Angel deals still represent one of the few places in the market where you can invest in a “moon shot” and ride along for the journey. Granted, there are many pitfalls along the way! As such Angels are often hard to pin down as a “group.” They very in their need to participate, their risk tolerance, and their level of altruism, something from which VC’s to not suffer. But, trends in angel investing over the years are easy to identify. Looking back, what we observe in angel investing is a trend from mostly passive investing (with notable exceptions that take very active roles in the companies in which they invest) to the modern, active investing approach and from laissez-faire to fully engaged in the diligence, negotiation, closing, and post-closing curation process.
Something happened in 2002 that changed the venture capital world: Sarbanes Oxley (SOX Act, aka SARBOX). Despite the good intentions of this Act, it disproportionately affected the VC market. Previously, a company could seek IPO at $10M in revenue. Thus many “small cap IPO’s” were constructed and value and liquidity could was created in the public market. However, once SARBOX went into effect, that number jumped to $100M because the company compliance costs alone added approximately $1.5M in overhead to the individual business. And, today, that number, in practice, is significantly higher. It introduced new liabilities for CEO’s and CFO’s, which drove executive salaries up dramatically and added substantial legal and accounting costs. So, the VC model, which depended in large part on exits through the public markets suddenly had fewer options for liquidity. Companies had to grow to several hundred million in revenue before considering public offering. To complicate matters, public companies began to unlist!
Another interesting turn in the market, likely unrelated to SARBOX, occurred when public companies began to scale back internal research and development in favor of acquiring startups that had reached organic growth levels of revenue. Rather than invested in internal R&D, which had similar success rates to the broader startup industry, they began to cherry picking $10M – $20M growth companies that had proven their business model and product/services with a well-defined customer base. Basile Peters, coined this these “Early Exits.” So, VC’s began to make bigger and bigger bets in fewer later stage companies to make their numbers work (lower risk, higher return deals in theory, though not necessarily proven in practice). This left the angel investors alone in the space.
Historically, Angels either invested in very early, pre-seed deals or they followed the coat-tails of the VC’s. It was not uncommon for angel groups to simply follow early-stage VC’s into deals. The VC’s had done the homework for them and were regarded as the “pros.” Once the VC’s began to move upstream, the angels responded by moving slightly upstream and expanded their territory to fill the gap. Thus, the incubator, now turned accelerator, was born. Accelerator programs, which generally adopt a company at a prerevenue state, invest $25 – $50k, and coach then entrepreneur/team to build a business. At the same time, the VC’s began making larger investments, typically $3M and up, ceding the territory between the accelerators and themselves to the Angels. So, Angels, in the middle, had to become the new pros in the early stage market. This was especially pronounced in the period since 2008.
What we have seen since 2008 is Angels receive the graduates from the accelerators, invest in and curate these companies, and hand them off to the VC’s. That really means the Angels had to adapt to perform deep diligence and become active investors to see returns. It also means Angels had to become very strategic with deal documents and build direct relationships with VC capital to avoid the problems that sometimes arise from VC’s cramming down Angels. So, while Angels and VC’s need each other, there is a tension between them that must be recognized. There are numerous examples of VC’s cramming down Angels that have instilled in the Angel community the drive for self-preservation in the continuum of early stage capital. In other words, Angels know that they must be prepared to drive companies further and invest more than traditional Angel sized investments to ensure they have a seat at the table and protect their investment in later rounds.
Given the propensity for Angels to have issues with cram-downs and pointy-elbowed VC’s, we see Angels investing two and three times in a company to support the company to the point they are valuable enough that hand-off can be effected smoothly with a VC . We are also seeing angel groups syndicating together to invest in companies that can exit without taking VC money. Stats show that Angel deals exit earlier in the growth stage, but also sooner in time (Peters, Early Exits). Angel deals mature in 3 – 7 years. VC deals often don’t mature for 14 years, well beyond the life of many Angel funds. So, there is clear incentive for Angels to find new exit vehicles alongside the traditional M&A path. Anecdotally, this is having a pronounced effect on the Angel industry because organized angel groups are taking on fewer new portfolio companies realizing they must keep dry powder for healthy second and third rounds.
Given the issues with SARBOX: staying private longer, fewer going public, and some unlisting, the SEC expanded the prior Reg A vehicle (as opposed to the Reg D under which almost all Angel deals are regulated) to begin to restore the small cap IPO. The SEC denies it fervently, but there are few other reasonable conclusions. With the JOBS Act of 2012, the traditional Reg A (raise up to $5M in a private equity raise from nonaccredited investors with sufficient disclosure) was expanded to create the Reg A+ vehicle that allows a company to raise up to $50M in a private equity transaction from nonaccredited as well as accredited investors in an “IPO lite” method that can, if properly orchestrated through an investment bank, result in being listed on the major stock exchanges. Obviously, the company still has the challenge of market-making, but the net result is a relatively cheap IPO that allows for a private equity investment in an entity/equity with liquidity. Voila, the small cap IPO rides again!
At the moment, we are just seeing the first to go through this process and we Angels are waiting with baited breath. This vehicle could mean that Angels, when we find that mythical unicorn, “moon shot” portfolio company can now opt to take the company to the point of organic growth and then work with an investment banker to take these companies public to obtain the liquidity we all need to drive market expansion. The traditional M&A process is not going away. But, a new path to liquidity for Angels could mean we bypass the traditional handoff to the VC’s for winning deals that really have the right mix to become a successful public company. This is clearly not a panacea; not all companies should IPO. But, it does mean that Angels have a new path to liquidity if we are ready to cease the opportunity. And, we are starting to see private equity exchanges creep closer to market, likely using blockchain technology, that will mimic the public exchanges. So, we expect more paths to liquidity in the coming years for Angels.
Copyright Eric L. Dobson 2017
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