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How To Become ABusiness AngelPractical Advice For Aspiring

Investors In Unquoted Companies

By Richard Hargreaves

Hh

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First published in Great Britain in 2012

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ISBN: 9780857191731

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Contents

About the Author vPreface viiIntroduction ix

Part A – Angel Investing 1Chapter 1: The Basics 3Chapter 2: Deciding Whether to be an Angel 15

Part B – Investment Opportunities 35Chapter 3: Finding Investment Opportunities 37Chapter 4: Assessing an Opportunity 49Chapter 5: Investment Terms 73Chapter 6: The Enterprise Investment Scheme (EIS) 103Chapter 7: Legal Documentation 121

Part C – Managing Investments 147Chapter 8: Active Investment Management 151Chapter 9: Resolving Corporate Issues 177Chapter 10: Resolving Problems with other Investors 203

Part D – The Exit 225Chapter 11: General Principles of Exits and IPOs 229Chapter 12: Sale: Strategies and Process 243Chapter 13: Sale: The Consequences of Different Structures 263

A Final Thought 285Glossary 287Index 293

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About the Author

Dr Richard Hargreaves was educated as an engineer and conductedresearch in materials science before entering the world of venturecapital with the 3i, as it is now called, which was at the time the largest

investor in private companies in the UK. After ten years of makinginvestments in unquoted companies, he left to start Baronsmead plc whichhe developed over 13 years until its sale in 1995. During this period Richardwas involved in the development of the venture capital industry through theBVCA (the leading industry body and public policy advocate for the privateequity and venture capital industry in the UK), where he became chairman.During that period he was involved in the BVCA’s tax lobbying, which sawthe birth of the VCT and Baronsmead’s name is still on several of the bestperforming VCTs.

After its sale, he managed Baronsmead for two years before he started ClassicFund Management Ltd. He sold that company in 2004 and co-foundedEndeavour Ventures Ltd, which invests in young technology companies forits 250-strong client base of high-net-worth individuals.

Richard has nearly 40 years’ experience investing in young companies andhelping them grow. He is a highly experienced non-executive director andbusiness angel.

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Preface

Angel investment has become the UK’s most important source of equitycapital for companies seeking up to as much as £2m. That alone makesit a very topical subject.

Nowadays, it is frequently mentioned in the media and its importance to theeconomy has become apparent to government. In recognition of this,increasingly attractive tax breaks have been made available and government-supported funds, which match angel investment, have been launched.

This book covers all aspects of investing in unquoted companies as a privateindividual, or business angel, as such investors are often called.

It offers practical guidance, both to those who wish to make angel investmentsfor the first time and to those have invested before but who would like todevelop a more systematic approach than they have used previously. If youare looking to build a portfolio of investments in unquoted companies, wishto learn more about the technical side of investment – such as share capitalstructures and investors’ legal rights, or have capital to invest inentrepreneurial ventures and wish to do this in the most effective way, thenthis book is for you. It aims to help you find investments, how to assess them,how to structure them, how to manage them and finally – and veryimportantly – how to exit from them.

If the book encourages some of its readers to become involved – or moredeeply involved – with this fascinating activity and, at the same time, helpsthem avoid a few of the many pitfalls and thus improve their chances ofsuccess it will have served its purpose.

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Introduction

Many people find the idea of helping entrepreneurs enticing and areattracted to the potential financial rewards it can offer. And, as a bonus,helping a young venture succeed – be it with money, contacts or

mentoring – can be very satisfying. There are thus great attractions to beingan angel.

On the other side of the coin, the UK needs angels. Most of the economicgrowth and job creation in the UK comes from innovation and, in turn, muchof that takes place in early-stage entrepreneurial businesses. These venturesare increasingly badly served by both banks and professional venture capitaland the growing importance of angel financing to small companies, and thusto the health of the economy, is being recognised by many people – includinggovernment. As a result the government has provided increasingly attractivetax incentives to those who are prepared to take the high risks involved inangel investing.

