Private investors - so-called business angels - have long been a subterranean source of finance powering the growth of US high-tech companies.

But it now appears that the continuing growth and maturation of venture capital firms is resulting in the importance of angel financiers increasing, not diminishing. The relationship between venture capital companies and angel investors is becoming increasingly one of synergy.

According to one of the world's leading experts on business angels, Prof. Jeffrey Sohl, governments that concentrate their efforts on developing venture capital without promoting business angel markets are likely to find that they are still left with a capital gap that their high tech start-up businesses cannot bridge. It is a trap that Australia could well be falling into. See article Venture Funding; Is Australia Going Forward into the Past? and An Audience with Professor Jeffrey Sohl.

Prof. Sohl is the director of the Center for Venture Research and professor of management science at the University of New Hampshire. The center has research going back decades into the role of private investors in companies in industries such as software, telecommunications, biotechnology, energy, and environmental products. The center, in its published work, has long argued that the importance of private investors is far more important than has been generally appreciated.

Its research has found that typical angel investors are self-made wealthy individuals who have been entrepreneurs themselves, with net assets, excluding their home, of more than $US1 million. The center excludes the "friends family and fools" money from its definition of angel investors. These are people investing in corner-store type businesses that do not have an expectation of rapid growth in the value of their investment.

True angel investors are looking for serious investments that can deliver them big returns. Much of their money is going into high tech companies because the returns are high, but typically not in biotechnology, where the regulatory hurdles make risks too high. Also, they tend to invest in industries they know, and, as many of them have themselves made their fortune in IT&T companies, those industries are being fuelled most by angel money.

Sohl conservatively estimates the total amount invested by angel investors in the US at $US10-20 billion a year. Others have estimated the figure at something much higher, as much as $US50 billion, but Sohl says the figure cannot be accurately calculated and so prefers to take a deliberately low figure so as not to overstate the market.

Investment by venture capital firms has exploded in recent year from about $US2-3 billion in the early 1990s to $US12 billion in 1997. But the VC firms are investing larger amounts in a much smaller number of deals than private investors. In 1997, Sohl says VCs invested in a total of 2700 companies, many of which were companies in which they had previously invested. Angels invested in around 30,000 companies, putting in smaller amounts of money but at earlier stages -- seed or start-up funding rounds. He says the average individual angel's investment is probably $US300-500,000, but they often invest together.

A research paper published by the center in 1995 found that angels were the most common source of start-up and seed funding for technology-based companies in the US, despite the fact that there were no directories of private investors to help entrepreneurs to seek them out. Venture capital firms were another important source of early stage funding, but the most recent work by the center suggests they are of diminishing relative importance in seed and start-up capital markets.

Sohl says this is a function of the very success of the venture capital industry. The bull run on the share markets and massively successful initial public offers of companies such as Netscape and Broadcast.com, as well as huge trade sales such as Microsoft's purchase of WebTV, have fuelled a rush of institutional money into venture funds.

Indeed, so great has been the flood of money that there are even concerns that there is emerging a glut of VC funds available in Silicon Valley, with too much money chasing too few good ideas -- the reversal of Australia's long-time dilemma.

This has seen a rapid increase in the size of the funds, according to Geoff Baum, vice president of marketing for Garage.com, a recently launched internet-based early stage finance-raising business. But Baum says the venture capital firms are still relatively small enterprises, with the same number of partners assessing potential investment deals as were managing much smaller funds.

"The funds have gone from 50 to 75 to 100 million dollars, now they're starting to be 200 million, 250 million, 300 million dollars, but the partnership have gone from three to four maybe five people, sometimes the bigger ones have 10 partners. (They are not huge organisations and they are not going to become huge organisations in the next six months or year. They just can't ramp up the staffing and there's not school where you learn how to be a VC," Baum says.

The limit on the resources of the VC firms means they have not been able to increase the number of deals they can do at the same pace as the funds at their disposal have risen. This has forced them to concentrate on larger deals, in later stages of the development of investee companies, and usually with shorter time frames until they cash out, in order continue turning over their funds. "These funds have gotten so large … 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," Baum says.

"The effect of that is that the average VC deal which was about $US3million last year is now about $US5million. So there's that gap, and that's the gap that we're playing into. We're playing into the $500,000 to $US2.5 million. We're not really competing with the VCs, we're feeding the VCs," Baum says.

Garage.com represents the emergence of a new type of business that is, in effect, a hybrid of traditional angel investor groups and venture capital.

