Angels Investing in America

Stephen DeAngelis

September 1, 2010

When Senator Chris Dodd (D-Conn) started his push for financial reform, many analysts were concerned that the legislation he proposed would cripple entrepreneurs looking to raise capital from angel investors. The Wall Street Journal, for example, reported, “Senator Chris Dodd’s 1,400-page financial reform bill contains many economic land mines, and here’s one of the worst: Provisions that would make it harder for business start-ups to raise seed capital” [“Angels Out of America,” 22 April 2010]. What the newspaper found particularly “preposterous” was that the bill would require “start-ups seeking angel investments [to] file with the Securities and Exchange Commission and endure a 120-day review. Rare is the new company that doesn’t need immediate access to the capital it raises, and a four-month delay is the kind of rule popular in banana republics that create few new businesses.” The article notes how important angel investors have been for start-ups in the past.

“Amazon, Yahoo, Google and Facebook all benefited from angel investors, who typically target companies under five years old. According to a 2009 Kaufman Foundation study, such firms are less than 1% of all companies yet generate about 10% of new jobs. Between 1980 and 2005, companies less than five years old accounted for all net job growth in the U.S. In 2008, angels invested some $19 billion in more than 55,000 companies.”

I know that I couldn’t have started Enterra Solutions® without assistance from angel investors. Another concern about the legislation as it was originally written was that it also raised “the net worth and income thresholds [of potential angel investors] to $2.3 million and $450,000, respectively. The Angel Capital Association, a trade group, estimates that these provisions would disqualify about 77% of current accredited investors. Accreditation matters in luring other potential investors, such as venture capitalists who enter the picture once a company begins to mature.” Chris Farrell, writing for Bloomberg BusinessWeek, asserted that “the best way to finance small business growth and job creation is to foster angel investing that helps entrepreneurs” [“The U.S. Economy Needs a Host of Angel Investors,” 19 April 2010]. Farrell went on to write:

“[Angel investors] are mostly entrepreneurs and former entrepreneurs who invest in bootstrap companies too young and raw to attract attention and money from professional venture capitalists. Unlike venture capitalists that manage funds of money raised largely from such institutional investors as pension funds, angels risk their own money. Angels are in the vanguard of financing entrepreneurship and innovation and when an investment pays off, venture capitalists come in to further build up the company. Angels fund real companies. [Unlike Wall Street firms,] they don’t create collateralized debt obligations. … To be sure, angel investing cooled off somewhat with the downturn in the economy. Last year, some 259,480 angels invested $17.6 billion in 57,225 entrepreneurial ventures, according to the University of New Hampshire’s Center for Venture Research. The number of ventures held steady, compared to the previous year. Funding levels were down 8.3% percent but that’s a heartening number when you consider that the recent downturn in the U.S. was the worst since the 1930s.”

Like the editors of the Wall Street Journal, Farrell feared that the Dodd bill, as originally written, “could dampen angel investing far more than the Great Recession did.” Farrell believed that such a result would be tragic. He continued:

“The U.S. needs a greater number of successful angels to reinvest money and entrepreneurial talent in new ideas and new companies, not fewer. Angels have a knack for backing the types of companies that create additional jobs. And the angel community has been growing. Typically angels have hooked up with entrepreneurs through ad-hoc social networks—friendships created with other entrepreneurs over the years, perhaps at the country club or local philanthropic events. Since the late 1990s, however, there has been a proliferation of formal angel groups that screen investments and pool money on local or regional levels. ‘You would be hard-pressed to find a major metropolitan area without a good, robust angel community,’ says Susan Preston, general partner for the CalCEF Clean Energy Angel Fund, as well as CalCEF Clean Energy Angel Network.”

Farrell’s recommendation to Dodd was to leave angels investors alone. He concluded:

“Left alone, the pool of angel investors will likely grow. Angel investing has moved from the fringes of entrepreneurial society to the mainstream over the past two decades or so. For angels, the high-risk endeavor is social, fun, competitive, and potentially lucrative. What’s not to like from an entrepreneurial point of view? Even more could be done. For instance, many immigrants are well-educated in such tech-related subjects as math, engineering, and the sciences. Less appreciated is how many of these well-educated immigrants are attracted to entrepreneurial enterprises and later become angel investors themselves. That’s why moves to make it easier for educated immigrants to stay permanently in the U.S. may not only provide a short-term job-creating boost, but also increase the startup financing funding pool over the long term. With an unemployment rate at 9.7% and an increasingly competitive global economy, America needs its angels more than ever.”

Fortunately, the legislation that eventually passed in July had most of the offending sections involving angel investors removed. Although the bill that, as enacted, left the net worth test at $1 million and left the annual-income test at $200,000 individually and $300,000 jointly, “the net-worth test no longer includes the value of the investor’s principal residence” [“What effect will the financial reform bill have on angel investing?,” by Scott Edward Walker, Venture Beat Entrepreneur Corner, 19 July 2010]. Walker continues:

“Clearly, this is a big change – and it could significantly lower the pool of accredited investors. The other piece of bad news is that the bill expressly permits the SEC to conduct an immediate review and modification of the annual-income test if ‘deem[ed] appropriate for the protection of investors. …’ In other words, the annual-income test may go up – but we’ll have to wait and see. Finally, the bill also requires the SEC in four years (and once every four years thereafter) to review the ‘accredited investor’ definition ‘in its entirety’ and make appropriate changes – though the bill is poorly drafted and this four-year review may not apply to the ‘accredited investor’ definition for purposes of private placements under Regulation D (the typical private placement).”

