Friday 27 May 2011, by
Venture Capital and the birth of the Business Angels
The term Business Angels (BA) was created around 1985 by Professor William Wetzel, University of New Hampshire, USA. It is indeed in the preceding years, during the 60’s and the 70’s, that BA have expanded in the USA under the effects of a law passed in 1958 by the US Congress aware of the funding problems of start-ups: the Small Business Investment Act.
This law aims to encourage individuals to invest in start-ups creation. As shown by the preambles of the law, the Americans had realized that the venture capital, while growing fast, was not the solution for this kind of funding.
Venture capital has been invented in the USA by a French emigrant, General Doriot; in the immediate post World War II, he created ARDC, the American Research and Development Corporation, which became famous through its investment in Digital Equipment Corporation: it made its shareholders rich and contributed to the development of the first Silicon Valley, the Route 128 around Boston.
General Doriot saw one of his students, Arnaud de Vitry, trying to transplant the venture capital in France in the 60’s and 70’s without much success (ERDC) but was active in promoting the tunnel under the channel.
Through the ARDC experience and others, the Americans realized that notwithstanding its name, venture capital can rarely secure the funding of a new enterprise. The business plan and follow-up costs are indeed high and a venture capital company manager is not able to commit shareholders’ money (he is often one of them but not the only one) without preliminary technical and economic studies, deliberations and decisions of the Board and follow-up check-ups which take time.
In practice, it appears that projects with investment under $2 million are rarely profitable. Moreover, not to risk lightly shareholders’ money, it is preferable to enter into the funding of a firm only when the potential of a market has been proved and when the founder has shown that he is able to manage the company toward profits.
Very soon, venture capital focused on investments over $2 million in companies able to show one or two P&L and balance sheets.
In the firm development, this leaves in a financing gap, between $50,000 to $100,000 that the founder can meet through his family and relatives (the FFF, Family, Friends and Fools), and the $2 million proposed by venture capital that most often exceed the needs of a starting entrepreneur. This hole is called "equity gap", "Death Valley" or financing gap. Allowing the innovators to overcome this financing gap is the real challenge which developed countries are facing.
The only people who were able to meet effectively this challenge are the BA, the "deep pockets", individuals who are not necessarily very rich but that are attracted by the adventures of an investment in a new business, provided that tax incentives created by the government can make these investments competitive with less risky investments such as real estate.
Business Angels and full employment
The key role of the BA in the achievement of full employment and the disappearance of unemployment has begun to be understood in France only recently.
During the 50 years when BA grew in the USA and more recently in Britain, the French employment policies have continued to run into dead ends at the point that President Mitterrand exclaimed, "We had tried everything and nothing worked":
- First, policies aimed at making the unemployed more employable; France is one of the European countries where the corresponding expenditures are the highest. But render a workforce employable without creating jobs is a policy of short sighted;
- Then, asking public institutions to fund start-ups while venture capital itself has abandoned it a long time ago (see above);
- Finally, creating mutual investment funds to finance start-ups while these funds behave as venture capital and have no reason to be more efficient.
However, with competition from emerging economies, relocation, we definitely need to create jobs through innovation (most of which are not technological) and, for this, to fund innovators who have ideas.
This is where BA cannot be replaced and have given to the US, and to a lesser extent to Great Britain, a decisive economic advantage.
We can measure the economic efficiency of BA by comparing the results of one of their favorite vehicles in the U.S., Subchapter S Corporations (joint stock companies with the tax status of individuals, thus limiting the risk of the shareholder at the level of its contribution but a transfer of profits or losses directly to the shareholder into his income tax). According to IRS publications, losses deducted each year are about $20 billion compared to earnings that exceed $60 billion.
By comparison, for €100 invested by the French Government in ANVAR (before its absorption by OSEO) and dedicated to the funding of innovation development, about €60 are refunded of which €30 are absorbed by ANVAR running costs, leaving a return of €30 to the Government - for the French Government, a return of 30% of its investment against 300% in the USA.
