Friday, February 26, 2010

Don't Forget the Angels

To become a successful space entrepreneur, you need understand the process of securing funding. Most space business plans I have read lately start with funding from a rich Millionaire/Billionaire like Bezos, Branson, Bigelow, Musk, etc. Others assume Banks or venture capital firms will give them the cash they need. We need more entrepreneurs within the industry thinking about Business Angels. But what are business angels (BA’s) anyway?

As legend has it, before venture capital emerged as an industry, wealthy men met for lunch at the club at Harvard, MIT, Princeton, Cambridge and perhaps at the diner in your home town, inviting the local entrepreneurs to speak to their group. After the pitch, the entrepreneur would then be asked to step out of the room as these groups of high net worth individuals discussed whether to invest and if so how much. The term “Angel” was first used in the early 1900’s to describe the wealthy backers of Broadway shows, making speculative (“risky”) investments in these Broadway productions. We will define Business Angels (BA) as high net-worth individuals with significant potential to invest in private equity (PE) firms.

The takeaway from the above table is not the exact amount (since that varies by individual), instead note that Business Angels play a key role bridging the gulf between F&F and VC's.  As these Angel investment groups grew more sophisticated, some Angels hired professionals to manage their risk capital fund for them. The Venture Capital Industry grew out of the formalization of such an arrangement. Business Angels as a group invest almost as much as VC’s each year ($26B in 2007 vs. $30B for VC') but spread those investments over fourteen times as many companies (57,000 companies vs. 4,000 companies).

Contrary to popular lore, BA’s are not just interested in giving money away. BA’s investment portfolio is largely (over 90%) focused in stocks/bonds/real estate with only a small portion of their portfolio available to invest in risk capital like early stage private equity firms. BA’s usually invest in the early funding rounds. Every company was a startup at first: Google, Starbucks, Berkshire Hathaway (Warren Buffet’s company), and many other household names were initially funded by these wealthy individuals. Even Bill Gates received $280K from a business angel 30 years ago.

Over time, some Business Angels banded together, pooling their money to make larger investments. The management of these funds was gradually turned over to professional risk capital managers. Funds were established with different hurdle rates. Hurdle rates are the average financial return the fund was targeting to out-perform. Some closed Funds were established with a target exit date 10-15 years after the funds creation. Ever-Green Funds act more like a corporation with no pre-defined maturity date. Over time, Venture Capital began to be recognized as its own asset class entering the mainstream of public investing (the NASDAQ stock exchange helped with this too – more exit opportunities through IPO for many of the young startups that VCs have historically been interested in funding). For the first time, venture capital funds attracted institutional investors. This change increased the amount of money available to those creating new funds but reduced the tolerance for the high risk investments the sector had been known for. These new institutional investors demanded predictable results. Raising a new VC fund quickly meant recruiting a fund manager who had proven he could achieve returns in excess of that particular fund’s hurdle rate. Although performance above the hurdle rate is not significantly rewarded, performance below the hurdle rate is severely punished. As a result, more and more VC funds look to invest in the later rounds of funding where the risk is less.

VC funds usually have a more structured process for due diligence than the average BA. Statistics indicate the average VC evaluates 500-1,000 business plans annually but invests in only two to five PE’s per year.  Both BA’s and VC’s are interested in growing the Private Equity firms they invest in. They do this in at least three ways:
  1. Money – the cash
  2. Knowledge/Wisdom – many of the BA/VC’s are past entrepreneurs themselves
  3. Connections – these guys and gals share their relationships, connecting the entrepreneurs with key people they need to know.
Here is a great quote from Ron Conway, Super Angel investor in Google, Digg, and Twitter. Conway speaks about how he can help a company (more than just with his money) and why he is okay with owning a little slice of a big pie rather than a big slice of a little pie:

“If I invest in a company I open my Rolodex for them. I help them with business development introductions. I introduce employees. I give them credibility in the fund raising process. Let’s say the company was worth $1 million when I met them and I’ve helped them with both my Rolodex and my cash and they can now raise a round of venture capital at a valuation of $6 million. I would be hurting my own interests. A $500,000 investment at a 30% discount to a $6 million round is still priced and more than $4 million and is certainly worth much less than my investing at a $1 million pre-money where I could own 33% of the company.”
Do date, NewSpace companies have largely not looked appealing to these groups of investors. Here is a few reasons as to why:

