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

2. Industry Profile

Informal venture capital investments are best described given the following conditions:

• Individuals investing their own funds, not the pooled or collective funds of others;
• Sometimes play an active role by assisting entrepreneurs in some aspects of management and finance;
• Is not the investment of the initiating entrepreneur;
• Is long-term, or patient, often having no predetermined terms of repayment;
• Often assumes unsecured, highly illiquid risk;
• Generally participates in ownership so their return is tied to the ventures' performance; and
• Is made by an individual who is not an intermediary, nor paid a salary or commission to perform the investment activities.

Angels are individuals who engage in informal investing. Informal investors, or business angels, make risky, personal investments into the ventures of other entrepreneurs. With little formal interaction with one another, the activities of angels cannot yet be considered an 'industry.' However, their importance in the landscape of finance for seed, small and medium sized enterprises is being recognised. Hence, our growing interest regarding their activities suggests that more systematic analyses are needed. By using the industry competitiveness model, our insights about angels are explored to find what is, and what is not, known.

Methodology is important to the study of angels. It is important because the invisibility of informal investors makes it hard to define precisely their population parameters. In most of the following studies, two primary methods of sample selection have been used, snowball samples and random samples. Snowball samples are convenience samples that identify potential constituents and then draw on those respondents to find more respondents. In these studies, the non-random nature of the sample selection makes extrapolation of the findings to the general population of angels impossible. Riding, Haines, Duxbury, DalCin, and Safrata (1993) and DalCin (1993) employ similar methods of snowball samples. Careful judgement should be used in attempting to draw conclusions regarding the wider population of angels when convenience samples have been used.

Random sampling is at the heart of statistical analysis. It is a necessary criterion for extrapolation to the greater population. Random sampling means that each member of a population has an equal opportunity to be selected. In angel research, the difficult part is identifying the population. Farrell (1997) argues strongly for more methodologies that are based on random samples of databases which attempt to define the population. She argues that the characteristics used to create convenience samples are often already skewed since the criteria are based on the results of other convenience samples. Her work employs methodologies which focus on random samples of new or recently incorporated firms and identifies informal investors from surveying directors of these firms. The companies and directors are sought from the provinces incorporation records and are randomly selected. Lionaise and Johnstone (1999) use a similar process.

There is another important argument for attempting to generate more representativeness by random sampling. It is possible that habitual angels (more than one investment) will be over-emphasised when employing some types of convenience samples. Since snowball sampling requires sample members to identify other potential respondents, habitual angels may be more likely to identify other habitual angels because, as frequent investors, they may be more well known. Novice investors, will be less likely to be identified as subsequent sample constituents because they are less well known. Novices will, therefore, be under-represented.

A third method uses capture/recapture statistical analysis, methods employed in biological population estimation Riding and Short (1987). Experimental and theoretical treatments such as these are important to the development of the field and should be encouraged.

2.1.1 Personal Characteristics

A review of earlier findings and comparisons between the US, Canada and the United Kingdom can be found in Mason and Harrison (1992). Attempts to categorise angels have taken many forms. Gaston (1989) developed a 10-type category (U.S.), Stevenson and Coveney convened six types including those who had never invested and those which were formal venture capital (1994). Riding (1998) wrote about independent, archangels (syndicate leaders), and corporate angels (discussed later). Most of these categorisations employ investment characteristics as the distinguishing criteria. Farrell (2000 forthcoming) has developed a comprehensive, two-criteria typology based on behavioural characteristics. Using the numbers of investments and the exit patterns, her typology divides novice investors into two categories: first-time novices (those who intend to invest again) and one-time novices (those who do not intend to invest again). Habitual investors are divided into: serials (habituals who exit one investment before engaging in another), and portfolios (habituals who hold a number of investments at once).

