SME Investment - On a wing and a prayer

Finding capital for growing businesses is a critical issue. The fundraising environment, especially in the case of smaller companies, continues to be testing, and, in this regime, enterprises looking for between #20,000 and #150,000 have the toughest time.

The banks remain wedded to scoring potential investments on a basis of least risk to the investor. Venture capital, however, by its nature, is a risky business and in other cultures is offered for a promising idea or individual.

The absence of formal structures to promote concerted investment in SMEs has fostered the rise of the informal investor. The business angel, a title derived from the theatrical world where supporters of particular shows put in capital to sustain performance, has now emerged as a key player in the small business community.

Since as far back as the early 1990s, government, small firms and advisers have invested high expectations in business angels. They can provide the filling to fund growth in the so-called equity gap, where the bank says no to further cash, but where the business is too small to be of interest to venture capitalists.

Informal investments

By definition, informal venture capital is just that – a direct investment in a business by a wealthy individual. Finding an angel, however, is easier said than done. Most business angels value their privacy.

No-one wants every Tom, Dick and Harry who has a half-baked business proposition knocking at their door.

Research suggests some 60% of business angels are found through family and friends. Thus, although there has been a steady growth in angel investment through registered networking groups, in reality we have very little idea how many angels there are.

The British Venture Capital Association (BVCA) believes that there are about 5,600 business angels registered with a variety of networking groups.

Most angels do not register with anyone; the Bank of England suggests that there may be 18,000 active and potential angels out there.

Other sources have said there may be as many as 80,000. The number of angels is probably determined by the size and regularity of their investment.

For example, there may be 10,000 angels each of whom is investing more than #25,000 every year.

How much do angels have to invest? The BVCA estimates that 373 of its 5,600 networked angels invested more than #19m in the year to June 1997. As research shows, business angels invest cautiously and take a great deal of persuading.

Colin Mason, at Southampton university, suggests a ballpark estimate of current annual business angel investment activity at around #500m, in some 3,500 businesses. Mason believes that between #2bn and #4bn a year is out there, if only angels can be persuaded to invest.

Where did the business angel come from? In 1979, the Wilson report into small firms admitted that in the UK, ‘investment by Aunt Agatha’, the old name for an angel, was virtually extinct, killed by high tax rates which took discretionary capital out of investors’ hands. Research by Colin Mason and Richard Harrison first suggested that the 1980s’ drive to revive an enterprise culture created the right climate and angels were reappearing.

What is the typical deal? Patrick Coveney and Karl Moore of Oxford university suggest that the average initial investment by an angel is #70,000 and that most angels make a second investment in the business at some point; a stake of #113,000 being the average total stake. On average, the angel takes 35% of the business. Where the business makes it off the nursery slopes the returns are excellent, with an average of 58% for both the angel and the business owner.

A plethora of schemes has been set up to encourage potential angels to take the plunge. The government’s Enterprise Investment Scheme is targeted to provide convenient vehicles, with attractive incentives for angels.

Locally, almost every Business Links or TEC, has, or works with, some 43 local ‘dateline’ services, designed to marry local business angel investors and growth businesses. For instance, Techinvest provides an introduction service for private investors in the North West.

Vivienne Upcott Gill, Techinvest’s manager, says: ‘Since the launch of the service less than five years ago, small and new businesses have raised over #5m in amounts ranging from #3,000 to #500,000 with our help and contacts.’ There are a number of national agencies, such as Venture Capital Report and Local Investment Network Company that network across the country.

The banks have established a similar network.

To make business angel networks more effective, researchers have been trying to find out who the angels are and what makes them tick. Most angels can be easily stereotyped; they are middle-aged company director types. A survey by NatWest found that there are three main categories of angel investor. Patron Angels come at the top of the tree. These wealthy individuals usually have a net worth of #5m plus, either built up in business or as a family fortune accumulated over generations. Individuals in this category know that they will be targeted, and rely on informed investors coming to them.

