PARTNERING WITH ANGEL INVESTORS

By Ralph Kroman

WeirFoulds LLP

(416) 947-5026

What is an Angel Investor?

Individual private investors who invest in entrepreneurial companies are commonly and affectionately known as "angel investors". They prefer to take an equity position in the company either directly through the issuance of shares or indirectly through other instruments that are convertible into shares.

Since each angel investor is an individual, there are substantial differences between angel investors. The approach of an angel is more "seat of the pants" than a venture capitalist. A profile of a "typical" angel investor looks something like this:

While all angels want to make money, they are often motivated by the energy of a young company. At the same time, most angels demand high returns.

Angel investors like to see "exit mechanisms". An "exit mechanism" means that the angel investor has a means to cash out on the investment. These exit mechanisms include a public offering of shares on a public exchange, a "buy-back" of investor's shares by the principals of the company, or the acquisition of the angel's position, or the entire company, by a third party. This exit mechanism is often located in a shareholders' agreement.

Some angel investors are not too fussed about specifying a particular exit mechanism. What they want to see is a company which is run professionally enough to create value and to attract investments from other sources such as venture capitalists. These angels feel that, if your company is run professionally and you have the right product or service, eventually a buyer will surface or the company will be able to go public.

It is nonetheless important to approach any potential angel with a clear vision regarding the exit of the angel's investment. For example, if you are making a pitch to an angel, you should identify potential future purchasers of your business so that the angel has a sense of how the business might be sold in the future.

Corporate Angel Investors

Although angel investors have traditionally been viewed as individual investors, over the years, the term angel investor has been broadened to include different kinds of corporate investors. Indeed, the term angel investor is sometimes applied broadly to include many kinds of investments which are made in a company which is in the early stages of development.

Many of these corporate angels are making their equity investment in connection with a strategic alliance between the corporate angel and the company. These corporate angels are looking for strategic synergy.

This equity investment may be used to assist in the diversification of the corporate angel's operations (an investment in a non-related industry) or to promote development in their own industry by the financing of a supplier, technology developer or other industry participant.

A corporate angel wants to know how a strategic investment can help their business. The corporate angel may be looking for distribution, access to information or access to technology. The corporate angel is not seeking to make money solely from a return on the investment.

Because a corporate angel is looking for strategic synergy, this angel is often not interested in an exit strategy. A corporate angel can bring ideas to the table which an individual angel investor is unable to provide.

It should be kept in mind that interests do change and a corporate angel which is not a competitor today may become a competitor tomorrow. Personnel can change in a corporate investor and relationships can be affected. As with any proposed equity investor, the entrepreneur should conduct due diligence in order to make sure that the fit is right.

A Thing or Two About the Big "C" (Chemistry)

An angel is likely to be an individual with entrepreneurial experience who wants to get involved with the company rather than be a passive investor. Individuals who come by wealth through inheritance, for example, are unlikely to invest in private companies because they do not like the risks.

It is important that the proper chemistry exists between the angel and the entrepreneur. The angel and the entrepreneur should take the time to get to know each other.

Tough issues such as amount of control which will be granted to the angel should be dealt with up front. An angel who has entrepreneurial experience may have high needs for achievement and dominance, and the entrepreneur should ensure that they are compatible. It is okay for an angel to have strong views but the angel needs to accept that the entrepreneur is ultimately in charge.

By making every effort to ensure that the big "C" is there, the entrepreneur can avoid disputes later on (these type of disputes can get very nasty and expensive). Although a dispute resolution mechanism in a shareholders' agreement can reduce problems, the best choice is to ensure that the appropriate chemistry is there right from the start.

Of course, the angel is also looking for the right chemistry and the entrepreneur can kill it by hinting that the entrepreneur is concealing something or is not being completely honest.

If an angel has syndicated the investment to other angels, the entrepreneur should spend the time to get to know all of the angels.

When Do Angel Investors Usually Invest?

An entrepreneurial company goes through several stages of development which are sometimes described as follows:

Seed or Concept - A concept exists if there is no management team, no prototype or business plan.

Start-up - A prototype has been or is developed, and the initial business plan and marketing plan are being refined.

First Stage - The company is now a going concern and is selling a product or service. A management team is in place and there may be some setbacks or "growing pains".