Profile of a Business Angel
A BA is not a very rich person: R. Gaston, in studies on the US, showed that their wealth was equivalent to the average value of 30 Renault Megane. The very rich like Bill Gates do not play in same field as BA but in the field of venture capital, as investments by BA are too small and the dispersion of their investments would cause insurmountable management problems for very rich people.
Conversely, BA are not spoilers that would deprive the innovator of its efforts. Legislation such as the English EIS limited the capital share that a BA can hold to 30%.
BA are mostly business executives, business managers or entrepreneurs who have sold their enterprise and reinvest their money.
These are not financiers because what attracts them is as much the excitement of participating to a new adventure as the prospect of making profit; and it is as much the involvement in management than the profit that motivates them. So they invest almost always in enterprises located less than 100 kilometers from their home to be able to spend a part of their weekend working on the new project. BA do not invest abroad while 30% to 50% of the French venture capital comes from or go abroad.
By repeating the anthology of young entrepreneurs at a recent roundtable, a BA “would be able to:
- understand our business (i.e. be an industrialist, not a financier)
- humanely appreciate the entrepreneur: the relationship and personal trust are vital (a structure has no feelings, but, at this stage, they must play a major role)
- by his entrepreneurial experience, to make decisions more relevant than what may come from an analysis of business plan + due diligence + investment committee
- take decisions not in line with the dictatorship of fashion (a successful business is generally not a "me-too" but takes the opposite of the obviousness: everyone agreed that it is something that an institutional investor cannot afford that as this could lead to professional dead)
- provide an understanding of the market ... and of the customers (especially open doors of large companies in particular to win a first reference)
- help to recruit the management team thanks to the quality of its address book
- assume the role of coach because “he has already been there": we terribly miss people who ask the good questions at the right time and who are able to think with us
- … and to provide, through their reputation with investors (other BA, VC - venture capital, local capital) and their knowledge of the stakeholders, the needed partners to form successive roundtables to support the business growth
We need to have in front of us a man (not a structure), able to play all these roles! and these men are now very few. The VC comes only in the later stage of development and at this stage there is no problem to find the money.
Not only processing costs of the small files (estimated at €300,000 per accepted file) prevent the VC to invest in the "early stage", but it is "congenitally" impossible for them to intervene appropriately and effectively at this stage of development: they are not equipped to make the right decisions, in the good timing and to provide the entrepreneur with what he needs and not only capital."
Some figures about Business Angels
In the U.S.A., according to the SBA (“Small Business Administration”), there would be about 25.8 million small businesses in the U.S.A. (defined as having less than 500 employees) and 671,800 were created in 2006, as reported by R. Gaston.
Over this total, BA would have invest in 49,500 enterprises for a total of $23.1 billion, or $470,000 per company (source: Professor Sohl, Center for Venture Research) while venture capital would have invested $22.1 billion in 3,008 companies representing $7.4 million per company. This shows that the BA come at a prior stage than venture capital.
In Great Britain, there are about fifty thousand BA with annual total investments that would be of several billion pounds.
In France, there are about 4,000 BA but with a total investment less than one billion euros.
One may question about the reason for such differences: they come mainly from the existence or not of tax measures encouraging or not those who have incomes or assets to invest a part of it in start-ups.
This issue is widely discussed in "financing and taxation".
To sum up, we can say that in 100 years, the risk of investing in a start-up has not changed: the number of companies that disappear after 5 years is still around 50%; however, profits have been roughly halved by various taxes, including income tax, or VAT, which did not exist 100 years ago.
This imbalance has considerably reduced the number of companies able to provide a profit expectation and hence the number of jobs created ... except when Governments have countered the imbalance by taking charge of half the risk through the Subchapter S in the U.S.A., or by allowing tax deductions as through the Enterprise Investment Scheme in Great Britain.