A Literature Review and Industry Analysis of Informal Investment in Canada: A Research Agenda on Angels

Executive Summary

The Porter's Five Forces Model of Industry Competitiveness was used to evaluate the status of the angel investment industry. The Model details the five competitive forces acting upon the players in an industry – in this case, angels. The findings are summarised as follows.^{Footnote 1}

Suppliers:

Government actions can impact on the number of angels supplying capital to the entrepreneurial community though it is widely felt that governments could do more.

General economic factors such as interest rates contribute considerably to the desirability of informal investing.

There is evidence of significant informal investment in poorer pockets of the country. During times of significant financial market distress, informal investing still seems to be high.

Rivalry:

The protective and secretive sentiments of trades associations imply that there are not enough angels to meet the demands of their local entrepreneurs.

Angels report not being able to find enough demand (good entrepreneurs) to satisfy their supply of capital. The industry and market are at odds on this matter.

Angels have not taken advantage of information technology to learn about the actions of other angels in their own industry. This suggests informational inefficiencies are still at work. As they are unaware of one another's activities, rates of return, investment criteria and venture opportunities, there is little room for rivalry.

New Entrants:

It takes a significant amount of after tax capital to invest in the ventures of entrepreneurs, but the barriers to entry are not as high as some studies would suggest.

Though it is felt that the detailed and specialised knowledge, and learning and experience curve effects would be significant, the presence of many novice investors suggests informal investors do not feel they need to be over cautious.

Business introduction networks represent significant efforts to bring entrepreneurs and informal investors together, but the formula has yet to be perfected.

The poor capacity for most angels to exit as well as the poor returns associated with exits represents some of the industry's most significant barriers to overcome.

More encouragingly, the presence and apparent growth of serial, and portfolio informal investors as well as corporate investors gives cause for optimism.

The growing understanding that angels are borne of entrepreneurs fuels more optimism as these areas gain research interest.

Substitutes:

Family and friends may be difficult substitutes for entrepreneurs as family and friends may have been exhausted as a source of capital first, or they may be uneasy observers, too close for comfort for the needful entrepreneur.

Venture capital, conversely, is often desired by entrepreneurs, but there are very few who meet the exponential upside potential and strict venture capital requirements.

Debt capital is generally a poor substitute for start-ups and seed stages of finance as the historical ability to pay or asset based collateral are not present. Government-assisted programs have widened the net.

The theory of high- and low-ability entrepreneurs may determine the sources entrepreneurs seek and their ability to access substitutes.

Power of Customers:

Entrepreneurs who have found angels may have substitutes, but will probably incur extremely high switching costs to unburden themselves of the angels.

Investee entrepreneurs have little in the way of good information about other entrepreneurs' situations because of their loose association with other entrepreneurs and they also have little way of acquiring knowledge about angels' prices, costs and products.

High quality entrepreneurs may have discretion over whether or not to work with an angel, but because angels are thought to be the last source of capital for many entrepreneurs, the investees cannot exercise considerable power after the deal has been consummated.

One area where investees can exercise considerable power over their financiers is when they are in a position to negate or refuse to execute harvest strategies which benefit the angel.

Research Recommendations:

Increase support for "deal generation" research. Deal generation represents the actions in which angels engage to find entrepreneurs. It is the least understood aspect of the informal investment process. Informal informants and business introduction networks are only two components of a much larger picture which is, yet, not understood.

Develop and support research in support of "exit process" discovery. Exits are crucial to the angel investment process. They represent the likelihood and potential for payoff. We are still very far away from having a well rounded understanding of how angels pursue exits, if they do, the primary methods of exit, and the details of the relationships between the entrepreneur and the angel five to seven years hence. Better exit opportunities, better exit returns and better exit relationships will undoubtedly improve repeat angel activity.

Develop an understanding of the heterogeneity of angels particularly the differentiation between novice and habitual informal investors. Novice angels invest once and may or may not invest again. Habitual informal investors have already decided to re-invest. The deal characteristics suggest there are considerable differences in attitudes, motivations and behaviours between the two. Novices make considerable contributions collectively and generally invest a greater range of funds. Habitual angels are important because their individual contributions over a period of time can be substantial. Research in this area also highlights successful "corporate" angels who are associated with this category.

Pursue informal investment within the context of other disciplines that have acquired more scholarly attention such as entrepreneurship. The former entrepreneurial role played by a significant number of angels is a characteristic that is central to understanding angels. Other theoretical disciplines such as finance, psychology, and economics contribute to a more complete understanding.

Focus on the tax implications of selling shares profitably. Regardless of the success or profitability of the investee company, angels do not have success investment portfolios unless the balance of their returns is positive. There are growing indications that about one-third of investors suffer at least one full loss. Favourable tax treatment on the exit side may encourage more investment by improving overall returns.

Encourage research depth and breadth to allow bases for comparison within the same research design and sampling methodology. When research efforts narrowly define and isolate small groups for study, the ability to make comparisons is reduced because research designs and sampling methodologies differ. When research which seeps across the boundaries between angels and family investments, angels and formal venture capitalists, habitual angels and novices, angels who have been entrepreneurs and those who have not been entrepreneurs, rich comparisons can result.

Family investments need to be included in the angel "literature." The notion that family and friends are less than arms' length and should not be included in the angel literature is limiting. Research is now beginning to suggest that the best investments are made to entrepreneurs who are known to the angel prior to the investment. Eliminating family investments limits the search for understanding.

Develop research designs which include more representative sampling methodologies. When research is commissioned, funds need to be devoted to ensure sampling methodologies permit more inference since Canada's large geographic expanse does not allow us to easily draw conclusions from one pocket of angels to another.

Expand the policy focus to "investor focussed", not just "entrepreneur-focussed". Current interest emphasises the entrepreneurs' search for capital, the entrepreneurs' difficulty in finding angels, the entrepreneurs' need for assistance in developing business plans, and finding ways to identify and meet angels. In order to help angels, focus on angels in their entrepreneur/angel relationship.

Increase the volume of commissioned work. Aside from anecdotes about angels and the two reports since 1995 (Farrell, and Lionaise and Johnstone) all of the original research is relatively old. The industry needs new insights to advance. Now that there is an appreciation for the magnitude and nature of the angel phenomena, it is reasonable to pursue why in a more current context.

^{Footnote 1} A. Ellen Farrell is an Assistant Professor in the Frank Sobey Faculty of Commerce at Saint M ary's University. Canadian angels are the subject of her doctoral dissertation. She is studying at the School of Finance and Management at the University of Nottingham. She gratefully acknowledges the helpful comments of Professor Mike Wright, Dr. Carole Howorth, Dr. Harvey Johnstone and Cindy Joe.