SUPPORTING ANGEL INVESTING IN THE CORONAVIRUS CRISIS: A CONTRIBUTION TO NACO’S ENTREPRENEURSHIP CAPITAL ACTION PLAN 1 Colin Mason Professor of Entrepreneurship, Adam Smith Business School, University of Glasgow, Glasgow G12 8QQ, Scotland, UK. Email: colin.mason@glasgow.ac.uk and author of NACO’s Annual Investment Activity Report.
11th May 2020
The critical role of angels in the entrepreneurial ecosystem
Venture capital is well-recognized as a key driver of the entrepreneurial ecosystem. The Canadian Venture Capital and Private Equity Association (CVCA) reported that the industry invested a “Record Breaking CAD $6.2B in 2019.” But the vast majority of this was invested in a small number of large mega-deals – just 28 investments of over $50m accounted for 55% the total amount invested. Venture capital (VC) frms play a crucial role in enabling entrepreneurial businesses to scale-up, but they rarely write the frst cheque. Of this fgure, venture capital funds across Canada invested only $41m (less than 1%) through 116 investments of $1m or less. Moreover, this sum represented a decline relative to 2018. Angel investors are typically the frst external investors in new and emerging businesses and play a critical role at the start of the entrepreneurial pipeline. Many angel-backed startups go on to raise fnancing to scale up from VC frms – including Shopify in Ottawa, Solium in Calgary, Skip The Dishes in Saskatoon, Blackberry in Kitchener-Waterloo, Verafn in St John’s, and Enthusiast Gaming in Toronto. Clearly angel investors play a complementary role to the VC industry. More broadly, angels invest in startups that – while offering good potential returns – are not engaged in leading edge innovation and hence do not offer the rapid growth required to attract VC investment. In many cases, however, these angel-backed businesses will be attractive strategic acquisitions for larger companies, fueling growth in well-established companies. Moreover, angel investors live and invest in every province, city, town, and community across Canada. VC investments in contrast are concentrated in Toronto, Kitchener-Waterloo, Montréal, and Vancouver, with Ontario, Quebec and British Columbia together attracting 85% of the dollars invested in 2019.
1 This draws on some of the content of C Mason (2020) The Coronavirus Economic Crisis: Its Impact on Venture Capital and High Growth Enterprises , Publications Office of the European Union. European Union Joint Research Centre JRC120612 http://publications.jrc.ec.europa.eu/repository/handle/JRC120612
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National Angel Capital Organization’s (NACO) annual reports demonstrate the critical role that angel investment activity plays in Canada’s entrepreneurial ecosystem. NACO represents over 4,000 angel investors, 44 angel groups, and 45 Incubators and Accelerators. The 2019 Annual Report includes data from 30 active angel group, 25 of which made investments in 2019. The groups reported 299 investments that attracted $163.9 million of investment by angel investors. The median size of investment was $169,814, with a mean of $506,987, refecting a small number of atypically large investments. Moreover, these fgures under-represent the magnitude of angel investment activity in Canada. First, it excludes investments made by angel groups that did not participate in the survey. Second, it does not capture investments made by angels on their own and in informal groups that go unrecorded. This segment is to be 10 to 20 times larger than the visible market. The importance of angels goes beyond their money. Angel investors are successful founders, business professionals (e.g. accountants, physicians, lawyers) and board members in large corporations to contribute their knowledge and expertise, networks and psychological and emotional support to their startups. A recently formed network of physician angels is working with NACO to turn some of Canada’s more than 89,000 medical doctors and health care professionals into active angel investors and mentors to entrepreneurs. This non-fnancial support is at least as signifcant as the money that angels invest. The coronavirus pandemic has placed both the Canadian and global economy at risk of an economic depression of unprecedented scale. Innovative equity-fnanced companies will play a key role in the economic recovery. The disruptions that economic crises cause to established markets create opportunities for entrepreneurs to launch innovative businesses based on new products, services and business models. After the 2008–2009 recession, WhatsApp, Slack, Airbnb, Stripe, Uber, Waymo, Pinterest and GitHub grew to global success. It is therefore critical that angels continue to invest in startups.
