SME Financing in Canada, 2003 — Part IV: Profile of Risk Capital Financing

2. Informal Investors — Friends, Family and Angels

There are important linkages between informal investors, the VC industry and public markets. As seen in Figure 47, before seeking VC, new firms likely obtain initial funding through informal channels (family, friends and angels investors).

Informal investors play an important role in the initial phases of SMEs' development, particularly for start-ups and early-stage firms. These investors have had an increasingly important impact on the businesses they finance, providing investment capital and managerial support. In the US, the informal investor market has been identified as the most important source of risk capital.⁹⁴ Data on the Canadian informal market are still scarce and regionally focussed, which makes it difficult to assess the size of the informal venture capital market. In fact, current estimates of total annual informal investments range from $1 billion to $20 billion.⁹⁵ However, it is likely that the volume of angel investment is somewhat larger than that of venture capital. As discussed later in this section, assessing the role and impact of informal investors (particularly business angels) on SMEs is one of the key research objectives of the SME Financing Data Initiative.

Love money: very early-stage source of financing
Measuring the impact of love money on start-ups is challenging, as this market remains highly informal and unstructured. Some research suggests that investments provided by relatives, friends and associates makes up more than 90 percent of the start-up capital in Canada.

Defining an Angel: Angels are individuals (and not the firm's principals) investing their own funds, often assuming unsecured, highly illiquid risks. Sometimes they play an active role in the management or finances of the firm, and they generally gain an equity position in the firm in exchange for the investment. Angel investments are generally said to be long-term, or "patient," often with no predetermined end or "exit." Source: Ellen Farrell, Literature Review and Industry Analysis of Informal Investment in Canada: A Research Agenda on Angels, 2000.

Due diligence requirements are often less stringent for love money investments than they are for more formal sources of financing. Family and friends tend to base their decisions on the nature of their relationship with the investee, and pay less attention to the nature of the deal or the potential risk. Love money generally comes in smaller amounts and is usually exhausted before a firm has reached a sustainable stage of development.

Angel investors: providers of early-stage financing and intellectual capital
Business angels usually go through an extensive due diligence process and base their investment decisions on the expectation of high rates-of-return. Angel investors also provide value-added managerial expertise to their portfolio firms. While some start-up companies remain with business angels throughout their entire life cycle, others eventually turn to VC financing to meet the rising costs associated with later stages of development. Studies show that in the US, business angels work in cooperation with the VC sector by seeking out and screening new projects, which encourages start-ups and increases deal flow for VC firms. In fact, studies have found that more than half of all VC-funded high technology projects in the US had business angel participation, and that this proportion was even higher among smaller and newer firms.⁹⁶

Angels are wealthy and business-savvy investors and: predominantly either current or former entrepreneurs 98 percent of them were male, their average age was 50 had between $50 000 and $250 000 to invest (sometimes more, but almost always less than $1 million) their own net worth was often over $1 million, and their average annual income was over $150 000 Source: Informal Equity Capital for SMEs: A review of Literature, Equinox Management Consultants, 2000.

The presence of a well-regarded and connected business angel in a previous financing deal may assure VC investors of the quality of the firm and deal. In addition to supplying capital, business angels provide business advice, contacts and access to an extensive, well-developed business network, which can assist the firm to make appropriate strategic decisions as it grows.⁹⁷

Recent research on SMEs reveals that since 1990, 11 percent of Canadian SME owners have invested privately in 217 000 other businesses. Seven in ten of these SME owners were involved as operators in these other businesses; three in ten invested less than $25 000, one third invested between $25 000 and $100 000 and 38 percent invested more than $100 000.⁹⁸

Financial impact of business angels on SMEs: a research agenda
Angel investors fulfill an important role in financing businesses, particularly SMEs. Since angels generally prefer to remain anonymous, however, their investment strategies and impact on SMEs' development are not well documented. The general conclusion of several research studies commissioned by Industry Canada was that future areas of study should focus on a more rigorous empirical approach to assess the financial contribution and economic impact of informal investors.⁹⁹

From a public policy perspective, determining the potential population of informal investors and their potential investment capacity is essential to determining future policy recommendations to stimulate informal investment. A methodology to capture current and potential informal investment activity is being developed as part of the SME Financing Data Initiative.

In 2002, Industry Canada held a research workshop involving academics from across Canada, the US and the UK to discuss the various measurement challenges involved in sampling informal investors. Researchers agreed that a random household survey would capture an accurate estimate of current and potential angel investments; they also recognized the importance of friends and family as a significant source of informal financing.

As noted earlier, many high-growth-potential start-ups that survive the seed financing stage turn to venture capital financing for development and expansion. The following section examines Canadian venture capital activity in 2001 and 2002 — two years of intense market turmoil. The data show that despite difficult market conditions, the Canadian VC industry remained strong, especially compared to its American counterpart.

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94. The Centre for Venture Economics (1995), in a report of the Office of Advocacy of the US Small Business Administration, estimated that approximately 250 000 angel investors were investing about US $20 billion in 30 000 small companies each year. That is approximately twice the value of annual investment by US institutional venture capital funds and about fifteen times the number of companies receiving investment (Freer, Sohl and Wetzel, 1996 in Acs and Tarpley, 1998).

95. Equinox Management Consultants Ltd.,"Informal Equity Capital for SMEs: A Review of Literature," 2000.

96. The VC industry allocated 42 percent of total capital invested (or $1 billion) towards companies in early development stages. See Freear and Wetzel (1990) and Fenn, Liang and Prowse (1998).

97. Equinox Management Consultants, Value Added By Informal Investors, 2001.

98. Statistics Canada, Survey on Financing of Small and Medium-sized Enterprises, 2001.

99. Ellen Farrell,"A Literature Review and Industry Analysis of Informal Investment in Canada: A Research Agenda on Angels," Prepared for Industry Canada, March 2000, page 43; and Equinox Management Consultants, Informal Equity Capital for SMEs: A Review of Literature, March 2000, a report prepared for Industry Canada.