest in. The best entrepreneurs have many choices, so there is plenty of competition to invest in the best deals. Chapter 2 will help you Find Good Companies through good sources of deal flow, screening techniques and managing deal flow. Various examples of different practices across Canada by several Angel groups are described. The process to Pick Good Companies is referred to as due diligence, always a popular topic among Angels (e.g., NACO Academy Module 103). Chapter 3 guides you through assessing the character of the entrepreneur, looking for skeletons, identifying the crown jewels, validating key assumptions and risks, and building trust with the company executives before you give them your cash. Chapter 4 covers the nuts and bolts of how to Make Good Deals . This is the longest section of the book and includes big topics to which the book Age of the Angel devoted five chapters, namely: negotiations, term sheets, valuation, trust and deal syndication. Dozens of Angels generously provided sample documents that are available on the NACO website under NACO Online Sample Documents. Once the entrepreneur has your cash, how do you Grow Good Companies ? Chapter 5 discusses being on a board of directors, corporate governance, coaching entrepreneurs, sourcing talent and managing follow-on investments. Anyone can give their money to a company – the hard part is getting it back again! Chapter 6 discusses different exits that Angels achieve across Canada and gives advice on how to Create Good Exits . This includes knowing when to sell and how to maximize exit values. We also dig more deeply into the issues of the time value of money, dilution, multiples and rate of return. Don’t forget to check out the Appendix, where you’ll find references for this book, a list of NACO Academy Modules, and a list of NACO Online Sample Documents available on the website. The Role of Angel Investing in the Economy “No money – no company. It’s as simple as that. Without investment capital, there would be no new companies and no new jobs – our economy would be in the dumps!” (Carl Furtado, Golden Triangle Angel Network) Small to Medium-sized Enterprises (SMEs – companies with fewer than 500 employees) represent over 98% of companies in North America and Europe and employ over two-thirds of all workers (Lukács). A small fraction (around 4%) of these SMEs, however, are high-growth companies (called Gazelles) that create virtually all new jobs (estimates range from 50–100%) in the entire economy. (Littunen & Tohmo; Acs, et al.; Henrekson & Johansson)
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Job Creation from Startups
4K
2K
0
-2K
-4K
-6K
-8K
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Date
Firms 0–5 years old
All others
Source: Mandel , How the Startup Economy is Spreading Across the Country — and How It Can Be Accelerated
Virtually 100% of all new jobs in the last 30 years have come from new company startups. This is true of all developed countries, and the US job data shows this particularly well. Angels play a critical role in the economy, investing in 27 times more startups than VC investors (NACO Academy Module 101). The total size of the Angel asset class is now as large as the entire VC industry in Canada. As the infographic from GTAN shows, their group’s investments alone have created over 1,000 jobs.
16 A Practical Guide to Angel Investing
Two major forces are affecting the Angel asset class. First, entrepreneurs need less cash than ever to prove their business models and achieve an exit using agile lean techniques. This has created the rise of the “one-and-done” investment and has meant that VCs are becoming less important in the early-stage investment ecosystem. Second is the ability for Angels to co-invest and syndicate deals. This allows larger deals, which again pushes VCs into later-stage and even-larger-sized investments. Some of the most attractive Angel investment opportunities use technology-based barriers to entry to achieve competitive differentiation and high exit valuations. While Canada invests heavily in scientific research and development, it is difficult to commercialize these technologies and bring them to market with solid business models. Angels provide a vital bridge across this commercialization funding gap, filling the gap in the funding continuum between initial seed capital from “friends and family”, and the larger-scale investments made by venture capital (Global Angel Investing Community Trends – Plenary, NACO National Angel Summit, 2015). If funding is not available through this often-lengthy interim development phase, many startups fall into the “valley of death”, reducing the pipeline of businesses for later-stage growth and development. As summarized by Bryan Watson: “It was not that long ago that the majority of policy and support programs were designed primarily for supporting VC-backed companies only. Angels, a collective of individuals, were a difficult entity to develop policy for. The economic crisis of 2008 and crowding out of Angel investors in the Canadian market (Cumming & MacIntosh), coupled with increased sophistication of Angel groups, allowed Angels to communicate with all levels of government. This led to programs that Angel-backed companies could leverage to cross the funding gap while also helping offset the risk Angels faced.”