These risks are not always immediately evident because any promoter of aninvestment opportunity will stress the upside of the deal. This book will takeyou through many of the problems you may face and offer you practical helpwith understanding them and finding ways to take sensible precautions tominimise risk.

Whatever your investment approach, you can always learn something fromthe experiences of others. The book draws on my own experiences as aventure capitalist as well as my own wide experience as an active angel andnon-executive director. Over the years I have been involved with 100s ofventures many of which, latterly, have been angel financed using the taxbenefits available for such deals in the UK. As a result, there is little I havenot seen as companies have started in life, raised money, grown, dealt with

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challenges and exited. I have tried to convey the essence of these to the reader,both in main body of the text and in the many examples and case studies.

I have had many successes and I have had many failures. So I do know a lotabout the ups and downs of backing smaller companies. And I would notswap the excitement and satisfaction of that for something less absorbing.

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How to Become a Business Angel | Richard Hargreaves

Part AAngel Investing

Chapter 1The Basics

IntroductionIn this chapter I discuss what a business angel is and how they fit into theoverall spectrum of sources of long-term capital. I also look at whyentrepreneurs like angels and often prefer them to venture capitalists.

The importance of angelsAngels

The term angel was first used to describe wealthy individuals who providedmoney for Broadway productions. Then in 1978, William Wetzel publisheda study on how entrepreneurs raised seed capital in the USA and used theterm angel to describe the investors.

Today, business angel, or just angel, is a term widely used to mean a privateindividual who invests his or her own money in early stage growthcompanies. The other principal source of long-term investment in suchcompanies is venture capitalists (VCs).

There are two fundamental differences between these two groups:

1. Angels invest their own money whereas VCs manage and invest a pool ofmoney belonging to others.

2. The individual angel makes their own investment decisions whereas a VCfirm will have an investment committee of partners who make decisionscollectively.

The scale of angel financing

You may be surprised to learn that in the USA angel financing accounts foralmost as much money invested as all venture capital funds combined – butinto more than 60 times as many companies.

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In 2010, angel funding totalled $20 billion into 61,900 companies comparedto $23 billion of VC funding into 1,012 companies. The average amount ofmoney raised from angels was approximately $300,000, compared to nearly$23m from VCs, which shows that angels are much more important than VCsat the smaller end of the market.

Technology dominates the type of venture backed but where the investmentis made varies widely from year to year. For example, in 2010 investments inhealthcare rose to 30% (from 19% in 2007) and investments in software weredown to 16% (from 27% in 2007). In the USA, Silicon Valley businessesaccount for the lion’s share of all angel investments and in the States there aremore than 250,000 active angels.

In the UK a 2009 research report ‘Siding with the Angels’, published byNESTA (an independent body with a mission to make the UK moreinnovative), concluded that business angels have grown in importance in theUK since 2000. The percentage of all early-stage deals with angel involvementincreased from 16% in 2000 to 41% in 2007. Indeed, the report concludedangels are often the only source of capital at the smaller end of the market.The report estimated that there were between 4,000 and 6,000 angel investorsin the UK with an average investment size of £42,000 per investment.

In contrast, the UK Business Angels Association (UKBAA) said on its websitein 2012:

“an estimated £850m per annum is invested by angels annually in the UK. Thisis more than 2.5x the amount of venture capital invested in early stage smallbusinesses annually. Whilst it is also estimated that there about 18,000 angelinvestors around the country, there is a need for more individuals to becomebusiness angels to provide finance to meet the needs of the growth potentialentrepreneur”.

Obviously there is disagreement in the figures here and I do not have anexplanation for the discrepancy in these two estimates of the market size.Suffice it to say, however, that the UK angel market is large and growing.

