Angels and Capitalists

Angels and Capitalists

The pathway to wealth

Ken McDonald PhD

The story of business angel investors and venture capitalists:

Who are these private marketplace investors?

What factors influence their decisions to fund the seed, start-up, and early-stage ventures of entrepreneurs?

And what has been their role in the initial funding of some of the most successful and profitable high-technology enterprises of all time?

Kenneth Ian McDonald BA, LLB, PhD.

Angels and Capitalists: the pathway to wealth

Copyright © 2013 by Ken McDonald PhD

Smashwords Edition

The moral right of the author has been asserted.

All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording, scanning, or otherwise), without prior written permission of the author.

The information, views, opinions and visuals expressed in this publication are solely those of the author and do not reflect those of the publisher. The publisher disclaims any liabilities or responsibilities whatsoever for any damages, libel or liabilities arising directly or indirectly from the contents of this publication.

Limit of liability / Disclaimer of warranty: Whilst the author has used his best endeavors in preparing this publication, he makes no representations or warranties in relation to the accuracy or completeness of the contents of this publication and he specifically disclaims any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales material. The advice or strategies contained herein may not be suitable to your situation. The publication contains the author’s opinions and is designed to provide accurate and authoritative information. It is sold with the understanding that the author is not engaged in rendering legal, accounting or other professional services and you should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

The author has used his best endeavors to ensure that the URLs for external websites referred to in this publication are correct and active at the time of going to press. However, the author has no responsibility for the websites and can make no guarantee that a site will remain live or that the content is or will remain appropriate.

Author: Ken McDonald PhD

Edition: 1st

ISBN: 9781742843193 (pbk.)

Published by Bookpal

www.bookpal.com.au

PO Box 3422

Sunnybank Hills LPO

QLD 4109

About the Author

Dr Ken McDonald is the co-founder of a number of several start-up enterprises. He has university degrees in arts and law and a doctorate in philosophy.

Acknowledgements

I am grateful for the support and assistance I have received from many people, in particular my wife Linda and daughters Mandy and Sally who have given me the encouragement and motivation to remain focused on the task in hand. I am also grateful for the continuing encouragement of a number of good friends.

I take this opportunity to thank Emeritus Professor Frank Clarke for his generous contribution to this project in terms of sound mentoring. Thanks also to Dr Alison Basden, Millicent Chalmers OAM, and Paula Wynyard for editorial and formatting assistance.

Participants in the private marketplace have generously given me their time and knowledge and have helped me to understand the aspirations and challenges of those entrepreneurs who seek capital and those business angels and venture capitalists who fund ventures in this space. They are creating stronger and smarter societies through the integration of innovation and capital in the private investment marketplace.

