JOURNAL OF SMALL BUSINESS STRATEGY ANGEL INVESTMENT CRITERIA Richard Sudek Claremont Graduate University [email protected] ABSTRACT Start-up businesses often need external financing to grow. These new ventures frequently turn to business angel investors for capital. Angels, who are often wealthy individuals, provide early stage financing, called seed capital, for these start-up ventures. This study examines what a group of angel investors in Southern California consider when reviewing an investment opportunity, and how they prioritize their investment criteria. The study utilizes a two-phase approach consisting of a qualitative first phase and a quantitative second phase. The results of this study show that trustworthiness of the entrepreneur, quality of the management team, enthusiasm of the lead entrepreneur, and exit opportunities for the angel are the angels’ top criteria. INTRODUCTION estimate the exact size of angel investment due to its highly fragmented nature, in 2004 This study examines what business angel it was reported to total $22.5 billion (Sohl, investors consider when reviewing an 2005). This estimate puts total angel investment opportunity, and how they investments higher than formal venture prioritize their investment criteria. Angel capital investing for 2004 (Sohl, 2005). investors, who are often wealthy individuals with experience building a business, provide Angel investing has provided seed capital for early stage financing, called seed capital, for some famous U.S. businesses such as Bell start-up ventures. Venture capitalists (VCs) Telephone in 1874, Ford Motor Company in typically provide later stage financing, after 1903, and Apple Computer in 1977 (Van the angels’ investment. Osnabrugge & Robinson, 2000). Entrepreneurial ventures dramatically affect Many start-up businesses need external the U.S. economy and are the primary job- financing to grow (Tyebjee & Bruno, 1984; creating engine of our economy, providing Hisrich & Jankowicz, 1990). If these new three out of four new jobs (Ojala, 2002). To ventures anticipate quick and aggressive put this in perspective, it is estimated that growth, they often turn to angel or venture new business start-ups averaged capital investors for capital. Angels invest approximately 550,000 per month between more funds in more firms than any other 1996 and 2004 (Kauffman Foundation, source of outside financing (Freear, Sohl, & 2005). The Small Business Administration Wetzel, 1992). Although it is hard to estimates that 51 percent of private sector 89 Journal of Small Business Strategy Vol. 17, No. 2 Fall/Winter 2006/2007 output is from small business (Van of the due diligence process (Van Osnabrugge & Robinson, 2000). Between Osnabrugge & Robinson, 2000). Since angel 1995 to 1999, the Inc. 500 (the 500 fastest investors invest their own money (Benjamin growing privately held companies in the U.S. & Margulis, 2000), they are less accountable reported by Inc. magazine) created 6 million than VCs, and their lack of rigor can lead to of 7.7 million new jobs (Van Osnabrugge & poorer investment decisions. Robinson, 2000). Clearly entrepreneurial businesses are a powerhouse in the U.S. Angels and VCs also differ in their motives, economy. their entrepreneurial experience, and their expected involvement (Van Osnabrugge & LITERATURE REVIEW Robinson, 2000). In general, angel investors are much more involved with the companies Most of the literature which addresses the in which they invest than VCs, and are often start-up investment decision process has involved more in day-to-day operations than focused on how VCs make investment VCs (Benjamin & Margulis, 2000). In the decisions. (Elitzur & Gavious, 2003; Mason U.S., 87 percent of Angels have operating & Harrison, 2002). There has been little experience (Freear and Wetzel, 1991), while attention given to angel investors in the a typical VC has little or no operating literature due to its private fragmented experience (Van Osnabrugge & Robinson, nature. In fact, to the author’s knowledge, 2000). Angels typically have more this is the first empirical study addressing entrepreneurial experience than VCs; U.S. Angel investment criteria. It has been research has shown that 75 to 83 percent of difficult to locate and survey angels (Mason angels have start-up experience as compared & Harrison, 2002). However, since the late to approximately 33 percent for VCs (Van 1990s, angels have started to form Osnabrugge & Robinson, 2000). Often, organizations that help coordinate their angels will work part-time, with periods of efforts (Kauffman Foundation, 2002). Also, full-time commitment, to help entrepreneurs we can draw from the venture capital through challenging issues (Van Osnabrugge literature for angel investors due to