There is no doubt that tax advantaged schemes, developed over many yearsby successive governments, have been a major factor in the growth of UK

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How to Become a Business Angel | Richard Hargreaves

angel activity. In a 2011 Budget Commentary, NESTA referred to the impactof the Enterprise Investment Scheme (EIS, see Chapter 6) and stated:

◼ “Since its inception, EIS had provided 48% more finance to early stagebusinesses than the VC industry; and

◼ “EIS provided more funds than VC for amounts less than £2m. In 2006-7, for amounts up to £2m, EIS provided 63% more funding than the VCindustry.”

The commentary also cited a survey in which 80% of business angels saidthey had used the EIS at least once. Notably, 53% of them would have madefewer investments without EIS tax incentives.

Angels and innovation

Innovation and the founding of new ventures are crucial to economicdevelopment because successful new companies create both wealth and jobs.

‘The Vital 6 Per Cent’, a 2009 NESTA report, highlighted the importance ofthe small number of fast-growing businesses that between 2002 and 2008generated the lion’s share of employment growth in the UK. These businesseswere in all sectors and included established firms and start-ups, smallbusinesses and large ones.

A follow-on report in 2011 entitled ‘Vital Growth’ argued that high-growthbusinesses remain vital to the economy. However, it highlighted somechallenges that such businesses face. In particular, they have both a greaterneed for capital than lower growth firms and, ironically, may find bankingharder. Coupled with this, the report found there had been a sharp declinein risk capital funding in the UK since 2008.

Angels are an essential and growing source of funding to the smaller andyounger members (and potential members) of this high-growth groupbecause of the absence of alternative sources of equity capital.

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The Basics | Chapter 1

Where angels fit within the financing spectrumInvestment by angels is a vital bridge between start-up finance from ‘friendsand family’ and venture capital.

Friends and family

Ever since aspiring entrepreneurs have started new ventures they have neededmoney to pay for goods, staff and other things. It is a rare venture that doesnot need financial help in some way or other. The first port of call is usuallythe piggy bank – which is often empty – followed in short order by familyand friends or, as the Americans jokingly call, it FFF (friends, family andfools).

Family and friends are excellent investors as they are loyal and helpful. Indeed,in some cultures it is common for families to work closely together inbusinesses that then manage without external help partly because salariesonly get paid when there is money to do so.

However, many would-be entrepreneurs today have business ideas thatcannot be developed without substantial amounts of cash and their families,however supportive, do not have sufficient money to help them beyond a veryearly point.

Banks

Having exhausted the support of family and friends, the entrepreneurnaturally looks to their bank – or used to. In reality, though, banks have neverbeen very helpful with early stage ventures. They want readily realisablesecurity for the money they lend and firm evidence that it can be returnedfrom the cash flow of the business. Many start-ups simply cannot providethis.

Having failed with their bank, the entrepreneur often next thinks, or used tothink, of venture capital firms – an institutional rather than personal sourceof equity capital – if only because they are easy to find.

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How to Become a Business Angel | Richard Hargreaves

Venture capital

The provision of venture capital in the UK evolved dramatically during thesecond half of the twentieth century.

In the 1970s, the principal source of venture capital in the UK was what wasthen called ICFC (now 3i). ICFC was started in 1945 with a government pushand the backing of the then clearing banks. Its role was to provide long-termcapital to private companies. ICFC dominated the market until the mid-1980swhen independent venture capital firms (VCs) started to spring up likemushrooms.

These venture capital firms backed many start-ups and small ventures in theearly days of the industry’s growth. Over time though most of the industrymigrated upmarket to become today’s private equity groups because of theeasier pickings. As a result venture capital for early stage companies becameharder to find.

In contrast to venture capital, private equity groups typically buy – not back– existing large companies with predictable cash flows and partly use hugesums borrowed from banks to do so. They then hire new management whoare incentivised with significant equity stakes.

The reasons for this are compelling from the private equity firm’s point ofview. The large size of the deals means the management fees (1% to 2% onthe capital raised from institutions) pay the private equity team fat salaries.Added to this are performance fees (typically 20% of profits made after thebenefits – in good times – of heavy leverage from bank debt) that are alsolarge on big and successful deals.

