John Garcia was in the right place at the right time. It was
1982 when he sold his surgical supply company to Baxter Healthcare
and started looking for investment opportunities. It wasn't
long before he found several small, private companies looking for
financial help--including a little-known retail concept called Mail
Boxes Etc.
Garcia's investments eventually returned several times his
money, catapulting him into angel investing. Now, at 45, he makes a
full-time job of connecting businesses with angel capital.
Garcia, founder of Angel Strategies in Tustin, California, has
seen the nature of angel investing change. "There was a time
when we all believed in 100 times returns. But most angels today
would be happy with 10 times--and they'll settle for 3 to 5
times."
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Tarby Bryant, founder of The Gathering of Angels in Santa Fe,
New Mexico, concurs. "Today, angels are looking for 40 to 50
percent internal rate of return." That translates to about 4
times their investment over three years.
Changing
Expectations
18%
of fast-growth companies received new financing
in the third quarter of 2002 (mostly in bank loans).
SOURCE:
PricewaterhouseCoopers
|
It's no mystery why angels have lowered their expectations.
During the heyday of the public markets, angel investors were able
to cash out when a company went public. The public was paying big
bucks for small-company stock, and that unlocked huge gains for
angel investors. But today's successful small business is more
often acquired by a larger company--at a price that is sometimes
below average because of overall economic conditions.
The decline of the IPO market has brought another significant
change to angel investing. Rather than count on any kind of
investment liquidity, many of today's angels are looking for
something almost unheard of in the past: dividends. "Angels
may be willing to forego higher return if they can get some part of
the revenue stream on the back end," according to Garcia.
Today's savvy investor simply has more conservative
expectations. Unfortunately for the entrepreneur, lower expected
returns are accompanied by lower initial valuations. Just as all
boats rose with the IPO tide, all boats fall as that tide
recedes.
In fact, valuations of private companies have fallen right along
with those of public companies. Entrepreneurs won't get top
dollar for their private stock, as Garcia points out, when public
stocks like Microsoft and Oracle are trading at 30 to 50 percent
below their highs.
Tightening the Belt
Falling public exchanges have a double impact on companies seeking
financing--not only devaluing private stock but also wiping out
vast amounts of angel capital. Garcia estimates Angel Strategies
investors lost an average of 50 to 60 percent of their net worth
during the declines of 2001 and 2002.
When private investors see their portfolios shrink, they become
more conservative. These days, money that might have gone into
early-stage, private investments is headed to safer harbors like
real estate, CDs and mutual funds.
As investors lick their wounds, offer them less risk and more
reward. "The new ideal," says Garcia, "is to be
profitable in year one--and by year two, to have excess profits for
reinvestment."
Businesses that can show strong sales growth, share profits or
offer creative exit strategies will have better chances with angel
investors. Today, entrepreneurs who ignore investors' demands
for strong sales and profits do so at their own peril.
The Good News
Despite being somewhat pickier in their deal-making, angels are
giving entrepreneurs reason to hope.
As venture capital investments decline (see "Dollar
Signs" from December 2002), many angels are aggressively
seeking to fill the gap. "Fewer VC dollars means better deals
for angels," explains Bryant, who sees more and more
individual investors stepping up to the plate.
The level of activity is also on the rise within Garcia's
Angel Strategies group. In 2002, the group closed more deals than
in the previous two years combined. The success of such groups as
The Gathering of Angels and Angel Strategies, which bring
individual investors together to find, evaluate and nurture growing
companies, is an encouraging sign. Similar groups are popping up in
almost every city. If your banker or lawyer can't point you
toward one, contact a local VC or SBA office.
Entrepreneurs have a better chance of finding interested angels
when they're presenting to one of these groups. Further, when a
deal is done, companies also stand to benefit from the collective
expertise that such organizations offer.
Devil's in the
Details
Any business that is looking for financing these days should not
overlook the huge opportunity that angel investors present. Whether
individually or in groups, angels are an important source of funds
for entrepreneurs--perhaps even more so now that VCs have pulled in
their horns.
Be prepared, however, for an angel to take a long, hard look at
your business and financial plans. Few investors will be fooled by
a promise of a quick IPO, and many might prefer a reasonable,
steady return on their capital. That, plus a realistic valuation
and a reasonable assurance of return, will go a long way toward
attracting today's individual investor.
| SIGNIFICANT VALUE | |
| If you found a private
investor today, what price would you put on your company's
stock? It's a key question that can make or break a deal, and a
reasonable value is one of the first things that an angel investor
looks for. Valuations of private companies fluctuate along with stock
prices on the public markets. They are also impacted by general
market conditions as well as industry-specific trends. Setting a
valuation during investment negotiations is often described as more
art than science. Still, there are basic calculations that will
help entrepreneurs and investors start their negotiations on common
ground. Tarby Bryant, CEO of The Gathering of Angels, starts with the
company's projected third year net after-tax operating income.
"I take that, times the particular industry multiple, to get a
future value for the company. Next, I discount by the
investor's expectation of a 50 percent internal rate of return
to bring the valuations back to today's net present value
(NPV)." But even that valuation is too high for most young companies,
he laments. Based on the entrepreneur's experience and
management skill, Bryant discounts NPV further by 30 to 90 percent
for management risk. If the entrepreneur and the investor understand and agree to
this equation, then a fair valuation will result from focused
discussions of just two main issues: the investor's expected
return and the strength of the company's management
team. |
David Worrell is an early-stage finance and strategy
specialist in Charlotte, North Carolina. Contact him at david@plan2ipo.com.
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