Table of Contents

About the Author

Acknowledgements

Table of Contents

List of Figures

List of Tables

List of Appendices

Introduction

CHAPTER 1: The private marketplace

1.1 The nature of capital

1.2 Private marketplace terminology

1.3 Factors in private marketplace investment

1.4 Summary

CHAPTER 2: Investor characteristics and structures

2.1 Types of investors

2.1.1 Business angels

2.1.2 Venture capitalists

2.2 Characteristics of different types of investors

2.2.1 Business angel characteristics

2.2.2 Venture capitalist characteristics

2.3 The investment marketplace

2.3.1 The business angel marketplace

2.3.2 The venture capital marketplace

2.4 The nature of investment

2.4.1 Sources of capital

2.5 Business investment structures

2.5.1 Legal, corporate and financial considerations

2.5.2 Investment in public and private companies

2.6 Summary

CHAPTER 3: Investment criteria

3.1 Funding in the private marketplace

3.2 The context of investment decisions

3.2.1 Role of entrepreneur in investment process

3.2.2 Accessing capital by the entrepreneur

3.2.3 Investment risk factors

3.2.4 Funding high technology investments

3.2.5 The taxation environment

3.2.6 Government funding and support

3.3 The making of the investment decision

3.3.1 Business angel investment decision

3.3.2 Business angel rejection of the deal

3.3.3 Venture capitalist investment decision

3.3.4 Venture capitalist rejection of the deal

3.3.5 Key similarities and differences

3.4 Models for evaluating decision-making factors

3.5 Summary

CHAPTER 4: High-technology ventures

4.1 Microsoft 1975: Computer software

4.1.1 Initial investors

4.1.2 Later investors

4.2 Apple Inc. 1976: Computers

4.2.1 Initial investors

4.2.2 Later investors

4.3 Amazon 1994: Online bookstore

4.3.1 Initial investors

4.3.2 Later investors

4.4 Yahoo! 1995: Internet services

4.4.1 Initial investors

4.4.2 Later investors

4.5 eBay 1995: Online shopping

4.5.1 Initial investors

4.5.2 Later investors

4.6 Google 1998: Computer software

4.6.1 Initial investors

4.6.2 Later investors

4.7 Facebook 2003: Online social networking

4.7.1 Initial investors

4.7.2 Later investors

4.8 Twitter 2006: Online social network/micro-blogg

4.8.1 Initial investors

4.8.2 Later investors

4.9 Perspectives – technology/business breakthroughs

4.10 Investors and their networks

4.10.1 Business angel investors

4.10.2 Venture capitalists

4.11 Summary

CHAPTER 5: Conclusions

5.1 Accessing the private marketplace

5.2 Past studies and the present undertaking

5.3 The decision-making process

5.4 High-technology investments

5.5 Implications of this book

5.5.1 Public awareness investment opportunities

5.5.2 Investors not in the private marketplace

5.5.3 Legislative and administrative incentives

5.5.4 Investor ‘gender equity’

5.5.5 Commercial implications

5.6 Summary

Glossary

References

Appendices

Index

List of Figures

FIGURE 2.1: Where angels (and venture capitalists) fit in the mix

FIGURE 3.1: Entrepreneurship/management balance

FIGURE 3.2: VC fundraising

FIGURE 3.3: Venture-backed IPOs and funds raised

FIGURE 3.4: Seed and early-stage proportion of deals

FIGURE 3.5: Venture capital fluctuations 1990–2001

FIGURE 4.1: Smart investors in high technology

List of Tables

TABLE 2.1: Business angel characteristics

TABLE 2.2: Venture capitalist characteristics

TABLE 2.3: Business angel marketplace

TABLE 2.4: Venture capitalist marketplace

TABLE 3.1: Business angel investment decision

TABLE 3.2: Business angel reasons for rejecting deal

TABLE 3.3: Venture capitalist investment decision

TABLE 3.4: Venture capitalist reasons for rejecting deal

TABLE 3.5: Business angel/venture capitalist similarities and differences

TABLE 3.6: Factors that may influence the investment decision

List of Appendices

TABLE A1: Definitions and interpretations of business angels

TABLE A2: Definitions and interpretations of venture capitalists

TABLE A3: Emerging themes and classification

Introduction

This is the story of investors known as business angels and venture capitalists located in the private marketplace. These investors provide seed, start-up, and early-stage capital for entrepreneurs who may initially possess little more than an idea or invention, energy, and optimism.

The book investigates how these investors and entrepreneurs locate and connect with each other, why investors choose to fund certain entrepreneurs and their ventures and not others, the timing of these decisions, and the investment factors considered relevant in funding what can be high-risk investments.

It is the story of later-stage investment in well-established private and public companies by institutional venture capital firms, is it the story of private equity investment through the leveraged buy-outs of companies.

In passing, this book also discusses a number of celebrated cases, in the realm of high technology, where start-up ventures initially funded by private marketplace investors have gone on to become some of the world’s most successful and profitable corporations.

The book looks at the investment stages in the funding process for each of these high-technology ventures and the influence of informal networks in the sourcing and funding of these investment opportunities.

Finally the book goes on to look at some of the important issues arising through the development of the private marketplace and the implications for future growth and prosperity in this vital space.

CHAPTER 1

The private marketplace

No man can tell what the future may bring forth, and small opportunities are often the beginning of great enterprises.

