Why Angel Investment Is Ripe For Disruption

Having been an entrepreneur for seventeen years and having sought seed funding numerous times, I have long wondered why the seed-stage fundraising process is so difficult and unrewarding. The answer lies in a set of artificial market conditions that have warped expectations and the definition of ‘normal’ for so long, few even think to question them. But a series of technological and regulatory changes promise to undo eighty years of wrong return us to a more ‘natural’ state.

1933 Regulations in 2013 Conditions

In 1933, it was decided that the public needed to be protected from purchasing stock. The number of stockholders of record in the United States had increased from 4,400,000 to over 18,000,000 in the period between 1900 and 1928, and public opinion held that the crash of 1929 had been driven at least in part by deliberate fraud on the part of stock swindlers. Anecdotes to this effect were used in rationalizing the Federal response, to great effect.

The result was the 1933 Securities Act, which said that companies looking to raise equity had two choices: they could either A) register with the SEC and offer shares to the public, or B) raise funds from people who didn’t need SEC protection. That law created the idea of an “accredited investor,” defined as:

any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000…[or] any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

The rationale was this: if you were worth a lot of money you knew the risks of investing and if the investment failed it was your problem, not the SEC’s. Putting aside the fact that mere aggregation of wealth did not in and of itself equate to sophistication (Paris Hilton is an “accredited” investor, while Craig Newmark (of Craigslist fame) is not), what the SEC regulations effectively did to was prohibit people who weren’t already wealthy from investing in companies that weren’t already well-established.

What’s interesting is that the 1933 SEC regulations didn’t exclude the non-rich exclusively. In response to the anecdotal ‘fraud swindler’ problems, the SEC rules actually focused significantly on the way stock was offered to investors, and whether potential shareholders had enough information to estimate an investment’s risk, return, and their position in the shareholder pool. In other words, it was the lack of available information that presented the greatest risk to investors. 1

One of these anecdotes concerned George Graham Rice, who at one point “touted the stock of Idaho Copper, a corporation … [whose] property consisted of a water-filled, abandoned mine, the entrance to which was so overgrown that the federal investigators had difficulty locating it.” His investors had little information other than the information he provided to check out the validity of his claim, but apparently invested aggressively.

One might argue (the SEC did) that the difference between a responsible investment and an irresponsible one is the amount of information the purchaser knows at the time of the investment. In 1933 and for most of the 20th century, the ability to provide or regulate that information was expensive and inefficient. In fact, once the vague 1933 regulations were in place it became clear that regulating the information provided to investors when stock was offered was extremely difficult. For two generations the issue was never satisfactorily addressed with subsequent legislation, so the ‘accredited investor’ definition became the de facto barrier to participation by the public in early ventures.

And then the startup revolution happened.

Starting with Hewlett-Packard and extending through Apple, the dotCom boom of the 1990s and the current web/social media/mobile explosion, it has become clear that startups have the potential to create enormous wealth, quickly, starting from nothing. Perhaps more importantly, the cost of starting a company has been steadily decreasing.

So remind me again why only wealthy people get to benefit from them?

If you’re an entrepreneur these days, there are only two realistic ways to get your venture from concept to market: fund it yourself (or among family and friends) or find angel investors. By definition, angel investors are wealthy enough to have crossed the ‘accredited’ threshold, which by definition excludes 97.13% of the U.S. population (2005 U.S. Census Data). In today’s world, this restriction creates an environment where the number of ventures (supply) vastly exceeds possible investors (demand). Economic theory dictates that when demand exceeds supply, prices go up, which in this case manifests itself in the difficulty early-stage ventures encounter in finding funding sources and in the valuations investors are able to demand for their participation.

In fact, this situation has been in place for so long that it is regarded as normal and fair that the contribution of an entrepreneur who is putting their intellectual property, business and product and industry acumen, opportunity cost and personal savings on the line for a company is regarded as more-or-less co-equal to the contribution of simple cash. This has been true so long it goes by without question. How much of this expectation is fair and how much of it is a result of an artificial constraint created by the SEC in 1933? If the environment for early-stage capital was more competitive, would the contribution of the entrepreneur be valued more highly?

Putting aside economic arguments – isn’t there a moral argument here? Accredited investors, already wealthy, have their pick of ventures to invest in and can demand disproportionately large shares of the equity pool, while a knowledgeable, eyes-open investor making $100K/year is prohibited from putting in $5000 of their savings into a venture created by someone they don’t already know. If successful, accredited investors get richer and get to invest even more. And that privileged position is protected by law.

