How to Dance with Angels

Small businesses often prefer to slow dance with angels than boogie with venture capitalists. But knowing when to change partners is also important.

Serial entrepreneur Sam Yagan considered financing his third start-up company with venture capital, but passed. Instead, he secured $6 million in funding for his free online dating Website, OkCupid, from five angel investors. One of his primary motives for eschewing VC money was that he wanted the freedom to grow the business gradually if necessary, and not be forced to pull the plug if it didn’t hit a financial home run within five years, a typical private-equity timetable.

By forgoing VC investment, the entrepreneur gave up the high-powered advisers — and their well-stocked Rolodexes — that usually accompany VC funding. Still, Yagan isn’t tempted by the money or the access. One of his angels, the backer that made the smallest financial investment, is a well-known professional investor who has “seen a lot of deals” and knows “a lot of people,” says Yagan. By putting him on OkCupid’s board, the investor can act as an adviser and Yagan won’t have to worry about who will play that role as his company grows.

Yagan’s decision to rebuff VC money is just one example of a larger trend being played out by small-company owners who currently seek both autonomy and second-round funding. With sizeable amounts of early-stage capital chasing deals, entrepreneurs are in a good position to go it alone rather than rely on institutional funding. “You can attract money from nonventure-capital sources if you’ve got the right team, the right idea, [or] the right technology,” contends Tom Savini, CFO of AirDefense, an Atlanta-based provider of security for wireless networks.

Last year angels — wealthy individuals who hope to take advantage of ground-floor investment opportunities in new companies — provided $25.6 billion to burgeoning businesses, an increase of nearly 11 percent over 2005, according to the 2006 Angel Market Analysis released by the Center for Venture Research at the University of New Hampshire. Furthermore, the number of ventures to receive angel funding rose 3 percent, to 51,000, last year, and average deal size grew by 7.5 percent. “This continued rise in total investments points to a healthy angel market,” concluded the report.

At the same time, “there’s a huge amount of institutional money” still available from VC firms, comments John Taylor, vice president of research at the National Venture Capital Association (NVCA). In 2006 VCs invested $25.5 billion in 3,416 deals, representing a 10 percent increase in deal volume and a 12 percent increase in dollar value over 2005, according to the MoneyTree Report, issued by PricewaterhouseCoopers and the NVCA. The year marked the highest level of investments since 2001.

In Demand

The available capital puts many small-business owners in the catbird seat. “I probably have calls once a week from people talking about investing and giving us money,” says Sara McNeil, president and CEO of Boston Software Systems, in Sherborn, Massachusetts. “I tell them we have no cash restrictions…[and] there really is no reason to give a venture-capital firm a piece of the action.”

While it is nice to be pursued, small-business owners still have to choose what kind of funding they are most comfortable receiving. Consider the differences between angel and VC money. Angels typically want a return on their investment that is 10 percent to 15 percent above the return earned by the S&P 500. What’s more, they usually remain passive investors. By contrast, VC firms, which raise capital from individuals, investment banks, and other financial institutions, traditionally take an equity stake in the portfolio company they invest in and demand a say in company decisions. VCs also expect a higher return — 20 percent or more on their investment.

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