Emtrepreneurs who launch smaller-scale enterprises know that
commercial banks generally don't lend funds to ventures with
little or no assets, customer base or sales track record. And
venture capitalists typically work with business concepts that are
already up and running with the potential for multimillion dollar
revenues. Many of the owners of smaller firms have heard that
"angel investors" can provide funding and even some
much-needed expertise and referrals for these in-between business
deals. So who are these people and what kinds of investment terms
can owners expect?
Angel investors got their name 100 years ago in New York City
when struggling playwrights--with limited financial means--had
theatrical productions funded by a wealthy and visionary individual
(usually at the last minute). It was likened to an angel floating
down from heaven with money so the show could go on. But these were
also very astute investors with a keen eye for plays with great
market potential for tremendous profitability. The bottom line is
that these angels funded productions to get in on the ground floor
of an extraordinary opportunity for financial gain. Plain and
simple, they were in the deal to make money, and in today's
business financing arena, that hasn't changed.
Many of the angel investors have made their relative fortunes in
other businesses where they had an active role in managing and
directing. They typically understand business risks, competition
from others in the proposed venture's industry, and the kind of
financial structure and performance results necessary to ensure
operating success. They expect to see their stake significantly
appreciate in value to the next stage when a bank, venture capital
fund or acquiring company puts together a larger financial deal to
support the continued growth of the firm.
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Angel terms usually are structured in one of three ways:
1. They initiate funding with a promissory note, defer
monthly or quarterly interest payments for a year or two, and then
exercise successive options at various performance benchmarks,
converting the debt into an equity position of 15 to 30 percent
(depending on the venture scope). They begin as passive creditors
during the formative launch phase, but they'll want to see
detailed financial statements every few weeks or once each quarter.
They'll also require a seat on the board of directors and will
hold the entrepreneur to a strict set of sales targets for the
first one to two years.
2. They initially take a cumulative convertible preferred
stock position. They allow the firm to defer fixed cash dividends
for four to eight fiscal quarters while holding a board seat and
keeping the entrepreneur tied to the same performance measures as
outlined in the first format.
3. They take a common voting equity position right up
front, have their place on the board and such but are also actively
involved in company management. They may want to bring in one or
two associates for 12 to 18 months to assist with the operations,
marketing and distribution launch. This can often be the best
situation for the entrepreneur and the angel. The owner gets
funding and one or more people with specific business experience to
help the business get going, and the investor gets a voting equity
stake as well as hands-on involvement in running the firm to
decrease some of the perceived risks.
Overall, the deal hinges on the quality of the relationship
between the angel and the entrepreneur. But remember, angels want
to make a huge profit on their funds given the high risk of an
early-stage venture. They'll require strict budgets and sales
goals. But for the entrepreneur willing to give up some equity and
perhaps share some decision-making, angel terms can provide an
excellent funding source for new venture development.
David Newton is professor of entrepreneurial finance at
Westmont College in Santa Barbara, California. He is the
contributing editor on growth capital for Industry Week Growing
Companies and a moderator on small-cap stocks for eRaider.com. His
books include Entrepreneurial Ethics (Kendall-Hunt) and
How To Be a Small-Cap Investor (McGraw-Hill), named November
1999 book-of-the-month by Money magazine and a 1999 Top 10
book by Forbes. His latest book is How To Be an Internet-Stock
Investor (McGraw-Hill). He has written or contributed to more
than 80 articles for publications including
Entrepreneur, Your Money, Business Week and
Solutions, and has been a consultant to emerging, fast-growth
entrepreneurial ventures since 1984.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.