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

3. Porter's Five Forces Model of Industry Competitiveness

Industries differ widely in their economic, profit and competitive characteristics. Retail differs from manufacturing which differs from financial services which differs from information technology. Even the economic and competitive traits of formal versus informal venture capital differ. The Porter's Five Forces Model of Industry Competitiveness is a tool used to systematically investigate the main sources of competitive pressure. The five forces are:

• The rivalry amongst competitors in the industry – how angels compete with one another;
• The ease with which customers can readily make use of substitute products offered by other industries – are entrepreneurs lured easily and attractively to other sources of finance;
• The threat and potential entry of new competitors to the industry – how hard or easy is it for other angels to enter the field;
• The bargaining power and leverage of suppliers – the impact that crucial elements of supply have on angels; and
• The bargaining power and leverage exercised by customers – when angels have selected an investee, how much power can the investee exercise.

3.1 Power of Suppliers of Inputs

In the Porter's Five Forces Model of Industry Competitiveness, suppliers are those organisations that provide essential factors in order for industry members to conduct their business. Suppliers to an industry can exert power if their forces are stronger than individual industry members. This condition is often associated with limited supplies, or few suppliers. When suppliers' actions can severely limit the industry, or when the actions of suppliers are crucial to the industry's performance, then suppliers play a powerful role. However, when an industry survives and thrives despite adverse actions by suppliers, suppliers do not have a powerful role. In the fledgling angel industry, matters of supply relate to the provision of capital to angels, and governmental, economic and entrepreneurial forces that encourage informal investors to invest.

The provision of capital to the investors is very different between formal and informal venture capitalists. Formal venture capital funds investors hire general managers who execute investment decisions and who are conduits between the funds providers and the investees. Therefore, the supply of funds to the general partners is an important source of supply. This scenario necessitates agency concerns (the issues surrounding the actions of agents on behalf of principals) between the funds provider and venture capital general managers, as well between the venture capital general manager and investee (which is more commonly discussed in the literature^{Footnote 4}). The supply of funds to formal venture capitalists can be affected by their actions. However, there is no separation of the funds provision and decision making roles for angels and so there are no inherent agency concerns raised. In the informal investment industry, angels perform the dual role as both the funds provider and the executor of the investee transaction. Therefore, the supply of funds and related agency concerns are not issues for discussions relating to informal investors.

A number of other important factors warrant discussion in this section. They include government incentives to encourage informal investment, general economic conditions such as wealth and interest rates, and the specifics of the deal search and decision making characteristics as they related to the supply of proposals from which to select. (After the investor invests, the entrepreneur becomes the customer – the recipient of the investor's product – dealt with in a later section on the Power of Customers.)

3.1.1 Government Interventions & Incentives

To encourage investment, governments can act in two ways. They can encourage investment by actively intervening and supplying venture capital, becoming intermediaries and training entrepreneurs. Or, governments can incite individuals to action by providing tax breaks and eliminating income tax (Clark 1994). Canadian governments have engaged in two classes of activities; they have employed efforts to encourage business introduction agencies, and they have designed provisions to protect and encourage investors and entrepreneurs, and they have applied tax incentive programs. Neither has been reviewed conclusively. At times, securities legislation, implemented to protect investors, seems to act like an impediment. Furthermore, it is not yet clear that tax initiatives, designed to encourage individuals to invest, act as motivation for investors. Despite the questionable efficacy of recent policies, these methods are preferred over direct handouts which are seen as more political manoeuvres ("Best Way to Help" 1994).

In the formal venture capital industry, Canadian tax incentive schemes are instrumental in raising billions of dollars of formal venture capital funds (Mayers 1996)^{Footnote 5} though the funds are reported to have suffered from passive investments, exit problems and political and bureaucratic agendas (Harvey 1995). More money in these formal venture funds implies that additional worthy venture projects would be funded. Criticism has been levelled at the program, however, because investments have been made in public companies (Mayer 1996) and other larger firms. Regulations in the 1999 Federal Budget provide incentives designed to encourage labour-sponsored venture capital companies (LSVCC) to invest in businesses with less than $2.5 million in assets (Canadian Institute of Chartered Accountants 1999). As well, others criticised the revenues lost to governments particularly during high deficit periods ("Labour funds need tax breaks" 1995). As of 1999, Canadians are able to take advantage of a 15% federal tax credit for buying shares up to $5,000 in a LSVCC.

The intention of similar tax initiatives directed at informal investors is to encourage and develop the informal investment industry. These tax systems provide direct tax relief to the investors in the year(s) following the investments reducing the effective net investment by as much as 40%. A $20,000 investment can be reduced to $12,000 over a year or two by providing direct tax relief to the investor's tax paid. Needless to say, a reduction in the net investment has implications for the effective rate of return. If a $20,000 investment paid $30,000 in seven years, the investor would have received a 6% annual return. If the $20,000 investment is subject to a 40% tax credit, the effective rate of return annually increases to 14%.