All of this means the private equity principals get rich provided they hire theright management to run their companies and the economy is stable so thatleverage works for, and not against, them. The financial collapse in 2008 did,however, bring the risks of the highly leveraged deal into sharp focus.

Regrettably, today there is only a small and declining number of specialisedventure capital firms who will consider investing in small start-up or early-stage ventures and they do very few deals.

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The Basics | Chapter 1

Government-sponsored funds

Successive governments have expressed alarm at the decreasing number ofVCs who make smaller investments. To counteract this trend, both the UKgovernment and the European Community have sponsored a wide range ofproviders of equity capital for young businesses. Often, though, theavailability of this capital depends on where a business is based, or is to bebased, and the investment focus is often driven by job creation.

The problem with such funds is they are institutional in nature. They can beobsessed with due process – no doubt because they are accountable for thepublic funds they invest. They thus tend to be slow and bureaucratic. Addedto this, almost none of these funds, in my experience, seems to understandhow to structure a young company’s balance sheet.

The angel investor

The bottom line for companies wanting to raise less than £2m (and somewould say rather more) is that they find it very hard to raise equity financefrom the VC world. Which is where the angel investor comes in. Even thoughangels are rather harder to find than VC funds, they are a vital source ofcapital for smaller ventures.

As an angel, it is worth remembering how important your money can be tothe venture when you are asked to invest. You, and your fellow syndicatemembers, may be the only source of equity capital available.

Government stimulus for angel investing

Throughout this book you will find many references to the Enterprise InvestmentScheme (EIS), which is a series of tax advantages for private individuals investingin smaller companies. It is described in detail in Chapter 6.

To complement the EIS, in 2011 the government launched the Angel CoFundfor companies based in England – with Scotland and Wales having their ownregional funding through Scottish Enterprise and Finance Wales. It is a £50mfund which is prepared to invest amounts from £100,000 to £1m alongside asyndicate of angels and on the same terms. It is of particular importance thatapplications to it must come from the angel syndicate and not from thecompany that needs money.

The CoFund is discussed further under ‘Angels and syndicates’ in Chapter 3.

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How to Become a Business Angel | Richard Hargreaves

Why angels are attractive investorsHow entrepreneurs compare angels and VCs

There is no doubt that VCs have an image problem.

In May 2012 Coutts – a bank with many entrepreneurial clients – publishedthe results of a survey amongst those clients. The results were interesting.Nearly 25% of those who had never used venture capital believed it wouldincrease the risk of their business failing compared to 19% who believed VCwould help deliver sustainable growth. Ironically, of those who had used VConly 13% regretted it. This boiled down to previous users of VC being twiceas likely to use it again compared to those with no experience of it.

Coutts acknowledged that for many fast growing companies seeking less than£2m venture capital is not the best form of funding and that capital fromwealthy individuals or investment syndicates (i.e. angels) is a betteralternative. The research showed a real reluctance amongst many ambitiousentrepreneurs even to consider VC support.

The VC community should be deeply concerned by these results. On theother hand the increasing opportunities for angels to prosper are clearlyapparent when the once main supplier of equity capital is held in such lowregard.

How angels and VCs differ

It would be wrong to think of angels as just another source of capital becauseangels have a number of characteristics which are quite different to otherinvestor groups – particularly VCs.

I touched on these differences earlier in the chapter and I shall now amplifythem, together with their consequences from the entrepreneur’s point of view:

1. Angels invest their own money whereas VCs invest otherpeople’s money structured into a fund

This makes the angel a more sympathetic and supportive investor. He can bemore loyal and less brutal when hard decisions have to be made. He will alsowork harder to protect his own money – a normal human trait. An angelrarely invests only for financial motives.

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The Basics | Chapter 1

2. Angels are quick decision makers. They don’t need to consultothers when they invest – in contrast to VCs

Many angels make decisions based on an informed view of the opportunityand a liking for the management team. Due diligence is usually a softer andless bureaucratic process than with venture capital.

