InfoDev, an innovation and entrepreneurship program of the World Bank Group, recently published an international guidebook on angel investing focused on both entrepreneurs and angel investors from around the globe. VC4Africa is publishing a series of articles based on texts from this guidebook, by Laura Catherine Baker / infoDev – The World Bank Group. Read the first part below.
Why is ‘angel investing’ important?
Filling the funding gap: Entrepreneurs around the world often face funding gaps between what friends and families can offer and what banks, VCs, and private equity (PE) ﬁrms are willing to contribute.
In 2008 a WorldBank / InfoDev study showed that in developing countries, friends and family usually contribute up to $50,000, enough for an entrepreneur to get started but not enough to generate sufﬁcient revenues to scale the business.
To grow rapidly, entrepreneurs may need an injection of capital, but banks have little appetite to lend to high-risk businesses with insufﬁcient cash ﬂows. VCs and PE ﬁrms (which may not exist in some countries) usually do not invest less than $1 million; too much for a seed stage start-up. This gap in funding between what friends and family can provide and what VCs and PE ﬁrms are willing to invest is referred to as the “Valley of Death,” and it can be nearly impossible to traverse without the help of ‘angels investors’ and ‘angel groups’.
In countries that lack VCs and PE ﬁrms, angel groups ﬁll the void by supplying additional rounds of funding to growing companies.
What’s the definition of angel investing?
There is no universal deﬁnition of angel investing, but it is generally understood as the practice of high-net worth individuals investing their own time and money in new businesses with the goal of proﬁting from their long-term growth. Such investments are characterized by very high levels of risk as most companies are in the earliest stages and will likely fail. Angel investors are different from venture capitalists (VCs) in that VCs invest other people’s money. Motivations are another important distinction between the two; angels are typically interested in more than just receiving a ﬁnancial return. Personal interest, the desire to give back, and the thrill of being involved with an innovative company are just a few of the reasons why people decide to become angel investors.
The practice of wealthy individuals and groups investing in entrepreneurs has existed for centuries and across many cultures. In some traditions, wealthy family members, friends, and/or community members provide ﬁnancial support for business ventures, some with expectations of a return on investment or sharing of proﬁts. This is different from most western deﬁnitions of angel investing, today, which describe angels as having no meaningful relationship to the entrepreneur prior to investment. Friends and family generally provide the ﬁrst round of funding to help an entrepreneur get started, and angels step in when the business needs another injection of capital to develop and grow. That is why angels are often associated with high-growth companies.
What do exits and returns look like for angel investors?
The reason that angel investing is so risky is that most start-ups do not achieve their founders’ goals and are closed. Research indicates that 56 percent of companies fail, giving their investors negative returns.
For this reason, angels invest in portfolios of companies. Among the successful companies, 9 percent provide investors with returns of 10 times their investments, which compensates for failed investments. Most exits in the developed world are in the form of strategic trade sales, with overall returns of 2.6 times the original investment in the U.S., and 2.2 times the original investment in the UK, with proﬁtable exits taking around 6 to 8 years to achieve.
Data on exits and returns in the developing world are much more limited, but some studies indicate that angels in emerging economies enjoy good returns as well. According the Kauffman Foundation’s research on angel investors in Asia, between 75 to 79 percent reported returns meeting or exceeding initial expectations. The study attributed the results to angels’ commitment to in-depth due diligence before investing and close monitoring of investee companies.
Angels in developing countries ﬁnd exits via trade sales, buybacks, or by selling shares to other funds. Initial public offerings (IPOs) are not possible in most markets. Without foreseeable exits, angels may have to hold onto investments longer than anticipated. Until then, angels can get some cash ﬂow through proﬁt sharing, dividends or royalty payments.
OECD, 2011. Financing High Growth Firms: The Role of Angel Investors. OECD Publishing, pg. 63
What are the common problems facing angel investors?
Angel investing is a high-risk endeavor no matter where you are in the world. However, certain risks are more prevalent in some countries than in others. According to recent research on angel investing in four Asian emerging markets, angels “face relatively more challenges compared to business angels investing within developing economies.”
Angels interviewed for our research agreed, and highlighted the following specific environmental factors:
– Lack of awareness among angels and entrepreneurs of angel investing and that it is a hands-on process.
– Weak entrepreneurial ecosystems that fail to produce and support innovative start-ups..
– Lack of successful and visible angel investing models to follow in most countries
– Lack of trust among angels and/or between angels and entrepreneurs.
– Lack of industry expertise/mentors to help start-ups improve business models, connect with markets and grow.
– Weak regulatory frameworks that may discourage, or at least fail to encourage, angel investment and/or the creation of start-ups.
– Lack of educational resources for new angels to learn best practices and technical aspects of investing in high-growth companies.
– Fear of loss of capital and “face” in this risky asset class.
What are the advantages of creating or joining an angel group?
While individual angels are incredibly important, there is only so much one person can do alone. Angel groups, which pool the resources and knowledge of their members, can overcome many limitations associated with solo investing and investing in risky environments, such as emerging markets. Because of this, angel groups are helpful in the following ways: Through groups, individual angels can access a higher number of better deals, especially when groups are recognized as having a particular investment focus.
– Groups can aggregate resources to secure staff, interns, and facilities to enhance the deal process.
– Angel groups have more efficient deal screening processes that allow for multiple “checks and balances” by having a diversity of knowledge about the market, management, and financial assumptions.
– Angel groups can make larger investments and fill larger funding gaps by combining resources of individual investors.
– Angel groups allow people to syndicate on a deal and share the risk.
– New angels can learn from experienced angel investors on all aspects and steps of investing.
– The pooling of investment capital gives angels greater economic power and influence, which enhances investment terms negotiation. It also reduces risk by allowing angels to diversify their investments across several deals.
– Angel groups provide the intangible values of camaraderie and sharing of common goals.
– Angel groups can have an influential voice collectively when raising regulatory and policy issues with government and can contribute to the creation of new and better policies
What follow-on funding options exist?
In developed markets, venture capital firms (VCs) provide subsequent rounds of funding to certain companies so that they can continue to grow and eventually be acquired. A lack of VCs in a country should not stop an angel group from kick starting operations, as there is evidence that companies can be quite successful without them. A recent report showed that of the tech companies acquired in 2012, 76 percent had bootstrapped or only used angel financing. If it is likely that your group will be responsible for additional rounds, prepare for this scenario by setting aside funds in advance. If this is not possible, there might be chances of cross-border investments from internationally based VCs or angel groups.
The ladder of finance varies from country to country. Here are just two examples of how angels can contribute to start-ups.
For more please see infoDev’s full Guide for Creating Your Own Angel Investor Group!
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