Demosthenes (385-322 BC) Ad Leptinum 162¹

This is a book about business angels and venture capitalists who invest in the ideas and inventions of founders and entrepreneurs, generally referred to as entrepreneurs in this book, providing capital for the seed, start-up, and early-stages of such ventures. The funding of these ventures has important implications for a national economy as new business drives employment growth, competition, innovation, and export potential (Mason 2002).

Whereas various authors have documented the rise of enterprises from the ideas and inventions of entrepreneurs (Battelle 2005; Maynard 2005; Young and Simon 2005; Kirkpatrick 2010), there is a need for more discussion and research focusing on the reasoning processes that drive the investment decision.

A number of authorities contend that this topic is under-researched (Gupta and Sapienza 1992; Sohl 1999; Prasad, Bruton, and Vozikis 2000; Freear, Sohl, and Wetzel 2002; Haines, Madill, and Riding 2003; Paul, Whittam, and Johnston 2003; Paul, Whittam, and Wyper 2007) and this book supports that contention.

Accordingly, this book pursues these issues, as outlined in the appendix, Table A3

, with a view to offering a greater awareness and understanding of the private marketplace, its participants and, in particular, the investment decision-making processes undertaken by business angels and venture capitalists.

Of particular interest in this context is the role that capital plays in the formative stages of seed, start-up, and early-stage ventures of entrepreneurs. These stages in the development of the venture are also reference points for the funding of the enterprise. Entrepreneurs when seeking capital and investors when seeking to invest are able to readily understand and identify the stage that the enterprise has reached, the type of funding required, and the attendant risk that can accompany each stage. As will be seen, the risk is highest at the earliest stage of funding where the venture may be little more than a concept.

Seed funding provides small amounts of capital for initial product feasibility studies, development, and market research. Start-up funding allows for the completion of product development, securing the management team, finalizing the business plan, and commencing marketing. Early-stage funding provides for the testing and/or pilot production of the idea or product, at which stage the enterprise will have existed for less than three years and may be generating revenue (Sherman 2005). The greatest challenge for entrepreneurs in starting and growing an enterprise remains simply money (Preston 2007). Early capital can be provided by the entrepreneur and, where available, by family and friends, but when these funds are exhausted or unavailable, the approach will be to the business angel or venture capitalist for the requisite capital.

1.1 The nature of capital

The term evokes different connotations. encompasses the personal attributes, skills, and experience an entrepreneur brings to the venture, whereas denotes the monetary means with which it is pursued. The two may be substitutable without detriment to the venture (Chandler and Hanks 1998). Usuallyrefers to financial capital or the capital provided almost inevitably the founder or entrepreneur (Banfe 1991; Bodde 2004). Funds may be sought from a network of family and friends, emotional investors (Sherman 2005, p. 8) who also provide affective, educative, and network resources (Steir 2003). Having a relationship to the entrepreneur, these investors may offer flexibility and concessions in terms of the funds advanced and percentage of shareholding claimed (Sherman 2005). In due course the entrepreneur will seek funds from private marketplace investors.

Start-up ventures require (i) initial capital to generate the start-up and maintain momentum until the business can begin to fund itself, and (ii) working capital derived from profits or other sources to drive the enterprise until expansion capital is needed to drive the growth phase(s). In this context, working capital ordinarily includes the cash reserves and assets readily convertible into cash to pay current obligations such as rent and wages.

Fixed capital refers to durable assets with a continuing, often long-term connection to the business – real estate, fixtures, fittings, infrastructure items, and movables such as machinery and furniture. Working and fixed capital needs can vary from time to time (Baumback 1988).

Two types of capital investment, external and internal funding, generally fund new ventures (Ronstadt 1985). External funding can comprise equity funding and debt funding, each having costs and benefits bearing on the decision. Indeed, most companies raise capital in a manner consistent with finance theory and, in the case of debt and equity, relative costs will affect the choice of financial strategies (Carter and Van Auken 2005). Whilst both equity and debt funding can be used to finance either fixed or current assets, the two should not be perceived as mutually exclusive. With debt it generally follows that the monies borrowed should generate the means of repayment, short-term funding from current assets and long-term funding from earnings (Baumback 1988).