3. Angel syndicates can be difficult to pull together because theymake decisions independently of each other whereas a VC writesone cheque once he and his colleagues have agreed to invest

A major issue with angels is pulling the syndicate together. It can be veryhelpful to have a facilitator involved – which is what many angels’ networksand syndicate managers do.

Despite this, the VC’s ability to write one cheque does not mean he is fasterto invest. The reality is that the VC can be the slowest of all funders (see thecase study later in the chapter).

4. Angels will usually opt for a simple investment structure (theEIS requires it) and ask for simpler controls on decision making asthe venture develops

In the UK it is common to see a small amount in equity and most of themoney in a loan stock with interest and repayment. This is the methodpreferred by many VCs but it is an inappropriate structure for early stageinvestments (see ‘The benefits of ordinary shares’ in Chapter 5).

On the other hand angels will usually invest in some kind of ordinary sharesand are required to do so if they want EIS tax reliefs. This is without doubtthe best structure from the early-stage investee company’s point of view.

5. Angels can add value from their own experiences and contacts.All VCs say they can but it is not always true

In the UK, angels are often older and more experienced than most executivesin VC firms. They can offer valuable advice, mentoring and contacts to theentrepreneurs.

All VCs argue they add value but most don’t. In contrast angels are often moremodest about what they can offer, though they can be the source of a greatdeal of help.

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How to Become a Business Angel | Richard Hargreaves

The VC industry is characterised by the arrogance of its executives. In thisarea too angels are preferable, as they can appear much more approachableand sympathetic to deal with.

6. Angels are less punitive in their approach to further investmentwhen things don’t go well

VCs are notorious for being nothing less than vindictive if projections are notmet and further funding is required. That is, of course, not a good momentfor a company to go to its investors with cap in hand.

Angels, on the other hand, tend to be more understanding in thosecircumstances and the terms they then demand are often much less punitive.

***

Most of these characteristics make angels a very attractive source of capital.

The combination of quick decisions and the ability to bring directly relevantexperience to the table is particularly appealing to entrepreneurs. So is therelative simplicity of the investment documentation.

Angels are also good at following on with further money when the businessneeds it. The only major negative is that it can be difficult to pull a syndicateof angel investors together which is the reason the government launched theAngel CoFund referred to above (and discussed in Chapter 3).

Increasing numbers of entrepreneurs recognise these very positive featuresof angel investment. And that puts the angel in a strong position when itcomes to negotiating investment terms.

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The Basics | Chapter 1

Case StudyThis case study is an extreme illustration of the slowness of VCs comparedto angels.

I began negotiating with one such VC firm on behalf of a young technologycompany for a £500,000 investment in February and it completed in August.However, it was August the following year – a total of 20 months. It even tookuntil December to have an agreed terms sheet.

In the meantime a number of angels looked at the opportunity and invested,taking on average six weeks to do so.

As you might expect given the take time taken, the documentation was ascomplicated and onerous as it gets. I don’t believe for a second that thisprotected the fund investor better in any meaningful way. It was, though, asure way to start the relationship between entrepreneur and investor badly.

Learning point

As an angel you need to be concerned with whether all the expected moneywill be available and when. The lesson of this story is never take any potentialfunder’s comments about timescale at face value. Sometimes you can checkwith others who have previously worked with prospective investors how fast(or slow) they are. Always be prepared for a much slower process than youwould like.

SummaryThis chapter has discussed the importance of angels to the UK economy inthe development of innovative early-stage companies. The angel is a growingpresence amongst the providers of long-term capital and is vital whenventures need £2m or less of equity capital.

The angel is often the most welcome of all investors in a company because ofdecision-making speed, simplicity of investment structure and the ability toadd value. And angels are friendly and supportive, which is regrettably nottrue of all VCs.

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How to Become a Business Angel | Richard Hargreaves

How to Become aBusiness Angel

Practical advice for aspiring investors inunquoted companies

Richard Hargreaves

www.harriman-house.com/becomeabusinessangel

Paperback: 9780857191731eBook: 9780857192875

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