While investment tax schemes improve returns – provided all the other necessary conditions are met – it is not clear that they actually encourage or motivate informal investment. Some studies have focused on individuals' reports of their motivations which can be different than observed results. Riding et al. (1993) found that less than a third of respondents were encouraged to invest informally as a result of the Canadian $100,000 capital gains exemption. In fact, 69% actively indicated it did not prompt their decision though most said they would like to see the capital gains exemption increased. Of the thousands of informal investments estimated to have been made over a multi-year period in Atlantic Canada (Farrell 1998), only 113 companies were reported to have been registered with the Province of Nova Scotia's Equity Tax Credit records since its inception in the early part of the decade^{Footnote 7}. The Provincial Venture Capital Corporations (PVCC) of the 80's, intended to provide tax benefits linked to the size of investments, were found to have been little used by angels. The PVCC's requirements for professional legal and accounting information for even relatively small investments was seen to be an impediment. Therefore, there is little evidence that tax incentive schemes contribute significantly to the development of informal venture capital investing. If the relationship exists, it has not been widely studied or reported.

Interestingly, angels are more interested in improving conditions for the venture businesses in which they invest rather than obtaining tax credits for themselves (Riding et al. 1993). When asked by researchers what they would do to improve the rate of informal investing, the most frequently stated comments related to tax holidays, accelerated capital cost allowances, and reductions in tax rates for small businesses. As well, respondents felt if larger corporations were able to take advantage of tax breaks for investments under $100,000, informal investors may be better able to find adequate exit routes thereby improving the overall investment picture. Reductions and elimination of capital gains taxes on small and medium-sized enterprises were the next most common comments.

Other suggestions regarding taxation related incentives are those that can be applied at the exit stage rather than the investment stage – namely capital gains exemptions or reductions. Some critics argue that tax breaks on investments at the beginning of the investment cycle are like giving the prize at the beginning of the race while taxing capital gains represents an unnecessary penalty for investors at the end of the investment ("Do labour sponsored" 1999). Some would prefer that a greater capital gain incentive be applied at the exit stage though Suret et al. (1995) noted that though the small business capital gains exemptions were important, many of the angels they met had "already completely exhausted this deduction" (p.59).

Experience in the U.S. during the late 60's and 70's showed a distinct indirect relationship between the rate of capital gains tax and the amount of venture capital flowing into venture capital pools (Tefft 1985). In the mid-80's, in response to indications of increases in the capital gains tax rates, the Canadian formal venture capital industry entered into discussions with governments about the tax rates on capital gains in Canada indicating the potential for disaster in the industry if the rate were increased. Comparisons between Canadian, U.S. and British capital gains tax rates showed that angels who have exhausted their $500,000 small business capital gains exemption "pay significantly higher taxes than would an investor in the United States" and the United Kingdom as the length of time the investment is held increases (Cleveland 2000, p.1). Exemptions in the U.S. are applied at a rate of $10 million per family and the British equivalent is unlimited as long as the maximum £150,000 investment is held for five years. The Canadian budget released in February 2000 includes provision to rollover investment proceeds "where the proceeds are used to make other eligible small business investments" CICA 2000, p. 6). The deductability of losses in the U.S. and Britain are also more favourable to the investor than they are in Canada (Cleveland 2000).

Other initiatives, designed to protect unsophisticated investors from unscrupulous venture promoters, have had mixed results. Securities legislation, enacted to protect investors, is complicated to say the least. To comply with Ontario securities legislation, companies selling equity to individuals in amounts less than $150,000 require a prospectus (Macintosh 1993). Using the seed capital exemption, companies seeking capital from fewer than 50 investors with sales to no more than 25, are exempted from preparing a prospectus, but all potential investors must have access to information similar to that which would be found in a prospectus. Other exemptions apply to companies if the securities "are not offered for sale to the public" (Macintosh 1994a p.59).

Riding (1996) suggests that the difficult and protracted nature of these initiatives encourages informal investors to seek legal counsel. Layering legal, accounting and prospectus-related requirements to a $20,000, $50,000, or $75,000 investment significantly adds to the cost. When the investor feels these actions are required, they substantially reduce the initiatives' impact. Increasing impediments, he suggests, may well be the reason Canadian investors invest less frequently and for larger sums. "Complex regulations and prohibitive costs only serve big players" (DeJordy 1989b). Angels, however, continue to invest regardless of the securities regulations. "Ordinary Canadians are already making these informal private investments in high risk start-ups without such protection" (DeJordy 1989b, p. B3). Exactly whom do the regulations benefit? The trail of small investments demonstrated in the Atlantic Region (ranging from $1000 to $1,000,000) strongly suggest that many investments are being made without regard for the regulations (Farrell 1998).

