Jeffrey Sohl is the director, Center for Venture Research, Professor of Business Administration Whittemore School of Business and Economics, University of New Hampshire. The Center is a world leader in research into the size, role and significance of business angel investors, with data tracking the market over decades. In this Q&A, Professor Sohl examines the state of the business angels and venture capital markets in the United States, and makes some informed predictions about what he believes the future will hold.


How the amounts of investment define the categories
Question: What are the categories of business angel investors?

Answer: If you think of it as a spectrum where at the left side of the page is the early seed start-up and you go all the way to the right side of the pages and that would be the later stage, larger deals. Starting at that left side - the very early stuff - that would be friends, family, bootstrapping, everything that the entrepreneur might use to get started. But as you move a little further up and hit the $US50-$US100,000 threshold, up to about $US1 million or $US2 million range, that's where the angel activity is. Early stage, average deal size around somewhere like $US500,000, maybe $US300,000, somewhere within the $US100,000 to $US1-2 million range is where the angels play, on a total deal size. Clearly early stage seed, start-up stage.

Then you move to the right. Then the venture capital funds have moved tremendously to the right both in stage - they are predominantly later stage now - and size of deals. Average deal size now in the last two and a half years, the latest data is for the first two quarters of '98, has jumped from somewhere around $US2 million in '94 to now, it's hovering close to $US5 million average deal size.

So they are very, very large, later stage deals. Still risk capital, but no longer the early stage risk capital that they once provided. They've really moved out of that early stage.

Moving through the investment categories
Q: So this is not just a shift in the market, that deals in the early stage require more capital? The venture capital funds have actually moved their activity further along the spectrum.

A: Absolutely. They are predominantly later stage. These funds have gotten so large, $US100 million funds now, that they can no longer do a seed deal of a $US100,000, even a $US1 million seed deal. Because they would have to do too many of them. And the general partners can't be expected to be good at seed and later stage investing, and with the fund so large - $US5 million deal size, in a $US100 million fund - you can do that. It's 20 deals. They can't be the best of everything so they concentrate on the later stage stuff.

And then that fund turns over, and there's some pressure from the limited partners to get some returns, so they want to get some turnover in a year of some of the firms in their portfolio.



Later stage investments mean shorter terms
Q So they've actually shortened the term of their investments as well?

A: Well, because they're later stage, it's naturally shorter as well, because they're close to doing a merger or acquisition or public offering.



Due diligence and the growth of angel alliances
Q Has that also made them more conservative in the types of assessments they are doing? Do they require a higher level security?

A: No, it's still equity. It's still risk capital, for sure. Due diligence probably takes about the same. It's still longer due diligence than the angel. But, I wouldn't say the due diligence has changed any. It's just larger deal size, later stage, which means a shorter deal life. Although the VC fund itself is still around a 10 year length, but again there's many in that portfolio and they turn over within that 10 years.

But the complementary relationship is still there, where the angel deal is really the farm system for the venture capital fund. Some of the latest phenomenon we've seen is some large, large groups of angels called alliances, and some co-investing in that $US2-5 million range, a little higher than the two to six angels in a group, so there's the large groups of angels, not necessarily investing as a hundred, but large angel alliance of maybe a hundred or so angels that would put together a deal in the $1-2 million range and in many cases co-invest with a VC. Kind of fill in that $2-5 million range.

Some of these angel alliances, it's a little bit different phenomenon to some of the angel groups. These are angel alliances of maybe 100, 200 angels in a group. Very large. Relatively recent phenomenon. And what that gives them is a different entry mechanism. If an angel is going to invest in an entrepreneurial venture, they'll bring that entrepreneur to that large alliance and in a short presentation, the entrepreneur will explain the business plan. But the difference is they already have some angel money, namely the angel who's a member of this large alliance. And the other angels are invited to round out the deal. It's like a venture forum.



Syndicating for a deal
Q: It sounds almost like they have become what the venture funds once were.

