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.

For some entrepreneurs, who want to guide their companies to expand gradually in lock-step with revenue growth, angels are a better fit. Consider McNeil and her husband: the duo started Boston Software in 1986 and built it steadily via sales growth. The company, which develops work-flow automation systems for the health-care industry, has increased its sales by 25 percent annually since 2000, and now boasts 1,500 customers in four countries. Early on, Boston Software worked with a partner that licensed the company’s software technology and provided sales and marketing support. The partnership helped Boston Software grow without having to boost funding or hire a staff.

McNeil says taking cash from VCs is risky. Boston Software has always been focused on moving “to second base…and that’s what [has] kept us very, very profitable.” But stopping at second isn’t good enough for VCs, opines McNeil. They want home runs, and if the return they expect doesn’t materialize within a few years, the business either goes belly up or its assets, including proprietary products, are sold for pennies on the dollar.

As the name suggests, angel investors also tend to be more tolerant of typical start-up mistakes. Witness Ed Adams, CEO of Security Innovation, a software-security firm. Had Security Innovation been financed with institutional money, says Adams, he would have been fired after making a strategic sales-related error.

At the end of 2005, Security Innovation had revenues that represented a 200 percent increase over the previous year. That bump came from spin-off business created to focus on the federal government earlier that year, as well as a training unit for software developers, architects, and testers launched the year before. Unfortunately, management also was sitting on a proprietary software tool that wasn’t selling. According to Adams, company engineers had built an effective tool that only software geeks like themselves could appreciate.

No one got the word out about the product, and without customer education, sales came to a grinding halt, recounts Adams. If institutional money had been backing his company at the time, he posits, he would have been out of a job. He believes that angel investors put a lot more trust in management than VC firm managers would have allowed. “VCs are much less forgiving of strategic errors,” but it’s those kind of errors that help entrepreneurs grow and succeed, says Adams, whose company has been operating for five years.

Devil’s in the Details

Still, companies backed by angels don’t always have a heavenly experience. Shunning institutional funding often leaves new companies with a dearth of start-up cash, as angel investors don’t often have the wherewithal to supply extra padding, such as working capital, on top of their initial investment. That often leaves a nascent business with insufficient reserves to survive market slumps. “You have to be a bit more conservative in your risks,” says Yves Schabes, co-founder and president of Teragram Corp., a search software company based in Cambridge, Massachusetts. In hindsight, Schabes says he could have reinvested more of his revenues into his business in the first three years, but at the time, the lack of a financial cushion from his investors held him back.

Small-business owners also need to keep an eye peeled for potential legal snares related to angel investors, says OkCupid’s Yagan, who also founded study-aid company SparkNotes. “Don’t go cheap on lawyers. A cheap lawyer costs more than an expensive lawyer,” warns Yagan, who learned that lesson the hard way when he sold his first company.

A clause in the agreement between SparkNotes and its angel backers gave the investors the option to sink more money into the company at any point, thereby increasing their stake in the company. Yagan, a 22-year-old college student at the time, wasn’t sure the company would need to raise more capital beyond the initial investment, so he reached a verbal agreement with his investors that the option to increase their stake would be exercised only if SparkNotes required additional funding.

But the following year, the day before the company was sold to Barnes & Noble, the angels exercised their right to up their stake, increasing their investment by 10 percent. Yagan, his partners, and employees who already held a stake in the company lost 10 percent of what they would have made on the sale.

Speed may be another problem for companies backed by angel investors, mainly because organic growth takes longer than acquired growth. For example, a VC firm often decides to purchase companies, products, brands, or technologies that complement existing portfolio companies, thereby helping the existing business expand.

Adams says he understands the limitations of angel investment, and already has plans to move beyond this type of capital raising. He concedes that having autonomy over his business was good in the beginning, but when it’s time to sell the company, “my investor is going to be zero help. My time to pay the fiddler is coming.” When that happens, Adams says, he will hire an adviser to help with valuation and other tasks to prepare the business for sale.

Once company owners are ready to take the next step and accept VC funding, they will find that choosing the right angel investor at the start was important. Companies should be looking for angel investors who have been through the VC process as a CEO or who have ties to a VC firm, says the NVCA’s Taylor. In that way, the VC firm knows the company has been through “a very good farm system,” he notes.

Attracting VC money, when the time is right, will also depend on how angel financing was structured. Business owners should avoid terms that grant ownership percentages or liquidation preferences to investors that could repel VCs, says Taylor. (A liquidation preference gives investors the right, if the company is sold, to collect a set return on their investment before anyone else receives a payout.) “If the terms are too favorable to the early investor, it will poison the company,” says Taylor. “We see that all the time, especially with inexperienced angels.”

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