The Innovation Funding Continuum – Angels Fund Companies to Scale Up
Stages of Development
Ideation Proof of Concept
Seed
Growth
Maturity
Commercial Banks
Funding Companies to Scale Up
M&A/IPO $90M
Venture Capital $2M–19M
Angel Funding Bridge
Angel Syndicates & Funds $50K–11M
Angel Groups $15K–4M
Individual Angels $10K–2M
Crowdfunding & Accelerators $2.5K–1.5M
“Valley of Death”
Government & Incubators $10K–500K
Friends & Family $2K–300K
2 – 15 Years
How to Achieve Good Returns
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Successful Angels often syndicate deals and co-invest with everyone across this investment ecosystem, including internationally, with venture capitalists, Angel funds, founders and government programs.
The Canadian Early-Stage Investment Ecosystem We in Canada have perhaps the most stimulative government incentive programs in the world. The Scientific Research and Experimental Development (SR&ED Tax Incentive Program) tax credit pays back 65 cents on each dollar invested in research, and the Industrial Research Assistance Program (IRAP), the Ontario Centres of Excellence (OCE), and many other programs provide grants to develop new technologies. All together, these programs can add up to a stacking limit of 75% of all the costs of running a technology-based early-stage company. Some provinces also give the Angel investor direct tax credits. Our Investment Ecosystem Canada is one of the best jurisdictions in the world to invest in a new company. It is a great place to live, with safety and human rights. With a low rate of corporate taxation, solid intellectual property (IP) protection, low-cost currency, and great human capital, this is also a great choice of location to start a company. The Canadian Angel investment ecosystem is one of the most advanced in the world, with a wide array of players from which you and your investee companies can benefit. We not only have experienced Angels and Super Angels, but Angel group managers, Angel funds, Angel sidecar funds, government co-investment funds, and VC funds, as well as sophisticated banking and financial institutions. We have extensive government-supported and private-sector innovation centres, incubators, accelerators and business plan competitions. Canada has experienced serial entrepreneurs who have done multi-million dollar deals and lived in Silicon Valley. We have senior consultants, lawyers, accountants, limited market dealers and technology-commercialization experts. We have great human capital available with a world-class education system. We have an extensive system of tax incentives and government-support programs for early-stage companies. We do many cross-border deals with sophisticated US and global investors. And we have good access to public exit vehicles, such as capital pools, reverse take-overs (RTOs) and initial public offerings (IPOs). The current economic climate of low interest rates and stimulative government policies has boosted the Angel investment asset class. The Canadian ecosystem provides tremendous support for you and your investee companies, and this book will try to help you navigate this ecosystem.
18 A Practical Guide to Angel Investing
Set Good Targets 1
How to Achieve Good Returns
19
Set Good Targets
1.1 Personal Motivation for Angel Investing People have widely varying reasons for being an Angel, and it is vital to know your own. This personal-value-based approach will drive all your other investment decisions. Is it primarily about the money? working with interesting people and companies? making a contribution? socializing with other Angels? buying a job for yourself? There have been many academic studies of Angels’ motivations over the years (Morrissette). Sullivan & Miller were the first to show that a large number of Angels were willing to accept lower returns by essentially exchanging non-economic psychic or social rewards for financial ones. They classified them into three major types, depending on their primary motivation: 47% of Angels are economic investors who primarily want to maximize monetary wealth: • ROI is the most important • Highest ROI expectation (30% ROI expected vs only 21% ROI for non-economic investors) • Largest average investment size 31% of Angels also seek non-economic or psychic rewards: • Enjoy investing, like the entrepreneurial process and the fun of being involved in an exciting company. Enjoy the thrill of the ride! • Lowest ROI expectation (21% expected vs 30% for economic investor) • More likely to invest with a group • Skew slightly older 22% of Angels also have altruistic motivations and want to help entrepreneurs and/or society; sometimes called “pay-it-forward” reasons for investing: • See the value in supporting new business and/or socially beneficial products • Most patient investor, willing to hold for seven years or more • Smallest average investment size
20 A Practical Guide to Angel Investing
