Angel investors are one source when seeking capital. Darren Baguley looks at this potential pool of funds and how to manage the dynamics of the new relationship that ensues.

All companies start with someone having an idea. In the case of online auctioneer OZtion, it all began when programmer Kelvin Yip started tinkering with a code, and in 2004, he had come up with a truly groundbreaking website technology.

At the same time Philip Druce was running a computer consultancy business and developing and selling software to automate management of online auctions. When Yip showed Druce what he had done, going into business together was the outcome.

Two months after completing the business plan, Druce and Yip were approached by an angel investor.

While most people are aware of stock market listings and venture capital, angel investors are not as well known in Australia. Simply, they are individuals who have made, or perhaps inherited, a lot of money and are prepared to invest in, commonly, small companies that need capital to grow.

Druce and Yip as OZtion founders – now Technology Architect and Managing Director, respectively – had intended to fund the business out of their own capital, but liked the idea of spreading the risk. After discussions with their accountant, they went back to the investor, as well as family and friends, to raise seed capital.

Going head to head with dotcom behemoth eBay was a big step but with their angel investors Druce and Yip decided to develop an Australian online auction site and went live on New Years Day in 2005.

Angels on the ground

Formal research on angel capital in Australia is scanty, but Business Strategies International (BSI) Executive Director Alan Milwidsky says it's estimated there is around $2 billion in private investor capital moving around the Australian market. This figure comes from a broad definition of angel capital that includes family members and friends investing in start-ups; it also includes people buying into franchises as well as entrepreneurs trying to make a great idea happen.

Brisbane Graduate School of Business Senior Lecturer and co-author (with Howard Frederick) of Sources of Funding for Australia's Entrepreneurs (published by Lulu.com), Dr Siri Terjesen, says, "On average, Australian business angels have [a] mean annual income of $180,000, a net worth of $2 million, and invest 10–12 per cent of their capital in entrepreneurial firms, expecting a minimum rate of return of 20 per cent, and exit in three years."

While the proportion of Australians who are prepared to invest in such ventures is less than in the US, it is on par with European countries such as Spain and Norway and ahead of the United Kingdom, Terjesen says.

Australian angel capital represents a far larger pool of funds and has advantages over the other common way of raising business finance: venture capital (VC). Anthony Mitchell, Director of advisory firm Bendelta, says that angel capital is the most appropriate when a business has either no revenue – because it's purely embryonic – or no established track record.

"Most VCs require a revenue history before they'll put money into something," says Mitchell. "If the VC doesn't require revenue history, it will usually require a lot of share and/or control.

"By contrast, angel investors do tend to be more generous with their terms. VCs are likely to be more rigorous in their risk-and-return appraisals."

Making a business case

One disadvantage of angel capital is that it can be harder to find than VC. Consultants, exchanges and brokers that aim to match investors with entrepreneurs do get involved, but 80 to 90 per cent of deals tend to be done on a personal basis. Just as with VC, however, it is still very important to look professional when chasing angel capital.

"The entrepreneur still has to think ‘how am I going to take this to an angel?'," says Mitchell. "If it looks like nothing more than an idea, an angel investor might think it's worth $500,000 and offer $250,000 for a half share.

"That same business put up in a different way could see the investor offering $500,000 for a 20 per cent share. So before an entrepreneur starts going around cap in hand they need to think through how to present themselves to look credible."

Once an angel, or sometimes a consortium of angels, has been found there can be a lot of benefits accruing to the business beyond the capital invested.

Most angels are successful businesspeople. If they decide to take a seat on the board as part of their investment, their experience, expertise, and often contacts, will come along with it, says Milwidsky.

"A sophisticated investor, who understands the business owner's industry and where the business is going because they've done it before, can act as a mentor. And often, in that case, the business can leverage off the angel's contacts in the marketplace."

Another potential benefit from angel investors is that they can confer a "halo" effect on the business they're investing in. Mike Carden, Sonar6 Founder and Executive Chairman, discovered this when Sam Morgan, the founder of TradeMe, New Zealand's largest internet business, invested in his company. Morgan became one of the richest people in New Zealand overnight, personally netting around $NZ300 million when he sold TradeMe to Fairfax for $NZ700 million in March 2006.

"There are two halo effects from having someone like Sam invest in your business," says Carden. "First, people think ‘Sam is a smart guy; he's investing, therefore it must be an OK company'. That helps in the early days when the company is unknown. Second, there is a PR effect, but it's double-edged because the PR is not always about the company."

While very few, if any, companies ever become large without some form of outside capital, there are pitfalls with taking on an angel investor. The major problem tends to be that the angel either takes too much or too little interest in the business.

Mitchell says, "Sometimes an angel puts in the cash and that's all. For some, that may be the ideal situation. At the other end of the scale, you might get an angel investor who puts in their money but then wants a finger in everything."

Milwidsky agrees with Mitchell but adds a few other concerns. "Interpersonal relations can be an issue. Or sometimes the angel doesn't understand that more money is needed [to get the product to market], so when there's a call for money and they can't do it, their input is diluted." Alternatively, the angel can have a shorter time horizon for realising their investment than the entrepreneur.

Managing the transition

Ultimately, most of the issues come down to managing the transition between a company running on internal capital and one that has external capital involved.

Serial angel investor and Virtual.Offis CEO, Craig Allen, says the main tool for managing the transition, apart from general standards of good governance, is the shareholder's agreement. "A good agreement should be a win-win for both parties and it should put targets in place within an agreed time horizon."

Milwidsky also advocates a shareholders' agreement, adding that it can give both parties certain rights they wouldn't have under a normal constitution. "If either side wants specific provisions, such as veto rights, it needs to be put into the shareholders agreement."

He warns, however, smart investors can put a lot of conditions into a deal – anti-dilution clauses, convertible notes that only convert to equity when it suits them – that certainly can have an impact.

"But the key thing angels want to see is monthly accounts," says Milwidsky. "The biggest difference is the entrepreneur now has partners and they have to think of the people who have put the money in. They need to spend time with them, make sure that they're involved and feel informed as to what's going on."

While there are obstacles to be negotiated, angel investing can still be very profitable for both entrepreneur and angel investor. "The early expansion of the late Anita Roddick's Body Shop chain was supported by an investment through a business angel whose £4000 investment was worth in excess of £140 million in the early 1990s," says Terjesen.

In the case of OZtion the money put in by the angel investors has led to continued growth, says Druce.

"We now get 1.5 million visitors to the site per month and one million page views a day. Year on year growth in membership was 160 per cent and growth in items advertised for sale was 51 per cent. Overall site visits had increased by 50 per cent and we've now got 212,000 registered Australian members."