The impact of the coronavirus crisis on angel investing: likely scenarios
The most plausible scenario is that angel investment activity will decline over the next 12-24 months while demand from founders for investment capital is likely to increase. In particular, tech entrepreneurs will seek to exploit new opportunities in a post-COVID-19 world. This scenario is based on fve likely developments. First, most VC frms are expected to focus on their existing portfolios, both to extend the fnancial runway of those frms and to refect their own inability to raise further fnance from their Limited Partners. VCs will not have the bandwidth to consider new investments. The
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CEO of one Canadian VC fund reported that they were spending two days a week supporting 8 portfolio companies, compared with one day a week before the crisis. The implication for angel investors is that the companies in their own portfolios that need to raise follow-on funding from VC funds may not be able to do so, requiring either more angel support or a sub-optimal exit that will generate low returns. Second, VC frms are reducing their valuations, with investment terms and conditions that are shifting in favour of investors. Investments that angel investors made before the onset of the pandemic will see a reduction in their valuations, with negative implications for follow-on fnancing from VC funds. It is likely that future investments will be ‘down-rounds’ which see a decline in market valuation. This scenario raises the possibility of a repeat of the post-2000 dotcom crash in which many angel investors saw their investments wiped out by the predatory behaviour of VCs, driving many angels out of the market. Third, there will be fewer opportunities to exit, and exits which do occur will be at a lower valuation. This will limit the scale of entrepreneurial recycling of capital – a process where cashed-out entrepreneurs become angel investors. In this scenario, the amount invested will be reduced, and angels will have fewer and smaller exits, reducing the capital they have to re-invest. Fourth, some angel groups have announced that they will continue to make new investments. But the likelihood is that most angels will seek to support existing companies rather than making new investments. Finally, the signifcant decline in fnancial markets will reduce the wealth and number of accredited investors. This decline will reduce the discretionary capital available for angel investing. It is therefore likely that there will be less angel fnancing for early-stage entrepreneurial startups. This fnancing constraint will mean fewer innovative start-ups and a less ability to scale-up successful new businesses.
What Should Government Do?
Governments around the world have introduced a wide variety of support measures for the small business sector to help them preserve cash. These efforts include: providing loans and guarantees, both directly though state agencies and through banks; subsidizing employee costs; and deferring taxes and social security payments. These interventions are focused on preventing a cascade of business closures during the immediate crisis as businesses
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exhaust their limited cash reserves. However, interventions to support the emergence of high-growth innovative start-ups have been limited. Their main assets are intellectual property and talent. Support for such frms needs to be focused on ensuring that the supply of equity investment, particularly from angel investors, does not dry up.
(i) Co-investment Initiatives (Matching Funds)
Co-investment initiatives are a common approach that governments in various countries have used to increase the supply of equity fnance. Prominent examples include the Scottish Co-Investment Fund, the New Zealand Seed Co-investment Fund, and the European Angels Fund, which is an initiative of the European Investment Fund. Co-investment initiatives are typically structured as a government fund that invests alongside private investors, committing one dollar for every dollar invested by private investors. Most co-investment initiatives partner with angel investors and VC funds. The co-investment fund invests under the same terms and conditions as private investors (i.e. pari passu). The government fund relies on the due diligence work by business angels to reduce costs. The risk of moral hazard is low because angel investors have ‘skin in the game’. The purpose of co-investment funds is to improve early-stage capital available by leveraging angel investors. The frst co-investment initiative -- the Scottish Co-Investment Fund -- emerged in the aftermath of the post-2000 dotcom crash to address the liquidity constraints faced by business angels and angel syndicates due to the withdrawal of existing VC investors from the Scottish market. By relying on an angel investor to write a frst cheque, business co-investment initiatives address concerns of adverse selection, government ineffectiveness, and the critique that governments should not ‘pick winners’.
The design of co-investment initiatives is critical. There are two basic models.
1. In the frst model, the co-investment fund invests alongside approved investment partners – typically angel groups and early-stage funds. Approved partners bring deals to the fund that meet its investment criteria automatically triggering the co-investment. Angel investors prefer this model because of the high level of certainty of matched funding and the speed of decision making. This model also greatly lowers costs for government.
2. In the second model, investors can bring deals where they have made an investment. The co-investment fund undertakes its own investment decision.
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Further design issues concern: the maximum size of investment under the initiative; whether it only applies to businesses raising their frst round of equity fnance; and whether follow-on investments are permitted. The co-investment initiative should be designed with as few exceptions as possible and give businesses as much fnancial runway as possible, suggesting that the maximum matched funding should be no lower than $5m (i.e. total investment of $10m) and that follow-on investments should be permitted. Evaluations of co-investment initiatives have generally been favourable, concluding that they are effective in leveraging investment capital from existing investors. They enable more and larger deals. And they do so in a manner that minimizes the cost to the public purse and the risk to public funds. Moreover, the limited evidence suggests that co-investment initiatives generate a positive return to the government and public over the longer term. The effectiveness of co-investment initiatives is likely to be reduced during the current pandemic because of constraints on the ability of angels and other early stage investors to invest. Hence, these initiatives need to be complemented by other support initiatives.