some & Robinson, 2000). In fact, some angels are similarity of the investment process by looking to work on a regular basis at their angels and VCs. However, let us start with investments, whereas VCs rarely have the the differences between angel and VCs. intention of being involved in operations (Benjamin & Margulis, 2000). For these An important difference in the process reasons, the angel investment often becomes between how angels and VCs invest is that more personal to both the investor and the VCs perform more due diligence than entrepreneur. An angel investor is typically angels: “a recent study found that 71 percent motivated beyond return on investment of venture capitalists, but only eight percent (ROI) (Benjamin & Margulis, 2000; Van of business angels, take three or more Osnabrugge & Robinson, 2000), while VCs references, with the two groups averaging primary reason for existence is ROI. VCs are around four and one respectively” (Van in business to return a profit on the partners’ Osnabrugge, 1998). Angels perform less investment, while angels enjoy helping professional due diligence than VCs, invest another entrepreneur build a business and more opportunistically, rely more on giving back to the entrepreneurial instincts, and do not calculate internal rates community (Benjamin & Margulis, 2000; of return (Timmons, 1990; Baty, 1991; Van Osnabrugge & Robinson, 2000). In Mason & Harrison, 1996; Van Osnabrugge summary, VCs are more objective with & Robinson, 2000). VCs may have a staff of regards to financial return, less emotionally people to perform due diligence or may hire attached, and more interested in ROI. professional firms to perform all or portions 90 Journal of Small Business Strategy Vol. 17, No. 2 Fall/Winter 2006/2007 The literature suggests that the entrepreneur Carter and Van Auken (1992) found that out is the most important factor when evaluating of 27 investment criteria, VCs found a start-up (MacMillan, Siegel, & entrepreneur’s honesty ranked first, and SubbaNarasimha, 1985, MacMillan, entrepreneur’s commitment ranked second. Zemann, & SubbaNarasimha, 1987; Van Van Osnabrugge and Robinson (2000) Osnabrugge & Robinson, 2000). Arthur performed a study of European start-up Rock, a legendary venture capitalist, once investments that showed enthusiasm and said, “Nearly every mistake I’ve made has trustworthiness were ranked first and second, been in picking the wrong people, not the respectively out of twenty-seven investment wrong idea” (Bygrave & Timmons, 1992, p. criteria for angels—see table 1. 6). Both angels and VCs feel that the entrepreneur and the management team (Van Although VCs are more focused on a ROI Osnabrugge, 1998; MacMillan et al., 1987; for their limited partners, they still rank Van Osnabrugge & Robinson 2000) are the trustworthiness and enthusiasm higher than two factors that attracts them to most deals. ROI. Coveney (1996) found that lack of trust Macmillan, et al., (1985), for example, found reduces investment by angels. Timmons and that for VCs the quality of the entrepreneur Spinelli (2004) stated that the entrepreneur’s ultimately determines the funding decision. commitment and determination are more Some literature suggests that angels are more important than any other factor when looking attracted to the entrepreneur while VCs for successful entrepreneurs. Benjamin and might be slightly more attracted to the idea Margulis (2000) stated that “Some investors (Van Osnabrugge & Robinson, 2000). VCs, are motivated by the passionate commitment for instance, often feel they can attract better of the entrepreneur. People committed to a management to a deal if the deal is venture can be persuasive; they have fundamentally sound (Van Osnabrugge & enthusiasm and solid entrepreneurial vision Robinson, 2000; Ehrlich, Noble, Moore, & [p. 95]” Benjamin and Margulis (2000) Weaver, 1994; Harrison & Mason, 1992; combined the themes of passion, Freear, Sohl, & Wetzel, 1997; Macmillan et commitment, and enthusiasm. al.). Timmons and Spinelli (2004) stated that the management team can make the The themes of passion, commitment, and difference in venture success. enthusiasm are used interchangeably throughout the literature (Coveney, 1996; Some literature suggests the management Timmons & Spinelli, 2004, Benjamin & team is the most important factor (Shepherd, Margulis, 2000, Van Osnabrugge, 1998). 1999; Dixon, 1991; Macmillan et al., 1987). Hence, this study treats them as the same Carter and Van Auken (1992) found the construct relative to characteristics of the management team second only to the entrepreneur. entrepreneur in a survey of VCs consisting of 27 investment criteria. Clearly, the In addition, Van Osnabrugge and Robinson entrepreneur and the management team are (2000)