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:
- Money – the cash
- Knowledge/Wisdom – many of the BA/VC’s are past entrepreneurs themselves
- Connections – these guys and gals share their relationships, connecting the entrepreneurs with key people they need to know.
Do date, NewSpace companies have largely not looked appealing to these groups of investors. Here is a few reasons as to why:
“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.”
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