Entrepreneurs who require funding for their startup have long counted on self-accredited high net worth individuals (angels) to fill their needs, after friends and family, and before they qualify for institutional investments (“VCs”). New crowdfunding platforms on the Internet, like Kickstarter and IndieGoGo, as well as the Jobs Act of 2012, are expected by many to ramp up regular people’s ability to fund new opportunities and kill the need for angel groups.
I just don’t see it happening any time soon. I just finished a new book, “Angel Investing,” by a friend and one of the most active angel investors in New York, David S. Rose. David is also the CEO of Gust, which is an online platform for startup financing used by over 50,000 accredited angel investors, 1,000 angel groups and venture capital funds, and 250,000 entrepreneurs.
According to Wikipedia, angel investors contribute over 20 billion dollars annually to entrepreneurs in the US, while the latest figures on crowdfunding show about 1.6 billion dollars collected in 2012. Of course, both are significant, but according to Rose, angel investing is as poised as crowd funding to take off because of the same online technology, and there is plenty of opportunity for both.
He does caution both entrepreneurs and investors to skip the hype and recognize the fundamental truths of the startup industry, before joining the crowd, or joining angels:
- Most startups fail: Small business statistics have long shown that the failure rate for startups within the first five years is higher than 50 percent. Running out of money, or not getting funded is often given as the cause, but it’s often more an excuse than a reason. Thus investing in startups should always be approached as a low odds game.
- No one know which startups are not going to fail: Even David Rose, who has invested in over 90 startups, and proclaims real success, reminds everyone that there are too many exogenous factors affecting business outcomes for anyone to be able to pick only winners. Professional venture capitalists will tell you the same thing.
- Investing in startups is a numbers game: Most startup investors today will tell you to put the same amount of money consistently in at least 20 to 25 companies, if you hope to approach a target 20 to 25 percent overall return. This is called the “portfolio approach,” which counts on hitting only a couple of big winners, while the others return very little.
- What ends up, usually went down first: Because unsuccessful startups tend to fail early, and big successful exits tend to take a long time to develop, graphing growth follows the classic J-curve. This means that winning investors need to spread their investments across a long period of time, as well as across a large number of companies.
- All startups always need more money: It doesn’t seem to matter what the founders’ projections are, or how fast they believe they will turn profitable. They will need more money. Thus every serious investor reserves a certain amount of his investment capital for follow-on rounds, which allows them to stay to course to success, even with dilution.
- If you subscribe to truths one to five, startup investing can be lucrative: There is a rarified brand of successful investors who can show average IRRs of 25 percent or greater over the years. Investing can be satisfying, if not lucrative, for the rest of us, for keeping up with technology, as a give-back to entrepreneurs, and building a legacy.
It remains to be seen whether all the recent crowdfunding enhancements, including the right to general solicitation (Jobs Act, Title II), and the still pending ability to crowd fund equity investments in startup (Jobs Act, Title III), will bring more value to entrepreneurs than burden. Compliance is definitely a regulatory burden and could become a nightmare.
Angel investors have long been required to “certify through signature” that their net worth or income qualifies them to become accredited, so their burden and risk haven’t changed yet. Some investors fear that this new general solicitation rule will lead to bank statement or tax return disclosures, increase their burden, and might cause qualified angels to back out of the process.
Angel groups fear the loss of members for the same reason. Here again, the entrepreneur will be the one hurt most, by having fewer funding sources to access. I predict that angel investors, who are generally early adopters, will actually be quick to adapt to the new requirements and online systems, and will operate side by side with the new influx of non-accredited investors.
After all, investors of all types who fund entrepreneurs, starting with friends and family, have always been all about creating win-win situations. The investor wins only when the startup wins, and today’s angels can only cover about three percent of funding requests. We have a long way to go, in this new era of the entrepreneur, before angel investors aren’t needed.
Reprinted by permission.
Image credit: CC by Chester Higgins Jr.