Mary Long-Irwin of Northern Ontario Angels agrees with the importance of this motivation: “We live in smaller communities and we know each other and want to make sure the companies are successful. The investors care about the economic growth of their communities. It’s about creating jobs and wealth where they live.” There are as many motivations for Angel investing as there are Angels. Understanding your own motivation or style will help you make better decisions and help you select better co-investment partners. Co-investing with someone is a long-term commitment, and you should know each other’s expectations before working together. What Kind of Angel Are You? Several writers have provided extensive descriptions of Angels (e.g., Gaston; Hill & Power; and Benjamin & Margulis). Do any of these describe you? • Archangel or Super Angel: Wealthy, powerful, experienced Angel who has done a lot of deals • Guardian Angel: Provides mentorship, advice and life coaching • Cherub: A neophyte Angel, usually following other Angels to learn the ropes • Angel-Knows-Best: Becomes bossy, arrogant or overbearing • Corporate Angel: Often a corporate venture capital investor disguised as small or nice • Will-Work-for-Equity Angel: Wants to barter services for a share of ownership (often not an Angel) • Unaccredited Angel: An oxymoron (like jumbo shrimp) • Dragon (aka Lion or Shark): Celebrity Angel who does deals on TV, often using extreme behaviour • Daddy Warbucks: Very wealthy Angel, often investing without extensive due diligence • Dark Angel: Wants to kick out the founders and take over the company • Fallen Angel: Lost reputation through bad behaviour, loss of wealth or liquidity issues • Consultant: Not an Angel at all, looking to be hired to do accounting, legal or other services • The Godfather: An Angel with an air of being well-connected and knowing everyone, usually retired • Peer: A fellow successful entrepreneur Angel (includes one-third of all Angels) • Dr. Kildare: An Angel who is a doctor, lawyer, accountant or other professional passively investing small amounts • Business Devil: An Angel who wants absolute control, insists on 51% or restrictive covenants • High-Tech Angel: Invests only in high-tech • Lead Dog: Rounds up other Angels to co-invest or syndicate deals • Lone Wolf: An Angel investing on his or her own • Silver Spoon with Silver Wings: An Angel with second-generation money, born wealthy and well-connected • Cousin Randy: A relative who invests small amounts and often wants to work inside the company • Chorus of Angels: Collective noun for a group of Angel investors, also called a consortium or syndicate
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2015 NACO Angel of the Year – Mike Cegelski Mike founded Beltron Technologies, a telecom test-engineering consulting firm with over 130 employees. He was CEO from 1984 to 2000, when he made a successful exit. Mike has invested in more than 30 companies and is an Angel investor and board member of Anges Québec, Quebec’s Angel investment association. Describing his motivation, Mike says, “I’m an entrepreneur. Success didn’t come easily, and I want to give back and help. I’m having fun doing it. I have a lot to give back, since I’ve been there and done that. You invest your money but you also invest your time. Your time is more important.” 1.2 Personal Capital Budget Available to Invest This amount should be selected in consultation with your financial advisor, spouse and heirs. The general opinion, especially for economic investors, is that no more than 10–15% of your total investment portfolio should be available for Angel investing. Another approach would be to first ensure that all your family needs are satisfied with secure investments, and then make the remainder available for Angel investing. (Example: Once you have set aside, say, $20 million to fill all your needs, it doesn’t matter if your Angel investments are $2 million or $50 million.)
% of Total Assets in Angel Investments
1–4% 5–9% 10–14% 15–24% 25–50% Over 50%
7% 18% 25% 21% 19% 9%
% of Angel Investors
In reality, only half of all Angels actually invest less than 15% of their total net worth. A study by Freear, et al., found that 19% of their sampling of Angels invest between 25% and 50% of their total net worth in Angel investments. You should account for the fact that Angels usually need to hold on to their investments for three to eight years. Some Angels in certain sectors hold for even longer periods. For example, Jim Estill, a Super Angel from Waterloo, found that his 150-plus investments had an average hold of 14 years prior to exit. These investments are very non-liquid. You need to ensure that you retain sufficient personal liquid capital assets in case of emergencies. If you have annual personal income, you should also estimate how your capital budget might change with time. For example, you might start by setting aside $200,000 but then add $50,000 per year so your portfolio target budget is $500,000 over six years. Don’t allow yourself to get caught up in the excitement of the deal and don’t allow the amount you invest to be unduly influenced by how much money other people are investing in a deal. Set your limits and stick to them!