The point of the above table is that you can create an Internet startup and bring your product to market for a only a few million dollars (or less).  NewSpace companies need more cash and will take longer to bring products to market delaying liquidity events (selling the company, IPO, merger, etc.).  As more suborbital firms start flying and as Bigelow and Musk reach higher and higher, interest will grow from Angels and VCs, but to become the darling of BA/VC’s, the industry may need to make some changes as it grows to look and behave more like a high-tech startup rather than an early state pharmaeceutical developer or computer chip designer (long R&D, huge cash needs, long product cycles, etc.). I will devote a full post to this topic of some practical things we can do make NewSpace more attractive to BA's and VC's. 

Here is a few definitions you should know (DISCLAIMER: super simplified definitions – there is way more nuance in is some cases then I include. Google for the details):

Pre-Money Valuation: The value of the company prior to an IPO. The general intent of both the entrepreneur and the investor is that the pre-money valuation of the company grows with each new funding round hopefully commensurate with the reduction of risk as the company accomplishes more of its business plan startup checklist. The growth in valuation from one funding round to another offsets some of the loss due to share dilution.

Investment Funding Rounds: Companies requiring significant cash to reach an exit (e.g. IPO/Sale), break the PE’s cash requirements down into the cash needed to reach the next company milestone (e.g. passing PDR, passing CDR, I&T, first product delivery, etc.). In the U.S., these funding rounds are typically referred to as rounds A, B, C, D, etc. with the share price increasing with each new funding round. Adroit VC’s will often time their investments in a PE immediately prior to the issuance of a new funding round, increasing their share price with the next round’s increased valuation. Since young space entrepreneurs will most likely have large cash requirements, they should anticipate requiring multiple funding rounds. They have enough to start but will need subsequent rounds to take them to the next milestone.

Dilution: The quote from Conway above hinted at how dilution affected him. Business Angels, especially, risk dilution of their ownership percentage if their PE requires more than one funding round and the BA is not able to make subsequent investments in those rounds to hold their percentage ownership. This loss of company ownership due to additional funding rounds is referred to as Dilution. The hope is the increase in pre-money valuation from one round to the next can partially offset this dilution.

Hurdle Rate: although mentioned before, it is worth repeating. VC fund managers are targeting a financial return above their hurdle rate. If the stock market doubles in 5 years, that is a 15% annual growth rate on investments. Target Internal Rate of Return (IRR) for BA’s and VC’s are between 30% and 100% per PE knowing that about quarter will end in bankruptcy. Thus most hurdle rates are between 20-40%.

Since Business Angels fill such an important gap between Friends and Family and venture capital, let’s spend a minute thinking about what could be done to increase the number of BA’s in general and increase their interest in making space investments:

  • Make it easy for individual BA’s to associate with other BA’s joining BA investment groups.
  • Make it easy for BA’s to quickly evaluate opportunities
  • Help BA’s by performing due diligence on their behalf. One idea would be for Business Incubators to expand their services to include business plan due diligence on behalf of BA groups – even due diligence for those PE business plans not currently represented by the incubator. In general, greater collaboration between BA groups and Business Incubators should encouraged and expanded. 
  • Each of these first three ideas are starting to coalesce at Angelsoft. Angelsoft is an electronic way to:
    • Organize BA investors
    • Organize entrepreneurs and their submissions (same formats across entrepreneurs)
    • Track results across all BA groups
    • 500 BA groups signed up to date
    • 1000’s of business plans submitted.
    • Not currently optimized for NewSpace but I have some ideas on this.
    • I will do a full post on Angel Soft soon with more details
  • Removal of Capital gains taxes on investment profits of this type.  If small business is the growth engine of the economy, then let’s get some more of it.
  • We need the NewSpace version of this
I would love to hear your ideas.  Add a comment.


  1. I just happened to come across your blog. Nice posts. I like this one very much. They are more content oriented than the usual ones you find these days. And the best part is the simplicity in your posts and the language you use in them. I have added you to my favorites. And I will continue to pay frequent visits to your blog. Expecting more such quality stuff from you. Carry on !
    Starting A Business

  2. Colin, great post! Aside from a few small technical quibbles, I think you're right on target with both your exposition of angel history and your suggestions for the future. At Angelsoft, we'd love to hear your ideas as to how we can help to optimize things for NewSpace!