A: The difference is, you've got 100 or 200 angels there but they are not all participating in the deal. There may be only a group of six to eight that syndicate for a deal. But they get exposure in a kind of venture forum format. There's a store front if you will, of what the angel group is, and yet the angels maintain their anonymity.

But if you look at the landscape, angels are still early stage, smaller deal and then they hand off that deal as it grows to the VC industry which is later stage larger deals.



A system of "farming the deals"
Q: SO the relationships, I imagine, between the VC's and the angel alliance are developing more closely?

A: The angels want a good relationship with the venture capitalists so they can pass the deals on to them as they grow, and then the venture capitalists would refer deals on to the angels that are too small for the VC's appetite. Because if that deal gets funded, then that's another deal that the VC can decide on later. So it's worth it for them to keep a vibrant farm system, if you will. The same reasons that the major leagues support a farm system. Keeps the talent going.


Estimating the size of the angels market in dollars
Q: Now there were a couple of figures I read that I wanted to run past you. In one article the estimate of the total amount invested in the US by angels was $US30-50 billion …

A: We never said $US30-50 billion. There's been some estimates that large and larger. Nobody will ever know that amount. We take a conservative approach. I'm sure we're underestimating the market, I'd feel very sure we are, but we'd rather underestimate something we don't know. We usually put that number at about $US10-20 billion per year.



Estimating the size of the VC market in dollars
Q: How does that compare with total VC investment?

A: Well, for a while there, they were about double. VC's are now hovering around $US10 billion.



Time frame for growth
Q: When did that grow?

A: About '97. I think '96 they went up to $10, '97 they went to $US12. But VC's, if you look at that $US12 billion, they are only investing in less than 3,000 companies. Last year, it was only 2,700 companies. It's a very small number of companies. And many of those would be second round, companies already in their portfolio. Whereas the angels invest probably in about 30,000 companies per year.



The average investment
Q: The average investment I read in one document was about $US80,000.

A: I would think the best way to think about it would be somewhere in the range of $US100,000 and $US1 million, and they probably average somewhere between $US300-500,000. But again, it's not just one angel in there though. They'll syndicate into groups. Maybe three, five, eight angels.



Factoring out the friends, family and fools
Q: When you are calculating these figures, are you including investments by parents, or family friends in a …

A: No. One thing we try very hard to factor out of all our research is what we call the friends, the family and the fools' money. The really early stage Uncle Harry and Aunt Harriet money. We're really looking for that arm's length transaction. A real business deal. Not a relative investing in another relative.

A lot of that relative money is investing in small businesses, not high growth businesses. You know, a dry cleaner, laundromat, that kind of stuff.



Who are the investors?
Q: So these investors, would they typically be people who had run their own business before, who perhaps had been recipients of venture money and made a poultice at some point and were now looking to place that money around? Or would they be people still running businesses?

A: Well, in the first case absolutely. That's the big profile, the cashed-out entrepreneur. They want the involvement to be with the business, but they don't want to run another business. So they still want to be involved at the early stage market, and this is a nice way for them to be involved.

For an entrepreneur to be running a business and at the same time investing and then trying to help another business run would be a little bit of a time constraint. So its typically the cashed out entrepreneur. It's not the inherited money and it's not what we call the doctor and dentist money. 'Cos that's real passive stuff.



Staying close to home
Q: And they're by and large active investors? So they get on the board and they …

A: Absolutely. And what keeps coming up in all our research is they invest close to home. Within half a day's travel time. It's a very regional phenomenon.



"Good deals don't have feet"
Q: Even in the big alliances?

A: Yeah, they won't go far afield. As they say, good deals don't have feet! They rarely go very far afield.



Multiple deals at the one time
Q: How many would each of them be involved in at any one time? Would they concentrate on one or two?

