The Rise and Fall of the Angel Empire

April 16, 2012

9:47 am

The Rise of the Angel Investor

If the last 5 years was the Rise of the Angels, the next 5 years may be the fall of the same.

After the last market crash, many factors led to the fall of the Venture Capital (VC) Empire to pillaging hoards of angels.

  1. Market Contraction – The Dodd-Frank Act, market bubbles, hemorrhaging public stock markets, crappy venture returns, and recently-burned risk-adverse limited partners with less liquidity all led to the extinction of many VC firms. Ten years ago, there were over 2,000 VC firms. Today, that number is closer to 600.
  2. Lower Capital Requirements – Ten years ago, it cost about $6 million to create a software company. Now with open source, outsourcing, cloud computing, and more efficient programming tools, the cost to start a company has been reduced to around $1.5 million

The scarce availability of VC capital coupled with the lower capital requirements to create a company fostered an environment in which angel investors became more attractive to startups, and startup risk/reward scenarios became more attractive to angels.

  1. Angels – Lower capital requirements and fewer VCs meant that angels were less likely to suffer heavy dilution from follow-on investors.
  2. Entrepreneurs – Angels traditionally offer less onerous deal terms, more laissez-faire oversight and less intrusive deal terms than VCs.

These factors led to the rise of the angel investor. Venture investment and angel investment in 2010 was split nearly 50/50 ($23 billion in venture capital, according to the NVCA, and $20 billion in angel investments, according to the University of New Hampshire).

The Jobs Act Effect

Two provisions of the Jobs Act will have a profound and possibly chilling effect on the oh-so-hot angel ecosystem. Cooley LLP, a premier early-stage law firm with a focus on startups, venture capital deals, and IPOs, explains why:

  1. Crowd Funding – Securities laws will be amended to provide a new “crowdfunding” exemption from registration, meaning that private companies will be allowed to raise up to $1 million over a 12 month period from an unlimited number of investors, including unsophisticated investors.
  2. Private Holder Cap – Under current law, issuers are generally required to register a class of securities with the Securities and Exchange Commission (SEC) if the securities are held of record by 500 people or more.  This makes them subject to the burdensome reporting obligations applicable to public companies, including obligations to file detailed annual and quarterly reports with the SEC.

Prior to the Jobs Act, accredited investors had exclusive unfettered access to invest in the micro-cap, private company asset class. Now a whole new category of less sophisticated investors will enter the market placing smaller “Las Vegas-style” bets. This market influx of new money will duplicate the effect that uber-industrialized, oil hungry China and India had on oil prices. Demand is going to outstrip supply, and prices are going to rise.

The Rise of The Angel Effect on Higher Risk/Pre-Revenue Deals

When venture capital investment slowed, angels moved in to fill the gap. With fewer VCs, angels were presented with more quality deals. They became more discriminating and were afforded the opportunity to invest in better-quality, less risky later stage deals. The effect on entrepreneurs was a drought for the earliest stage, pre-revenue companies.

The Jobs Act is going to ease access to capital for earlier stage companies as new, less risk-averse investors enter the market. There are companies that aren’t getting funded today that probably should. Companies founded by first-time entrepreneurs that have great ideas yet lack the track-record, the contacts, the financial wherewithal to bootstrap will get funded. Hopefully this will unleash a plethora of innovation.

The Good

  • The 99% will get to participate in the American Dream of startup investing via crowdfunding
  • Innovation will be promoted when earlier stage, higher risk startups get funded
  • More jobs will be created

The Bad

  • Companies that should not exist will get funded
  • Rising valuations will increase market risk
  • There will be less outside guidance and less critical corporate governance
  • There will be corporate maleficence

Summary

I don’t have a magic eight ball view of the future, yet my prediction is that we can expect a power shift from the supply/funder side of the startup funding ecosystem to the demand/founder. I can envision a level of irrationally exuberant investing that will eclipse the Internet bubble – with less adult supervision.

In 1998, any kid with a PowerPoint landed venture funding. This time around, it will be kids with Prezi presentations. These crowd-funded companies will do without the kind of oversight provided by professional investors with a large financial stake in the company. The kind of counsel and mentorship supplied by professional investors and experienced entrepreneurs with a significant vested financial interest in crowd-funded companies will be lacking.

Angel investors will look at the higher valuations and shifting risk/reward scenarios and invest less. Angels will be squeezed by the crowdfunders below and VCs above.

The Golden Age of the Angel Investor will pass.

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Glen Hellman (@glehel), is an angel investor, serial entrepreneur, and works for venture capitalists as a turn-around specialist. He is the Chief Entrepreneureator at Driven Forward LLC, frequently muses on his blog, Forward Thinking, and works with entrepreneurs to help them figure out what to do and get them to do it.

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