SME Financing in Canada, 2002 — Part I: Risk Capital

Informal Investors

Informal investor¹⁸ activity in Canada: The Survey on Financing of Small and Medium-Sized Enterprises, 2000, which found that 18% of business owners have invested privately in other companies. As part of the SME Financing Data Initiative, more data will be gathered to determine their total contribution to the financing of SMEs. Data on informal risk capital investments in Canada are scarce, partly because informal investors often prefer to remain anonymous and do not tend to operate in visible networks and channels.¹⁹ Estimates of informal investment activity in Canada vary widely between $1 billion ²⁰ and $20 billion annually, with 60 percent of this amount targeted at SMEs in the early stages of growth²¹. In the U.S. angels have been identified as the single most important source of risk capital for SMEs.²²

Value-added by Informal Investors: The value that informal investors provide business ventures extends beyond financing. For instance, SME owners in the Ottawa region cited in a study conducted for Industry Canada²³ six other ways in which informal investors contributed to their growth and success. As shown in Figure 17, the study found that the two most common non-financial contributions of informal investors were advice and introductions to contacts and networks. Informal investors use their business knowledge and experience to assist owners with corporate and strategic planning, marketing, and managerial and general business guidance. Informal investors also sometimes sit on the boards of directors, providing industry information and lending credibility, particularly with respect to future financing.

Figure 17 – Contributions Made to SMEs by Informal Investors

Stage of business development for investment: Informal investors typically invest in the earlier stages of growth. A recent study by Equinox Management Consultants Ltd.²⁴found that 50 percent of investors responded that they had invested at the seed stage of projects, while more than 60 percent said that they had invested at the start-up stage (see Figure 18).

Finding investment opportunities: To find investment opportunities, most informal investors use their own networks, including professional contacts such as accountants, bankers, lawyers, and other investors.

Figure 18 – Informal Investors' Preferred Stage(s) of Business for Investment

Determinants of investment: generally, informal investors consider three factors when evaluating potential investment: the people involved, the product or technology, and the non-financial value that they see themselves adding to the venture.

Approval rates: for informal investors who examine, on average, 24 proposals each year are low by comparison with other forms of financing: just 12 percent of proposals were accepted according to a recent study.²⁵

Reasons for not investing: Generally, informal investors believe that most potential SMEs are not "investor ready," either because business plans and market knowledge are not well developed or because business owners are unwilling to relinquish control of their businesses. In fact, as shown in Figure 19, informal investors claim that lack of preparedness by SMEs for investment is the leading factor inhibiting informal investment in Canada, edging out taxation and regulation.

Figure 19 – Inhibitors to Investment According to Informal Investors

Exit Strategies: To realize a high level of capital gain, informal investors typically negotiate exit strategies at the outset of their investments. Usually, the terms are specified in the shareholders' agreement. Typical exit strategies may include buyout by a venture capital fund, third-party acquisitions, management buy-backs or initial public offerings.

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18. While all informal investors put their own money at risk in making an investment in a firm, not all informal investors are of the same type. Some are seeking investment opportunities with high rates of return as a professional investor. Others are approached to make investments which will support the growth of their industry to the benefit of their own firm as well as the investee. There may be many types of informal investors, which are yet to be described and understood. The SME Financing Data Initiative, and other work, has only begun to come to grips with this important source of risk capital investment. Some of the initial studies on informal investors can be found at http://strategis.ic.gc.ca/fdi

19. Current estimates of aggregate annual investments were developed around methodologies that extrapolate on regional studies of the size of local angel communities to a national level, therefore making numerous assumptions that need to be refined and tested.

20.Riding & Short, "On the Estimation of the Investment Perspectives of Informal Investors: A Capture-Recapture Approach," Journal of Small Business and Entrepreneurship, Vol.5, 1998, pp. 26-40.

21 E. Farrell, Informal Venture Investments in Atlantic Canada: A Representative View of Angels. Atlantic Canada Opportunities Agency and St. Mary's University, Halifax, 1998.

22. The Centre for Venture Economics, in a 1995 report for the Office of Advocacy of the U.S. Small Business Administration, estimated that approximately 250 000 angel investors were investing about US$30 billion in 30 000 small companies each year. This is approximately twice the value of annual investments by U.S. institutional venture capital funds and about 15 times the number of companies receiving (formal) venture capital investment (Freer, Sohl and Wetzel, 1996 in Acs and Tarpley, 1998).

23. Equinox Management Consultants Ltd., Value Added by Informal Investors, 2001, commissioned by Industry Canada.

24. Equinox Management Consultants Ltd., Practices and Patterns of Informal Investment, 2001, commissioned by Industry Canada. This study surveyed 51 informal investors in ten centres across Canada who made investments large and small in many different sectors.

25. Ibid.