The literature world-wide has attempted to identify personal characteristics of the persons who conduct such activities. The most significant effort to date, regarding Canadian informal investors (Riding, Haines, Duxbury, DalCin and Safrata 1993), is summarised as follows in Riding and Orser (1997):

• Angels feel that they personally can influence outcomes through their own ability, skills or effort.
• They have very high needs for achievement and dominance. That is, they seek to do things better or more efficiently, to solve problems, or to master complex tasks. People high in need for achievement like to put their competencies to work and will take moderate risks in competitive situations. High need for dominance means that angels like to control other people and external events.
• They possess moderately high needs for affiliation or the desire to establish and maintain good relations with other people. Yet they also require autonomy and the desire to be able to work independently.
• They are motivated by subjective feelings that result from performing well: hence, they are highly involved in their work and their investments.
• Finally, relative to other people, angels report high levels of perceived stress and they cope with this stress by working harder (p. 119).

There is an assumption that wealthy areas and populations harbour more angels. Riding et al. (1993) used the wealth of informal investors from their study to calculate estimates of investment potential. They used wealth and income as proxies for the number of potential angels and then extrapolated the rate of wealth and income from the study to the population in Ottawa-Carleton. Informal investors in the Riding (1993) study had family incomes in excess of $175,000 and a personal net worth of $1.3 million. The prevalence of angels in areas less economically endowed than the Ottawa-Carleton region suggests that extreme wealth is not necessary.

These characterisations show angels to be self-sufficient, dominant, like to maintain relationships yet work independently too, are motivated by success, and engage in enough activities to feel stressed. In many ways, attempts to identify psychological constructs mirror researchers' efforts to classify entrepreneurs. In the entrepreneurship literature, there is widespread agreement that the results of the psychological evaluations often mirror those of other successful non-entrepreneurial people; therefore, other disciplines must be pursued in attempting to define and possibly prescribe entrepreneurs, and by extension, angels (Gartner 1988). Conditions of wealth have been previously assumed, but communityminded orientations may increase the propensity and activity of angels in areas where significant wealth is less evident.

2.1.2 Investment Characteristics

Much of the significant work in Canada to date has been highly descriptive and has focussed on estimating numbers of angels, the amount of angel activity, and investment characteristics. The 1993 nation-wide study found informal investors have family incomes of greater than $175,000, personal assets of more than $1.4 million and a personal net worth of more than $1.3 million (Riding et al.). Highfamily income and high-personal net worth individuals were seen as good candidates for "public policy targeting (p. 14)" for informal investment initiatives. Nation wide, more than 85% of the deals identified in the study were for sums greater than $100,000. Most investors obtain little income from their investments, however, a third receive more than 50 percent of their income from their risk capital investments (Riding et al. 1993). Ninety-eight percent of the respondents are male. The largest proportion were in the 36 – 50 year age category making these respondents, on average, younger than those from studies conducted in other countries. Seventy percent had a university degree or graduate degree.

During the past two decades a variety of studies have been conducted in the Ottawa-Carleton area as a result of the interest of the group of researchers at Carleton University. In the Ottawa-Carleton region, respondents are males about 50 years of age, well educated with university degrees and professional designations, hold senior managerial and administrative positions as well as entrepreneurs and lawyers; have annual incomes in excess of $100,000 and a personal net worth of more than $1,000,000 (Riding and Short 1987a). With the exception of gender, Riding and Short's (1987a) study in the Ottawa-Carleton area showed the profile of informal investors to be similar to profiles in other areas, before and since their work . DalCin et al. (1993) reported investment averages of more than $100,000.Riding and Short (1987a) estimated that about five percent of wealthy, self-made individuals in the Ottawa Carleton area are active angels. Were that so, wealthy, high-income families would represent about 1,500 to 1,750 potential angels.

In a breakout of Riding et al.'s (1993) national report for Atlantic Canada, angels were identified as successful businessmen, 84% of whom had founded or was top manager in a start-up, had a net worth of $1.3 million and an annual income of $177,000. Seventy-three percent were university educated (30% had some graduate school experience). They accepted one deal in 40 and expected returns of 105% over 4.25 years (18.4% annualised). Seventy-three percent were co-investments, and 29% used active personal searches for their opportunities (APEC 1994; special break-down of Riding et al. 1993 study material).