Entrepreneur Angels make up the largest category. These are usually successful business people who can afford both to invest and take a professional interest in the business, backed by their wide experience.

The third category consists of Occupational Angels; individuals with relatively small sums, perhaps around #50,000, of life savings or a redundancy pay-off. Unlike the other two categories, this group is investing cash it cannot afford to lose. To this list should be added Archangels, entrepreneurial types who assemble syndicates of other angels.

Why do angels want to invest? The NatWest survey puts good old capital gain as the prime motivator at 88%, but enjoyment is the second motivator at 64%. Other factors fall some way behind.

Few attractive proposals

Only a small proportion of proposals are attractive to the angels. Various studies suggest that between 93% and 97% are rejected.

Why? Above all, an analysis by Colin Mason and Amy Rogers suggests that many angels start with a negative disposition and take a lot of persuading.

First, they look for five key factors: products and services with a unique selling point or competitive edge; a complimentary fit between their own skills and investment experience and the new investment opportunity; emerging markets – but not those that are highly competitive; management with a strong track record, able to minimise operational risks while maximising the up side of the investment; and a real financial commitment by the entrepreneur.

Other factors may shape a business angel’s considerations. A lower return may be acceptable if there are non-financial returns, such as interest and involvement in the project. Exit routes will be important. Most angels invest for three to five years, but they will want to see a clear way out.

The actual thought process angels use to screen proposals, however, is very fuzzy. Pre-conceptions appear to be an important part of the decision-making process. One investor quoted in Mason and Roger’s research, makes the initial comment on a proposition: ‘Rowing machines. Having been to a gym once or twice in my life, I can see the possibility …’ Such comments are not untypical of the way in which a number of potential projects are assessed.

These preconceptions can work against, as well as for, the entrepreneur.

Another investor was not sure what competition there was in the rowing machine market, but thought it was ‘quite a lot’.

Some angels use a ‘three strikes and you’re out’ approach. One or two reasons for rejection they might live with, but a third is a definite no. Having preconceptions means angels make inferences that may not always be entirely rational. Behind this there is a strong need for personal empathy with the client.

As angels are under no pressure to invest, personal preference is significant. Some have a geographic territory in which they invest, others prefer to avoid a certain trades.

William Wetzel of Babson College Massachusetts, identified that each angel is influenced by a series of ‘hot buttons’, such as personal altruism or personal interests. Thus one of Mason’s angels assesses a proposal by claiming to be ‘interested as an engineer to see how the product is different’.

With all the potential pitfalls and the failure rate of proposals, how do you maximise your chances of attracting an angel’s support?

First, many small firms will not consider a business angel in the first place. The Bank of England’s 1993 report on small firms showed that only 10% of small firms will even consider a business angel as a source of investment, of which two-thirds will take the notion no further.

If you are willing to consider the business angel route, your presentation must knock on the head as many preconceptions as possible. It must tell the investor why the product will win, why it is in the right market, what are the critical success factors and why the management team is right.

It must do this on page one. Then, you hope, the angel will read the rest.

What about the new Business Angel? The virgin angel could do worse than invest alongside an experienced angel to get to know the ropes. On their own, new angels should first be sure that they can afford to lose their investment. Experienced legal and accountancy advice is essential, as is a clear plan of how you will achieve a return from your investment. One businessman records that his business angel, ‘did a thorough job of detective work on me. He wanted to know about my track record. He also looked behind the scenes to make sure that there were no skeletons in the closet, such as bankruptcies or directorships of insolvent companies’.

Informal investors are an increasingly important means of filling the equity gap but, presently, for a limited number of businesses. The very informality of business angels may make formal efforts to maximise their investment potential extremely difficult. Yet that potential is clear.

For instance, in the US, business angel finance accounts for five times as much investment in technology-based firms as the formal venture capital sector.

David Harvey is secretary to ACCA’s small business committee.