From the November 2006 issue of Wealth Manager Web • Subscribe!

November 1, 2006

Funding Dreams

According to Wikipedia, angel capital is what entrepreneurs depend on before they can come to the attention of traditional venture capital firms, and after they have gone through the "Three F's"--friends, family and fools. Angel investors can consider themselves the shock troops of the venture capital world, funding tomorrow's superstar companies that are mere ideas today. Although such high-risk investments can often go bust, they can also pay off spectacularly. And for wealthy investors, there are other rewards as well.

The fundamentals of angel investing are worthy of a wealth manager's attention. Not only is there the possibility of high returns, but some investments make good causes for philanthropists, and there are, in addition, opportunities to educate or mentor that many investors find fulfilling. On the flip side, of course, are "pipe dream" ideas that never reach fruition and long, tiring hours of phone calls and one-on-one meetings with entrepreneurs who are in over their heads and might do better to go to school--or at least back to the drawing board--rather than exhaust the best intentions of their mentors.

"Of course, there are always possible problem scenarios with any investing idea," says Brian Babcock, a business executive who has belonged to an angel investor network. "I've thought about angel investing from a wealth manager's perspective, and they need to understand that if their risk portfolio is all about balance, this may not be the right choice, since angel investing is high-, high-risk stuff."

High risk does not mean impossible, adds Robert "Bob" Goff, founder and chairman of Sierra Angels, a group of about 50 angel investors from Reno and Lake Tahoe with interests in clean technology. This group is one of three large angel investor networks in Nevada and California that recently sponsored the 6th Annual Silver & Golden States Venture Capital and Entrepreneur Conference in Reno, where more than 50 investors met with some 30 presenters and entrepreneurs who turned out to seek funding.

"When we talk to wealth managers and investment managers about prospective deals, we always tell them that angel investments in early stage companies are highly illiquid and typically require three to six years of patience before receiving returns of investment," Goff says. "However, more substantively, the Internal Revenue Service Section 1045 allows tax-free rollover benefits on qualified small business stock under certain conditions."

Other food for thought about angel investing for wealth managers: The Access to Capital for Entrepreneurs (ACE) Act of 2006 (R.R. 5198) proposes to create a 25 percent tax credit for accredited investors and certain partnerships or "angel pools" that invest in qualified small businesses under certain conditions. Goff says that Susan Preston, founder of Seraph Capital Forum in Seattle and an "entrepreneur in residence" at the Ewing Marion Kauffman Foundation in Kansas City, is one of the main architects of the bill. The Kauffman Foundation is home to the Angel Capital Education Foundation (ACEF), which promotes education and research in the field of angel investing. ACEF holds conferences and meetings for angel group leaders, educational workshops and seminars for individual angel investors, builds data on angel investing, and supports research to advance the field. According to its Web site (www.angelcapitaleducation.org), the foundation's work is designed to improve the quality and quantity of early-stage financing available for innovative entrepreneurs.

"[Sierra Angels] is celebrating its 10th anniversary next year," Goff adds. "What we said in our formation meetings in regard to investments is that if you look at an investment portfolio with asset allocation in a pyramid, angel investing is the high end of the tip, the very high-risk end of the pyramid. But everyone knows that higher risk can mean greater returns. The suggestion I gave our group is that none of us should consider investing more than 5 percent of our net worth because of the risk."

Babcock likens a business start-up to having a baby. "You nurture it, go through growing pains, get emotionally involved," he says. "When I started my own business, it was really like watching a child grow. I don't have the energy now to raise children, but I am probably ready for grandchildren. I think angel investors can impart a sort of grandparents' wisdom to their grandchildren or entrepreneurs that they assist."

Angel-investment gains are threefold, Babcock adds, in that the angel is advantaged, the entrepreneur is advantaged and society gains when we strengthen enterprise and bring new or improved products to market.

The pitfalls for wealth managers who steer clients into angel investing are not about "handling risk," Babcock says, but about having a good sense of risk tolerance and the tolerance allowance in the client's portfolio. To elaborate, he offers what he calls "Babcock's quick eight rules of angel investing" to share with other investors and wealth managers:

1. Even if [the investment] has yards of due diligence in place, it's still all about people, people, people. It's important to have the right chemistry and fit.

2. According to Bill Sahlman of the Harvard Business School, execution always trumps ideas. From an angel's perspective, that means once they've gotten the funding, do they have a strong work ethic? Do they have the energy to work seven days a week nurturing that great idea?

3. Is the business plan realistic? A 40 percent return on investment may be possible in the illicit drug trade, Babcock says, but the average ROI is 14.5 percent. Angel investors usually will not receive much more than that.

4. It's all about cash. Cash is essential, so keep track of your entrepreneur's "burn rate."

5. What is the exit strategy, and how do you negotiate it? From both the angel investors' and entrepreneurs' viewpoints, this can be tricky--especially if the business is family-owned. Investors need clearly defined parameters here.

6. The investment must be something fundamental that the client can relate to, and you must be certain to get all the facts.

