From AZCentral’s Innovator’s Circle blog by Andrew Johnson:
Fledgling companies often turn to “angel” investors when they’re trying to fund start-up costs.
The term refers to individuals who invest small amounts of money – typically under $2 million – in early-stage firms. They hope to get a return on their investments once the firms start generating a profit.
Although such investors are more willing to funnel money to companies that are dealing with unproven technology or have a significant customer base, many still require companies to have a management team and potential for commercial success before they provide funding.
Thus, many early-stage entrepreneurs complain that they can’t get these early-stage investors to provide capital.
A study released Thursday by the U.S. Small Business Administration’s Office of Advocacy may provide a reason why some angels are apprehensive to take a risk on these firms.
The study, “The Importance of Angel Investing in Financing the Growth of Entrepreneurial Ventures,” says the majority of such investors do not experience positive returns after placing their money in the firms.
The reason, according to researchers, is that the most profitable investments typically come from companies that go public. However, “only a small portion of angel-backed companies go public,” the study says.
The study noted the difficulty in pinpointing exact returns for angels because of challenges in defining a truly representative sample of such investors.
However, the study cited other research conducted in 2007 in which 539 angel investors from 86 associations were surveyed.
Combined, the 86 groups had made 3,097 investments, from which they experienced 1,137 “exits.” An exit refers to when a company is bought by or merged with another firm or goes public. Typically such an events are when investors see the biggest return.
The average investment made by the sample in that study turned a profit of $295,000 on an investment of $191,000 in 3.52 years.
However, the median investment for this group was $50,000, and “that returned $40,000 or 80 cents on the dollar,” the study said.
The study included other information that differs from common perceptions researchers and start-up companies have about angel investing.
The market for such investments is considerably “smaller than is generally believed,” the study said. “Few companies are appropriate for angel financing, a fact that limits demand for this source of financing.”
Also, a big portion of angel investors fund their investments with debt or equity, contrary to the belief that they not as interested in taking an ownership stake in the firms they provide funding to.
Given the state of the economy and markets – this is not good press for those of us trying to raise seed funding.
As it turns out the recovery from every financial downturn has been led by small businesses. With micro businesses currently representing 95% of all U.S. firms we need to be aware that cutting off capital to “high risk” startups will deepen the current crisis… not improve it. The economy can only recover when we start developing high pay, high value jobs in the U.S. – more jobs at WalMart will not do it.
Why is this so important. Home prices are an issue because the cost of housing has increased while wages have not. Only when those numbers are brought back into balance can any real recovery take place. There are two ways to do that:
- Reduce the cost of housing
- Increase wages
The problem with the first option is that is requires tens of thousands of (more) foreclosures to bring things back into balance. Investing in small businesses is the best path to creating high wage/high value jobs which will support home prices at (something reasonably near) current values.
If all the capital evaporates from the SMB sector – specifically if individual investors (i.e., Angels) close their wallets the SMB sector will crash.
Net/net – watch the small business sector – if we start to see that sector crash we know this will be a long protracted downturn.