A: That's tough. We've seen in some of the research we've done they're in two or three at a time. But they're at various stages. They may still be an investor, but the company has grown and moved on the VC money. So they've kind of stepped a little bit back from that company. Whereas they'll be another one in their portfolio that's still a seed deal and they're very active.

For example, they invest in one company as a seed deal, then it grows, they still are invested in it, but the amount of hands-on would get less and less as that company grows larger and larger.



Keeping an eye for the next deal
Q: They're serial investors, then? They're looking for the next deal as each one matures.

A: Some. There's been some work done on serial investors and it appears there's a fair amount. There's no real statistic on of all the investors how many are serial investors. But it's not unusual for us in our research and for the research of others to find angels that are in two or three deals at a time.

But again, usually various stages. And the difference is, too, that in a group of say six to eight investors, one would take the lead and the others would take a little more passive role. Usually, the lead investors would perform the majority of the due diligence and have the seat on the board. So they could be invested in two or three early stage ventures, that are all at the early stage, but they would be the lead in one and not the lead in the other two. Their level of involvement would be less in the other two ventures. Their level of involvement would be through the lead investor. Whereas the lead investor, their involvement would be directly with the entrepreneur.



Leading the deal
Q: SO there would be involvement on the board but there would also be this sort of kitchen cabinet between the angels themselves? With them assigning one of the two or three of them to be more intimately involved but keeping them up to date …

A: Right. And that would be the lead person on the deal. And that lead would change. It would be the same person in the lead on each deal.



Basic profile of the typical angel
Q: What's the position of these people individually? What sort of net worth are we talking about and age …

A: We usually define it as $US1 million net worth, exclusive of your residence, is what we put as the cut off. The profiles, although they are changing, they are still predominantly white males, with some post graduate degree in the 55 year range. Now, I would suspect that, the latest research still held up on that profile, but I suspect if we went out now, the latest piece is now maybe two years ago, that we would start to see that profile maybe a little bit younger, because there are a lot of cashed out entrepreneurs. But not that much younger.



Relative wealth of the average angel
Q: So these are comfortably wealthy but not enormously wealthy people.

A: Well, some of them are enormously rich too! They are not going to place all their wealth into the deal. They are just going to use what they would define as a prudent proportion of their portfolio in high risk, illiquid investments. But there's some pretty fat net worths out there. Much bigger than I would ever get close to!



A broad collection of angels
Q: Sure. But I guess there are two popular impressions. One is that its the local doctor, dentist investing in the local dry cleaner, but the other is Bill Gates play money. But you're saying it's much broader.

A: Oh absolutely. The doctor dentist money is passive stuff. They may invest in the family, but they're not really angels, because they don't bring that value-added. They don't know anything about running a business. But I never use Bill Gates as a example, because then people think that's the average or the type, and he's really so far out. He invests. He's also still running his own business. But the classic angel has a much smaller net worth than that, although still a very large net worth, and that's their job, investing in these companies.



The other founder of Microsoft
Q: Paul Allen has an entire company devoted to this stuff!

A: Right, the other Microsoft founder. The one that cashed out. But again, his net worth is so high.



The range of time periods and equity proportions
Q: What are the types of terms of investments? What time, what proportion of equity are they looking for?

A: That varies. Certainly the terms and conditions, they know they're going to be in there for a while. They're there for the long run. Five to seven years before they cash out. But they certainly want to have some sense of an exit strategy in there because they don't want to be a minority investor in a company that's not growing. So there may be some buy back options, where the entrepreneur will buy back the shares of the investor at some pre-determined rate, some multiple of earnings or something like that.

There's usually some sense of what an exit strategy might be, merger, acquisition, IPO. The majority is the merger acquisition. Few actually go IPO.

So there's that, there's a lot of other options. Typically it's common stock, although sometimes some other form of stock instrument. Everything is equity-linked, for sure. I know the terms and conditions are a lot less formal than from a VC fund for example. A lot simpler, typically.

