Angel investors, individuals or informal groups who put their own money into business startups, are slowing along with the financial markets, but they’re still a viable option for small enterprises with solid business models and prospects for rapid growth.

Angel investors usually acquire an equity position. Angels don’t have a prior relationship with the entrepreneur, which would make them a friend or family investor.

“During the last three months of 2008, the angel market dried up just like a lot of the economy,” says Steve Solomon, a partner at venture capital firm Accrue Sports and Entertainment Ventures.

“It’s a difficult time to figure out the future, but I see strong investment opportunities, because investors will have the ability to strike deals with lower valuations.” In other words, entrepreneurs who value their companies at reasonable levels can still find angels.

The average angel investment in the first half of last year totaled $537,000, according to the latest data from the University of New Hampshire’s Center for Venture Research. Total angel investment registered $12.4 billion during that period, with 23,100 businesses receiving money.

The angel investment market is about the same size as the venture capital market, but it is dwarfed by the friends-and-family market, which amounted to $139 billion in 2004, the latest period for which there is definitive data, according to Scott Shane, author of the book “Fools Gold? The Truth Behind Angel Investing in America.”

Overhyped?

So, he says, “the angel capital market is important in that it finances high growth companies, but it’s not a huge market.”

Shane, a professor of entrepreneurship at Case Western University, says angel investing receives outsized attention because it is sexy, just like venture capital investing, and has helped launch some big name companies such as Google.

Given the riskiness of their investments, angels aren’t willing to settle for moderate success. “They want a 20 percent annual return to make up for a lot of zeros in their portfolio,” says Jeffrey Sohl, director of the University of New Hampshire’s Center for Venture Research. “It would help entrepreneurs if they understood that mind-set.” Angel investors generally hold their positions for five to seven years.

Shane says business owners should realize it generally will be much easier for them to get money out of a bank or a trade creditor than an angel investor. “Typically, small businesses should focus on that. Most kinds of entrepreneurial businesses can’t generate the kinds of returns that make sense to get external investors.”

Moreover, angel investors may gain enough control of your company to push you aside if a dispute arises. If you just borrow money instead, you don’t have to worry about that.

The importance of sector

The most popular industries for angel investors in the first half of last year were software, which accounted for 18 percent of money committed; health care/medical equipment at 17 percent; and industrial/energy at 10 percent, perhaps reflecting the current interest in environmentally friendly technology. Biotechnology, retail and media rounded out the top six.

With the Obama administration’s massive financial stimulus package, entrepreneurs would do well to seek angel investors for companies that can benefit from the increased government spending, says Nick Robbins, chairman of the Angel Investment Forum of Florida.

“Infrastructure, technology, health care and energy companies could do well — if you have a software program for road construction, for example,” he says. “Your business model should be situated for the current economy.”

Shane puts it in stronger terms. “You really have to figure out if your business is appropriate for angel investors. A lot of people are just wasting their time.”

Stephen Sammut, a lecturer at University of Pennsylvania’s Wharton business school who also has been an angel investor and entrepreneur himself, identifies several types of angel investors. More and more angels are teaming up with each other rather than investing alone.

Perhaps the most sophisticated angel group is the Silicon Valley’s Band of Angels. “They made their own wealth through technology ventures,” says Sammut, now a partner at venture capital firm Burrill & Co.

“They understand the dynamics of how these companies work — what kinds of research and other advances are necessary — and they understand the continuum between angel investing and venture capital.” Investment from friends and family comes first, then angels and finally venture capital.

Assessing angels’ value

At the other end of the sophistication scale are wealthy individuals ranging from doctors to lawyers to owners of retail and manufacturing businesses. “These angels, especially those with significant managerial experience, can be of tremendous value to the entrepreneur” as advisers, Sammut says.

The mental value of angel investors is nearly as important as their monetary value, experts agree. “Angel investors are generally looking to get involved in the business,” Robbins says.

“They are de facto agents or helpers for the business who can bring expertise sitting on the board, for example. The big issue is to be patient to make sure the person is the right fit for your business. If you’ve started a telecom company, you would prefer having a retired Lucent executive rather than a radiologist.”

Remember that you give up an equity stake in your company in return for the angel’s money, so you want to make sure you get a full return on your own investment.

Some angel investors want warrants and options on top of their ownership shares. Sammut recommends against these deals if possible, to avoid complicating the ownership structure.

One way to avoid them is by valuing your company at a realistic level, so angel investors don’t think they need anything beyond their equity stake to justify the investment. In light of the country’s financial and economic crisis, your valuation of the business may have to come down.

A low valuation would be part of the pull for an angel investor in this market environment. “This is a good time for angel investors, because valuations aren’t robust,” Robbins says.

Strategies for appeal

Shane points out that you will have to use different strategies for finding individual angels as opposed to groups of angels. “Groups are organized and looking for deal flow,” so they are easier to find, he says. Online searches should turn up groups in your area.

“For individuals, you have to network your way to them. Part of that is knowing what you’re after. Individuals aren’t generally interested in cold solicitations,” Shane says.

Angel investors tend to look more favorably upon entrepreneurs who are willing to invest some of their own money in their companies. “Angels like to see someone with skin in the game and serial entrepreneurs who have experience, even if it’s just as an investor,” says the University of New Hampshire’s Sohl.

And a checkered past doesn’t necessarily represent a disadvantage, he maintains. “If entrepreneurs went bankrupt in the past, that’s often seen as an asset rather than a liability, because they have learned — as long as they don’t blame it on everyone but themselves.”

Of course the most important factor in making an angel investment work is finding an investor whose aims exactly match yours — “vision alignment,” as Sohl puts it.

“This is a marriage without a divorce,” he points out. “The choices are just bankruptcy or an exit for the investor. If you have conflicting interests, that’s a disaster. Unfortunately, most entrepreneurs jump at a check. You must remember that vetting is a two-way street.”

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