22 A Practical Guide to Angel Investing
1.3 Portfolio Targets The next major decision is how to spread your personal capital budget among investee companies. We know that most Angels make 90% of their returns from 10% of their companies. So investing in only one or two companies is almost certain to lose money. Risk management theory tells us that the more companies you invest in, the lower the variability in your returns. The most common advice here for good risk management is that you should seek to hold at least 20 companies in your portfolio or augment a smaller number of direct investments by investing in an Angel fund or Angel sidecar fund. A Real Options Approach to Angel Investing Unlike traditional investing, Angels should have a different approach to portfolio investing, because the distribution of returns is not a standard distribution, but one in which more than 50% of investments fail – producing zero returns. The idea is that Angels invest small amounts in a number of ventures, with the idea that some will fail fast, while others will show progress, at which stage additional funds will likely be required (often from the original Angels). This is called a Real Options approach and has three fundamental consequences: 1. Investments of smaller amounts are made, with early milestones agreed, which if reached trigger subsequent rounds of funding. 2. The Real Options approach encourages Angels to look for investments that can be rapidly validated and either fail fast or show rapid progress (however small). 3. The number of investments made is larger, because the Angel does not have to keep as much money in reserve for follow-on investing, as they will not have to invest subsequent funds in the companies that fail. — Dr. Andrew Maxwell , Chief Innovation Officer, Canadian Innovation Centre To further diversify risk, you could consider whether you want to diversify by sector, or focus your attention on certain industry sectors in which you have a personal interest or expertise, or that you think are hot. Most Angels focus on certain sectors but might co-invest outside that sector only with highly trusted partners. Diversifying the business development stage, geographic location and number of co-investors is another way to manage portfolio risk. The simplest way to enhance your diversification is to invest in an Angel fund or Angel sidecar fund (see section 2.4). Virtually all professional investors – not just Angels – will also tell us that, in addition to the initial round of funding, you should reserve up to an equal amount of money for any potential follow-on rounds of financing. This reserve is referred to as keeping your powder dry.
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There are several reasons for needing dry powder. You will be able to negotiate a better deal, and suffer less dilution in any subsequent investment rounds, if you are co-investing on the same terms as your new investors. The vast majority of entrepreneurs, and Angels, underestimate the amount of money they will need. If a company unexpectedly runs short of money, the very last thing you want is to try to raise the next round of financing when the company is in distress. If you have $2 million to invest, you should consider investing half that amount in 20 companies, or around $50,000 per investment on average. If you estimate that you will hold each company for five years, it means doing at least four deals per year. On the Other Hand... This doesn’t feel practical to me. While it is good advice and mathematically sound, an Angel with $2 million ready to invest will not likely have the discipline to pace the initial $1 million over five years. It is more likely that once they get exposed to decent deal flow, two things will happen: 1. They’ll start seeing very good opportunities and they will seduce themselves into more than four deals – if not in the first year, then almost certainly in the second. 2. Similarly, they will want to invest more than $50,000. This is especially true early in their Angel life when they have more powder available to invest. If opportunities are good and Angels convince themselves that they can do $50,000, the threshold to convince themselves to go to $75,000 or $100,000 is lower than the first $50,000. This is why many Angels get tapped out before exits start replenishing the keg. It’s difficult for Angels to have the discipline to stay within targets (if they have them). That’s because once they’ve convinced themselves a deal is good, and that (for the immediate moment) it’s the best deal around, it’s natural to wonder, if it’s good for $25,000–50,000, why not $75,000–100,000? Other influences that come into play when deciding on the amount to invest: • Interpersonal “chemistry” with the founder/team • All that’s left before closing the deal is a small amount • The Angel’s experience/knowledge of the industry • The nature of the product and market opportunity • The co-investors • Intellectual property • The concept is in a race to market • Being flush with cash (e.g., partial or full exit just happened, bonus was just paid) — Frank Erschen , Charter Member, Golden Triangle Angelnet
24 A Practical Guide to Angel Investing
The major portfolio target variables are: • Percentage of total net assets (or total amount of Angel capital available) • Number of investments (if less than 10, consider including an Angel fund) • Percentage of cash in reserve (dry powder) • Average amount per investment Portfolio targets may also include preferred types of deals, such as industry sector, stage and location.
