Our Little Angels

Angel investors haven't left us; they're just scaling back their operations.
Magazine Contributor
6 min read

This story appears in the January 2003 issue of Entrepreneur. Subscribe »

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."

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

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.



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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