Suret, Arnoux and Dorval (1995) report that Quebec francophone angels share many of the same characteristics as outlined in studies previously conducted. Average investments were less than $100,000 in 68% of the cases. The Quebec angels' profiles, investment activities, methods of investment selection and expectations are unremarkable compared to others reported previously.

Farrell's (1998) Atlantic Canada entrepreneurs reported first investment averages of $78,000. When 'normalised^{Footnote 1}' to account for a small number of very large investments, the average first investment decreased to $22,000. In examining those who had invested more than once, second investment averages are $18,000 and third investment averages climb to $26,000. This study found that fully one-third of these were made to a family member and shows an incidence of female investors averaging 10%. Fortysix companies (15% of the sample) reported $5,303,500 in non-entrepreneurial investment capital suggesting an average of $115,000 per company was invested by an average of 2.2 investors per company (1998).

In Cape Breton, angels are middle-aged predominantly between the ages of 35 and 65 with the largest group between 46 and 55 (Lionaise and Johnstone 1999). The activity of the Cape Breton group showed that 37.5% invested more than once a year while 50% invested once every two to three years. The amount of experience as angels is a new characteristic (Lionaise and Johnstone 1999). This identifies the length of time the angel has been engaged in informal investments. The maximum investor experience was 24 years with an average of 13.6 years. Forty percent of the Island's angels had a maximum educational level of high school and 47% had an undergraduate degree or diploma. In the economically challenged area, there appear to be more angels operating with less education than reported in other studies. As a more isolated area, the level of education in Cape Breton might well be expected to be very different than the highly 'professional' environment of the nation's capitol^{Footnote 2}.

The angel phenomena is essentially local as the ability to track investments in far flung regions is near impossible, however, Canadians tend to invest further from home than other nationalities (Riding et al. 1993). Perhaps, related to our significant geography, Canadians have a greater physical area to cover.

2.1.3 Industry Size Estimates

As time passes, estimates increase greatly the amount of angel activity in Canada and the regions. The earliest reported Canadian study of informal venture capital estimated informal investments of $9 million in 1980 up to $27.3 million annually in 1986 (Languedoc 1989)^{Footnote 2}. In 1993, DalCin et al. estimated the rate of investment in Canada to be between $200 million and $400 million annually. In 1998, Riding is attributed with indicating that Canadian firms are the recipients of $1 billion a year (Gordon 1998)^{Footnote 3}. The more than one hundred-fold increase can be attributed to the growing understanding of the angels' importance, the greater numbers of angels than previously thought, and improved methodological approaches. Estimates of the amount available are reported as high as $15 billion annually (Bochove 1993).

Only a decade ago, an exhaustive study of private venture capital activities in Atlantic Canada failed to include "the direct funding activity of love money and informal investors (in the report)... due to the impossibility of assessing the amount involved, although it was determined with confidence that the role played by informal investors was far less important than observed elsewhere by others" (Gadbois 1991, p. 1). At that time, the 'confidence' with which informal investors activities were ruled insignificant was partially based on: 1) the lack of participation in Small Business Development Corporation (SBDC) loans or other provincially sponsored venture capital companies^{Footnote 4} (PSVCC) by those who identified themselves as angels, and 2) that the 'cluster' behaviour of angels would have made them hard to miss in the context of such an exhaustive study^{Footnote 5}. Hence, for a variety of coincidental and methodological reasons, angels were thought to be insignificant.

Three years later, a report issued by the Atlantic Provinces Economic Council (1994) suggested that informal investment is more widespread than commonly assumed. At that time, the Atlantic Provinces Economic Council's (1994) estimated informal activity in the Region at between $4 and $10 million. This estimate was based on 35 and 70 deals in the range of $155,000 per deal. Furthermore, informal investing had a better opportunity to gain ownership positions than formal venture capital (in Atlantic Canada) due to the local nature of angels' interests and the common associates and informants they share. Later, using a more representative sampling methodology, Atlantic Region (four province) estimates ranged between $25 and $85 million annually (Farrell 1999). Her most conservative estimates suggest that 525 angels fund 250 companies annually.