The Inefficiency of The Seed Capital Marketplace

The historically and artificially small size of the seed capital pool has led to other negative conditions:

  • Lack of Transparency. Because the balance of capital-to-venture is artificially out of whack, there is little market pressure to make the analysis, management and disclosure of seed-stage ventures more efficient. In a protected market, angels can take their time (angels spend an average of 3.5 months conducting due diligence on each investment), and even collude with each other before deciding to invest. Angel communities are notoriously insular and parochial (70% of angel investments are made within 50 miles of the investor’s home), relying on personal and idiosyncratic due diligence methods.
  • Difficulty of Diversification. The lack of transparency has another side-effect: it makes it extremely difficult for seed-level investors to club together to make investments.  On average, angels invest in around 10% of deals they consider, and most only do a handful of deals per year. In any other marketplace, doing such a small number of deals would constitute a deplorable diversification risk, and yet in the angel community it’s considered normal. Why not place more, smaller bets? Angels will tell you two things when asked about this: 1. due diligence is hard, and 2. there aren’t enough deals.
  • Disproportionately High Expectations of Return. If an investor is only placing one or two bets per year, they need to achieve a higher aggregate return to offset the risk. Given the early stage of these deals and the dilution of future investment, angels of necessity seek deals with blockbuster potential. A recent study showed that angels expect a 26% average annual return from their investments, and most cite ” insufficient growth potential” as a prime reason for passing on deals.For those ventures that do convince an investor of their potential to deliver a 26% (or greater) return, it stands to reason that the constant investor pressure to do so of necessity drives ventures to take higher risks … which logically leads to higher failure rates. (David Heinemeier Hansson writes about this eloquently here). Is there any question that ventures have a 56% failure rate when they are being pushed by their investors to ‘swing for the fences?’ Imagine the startup choosing between a low-risk strategy that promises a 15% return, and a high-risk strategy promising 30%. With angel investment on the books, which approach will the company choose?

Now look back at the fact that angels only invest in 10% of the deals before them and cite “insufficient growth potential” as one reason they pass. Ventures promising less risky, more modest growth are competing against ‘swing for the fences’ ventures for the same limited pool of capital.

Why Incubators Seem to Work

Which brings us to incubators. Over the past 24 months we’ve seen an explosion around the country of incubators and accelerators, promising headstarts for new seed-stage ventures. Entrepreneurs are responding in droves. Places like Kansas City and Honolulu, Hawaii, never known for their startup culture, are buzzing with clever entrepreneurs incubating great ideas.

And yet when those great ideas go looking for capital, they encounter a limited angel investor community and all that momentum just stops. Think of the wealth that is destroyed when a startup shuts its doors for lack of capital, the entrepreneurs taken out of the startup environment and plunked back into less creative professions, and the great ideas that ‘failed’ for the wrong reasons.

To prove my point: the survival rate for startups outside incubators is 44%, while the survival rate for incubated companies is more like 87% (as of 2010). The definition of ‘survival’ is ‘still operating five years later,’ and it stands to reason that at least part of the reason incubated companies survive is that they find capital more easily. Why? Do we really believe that the coaching accelerators provide can double the odds of a venture’s survival? Or do incubated companies survive because they find more and better outside investment? This is a correlation-is-not-causality question: are incubator alumni finding investment because they’re better? Or are incubator alumni better because they find investment? Having worked with both incubated and non-incubated companies, I would bet on the latter.

Again, this effect is a function of the nature of the seed-stage investment community: being artificially small and inefficient, angels concentrate their attention around accelerators as a shortcut for finding deals.

Correcting The Mistakes of 1933

Although ostensibly touted as protection of the general public, one of the clear beneficiaries of the 1933 Securities Act were accredited investors. (One would be forgiven if one speculated that one reason things have changed so little since 1933 is because these investors worked hard to maintain their protected status. One could also argue that the reason the SEC has delayed so long in implementing the law is due to lobbying by that very group.)

The modification of these archaic restrictions (when finally completed by the SEC) will have several positive outcomes:

  1. A vastly broader pool of investment dollars for early-stage companies
  2. More transparency around ventures, both before and after investment
  3. The opportunity to efficiently aggregate and diversify investor dollars
  4. More reasonable return expectations for both entrepreneurs and investors
  5. A higher early-stage venture survival rate

All of these results are effectively possible due to a vastly more efficient information distribution system, i.e. the Internet. The impact on the economy of the United States, as discussed at length during the generally non-controversial and shockingly bi-partisan debate over the JOBS Act, would be vast.  The sooner we can correct the technological mis-steps of 1933 and move forward into the modern era, the better.

(Interesting sources I found while writing this:)

  • http://works.bepress.com/cgi/viewcontent.cgi?article=1010&context=elisabeth_keller
  • http://lawreview.wustl.edu/inprint/86/3/finger.pdf
  • http://online.wsj.com/article/SB10000872396390443720204578004980476429190.html
  • https://www.equitynet.com/blog/angel-investors-vcs/
  • http://37signals.com/svn/posts/2874-the-problem-with-the-tech-worlds-swing-for-the-fences-approach
  • http://smallbiztrends.com/2012/12/start-up-failure-rates-the-definitive-numbers.html
  • http://techcrunch.com/2012/09/30/why-angel-investors-dont-make-money-and-advice-for-people-who-are-going-to-become-angels-anyway/

 

Michael Sattler

With a career spent in founding and technical leadership roles with new and enterprise-level organizations, Michael Sattler is a veteran in technology strategy, operations, and product management. He’s spent decades in B2B and B2C SaaS product development, software and application design, engineering operations, new venture creation, and innovation practices.

He has scaled and managed technical teams from 2-50+ across three continents, led large-scale cross-functional program management, and founded or co-founded six companies.