The anatomy of angel networks

Herding is critical to angel funding

Lessons learned from entrepreneur by David Saad
July 20, 2008 last edited July 22, 2008
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(Note: This was republished to highlight due to its popularity)

There are four main sources of funding including:

  • Angels like relatives, friends, colleagues, customers, partners, or vendors.
  • Angel networks like North Bay Angels, Sand Hill Angels, Pasadena Angels, etc. The focus of this article is on angel networks.
  • Funds like venture capital firms and pension funds.
  • Markets like NYSE, NASDAQ, TSE, OTC, etc.

Each source of funding corresponds to a stage that the company is at, the amount of funding needed, the usage of the proceeds, the ROI expected, the period, etc. 

An angel network is a group of accredited investors whose primary goal is to invest in startups hoping to get a higher return on their investment compared to conventional financial instruments.  Typically, they expect a minimum of 10x return on their investment considering the high risk associated with the ventures that they invest in.  In addition to this primary objective, members of an angel network have some secondary altruistic objectives including helping entrepreneurs, raising the socio-economical climate of their region,  keeping abreast of current developments,  and making use of their experience and networks on a part-time basis.

There are currently about 300 hundred angel networks in the US.  By examining the list of angels who are members of the Angel Capital Association you can find the angel networks in your region.  The great majority of angel networks are "not-for-profits" like Band of Angels, Tech Coast Angels, etc.  A small minority are "for-profits" like Keiretsu Forum.  The average size of an angel network is about 100 members with much diversified background, and the largest is actually Keiretsu Forum with about 700 members spread in many chapters worldwide. 

Angel networks include successful individuals who can afford to invest in high risk ventures.  While some are still pursuing their careers, the majority of angels in an angel network are semi-retired or retired.  With the exception of Keiretsu, angel networks are focused on local companies, especially considering that angels like to get involved in their ventures and contribute to the local economy.  Even though a good number of angel networks are focused on emerging high growth markets such as information technology, clean technology, and life sciences, most of them are quite diversified and invest also in mature markets such a retail, real estate, manufacturing, services, etc. 

Angel networks, like any organization, have certain culture.  Some are more serious, progressive, and aggressive in their activities than others.  The less established ones can quickly become too much of a social club intended to entertain or educate its members at the entrepreneurs' expense. 

Angel networks fall in between individual angels and institutional funds.  The characteristics of angel networks are the following:

  • Unlike individual angels, angel networks have a rigorous process, which is sometimes more laborious than the process of VCs. 
  • The fund raising cycle takes usually about 4 months.  If the entrepreneur is also a member of the group and has a good reputation in the network, which substantially increases the probability of getting funded, then the cycle can shrink down to 2 months in some cases.
  • Nowadays, angel networks invest mostly in early stages, and rarely, in seed stages.  Thus, they require proof of concept, or better, proof of early adoption.  Lately, even proof of early monetization is required for some angel networks.
  • The amount of money that entrepreneurs can raise from angel networks ranges from $200,000 to $2,000,000 with an average of $25,000 per angel.  Therefore, it is common to have 30 to 50 investors in a large round such as in Clupedia's case in which we raised the largest round at that time from Tech Coast Angels, Pasadena Angels, and Frontera Capital
  • The form of the investment is mostly equity through preferred shares with all the rights that you would expect from a VC round.  However, convertible notes are often used, especially if the round is small or if no agreement was reached on the valuation. 
  • Angel networks have moved upstream, referring their investment as a Series A round, especially if the round is large.  Hence, their documents are quite similar to a VC round.  Entrepreneurs need to avoid "cul-de-sacs" by being particularly careful about clauses in their angel round which might be unfavorable to a VC round.  However, those cases are rather rare because one of the main objectives of angels is indeed to secure a subsequent VC round.
  • The main objectives of the angel round are to increase the valuation of the company and secure an institutional round.  In order to do so, the usage of the proceeds of the angel round is typically intended to strengthen the product, solidify adoption, and proof the potential growth based on specific metrics which will be enhanced with the proceeds from the institutional round.
  • Unlike institutional funds where the proceeds come from the fund and not from the partners, in angel networks the proceeds come from each and every member of the angel network.
  • Unlike institutional funds where the decision making process is done through a consensus by all the general partners, each and every angel in an angel network makes a decision on his/her own.  However, the herding effect has a great deal of influence on angels.  Typically, when there is an interest in a venture, couple of angels who are experienced in the industry of that venture take a lead role by conducting a due diligence and making recommendations to the group, while the remaining angels interested in the venture usually wait on the side line.  Most of those are not necessarily knowledgeable in the industry of the venture but count on the lead(s) to make their decision.  When the venture starts to gain momentum, then a herd starts to form.  Only when the herd reaches a certain size, often specified in the term sheet by stating a minimum investment before the venture can consummate any of the proceeds, that the herd starts to commit.   The larger the herd the more funding is raised.  Corollary, no herd, no funding.  Therefore, the success of fund raising through angel networks relies heavily on the lead(s) and their ability to generate a sizeable herd.  Often times, leads are knowledgeable, respectable, reputable, and experienced, but they may not be influential or good promoters, and even if they were, they may not have the time or the inclination to aggressively promote the deal among their peers.  So, the burden is on the entrepreneur to lobby, socialize, promote, and network with the herd.  Thus, it is actually harder to raise money from an angel network than from a venture capital firm despite the fact that the hurdles are higher in the latter. 
  • More than VCs, angels tend to get involved in the operations of the company because: (a) the entrepreneur might be inexperienced; (b) they have the desire to contribute more than just their money by sharing their experience, knowledge, and contacts; and (c) they are paranoid of failing considering the high percentage of failure of startups. While angels' experience and talent can be greatly beneficial to the venture, such tight grip could lead to micromanagement which usually results into friction. The common problem that entrepreneurs have is that they don't listen, and they think they know, when they actually don't. On the other hand, the common problem that angels make is to directly apply instead of adapt their experience on the new venture. After all, there are many different ways of skinning a cat, and what was true then, may not be true now, and what is appropriate for one industry and for one company, may not be at all appropriate for another. Cookie cutters don't exist in emerging markets. Bottom line, either the entrepreneur is stubborn or the angels are imposing. Either case, the egos start to get in the way. Thus, entrepreneurs must walk a very thin line between following their intuition and following the angels' advices. A good entrepreneur knows how to push back diplomatically without necessarily creating conflict, which is much easier said than done. Having said that, you will probably be able to live with yourself if you fail because of your mistake rather than somebody else's.
  • Angels, like VCs, music labels, and book publishers, like to play the odds by diversifying their portfolio.  They invest in many deals knowing well that only 20% of their investment will produce 80% of their return.  That means that the probability that an angel follows up on a round is low preferring to invest in many different ventures instead of heavily investing in few.  The reality is that the great majority of entrepreneurs underestimate the time, effort, and resources required for their project.  Such diversification policy is appropriate for the two extremes: companies who are failing don't deserve to get additional funding, obviously, and those who are succeeding are well positioned to an institutional round, and therefore don't need any additional funding from their angels.  It is indeed those companies who are in the middle who take the hit and are victim of such investment policy.  Those are companies who made progress, sometimes very good progress, but not enough yet to attract institutional investors.  They need a bit more time, resources, and nurturing until they get there.  Therefore, there is a high probability that those companies, who still have good potential, will fail due to lack of funding and not due to poor performance necessarily.  Of course, making this argument to angels is likely to fall on deaf ears.
  • Not all angels are created equal.  Some are more helpful, more knowledgeable, more experienced, more connected, and more patient than others.  Because of the great influence that they sometimes exercise over entrepreneurs, they could actually be the cause of success but also the cause of failure.

In conclusion, the key to securing funding from angel networks is finding a champion in the group who is ready, willing, and able to become an influential evangelist for your venture, perform the due diligence, and generate a good size herd large enough to secure the minimum funding that you require.  Finally, don't expect any of that to happen on its own unless you make a genuine and concerted effort to lobby, promote, and network the herd.