Second Stage - Significant sales, assets and liabilities are developing and cashflow management becomes critical.

Third Stage

(also Mezzanine Stage) - The potential for a major success is beginning to become evident. Mezzanine or bridge financing may be necessary to bring the company to "harvest".

Stage Four - The company is determining its options for "harvest" such as going public, being acquired, or merging.

A company which is in the seed or concept stage typically obtains its financing from personal savings, friends and family money. Grants from government sources are also important.

An angel investor usually funds a company when it is in the start-up or first stage of development. Angels also become involved in a company which is underperforming and requires capital for a turnaround.

On the whole, financing from angel investors precedes any financing from venture capitalists and a good angel can often pave the way to a subsequent infusion of venture capital or other financing.

Things That Angels Bring to the Table

The ideal investor angel will not just bring money to the table; the angel will become a valuable business advisor who will help your business grow. Because companies in the early stages of development have limited resources, they usually cannot utilize the services of professional advisors to help their businesses grow.

The ideal angel investor has not only entrepreneurial experience but also relevant industry experience. It is useful to have both of these attributes.

For example, if an angel investor is a former executive from a large industry player, this angel can provide important industry knowledge and contacts but, if the angel has never created a company and made it grow, the angel may not have a great deal of entrepreneurial experience. Some angels may have a great deal of entrepreneurial experience and can help with building a company, but do not have the industry experience which can also be useful. Other angels are mere passive investors and cannot provide any business assistance whatsoever.

Among other things, an angel investor can help you:

The quality of angels runs the gambit from the sophisticated to those who do not know what they are doing. An angel investor will conduct due diligence before investing in your company and, by the same token, a company should learn as much as it can about the angel investor's track record before the investment occurs. References should be checked by all parties. If an angel refers you to a CEO who has dealt with the angel, consider asking the following questions from the CEO:

What kind of industry contacts does the angel have?

Was the angel able to make important introductions to prospective clients?

Did the angel connect you to strategic partners?

Did the angel help you recruit board members and management?

Angel ... or Devil?

Angel investors can be the salvation of a company but an improper angel can lead to serious problems. Because angel investors are individuals, you must accommodate their quirks but the situation should not be permitted to get out of control. It is important to do some "angel management".

When someone gives your company money, they expect certain rights and it is important to deal with these expectations at the time of the investment.

One of the more important aspects of "angel management" is to determine the manner and timing of communications. Some angels will make endless telephone calls to the entrepreneur and may require more details that you have time for.

At the time of the initial investment by the angel, a company should outline its relationship with the angel investor and agree upon the manner which communications will be conducted. It may be useful to settle upon monthly written reports as a way of dealing with any potential problems with communications.

On the other hand, you may be faced with an absentee angel investor who is too busy with other business obligations to help you with your business. If it is your expectation is to obtain expertise from the angel, you should sit down with the investor angel before the investment and be clear about the angel's time commitment to your business. You may wish to do so by inviting the angel over for dinner and, if the angel is too busy to accept the invitation, you should perhaps adjust your expectations regarding the angel's time commitment.

If the angel is prepared to make the time commitment for you that you expect, be prepared to spend a fair amount of time educating the angel about your business and your industry. The angel may have some industry knowledge (and perhaps even more knowledge than you) in which case there will not be much of a learning curve for the angel. If the angel is slow to learn, keep trying so as to avoid any problems because of the lack of understanding on the part of the angel.

Getting Prepared for the Toughest Sale

Because raising capital is a daunting process, a company needs to prepare seriously in order to increase its chances of getting capital.

Although angel investors do not treat the investment procedure as formally as venture capitalists, it makes sense to prepare for raising an angel investment in the same way as one prepares for an investment of venture capital. A lot of materials have been written on this subject (do not scrimp on your research) and here are some of the highlights:

  • Put together a complete management team - A solid, well-balanced management team is essential for any efforts to raise money successfully. The company will probably need people who know about marketing and selling products, manufacturing, managing people, and accounting. You may have to issue shares in order to attract key people and keep them committed (indeed, many angels like to see that shares have been issued to management personnel so that there is a true management team). If you do not have a complete management team on board, you need to identify areas where the team needs shoring up and provide the angel with a realistic plan for doing so. Don't try to fake it.