The McCallum Task Force to the Ontario Securities Commission (OSC) in 1995 recommended a lifetime limit of securities sold under exemption status representing a total of $3 million, and the establishment of a new exemption for a new class of 'accredited' investors who are more sophisticated about a specific company, or informal investing. Three years later, the OSC responded with suggestions of making sophisticated investors of those with a net worth over $2.5 million and $300,000 net income, and abolishing limited market dealers. These proposals were met with criticism for not being mindful of the Canadian conditions since sophisticated Canadian investors were shown to have net worth and income brackets of approximately one-half of that suggested by the OSC (Sharwood 1999)^{Footnote 8}.

In Atlantic Canada, specific regional initiatives by government agencies have attempted to provide a better supply of formal and informal venture capital. A decade ago, it was widely accepted that a lack of venture capital had caused firms to be over-leveraged with debt (APEC 1994), or they had self-financed their enterprises causing limited abilities to expand into larger markets. The Atlantic Canada Opportunities Agency's (ACOA) Action Loans Program was designed to supplement the "disturbing gap" (p. 5) for formal venture capital in the region (Vardy 1990). While the Action Loan Program was intended to remedy the venture capital gap by providing deferred interest loans, critics later argued that the government 'grants and subsidies' were the cause for the lack of formal venture capital investment in the mid- to late-90's. The short memory function has the cure becoming the cause. The reasons for a lack of venture capital in the Region require deeper introspection.

The strongest explanation suggests that Atlantic Canada does not share a similar demand function for venture capital as other parts of the country. It has been observed that, "even when equity investment is available, Atlantic entrepreneurs have tended to forego this option, possibly due to the lack of experience in sharing ownership with outsiders" ("Atlantic business development" 1994). Loans by the then Business Development Bank of Canada which represented 14% of the Bank's portfolio in 1994 far outweighed their equity investments in Atlantic Canada which totalled only $500,000. Anxious to correct the imbalance, the BDC tried to increase the rate of investments to loans. It is thought that if there had been a real demand for venture capital, the demand would have sought out the supply. The prevailing rationale suggests that the strong undercurrent of informal venture capital combined with a culture which supports a business tradition of small companies under tight control are the reasons for the anomaly (Campbell 1997).

In sum, reductions in capital gains and in business taxes are desired and there is some evidence to suggest they encourage informal venture capital at least in other jurisdictions. Initiatives designed to protect investors are easily complicated and lose their impact at a grass roots level when they become protracted. Direct government incentives, where they are debt-oriented, will always be preferred to equity programs.

3.1.2 General Economic Forces

Interest rates in general will affect how readily investors engage in informal investments. When interest rates are high on low risk bearing instruments, investors will tend towards the lower risk options. When interest rates are depressed, higher risk ventures will likely attract more dollars. Similarly, the attractiveness of the public equity markets which attract large amounts of investment monies may leave less available for informal investors to invest in early stage ventures (Langille 1998).

Other, larger economic forces can deal a fatal blow such as the stock crash of 1987. Formal venture funding for companies following the crash was dismal though anecdotal reports by angels indicated little harm done to their investment activities (Blackwell 1988). Angels may have been less unnerved by the crash than those investing in formal venture capital investees because the angels' early stage investees are further removed from the likelihood of going public soon.

3.1.3 Deal Generation and Pre-Investment Decisions

The flow of projects available for investment is composed of a number of factors including the number of proposals in circulation, the angels' search activities, and their subsequent screening, due diligence and decision making. Combined, these activities form the essence of 'deal generation' which contributes to the essential supply of entrepreneurial ideas and initiatives to the industry. The angels' search for proposals and the quality of those proposals are crucial elements of the supply.

There is a significant sentiment that angels do not want to be deluged with proposals so they keep themselves hidden, or 'invisible.' No one in Canada, or elsewhere, has specifically addressed the issue of anonymity although it has been oft-repeated since it was first uttered by Wetzel in 1983. The so-called invisibility and anonymity desired by angels precludes them from actively soliciting their intentions or making their names known publicly.

Yet, there is also significant sentiment that there are not enough good proposals to absorb the supply of informal venture capital (Riding et al. 1993; Suret et al. 1995). Suret et al. (1995) indicated the amount invested in Quebec would more than double were enough good proposals available so angels indicate a desire to see more proposals (Riding and Short 1987b). This feeds a curious dilemma since angels indicate a desire to see more proposals, but do not want to be seen doing so for fear of being deluged like new winners in a lottery. This would indeed be very peculiar behaviour for someone who wants to view more proposals to enhance the chances of finding more good proposals.