And as far as the percentage equity, what they try to figure out is how long is my money going to be tied up, what's the value of the company when I cash out. What's the value of the company now, how much am I putting up and how much is that related to an equity share. But it's in the 10 to 14% range, 40 being a little high.



A level of interest below 51%
Q: So they're not actually looking for a majority interest?

A: Absolutely. That's an anomaly, 51%, they never want that. Because then they're running in the business again. They're investing in the entrepreneur. They want that entrepreneur to work hard and they are going to be keeping their feet to the fire. But they don't want 51%, you rarely see that. It's around the 10 to 40, 20 to 30 probably being the most likely.



Word of mouth
Q: How do they find their investees?

A: They complain about a lack of quality deal flow. They have gatekeepers who look out for them. They belong to alliances, they belong to matching networks, they attend these clubs if you will, breakfast meetings looking for deals, there's a vast informal network of referrals, not even through formal gatekeepers but through this informal network of referrals. That's like a, hey that's a good deal but it's not in my area. They tend to invest in areas they know. The informal word of mouth is clearly a large part of the market as are these clubs and matching networks and alliances.



The gatekeepers
Q: What do you mean by gatekeepers? Who are they?

A: Gatekeepers will be sometimes hired by these groups to screen deals for them so that the gatekeeper would have to answer the phone calls and would cull out the dry cleaners and maybe investments in areas maybe like media that they don't want to be involved in, or in biotech, maybe they don't want to do any biotech deals. So they would screen for the investors and then bring to the investors those deals that meet their criteria. That's how a matching network works also.



The arrival of the big alliances
Q: When would you say this phenomena of the big alliances began to emerge.

A: I would say about 18 months to two years ago.



The favoured industries
Q: What types of industries are these people particularly looking at?

A: The key delineator is high growth. They want a high growth company that has found a niche it can dominate. But a lot of the time high growth is synonymous with high tech stuff. The big hot area is the internet right now. They're not doing a lot of biotech investing. Because what happens is time to market is so long, and without FDA approval they can get the rug pulled out on them at any time. Plus, there's not a lot of entrepreneurs who've cashed out of biotech companies, who would then be the angels to do the due diligence. It's very difficult to do the due diligence in biotech. There's some activity, but not an awful lot. Certainly, information technology, telecommunications, that kind of stuff.



Growth rates of investment
Q: What sort of rate of growth is there in the total investment in terms of the total amount invested?

A: It is almost impossible to answer that. What's my gut feeling? I would probably be right if I said it's growing at a decent percent, but it would be hard to estimate that percent with any accuracy. But certainly from what I've been observing, it's growing. If you look at the vast number of entrepreneurs that have cashed out now.



The specialisation of the venture capital community
Q: It would seem from what you are saying they are certainly becoming more important and more integrated into the established venture capital community, which itself is becoming more specialised.

A: Oh Yeah. I'm biased too, but I always feel that if you are going to mobilise a market your dollar is best spent mobilising the angel market. VC's will follow. They'll follow the deal.

But if you concentrate on the VC's, if they are successful, you'll wind up with a capital gap like everybody else at the early stage market as they do later deals. And they're just skimming. Skimming off the top of the later deals.

So if you can't get that early stage market going then you can't really get the later stage.

There are some VCs who still do early seed deals, don't get me wrong. And possibly in a new market, maybe that's the best combination, a vibrant angel market and some VCs that are playing the same role as angels do, value-added patient investing.

But if you get the early seed stage, then if they're successful, they are going to want more money, so you've got to get a later stage market going.



The role of the policy makers
Q: You'll certainly give some of the policy-makers in Australia a heart attack when they read this stuff, because the assumption has been that the VC market is the major gap that we have and that is the early stage investment!

A: Policy makers here have heart attacks too. They look at me like, what are you talking about. It's like Don Quixote and windmills sometimes! Luckily, the policy makers haven't done anything which is actually pretty good. Because the angel market has been growing and getting more publicity, so that's pretty good.