Dal Cin et al. (1993) estimate the Ottawa-Carleton informal investments to be $2 – 3 million. Four years later, in a report to the Ottawa-Carleton Economic Development Corporation it was reported that the untapped capital in the area amounted to $20 million. Between 100 and 150 active angels were accompanied by 200 – 300 potential angels (Aboud, 1997)^{Footnote 6}.

Suret et al. (1995) estimate that $232 million was conducted annually in the province of Quebec which has the capacity to double with more suitable projects. They estimate 2,175 represent the pool of angels from which 840 projects a year are invested. A total investment of $1.36 billion represents angels' capital, $300 million more than the total amount of formal venture capital invested in the province at the time.

2.1.4 Investment Preferences – Stage and Sector

The stages of investment where private equity capital can assist range from seed, start-up, expansion and mezzanine stages. Ventures need funds at differing stages of their development and informal venture capital investment and formal venture capital investment serve different stages. Industry observers extol the role of informal venture capital investors as complementary to formal venture capital investors – not competitive – since the markets they serve are largely different. Formal venture capital has been criticised in Canada and elsewhere for gravitating to the more profitable management buyouts and buyins and later-stage deals. Informal investment has largely been relegated to the seed and start-up phases of venture growth. Quebec, however, reports that only half of their informal investment deals (53%) are in the pre-start-up (seed) or start-up phase (Suret et al. 1995).

In terms of preferred sectors, the formal venture capital industry in "Canada has also put an emphasis on technology which accounted for 50% of 1992 investments" (Venture Capital in OECD Countries, 1996). Later, US reports of Canadian formal venture capital activity indicated that the technology sector continues to reign. In 1997, 63% of the 794 companies financed were technology-based businesses securing 67% (Cdn $1.2 billion) of total disbursements ("Canada's institutions return to the venture market" 1998).

There appears to be less of a technology focus in angel investments. As well, the focus of angels' preferences for investment in industry sectors varies significantly from region to region. Maritime angels prefer the service sector and construction investments while Quebec prefers industrial and consumer manufacturing, natural resources and real estate (Riding et al. 1993). Ontario's preferences are in industrial, consumer and high tech manufacturing, natural resources, real estate, service sector and the retail and wholesale (more so than financial, service or construction) while Western Canada is highly focussed on natural resources and real estate. Alberta prefers the energy industry (Riding et al. 1993). In Cape Breton, more specific information indicates informal investors prefer to know about the industry in which they will invest (Lionaise and Johnstone 1999).

Technology has dominated formal venture capital investments, but it plays a less active role in the informal market^{Footnote 3}. Francophone angels had 20% of their investments in high technology investments (Suret et al.1995) and Ottawa-Carleton seem to produce many high tech ventures. As the technology sector grows, technology entrepreneurs will obtain experience and success and informal investment in the sector will be expected to grow (Milburn 1999). As a type of evolution, the wait-and-grow process is not conducive to the immediate or present technology investment situation.

^{Footnote 2} Again, methodology is important; these results could be caused by the nature of the angel selection method. When we look to middle-aged, wealthy, high-income angels operating in relatively wealthy areas of the country who are identified by snowball and convenience sampling techniques, we find more educated, wealthy, high-income angels. When we survey angels identified by more random techniques (e.g.from incorporation registration records), we cover a greater spectrum of the possible angel population.

^{Footnote 3} Denzil Doyle, former CEO of Digital Equipment Canada, who has made a number of informal investments feels the estimate is less than $100 million ("In my opinion" 1997).

^{Footnote 4} SBDC was a provincially-based organisation providing loans to small business. The PSVCCs were provincial organisations established in many provinces and territories where private funds were matched by government funds and given attractive terms in order to encourage private equity placement. See Gadbois 1991.

^{Footnote 5} In more recent light, we acknowledge that angels do not necessarily cluster. Groups of angels are often in clusters as a consequence of the p revailing method used to locate angels such as convenience and snowball sampling. That is to say, if they are sought in clusters, they are found in clusters.

^{Footnote 6} As reported in Peterson, R. (1998). How is entrepreneurship different in Canada? The Financial Post, March 4.