Internal funding carries an assumption that the enterprise can use its assets and turnover to enable internal cash generation. This type of funding is more appropriate for an established enterprise. This book addresses primarily the funding of new ventures and so it focuses on raising capital through external funding, although the owner of an enterprise may require a combination of external and internal funding (Ronstadt 1985; Chandler and Hanks 1998).

1.2 Private marketplace terminology

The private marketplace encompasses the informal marketplace, where operate, and the formal marketplace, where are located (Sohl 1999). Their nature and characteristics are discussed in depth in Chapter 2. Informal and formal markets are generally known collectively as the private marketplace, as distinct from the public marketplace.

The private marketplace is where the parties who undertake seed, start-up, and early-stage ventures, known as founders or, more generally entrepreneurs, seek sources of investment capital – initially from business angels and in due course from venture capitalists – for growth, diversification, and general expansion. An awareness of the role and motivation of these entrepreneurs in establishing such enterprises may assist with an understanding of why only some entrepreneurs attract capital to their cause.

Business angel capital is provided by business angels from their own resources, directly in the private marketplace; venture capital refers to funds raised by venture capitalists from investor clients and invested by these VCs as financial intermediaries in that marketplace (Berger and Udell 1998).

Private investment covers activities from (business) angel investment (early-stage investment) to buy-out fund investing (Kunkel and Mukherjee 2004). Venture capital generally follows the initial seed and start-up investment by angels. Venture capitalists may pursue investments at the seed and start-up stages. However the vast majority do not invest at this stage (Preston 2007).

At this point the usage of the term private equity should be clarified as confusion can occur when it is used in the context of seed, start-up, and early-stage investment. The term is used to refer to private marketplace investment but it is also used in the context of later-stage financing of private companies and, on occasions, public companies involved in private equity deals.

As well the term is sometimes used in a broader context to define all private investment. Moskowitz and Vissing-Jorgensen (2002), and Marks, Robbins, Fernandez, and Funkhouser (2006) use the term private equity investment to distinguish it from investment in public companies and it encompasses group funds and investment companies that provide capital to private businesses on a negotiated basis.

Connolly and Tan (2002, p. 1) refer to private equity as investment outside of capital markets being variously categorized as start-up financing, expansion financing, turn-around financing and management buy-out (Connolly and Tan 2002), by business angels and then VCs.

Anson (2002) describes private equity as a generic term encompassing venture capital, leveraged buy-outs, mezzanine financing and distressed-debt financing. Venture capital as defined includes the financing of start-up companies.

Carey and Morris (2012, p. 138) note that the term private equity has long been used for venture capital investments in start-ups and other young companies-an investment approach that was widely lauded as fueling innovation and growth. The terms private equity and venture capital can be interchangeable (Connolly and Tan 2002).

Sohl (2003, p. 43) comments that the history of business in the U.S. is the history of equity financing. In a similar vein, Anson (2002, p. 379) has observed that the successful investing of private equity firms throughout most of the 1990s has attracted significant investor capital into the private equity markets. Payne and Macarty (2002, p. 331) refer to business angels as private equity investors who invest both capital and business expertise in early-stage companies whilst Moskowitz and Vissing-Jorgensen (2002, pp. 745, 755) note that the private equity market has received relatively little academic attention with venture capital pertaining to a very specific type of investment in private equity that may not provide much insight into the typical entrepreneur’s investment decision and returns.

Carey and Morris (2012) note that the term private equity was initially appropriated for the more controversial process of buying companies with borrowed money, and that the phrase has taken hold.

In that context private equity is best understood by reference to the emergence of private equity houses as a financial force in the United States in the second half of the twentieth century. Private equity funding flourished and by the 1980s the private equity firm of Kohlberg Kravis Roberts (KKR) had set records with the buy-outs of Beatrice Foods and RJR Nabisco in 1986 and 1988, respectively, through its US$6.1 billion 1987 fund. This record was not bettered until 2002 (Carey and Morris 2012).

However the stigma of the signature deals during the 1980s, the buy, strip, and flip (sell) approach, funded by debt