    I'm not sure if you realize it, but there is already an angel group focused exclusively on NewSpace-related deals. It's called SpaceAngels, exists 'virtually' on Angelsoft, and among the founding members were Esther 'Cosmonaut in Training' Dyson, and me.

    I'm looking forward to reading your next post on Angelsoft!

    -David S. Rose
    CEO, Angelsoft
    Founding member, Space Angels
    Investor in SpaceAdventures/ZeroG and Rocket Racing League

  3. David:

    Thanks for your comments. I am excited to see Angels focusing more on this exciting industry. Prior to posting my Angelsoft piece, i would love to get your feedback (and your ideas). if you want to drop me your email, I would be happy to give you a first read. cdoughan (at) gmail dot com.

    And I agree this post simplifies a lot (perhaps too much). I encourage everyone reading this post, if this topic excites you, there a many powerful blogs, and books on the subject that will do a much more complete job on the subject than this.

    a great blog to try is Fred Wilson is a venture capitalist in Internet startups out of NY and has some great stuff.

  4. Colin,

    While my expertise and experience is not in the same area as yours, it strikes me that your perspective is solid. Far too often I see and hear people speak about thinking outside the box when their focus really needs to be taking what they have been exposed to and begin by building a new box.

    I look forward to reading what comes across here in weeks to come.

    Larry Doughan

  5. What I found interesting here was the comparison between the high tech industry and new space. While a lot of the high tech industry (particularly the part that deals with software) has inherently fast development time and low start up costs (something that likely would not hold for new space ever), a lot of the problems with new space don't seem to be inherent problems of the field. What can be done to make the space industry more like the high tech industry?

    One well known obstacle is cost to orbit. This gets a lot of exposure in online debates (to the point of cliche), but the cost of putting things in space remains a very expensive ante to doing anything in space. The costs truly grow exponentially with delta-v required past that point (due to the additional propellant mass required). For example, if your business plan requires you to put a ton of mass on the Moon with chemical rockets, then that's probably somewhere around $50,000-$100,000 per kg (each kg on the Moon requires a considerable portion of propellant mass launched). So just to put the mass on the Moon, you are paying $50-100 million, using current launch costs and lunar landing technologies that we know work). You're already out of scope for the current discussion.

    Second, are a bunch of uncertainties that no one has yet to figure out and technologies that no one has ever used. What's interesting here is that a considerable portion of the problem is a public cost (I don't know the proper term for it, it's the inverse of a public good). If your plan requires people working on the surface of the Moon (either directly or the customer needs the people there for the product to work), then that has costs associated with it from the fact that we know nothing about the problems of people working and living on the Moon. Once someone figures it out, then the obstacle to the plan decreases somewhat (either your plan loses that cost directly or your customers face less start up costs in using your product).

    Finally (at least to my list), there's simply an absence of customers for many otherwise useful items. Why make a long duration life support system when there's only one potential customer, the International Space Station? Why build a platform designed specifically for relatively fast interstellar travel when there's no conceivable customers?

    The interesting question here is what can be done about these obstacles? Especially, if it turns out that public funds would be difficult or impossible to obtain? Keep in mind that the usual issues above are commonly discussed with respect to space program activities (eg, debates on whether NASA should be paying out prizes for commercial accomplishments like landing people on the Moon).

    The first item seems to be slowly working itself out even in the absence of any society-level organized attempt to reduce launch costs. There has been a rather slow decline in launch costs. Launch volumes seem to be growing over the scale of decades.

    The retirement of one-time risk seems far less likely to be addressed by society-level action (keep in mind that there's a host of relatively simple technologies like propellant depots, effects of low gravity on organisms, and aerocapture, that hasn't been addressed much over the past 50 years).

    The last thing, creation of new markets seems something that will require patience. Again, government has been proposed as a market creator. For example, you'll see proposals to use the ISS as a destination for manned commercial launch in order to seed a space tourism market (and other markets for manned travel to space). Growth in space activities seem to be likely to encourage new markets, if solely to better expedite the existing activities.