(ii) Tax incentives
Many countries offer tax incentives to business angels to shift the risk-reward balance of making high risk investments in early stage businesses. The UK’s Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) is one of the most generous, giving 30% tax relief on investments in qualifying businesses as well as a range of other tax breaks (such as loss relief and capital gains tax exemption). Investors can qualify for these tax breaks either by investing directly in qualifying businesses or by investing via professionally managed investment funds (EIS Funds and Venture Capital Trusts). Some governments might be uncomfortable providing tax incentives to ‘wealthy people’. There is plenty of evidence, however, that most investments made by angel investors fail and do not generate a return on investment. Moreover, angels are not typically paid for the value-added contributions they make to their investee businesses. Some studies suggest that tax incentives generate additional economic activity and that the tax revenues generated exceed the cost. Another dimension to consider is the desire of angels to have a positive impact on their communities. This is the rallying cry of Northern Ontario Angels (NOA), North America’s most successful angel group, which had invested over $155 million in the past fve years, protecting over 4,000 jobs. NOA has drawn contributions from investors across a
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geographically dispersed group region with a population of only 700,000. This rate of investment is the equivalent of unlocking more than $7 billion of angel capital from the Canadian population. Sadly, the current rate of angel investment for the rest of Canada is signifcantly below this benchmark. The key issue for tax incentives is how to design them. What businesses qualify and how? Most impose age limits on businesses, annual and total limits on the size of investment, and excluded activities. They may offer higher tax breaks for targeted businesses (e.g. seed stage, knowledge sectors). Other questions to consider are: ● How generous should the tax incentives be for investors? ● What form(s) should the tax breaks take (e.g. just on the amount invested)? ● What is the upper annual investment limit? ● How long should investors be required to hold their investment without losing their tax relief? A further issue concerns whether tax incentives should be transferable across provinces. On the one hand, limiting tax initiatives to investments made by residents in businesses located in the same province discriminates against investors in small provinces and those living close to provincial boundaries. On the other hand, it is understandable that provincial governments will not want to see lost tax income supporting out-of-province businesses. The reality is that angel investing is geographically concentrated due to local networks that angels use to identify and appraise investment opportunities. Hence inter-provincial investments will always account for a small proportion of total angel investment. And any fnancial gains that an angel derives from an investment in an out-of-province business might be reinvested in within-province businesses.
(iii) Convertible Debt Instruments
A number of commentators identify the need for governments to create a convertible debt instrument. This instrument should be aimed primarily, but not exclusively, at seed stage start-ups to buy them time to survive COVID-19 and get back to their growth trajectory prior to the pandemic. The drop in economic activity caused by COVID-19 will mean that successful startups will face postponed sales, curtailed growth opportunities and increased monthly "burn rates". Their growth milestones will shorten, and ultimately they will run out of cash.
Convertible debt instruments are a form of short-term debt that converts to equity at the next funding round. Investors effectively loan money to the business, with these convertible
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notes either subsequently redeemed (for a proft) or converted into "discounted" shares when the startups raises their next funding round. These securities are not a handout: they are an investment that should generate returns once the economy recovers. Government would work with early-stage investors to identify and assess eligible startups and to allocate capital via convertible notes. The key design issue is at what funding stage to target investment. Should it be limited to companies at the seed stage or extended to companies further along the funding path. Later-stage investments would require greater fnancial commitment by governments. It is also important that the tax incentives available should apply to convertible debt as typically they do not.
(iv) Non-Dilutive Finance
Initiatives to stimulate investment activity by angel investors and venture capital funds need to be complemented by intervention to increase the supply of non-dilutive fnance (NDF). Notable examples are grants for innovation and commercialization. NDF programs are important for three reasons. First, seed investors rarely invest in ideas alone. They recognise that the business plan is ‘a work of fction’. NDF supports the discovery and early commercialisation stages, funding ideas to market which, by providing evidence and validation that creates credibility, enhances their investability. Second, if entrepreneurs raise equity too early they will experience signifcant dilution by the time their business scales-up, with potentially negative impact on motivation and alignment. Employee incentives need to be aligned with share options. They need to be incentivised to become angel investors following a successful exit which, in turn, will increase future entrepreneurial activity. Third, NDF helps frms to achieve their milestones and increases valuation. With the COVID-19 pandemic shifting investment terms and conditions in favour of investors, the signifcance of these milestones and valuations has increased. The support that comes with NDF programs is also critical. Governments are encouraged to pay innovation grants up-front rather than in arrears and to adopt a light touch to auditing to make speedy payments.
The Federal Government has recognized the need for NDF, announcing $250 million in funding for the Industrial Research Assistance Program (IRAP) to assist Canadian small and
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medium-sized enterprises (SMEs) with a 12-week wage subsidy. However, the call for applications for IRAP funding closed within a few days of the announcement.
Summary
This paper highlights the critical importance of angel investors in Canada’s entrepreneurial ecosystem. Angels provide crucial fnancing and expertise at the start of the entrepreneurial pipeline. Although the angel investor community may continue to make new investments, our expectation is that aggregate investment activity will decline with capital reserved for follow-on investments. The paper has identifed four ways in which governments can intervene to support angel investment activity: co-investment initiatives, tax incentives, convertible debt, and non-dilutive fnance (Such as grants). It has emphasized that design of interventions is critical to target the desired types of investors and businesses. Governments often lack a detailed understanding of entrepreneurial fnance. Government offcials are not exposed to the realities and practicalities of how startups operate, with the result that well-intended interventions have at times had design faws that undermine their effectiveness.
National Angel Capital Organization MaRS Centre, West Tower
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