7. Investors and wealth managers should avoid the notion that "we do this for fun." Fun, Babcock says, comes after success. When coaching angel investors, wealth managers should emphasize that if they make mistakes, they should learn from them, adjust, create new opportunities, then adjust and make new opportunities again. Investing is a system that reinvents itself, he says.

8. Both angel investors and entrepreneurs need to be aware of sweeping, long-term global economic changes, and they must keep track of the evolution of the economic environment.

"Both angels and entrepreneurs need to be astute about satisfying a customer's needs," Babcock says. "Needs create markets, and markets create businesses. In a highly competitive market that's a result of a world economic change, then that can be a bad deal in the making. For example, a foundry operation where the talent is not from a highly educated workforce will soon go offshore to China or other countries. You have to look at the business in which you are investing your money from a global economic perspective."

When Babcock started out in business 24 years ago, he was a school bus contractor in Toronto with only three contracts, no money and lots of debt. One day, a corporate CEO told him that his services were no longer needed, and Babcock went back to his mentor and angel investor for advice.

"[He gave me]the best advice he could have given me at the time," Babcock recalled. "My angel investor told me I needed to redesign how my next meeting with that company was going to take place. He said I needed a skilled negotiator with me--not necessarily a lawyer or an accountant. That's what I did, and after the CEO had to answer some difficult questions in front of his board of directors, I got my contract back. The moral of the story is, if you have a problem, work it out, deal with it head-on and get past it."

Babcock Coach Lines Ltd. (charter buses and school buses) became a household name in Canada, and his company thrived. After that fateful meeting with the CEO who wanted to drop his contract, Babcock developed a reputation as "a skillful, hard negotiator." He owes much of his success, he adds, to the advice of his own angel investor.

"I'm simply trying to illustrate that this is the kind of hair-raising stuff that can happen from an investor's perspective and from an entrepreneur's point of view," he explains.

The kind of mentoring activity Babcock received is essential to an entrepreneur's success, adds Goff of Sierra Angels. "It's not just about the angel capital," he says. "Many, if not most of our angel investors, provide advice, guidance, mentoring and more to the entrepreneurs, and in that way, they reduce risk from an ROI viewpoint and help the business become more successful."

Goff, a former Silicon Valley executive, says it is possible for wealth managers to recommend angel investing as a sort of "passive investment activity" for their clients. But this is not usually true in the majority of angel investing scenarios, he notes.

"I am a firm believer in reducing the risk of angel investing by collaborating across angel members and angel groups nationwide," Goff says. "In that way, we can tap into a broader base of expertise and provide start-up businesses with coaching and connectivity, as well as much needed capital."

Entrepreneurs are responsible for most new jobs and the inventions and innovations that take place in our country today, Goff says. "From a wealth manager's viewpoint, there is a psychological sort of income in providing that capital to the budding entrepreneur."

Returns on investment in many angel projects may be overstated historically, Goff adds, so without the passion for the work and the satisfaction that comes from helping a worthy cause, angel investing may not be the best alternative for many high-net-worth individuals. In a perfect world, Goff says wealth managers would see that angel investing is important in advancing innovation in society and the economy; entrepreneurs need this funding, and good ones can provide significant financial rewards for an investor. On the other hand, there are rewards to be had from "doing good deeds. "Our motto at Sierra Angels is 'do some good, have some fun and make some money,' but not necessarily in that order," Goff says.

Doug Erwin, CEO of Pria Diagnostics in Menlo Park and Incline Village, Calif., says his company would not exist if it were not for angel investors.

"We are a company that manufactures medical devices and diagnostic tools," Erwin says. "We started in 2002, and since then we've raised $3 million in angel capital."

Sierra Angels was one of the first angel investors to work with Erwin, who started the company virtually in the investment group's backyard at Lake Tahoe.

"Pria Diagnostics is a very capital intensive business, and we asked for the money very early-stage in our company's development," Erwin recalls. "It was a high-risk endeavor, and the banks wouldn't even begin to talk to us about it. Our choices were to self-fund, talk to angels or obtain venture capital, and the venture capitalists were not at all interested."

Because Erwin had his patents in place early, "we were not basing our request for funds on just an idea," he says. "Some of our advisors in the Bay Area suggested we go the angel capital route. At that time, there were only a handful of groups, and they were much less organized than they are now." Today, he notes, the ACEF provides a "great resource for both entrepreneurs and prospective investors."

Pria Diagnostics is currently in the process of seeking another round of financing which Erwin describes as "a pretty inefficient process that can take a lot of energy...however, some of the most efficient money we raised is through wealth managers," he says. "They make a recommendation to clients and help them place some of their client's money in angel projects...it is a bit of work for the wealth manager, but it is a real value-add for their clients."

Adds Brian Babcock, a graduate of Harvard Business School's Owner President Management Program: "I am an older generation graduate who is supposedly wiser now and can provide that needed advice along with capital. Wealth managers can do the same by steering their high-net-worth clients into angel projects that might suit their portfolios and fit with their desire to give something back to society."

Marian Chang is a freelance business journalist and feature writer based in Reno, Nev. She may be contacted at marianbiz@aol.com.

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