Baum says Garage.com's business is based on the belief that there is a growing number of "potential blockbuster start-ups" that are not getting the funding they need because they are "a little too early in the process and VC's wouldn't look at them". If those companies are connected to people such as lawyers who have networks with potential angel investors, they have a chance to find the investment they need from private sources.

But with the number of start-ups falling short of VC's requirements growing larger as VC's look for shorter term, bigger sum investments, those lawyers or advisers who have traditionally provided the bridge to the angel investors simply do not have the time to keep up with all the investment opportunities. Garage.com hopes to step into that gap, providing a meeting point that combines alliances with leading services providers, such as accounting, banking and legal firms, with access to the finance networks and allow entrepreneurs to present themselves for assessment by would-be angel investors.

It hopes to expand the angel investor community at the same time by allowing them an entry point into the private investment market. "We figured that there's a lot of people in Silicon Valley and places like Boston and Seattle who had made a lot of money in the last few years with all the success in high tech companies, and a lot of them would be interested in investing in start-ups, but didn't really have any idea how to go about it. And on the other side, there's a lot of start-ups who would love the money and the mentoring but didn't have an idea of how to reach those people," Baum says.

He says the idea is to use the internet to make the angel market more efficient by speeding up the process of evaluating both investors and entrepreneurs, rather than replacing any existing elements of the angel market. Its alliance with service providers is intended to give both angel and entrepreneurs quick access to those services when they are needed. "We're a value-added match-maker. We'll help people find what they need faster," he says.

But Garage.com's revenue model requires it to be more than a dating agency. Start-up companies pay a fee for service when they receive funding through the firm, but this is just to cover the costs of the service. "The cash that we get as a placement fee is basically just going to be enough to break even for our operation. It's just going to pay the rent, pay the salaries, and pay for our computers and that's about it," Baum says.

More important is the return Garage.com hopes to get from the equity it takes in the start-up companies as part of the payment for the service, just as a VC would, as well as separate investments it plans to make through its own $US2-3 million venture capital fund. The period of its investments is planned to be three to five years; "About six months to a year longer than a VC," Baum says.

There are other interesting phenomena emerging in the angel market itself, Sohl says.

He says the most interesting change he has observed in the past 18 months has been the emergence of huge angel alliances, where 100 or more investors work together to introduce deals to each other. They come together in giant venture forums, where entrepreneurs can present their business plans to an audience of wealthy individuals looking for investment opportunities.

Small groups of angel investors also commonly work together on several investments at the same time, Sohl says. Typically, four of five might each bring to the table a proposal, they invest in it together, and the original promoter of the investment sits on the board of the investee company on behalf of the group, reporting regularly back to the others. In effect, they act as tiny VC firms, pooling their financial resources and management talent, and acting as a kitchen cabinet, assessing among themselves the progress of all of the companies they have jointly invested in.

Garage,com's business and the new networking methods emerging in the angel market represent a subtle but enormously important shift in the relationship between the angel investor market and the venture capitalists. They appear to be becoming more tightly integrated. A survey report from the Center for Venture Research, released in 1996, says that it confirmed the finding of a previous study, which showed there was a "sequential complementarity" between the two investor groups, with angels providing seed and start-up funding in small dollar amounts and handing over to VC firms for subsequent fund-raising.

But the 1996 study showed there was also "contemporaneous complementarity", with VC's moving up the financial food chain into later stage investment and either leaving the start-up stage funding to angel groups or investing alongside them at that stage. Increasingly, Sohl says, angel financiers are the feed farms for the VCs.

All of which means, according to Sohl, that the quiet engine room of finance for the new economy is about to be recognised as the integral part of the growth formula that it has always been.

Additional Reading

Journal of Business Venturing 5, 1990, "Who Bankrolls High-Tech Entrepreneurs?" Freear and Wetzel.

Worth May 1998. "Pennies from Heaven" Anne Field.

Early Stage Investors: A Study of Entrepreneurial Software Ventures. Freear and Sohl 1997

Entrepreneurship & Regional Development 7, 1995. "Angels: Personal Investors in the Venture Capital Market. Freear, Sohl & Wetzel.

The Early Stage Financing of High-Tech Entrepreneurs. 1997. Freear, Grinde & Sohl.

Red Herring. October 1998. Cover Story "The New Start-Up." Brian E. Taptich.

Israeli Venture Association Yearbook 1998. "Greening Silicon Wadi" Segal & Manor