News & Events

Spitzer Explains "Angel Clubs"

Reprinted with permission

Are you an entrepreneur with a good idea in search of funding? Perhaps you have heard of "angel clubs" as a possible source of capital for your company. What are these angel clubs and are they a good source of funds for you to consider?

Angel investors are individuals with sufficient capital who invest their own money directly in small businesses, typically in start-up ventures. The term is derived from the world of Broadway theater, where wealthy individuals have typically provided the funding to put together new shows. Like the investors in Broadway shows, business angel investors make very high-risk investments--there is the potential for high returns, but there is also the real possibility that the entire investment may be lost.

Unlike investments in publicly traded stocks, angel investing is a participation activity. Considerable time goes into the decision of whether to invest or not, and then the angel investor usually has a continuing relationship with the management of the company, often occupying a seat on the company's board of directors.

An angel club, as the name suggests, is a group of angel investors who pool their monetary and non-monetary resources. This pooling provides diversification to help mitigate some of the high risk, and allows the group to draw on a broader pool of expertise in evaluating proposals. The pooling also permits the investors to participate in larger deals. In this regard, angel clubs in the Corridor typically look for investments in the $50,000 to $250,000 range. For larger deals, several angel groups may work together to structure an investment. Most angel clubs seek to cash out their investments in five to seven years – typically looking for another company to acquire the venture at that point.

Angel clubs usually are seeking to invest in companies with both high risk, which is common to almost every start-up venture, and the potential for very high returns – which is not common to all start-up ventures. Unless your company has this high potential, it is unlikely to attract serious interest from an angel club. To capture the potential high returns, angel clubs make equity investments (or investments that are convertible into equity).

How do you find angel clubs? Ask your bank, your attorney, your Small Business Development Center and the John Pappajohn Entrepreneurship Centers at the University of Iowa, Iowa State and University of Northern Iowa.

Once you've found them, and you believe that your company has high potential, what do you do next? You need a business plan. You submit your business plan to the angel group's screening committee. These screening committees meet often; the committee members review the business plans and determine whether the group has an interest in pursuing the opportunity any further.

The screening committee usually applies a couple of preliminary screens to new proposals. First, is the company geographically close (within 100 miles, 200 at the most)? Angels typically require a board seat and they also like to visit their companies – so they do not wish to make investments that will entail significant travel. Second, would the group's share of the total funding requested allow it to play an active role with the company? A $200,000 investment as part of a $10 million round will not give the angel group a board seat. As a result, the angel group is likely to reject a company that is seeking $1 million or more in funding.

After the "preliminary screens" the major criteria is whether the business idea in the proposal "resonates" with the members of the committee – does anyone say "Hmm… this could really work." If the proposal fails to generate excitement from any of the committee members, it rarely proceeds any further with that angel group.

Another major criterion is whether the company has an experienced management team. Historically, there has been a view that angel investors would prefer an A+ management team with a B+ idea to an A+ idea with a B+ management team. That may have been true in the 1950s and 1960s when the business world was less competitive. No longer – now you must have both.

If some members of the screening committee express interest in the company, the company is typically invited to make a presentation to the screening committee, and a deal committee (usually two to four people) is assigned to work with the company. The deal committee will talk through almost every aspect of the company, and will review all of the numbers – past and projected. This activity typically takes several months.

If the deal committee concludes that the company has the potential the group is looking for, they will move to structure a deal. Here, the entrepreneur needs to be ready for some sticker shock. In valuing your company, the angel investor is likely to discount your future cash flows at an annual rate in excess of 50 percent. Thus, if you project that your company will be worth $1 million in five years, the angel group may value it at less than $132,000 today. That means that an angel investment of $66,000 in your company today will necessitate that the angels will own over half of your company.

How can such high rates be justified? The answer lies in the very real possibility that your company may disappear without a trace, or fail to provide any substantial return to the angel group beyond the money invested. In order to realize a moderate portfolio return, the angel group must achieve a very high rate--50 percent or higher – on the few investments that do hit their numbers.

If your company has the potential for very high growth and corresponding high returns, it will be able to accommodate the angel club requirements for return. The final deal structure is typically presented for a vote of approval by the full membership of the angel club. After approval, the closing documents are completed and the treasurer of the angel group writes a check to your company. You are launched.

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