So, I'm sure the policy makers in Australia are thinking well, I get a VC fund and look at me, I'm great. Whereas if you invest the money to facilitate what you've got, I'm sure you've got a lot of wealthy people in Australia who are probably willing. And Australia's big enough that you probably have a few regions around the country that could be designated hot spots.



Where the money is going
Q: What are the particular hot spots in the States? I imagine Silicon Valley …

A: Oh yeah, Silicon Valley is right there, and Route 128 around Boston are probably the oldest. There's been some market emerging over the last several years in North Carolina, Utah, Colorado, Seattle, the spin off out of the Microsoft millionaires they call them, Austin Texas, those are some of the ones off the top of my head.

Typically, it's a decent place to live, you've got some university around there that's producing both an educated labor pool and entrepreneurs. You've got the investors, you've got the innovators and you've got the entrepreneurs. Those three pieces and the linkages together and that's your market. Some areas have one or two, or don't have them tied together.

Some states for example have been fairly unsuccessful, which doesn't surprise me. They'll start a seed fund, this is a wonderful thing for a politician to say. They invest $US100,000 in each company of about 20 companies, the companies do great for a year, then the next round comes and there's no investors around, and the company dies.

I'm a firm believer, based on the research, that it's so much better bang for your dollar to develop what you have there rather than trying to, as I say, the Field of Dreams strategy, they build something and think everybody will come to see it.



The role of the Internet
Q: What about some of these agencies fitting into the space between the VCs and angel?

A: Yeah, it's interesting. I think what people such as Garage.com is doing is great. There's about 15 or 20 of these around now, these internet matching services. And I think they'll have a place in the market at some point.

But what I'm worried about is, for some countries that are getting into this area, again, it's a field of dreams strategy. Build an internet matching service and they think the work is done. There's so much more to be done, that's one of the later things to be done.

It's connecting, finding that investor community and entrepreneur community, being grounded in that. Because it appears to me that the internet based, eventually the role will be for deal screening and that will be it. Garage.com is actually one of the better ones, from what I've seen. It looks like it's set up pretty nice. It looks like they've done their homework and that's good.

But it's only one piece and it looks like it's a tiny piece of the market right now. But it's sexy. Still, I'm afraid people go for the sexy stuff without what I consider the more fundamental foundation building that needs to be done to create a successful market. Or to facilitate any market that you have.

But if there are those potential angel investors out there who are complaining about lack of deal flow …



The limitations of the Internet
Q: Lack of quality deal flow is the thing though. And that's important. And that's one way to get it, but there's this whole vast other array of market mechanism available. The last statistic that I saw was that less than 1% of all private equity raised was raised on the internet last year.

And the other statistic that I was really surprised about was a survey of high tech entrepreneurs, so these are the ones that you would expect to feel most comfortable and be absolutely wedded to the internet, and only 15% of those said they either intended to or had any success in locating investors through the internet.

That was the more telling statistic to me. That the high tech jocks were not necessarily jumping on that as fast as they thought they would be. And I assume they know a hell of a lot more about the internet than I do.

So I think that it has its place and I applaud any efforts to help get this market going, but I just get a little fearful, and I have to be careful, I don't want to knock the internet, because I'm an electrical engineer by training and I've used the internet all my life. But it's the means to the end and it's one part of the market and I want to encourage it's development and I hope everything works at some point but I just don't see it ever being the deal maker that it may be touted to be.



A peek at the future
Q: So it may be a piece of infrastructure that the gatekeepers could use?

A: Possibly the gatekeepers. Possibly the investors themselves. But I don't think it will replace the informal market and all that stuff. I think it will hopefully be a part of it. But if I had a look in a crystal ball 20 years from now, I think the components of the market will still be the informal market, the matching networks, the clubs, the gatekeepers, the amalgamation of all those things will actually be the market, rather than any electronic trading market actually being the market.