Portfolio Categories
Very Conservative Angel Portfolio $25,000 per investment x 2.0 (a powder reserve of 100%) x 15 investments = 10% of net worth Net worth required = $7,500,000 Conservative Angel Portfolio $25,000 per investment x 1.50 (a powder reserve of 50%) x 12 investments = 15% of net worth Net worth required = $3,000,000 Less Conservative Angel Portfolio $25,000 per investment x 1.35 (a powder reserve of 35%) x 6 investments = 25% of net worth Net worth required = $1,000,000 — Bill Payne , in Asset Allocation and Portfolio Strategy for Angel Investors Most of the Angels I have spoken with agree with Frank Erschen and frequently deviate from their portfolio targets. Many of them invest more money in fewer deals and keep less of their powder dry. In some cases, they augment this smaller number of deals and hit their portfolio diversification goals by also investing in an Angel sidecar fund or Angel group fund to reduce risk (see section 2.4). Mike Cegelski, on Angel portfolio targets: “I invest around 20% of my net worth – I know that’s considered a lot, but it’s something I know and feel comfortable with. I maintain a portfolio of more than 20 companies and try to keep it under 30. I’m early- stage but not too early – I like to see revenues. I keep 50% for powder and I like to follow-on invest when needed. I prefer “one-and-done” investments and earlier exits. I’m not seeking unicorns. I’m happy with 2–5X returns instead of 20–30X deals that need a lot of money. I’ll invest $100,000–150,000 and potentially another $300,000– 500,000 in a follow-on round per company.”
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Keeping Track If you are trying to maintain a portfolio of companies, it can quickly become a titanic task to monitor all of your investments, yet this is one of the only ways to stay disciplined about your investing. It is for this reason that tools such as Hockeystick (www.hockeystick.co) have been developed – by a serial Angel investor no less – endorsed, and used by Angels and organizations such as NACO. — Bryan Watson , Partner, Flow Ventures 1.4 Value Investing vs Momentum Investing Angels should consider whether they are going to take their time to look for long-term value or try to catch a wave with momentum investing to get in on a hot deal. The NACO Academy modules emphasize the value investing approach, but there are other approaches that can also provide good ROI. In Startup Wealth: How the Best Angel Investors Make Money in Startups , Josh Maher classifies Angels into three different types of investor: value investor, momentum investor and alternative investor. In some cases, quotes from different types are so at-odds with each other that one can hardly believe each can be classified as an Angel. When hearing conflicting advice from successful Angels, consider that they might be speaking from different camps. “One of the biggest dichotomies right now is there’s this rift between this somewhat consumer-led, consumer-mobile kind of deal flow that is prevalent in Silicon Valley [momentum investors] and the rest of the world [value investors]… [Momentum deals] are like popularity contests and it’s all about moving fast… [Value investors] are trying to find great teams and great opportunities at good companies – need-to-have products, rather than nice-to-have products… and then – and this is crucially important – help the companies afterward.” (Christopher Miribile, in Maher) The momentum approach recognizes that at times there is competition for the best deals, and the meta-trend is that it is becoming easier and easier to find smart money. So the best entrepreneurs may have lots of choices and get the most money from the best investors. The only way to get in on these great deals is by being better- connected, writing cheques faster, and/or offering better deal terms. Some Angels view each deal independently and assess whether the deal itself requires a momentum, value or alternative approach.
26 A Practical Guide to Angel Investing
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