  • Organize in a form that attracts investment - You should make sure that any financing which is already in place from founders, family and friends is in place in a sensible way which will not impede other investments. Entrepreneurial companies use varying combinations of debt and equity, and the company should be structured in a way which is appropriate for its growth and profitability. Any employee stock options should be priced appropriately. Big salaries and flashy perks turn off potential investors of young companies.

  • Prepare an effective business plan - A good business plan needs to state more than why the company is such a great business opportunity. A good business plan should include sound financial projection, a detailed discussion about operational control, a marketing plan and a sales plan.

  • Protect your intellectual property - A company needs to protect its copyrights, trade marks, patents and trade secrets. This protection is becoming more and more important as more and more companies are basing their success upon proprietary intellectual property. Potential investors will want to know what steps have been taken to protect your intellectual property. They will also want to know whether your intellectual property may infringe the rights of others. Intellectual property must be protected but of course it must be done with sound legal and business strategies and common sense.

  • Practice your pitch and do not get discouraged - While many variables are at play, it is reasonable to expect that you will go through many attempts at raising money. If you do not succeed, get feedback. Because raising money requires sales skills, you need to ask for feedback so that you can improve your skills. You must develop a scuff-resistant ego.

    The Local Angel Investor Market

    The angel investor market in the United States is well organized compared to the market in Canada. In the United States there are a number of private and public entities which bring angel investors together with entrepreneurs (many of these organizations have web sites; see, for example, garage.com). Some web sites permit information about the entrepreneur to be entered into a database and matched with potential investors. Many of these services charge both parties a fee and there is no guarantee that either the entrepreneur or the investor has been checked out by the matching service. Other services conduct some screening.

    The angel investor market in the United States has become so developed that in some jurisdictions few venture capital deals are closed for less than a U.S.$3,000,000.00 investment.

    In Canada, virtually all angel investment is sourced through personal contacts as there are few services dedicated to angel investment (Venture Street is a group which has formed recently).

    You Too Can Find an Angel - Build Your Pipeline

    The best way to source an investor angel in Canada is through referrals. You need to be introduced by a credible source. Networking is a tradition which works and is especially important when you seek an angel investor. Networking is hard work; it requires time, energy and follow up. Do not expect networking to pay dividends immediately. It is a long haul so be prepared.

    It is not easy to find angels. Most of them value their privacy and do not want to be approached by every person who is looking for funds. Knowing the right person is the key to getting an introduction to an angel investor.

    You should try to meet as many business owners as possible. Many of these business owners may be or may want to be angel investors. Alternatively, these business owners may be willing to refer you to investors who they know.

    In order to make the right contacts, the entrepreneur should become immersed in the local business and social community. It is important to join trade associations that have regular meetings.

    You should also consider memberships in civic and community organizations as another potential source for networking.

    With respect to any organization, it is not enough to merely pay your dues; you must become an active participant or else your membership is a waste of time. Members of groups are usually grateful to those who assume a leadership role and your networking possibilities will be greatly enhanced if you do so. Time is a very limited resource for all of us and the entrepreneur should research the networking potential of any group before becoming actively involved with it.

    Cruise the Internet and look for advertisements for local venture fairs and other events where there will be people with money. The Toronto Venture Group has regular meetings. Go there in order to meet people.

    Another way to get an introduction is to connect with your accountant, lawyer, banker, customers, employees, doctor, dentist, consultants, or your professor at a local university, especially one that specializes in entrepreneurship.

    In order to find money you may need to be aggressive; for example, consider calling the CEO of a company that is similar to yours, but not a competitor, and see if you can get the CEO to introduce you to a potential angel or someone who might know angels.

    If you meet any venture capitalists, keep in touch with them even if they are unable to invest in the company. Some of them have contacts with angels. By the same token, you should cultivate contacts with investment bankers and other intermediaries as they also often have contacts with angels.

    There is Hope

    It is tough finding angel investors. There is a strong perception that there is angel money waiting to be invested but the conduit is not as developed as it should be in order to match entrepreneurs with angels. The good news is that it looks like more local resources will be developed in the future to help bring entrepreneurs and angels together.

    Ralph Kroman
    (416) 947-5026
    kromanr@weirfoulds.com
    November, 1999