Perhaps the clearest sign that the Dodd bill, as passed, hasn’t yet hurt angel investing is the fact that there is evidence that some angel investors are “no longer flying solo” but are attracting “others to juice start-ups” [“‘Super Angels’ Alight,” by Pui-Wing Tam and Spencer E. Ante, Wall Street Journal, 16 August 2010]. Tam and Ante report:

“Much of the venture-capital industry is undergoing a shakeout. But a growing breed of start-up investors dubbed ‘super angels’ is rapidly raising new money—and ratcheting up competition with established venture capitalists in the process. Aydin Senkut, a former Google Inc. executive, plans to announce that he just closed a $40 million super-angel fund from institutional investors and wealthy individuals including hedge-fund manager Peter Thiel. His fund follows a $20 million super-angel fund by start-up investor Ron Conway in May and an $8.5 million fund from by former Google executive Chris Sacca in June. Meanwhile, former PayPal Inc. executive Dave McClure is raising a $30 million super-angel fund, according to a regulatory filing. And super-angel investor Mike Maples, who raised a $33 million fund in 2008, is raising a new $73.5 million fund, according to a regulatory filing.”

Tam and Ante report that “many super angels started out just as mere angels, wealthy current and former Silicon Valley entrepreneurs and executives who invest their own money in technology start-ups.” What makes them “super,” claims Tam and Ante, is that, when these successful entrepreneurs invest in a business, their participation has a “magnetic effect … on other investors—a main reason entrepreneurs like to do business with them.” They continue:

“And for super angels, investing has evolved into something more than a hobby. These players are now raising funds with outside money, investing full time and competing with VCs. While their funds tend to be small, super angels have had an outsize impact on Silicon Valley. As many traditional venture capitalists retreated after the tech bust last decade, super angels filled the gap, investing small amounts of $25,000 to $1 million in dozens of new start-ups such as Facebook Inc., Mint.com and Zynga Game Network Inc. Super angels also work with established venture capitalists to bring them new deals. As these micro-cap venture capitalists now raise their own funds—giving them more ammunition to participate in later financing rounds of a start-up—they are siphoning off more investment deals and fund-raising dollars from larger venture firms.”

As noted earlier, angel investors have traditionally invested in start-ups that have little or no track record; thus making them higher risk than more mature start-ups. And, Tam and Ante note, “unlike venture capitalists, who have hundreds of millions to invest, [angels and] super angels generally don’t have enough money to fully fund a company to fruition.” They continue:

“Still, super angels are increasingly jockeying with established venture capitalists for stakes in start-ups. Geoff Yang, a venture capitalist at Redpoint Ventures, which closed a $400 million fund earlier this year, says his firm has been ‘squeezed’ into a smaller ownership share in some investments because super angels wanted a bigger slice of the deal. While angels have brought many new start-ups to Redpoint’s attention, ‘every [venture capitalist] is trying to figure out what their strategy is’ with them, he says. ‘Are these guys friend or foe?’ Some start-up entrepreneurs say super angels have thrown them lifelines they couldn’t secure from venture capitalists. Ryan Howard, chief executive of San Francisco online health-care start-up Practice Fusion Inc., says venture firms turned him down in 2008. They ‘want no risk,’ he says. Super angels wrote Mr. Howard checks for $25,000 to $100,000, so that he was able to raise $1 million by early 2009. ‘Their network is mind-blowing,’ says Mr. Howard, whose firm raised a venture round from Morgenthaler Ventures late last year.”

Tam and Ante report that the Great Recession has had a chilling effect on venture capital groups. “The number of active venture firms is nearly one-third less than the 1,326 in 2000, according to research firm VentureSource.” At a time when the U.S. needs more, not fewer, start-ups to boost the economy and create jobs, the importance of angel and super angel investors has never been greater. To help encourage angel investors, Senator Max Baucus (D-OR) is sponsoring a bill that would eliminate capital gains taxes on money invested in start-ups and held that investment for at least five years [“Senator pushes 0% capital gains for start-ups,” by Joseph Wallin, Oregon Business Report, 29 July 2010]. Wallin concludes:

“It is a great idea, and one that will certainly be a boost for startup company investment. We need more angel investments. … It is unfortunate that the tax incentive is only for a limited time period, but perhaps it will be extended and ultimately made permanent. … We need a global, coherent legislative strategy to make the lives of startups easier and better. I like the temporary tax incentive the Senate is considering, but it would be nice if the small business bill did other things to make the lives of startups easier rather than just pass a temporary tax incentive.”

I couldn’t agree more.