This dilemma raises questions about the activities in which angels engage to identify and search for deals. Of this we know little to nothing. The angel literature outside of the Canadian experience has focussed on informant reliance (Fiet in the US) and the role of business introduction networks (Mason and Harrison in the UK and Heidrich in the US) as the predominant deal search activities. Riding et al. (1993) and Lionaise and Johnstone (1999) found similar patterns. However, both these methods of deal generation involve very passive involvement by the angel which seems inconsistent with intuition and anecdotal evidence. For example, it is unreasonable to think that Terry Matthews of Newbridge Networks, an active and highly successful entrepreneur and informal investor, is sitting about, awaiting a lawyer or a colleague to call him about a spectacular investment opportunity. There is a complacency about networks and informant reliance; the most recent doctoral dissertation on angels processes ignored deal selection (van Osnabrugge 1998).

Relying on existing research regarding informant reliance and business introduction networks does not help us understand their actions and motivations. The literature tells us that angels engage in a very passive deal selection process, but our intuition tells us other activities are likely being engaged. It is not clear what angels do in their formal or informal search for proposals. Are angels observant of entrepreneurial signalling behaviours? Do they regularly put themselves in situations where entrepreneurs or successful business operators congregate? Are angels exhibiting signalling behaviours (actions that act as indicators of interest to other angels or potential investees)? What are they reading? To whom do they listen? To whom do they talk? Where do they advertise? How do socialisation patterns affect their deal search and decision process? What motivates their actions? Answers to these questions are more likely to provide practical applications in the long run than prematurely providing prescriptions about how to find angels.

Researchers have become complacent with the standard 'informant/business introduction service' response^{Footnote 6}. Angels (corporate or otherwise) must engage in some search activities. Identifying their behaviours and deal search activities would improve our understanding. Interestingly, the Cape Breton study indicated cold calls from entrepreneurs and other individuals were the third largest sources of deals for investors (Lionaise and Johnstone 1999) – a first in the literature anywhere! More new information of this nature is needed.

It is reasonable to hypothesise that if angels want to view more proposals it would be better to publicise their intentions as it would improve the proposal selection process as it makes it easier for entrepreneurs to find them. Ned Macaulay's comments confirm this notion (Sheldon 1999). Another angel, however, feels that the process of investigation engaged in by the entrepreneur in order to find the angel is a testament to the entrepreneurs' perseverance and fortitude – a sort of hurdle to be overcome (see Creig Clark's comments in Greenwood 1994).

In the formal venture capital experience, hundreds of proposals are regularly rejected; angels could have access to these business plans if they actively sought them or made themselves known. Angels are known to be less rigorous about hurdle rates of return, selection criteria, screening and due diligence activities than are formal venture capitalists, thereby making the projects of most entrepreneurs more available to angels than to formal venture capitalists. The lack of due diligence may be a result of less time or less ability, but is sufficient to reduce the inherent cost of evaluation and therefore the returns required. This makes more proposals available to them than to formal venture capitalists (though it does not necessarily work to the angels' advantage as angels indicate regret at not conducting more due diligence (van Osnabrugge 1998) perhaps because a great many invested deals fail (Farrell 1998)).

Quantity aside, the relative quality of entrepreneurs plays a role. Most entrepreneurs, it is felt by angels, are lower quality entrepreneurs (Riding et al. 1993) whose business plans may be viable, but are not capable of producing exceptional returns^{Footnote 9}. This group of entrepreneurs has little power in the investor-investee relationship.

High quality entrepreneurs, on the other hand, who have other resources available and are shopping for the best value, support and price to accompany their capital, will have high power in the relationship. These are the entrepreneurs for whom angels desire an opportunity to invest, but are less likely to be encountered because high quality entrepreneurs will find finance opportunities faster (Amit, Glosten and Mueller 1993). This would suggest they are in the market for finance for a shorter period of time. Angels looking for high quality entrepreneurs will need to be active and involved to meet the high quality entrepreneurs within the short time frame they will be in the market.

There could be a strong argument for the proposition that high quality entrepreneurs turn non-investors into investors. Something must turn non-investors into novice investors. Meeting a high quality entrepreneur with a successful business plan may be the necessary pre-qualification that converts noninvestors into first time investors. That little is known about this conversion process emphasises the many important elements of angel investing which have yet to be uncovered. Because of the extreme upside potential of investing in a high quality entrepreneur, it is likely that the power held by the entrepreneurs, in their relationships with their angels, is high.

3.1.4 Summary

A number of factors impact on the power of crucial contributions (supply) to the industry. 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 would be expected to contribute considerably to the desirability of informal investing. Though wealth and economic factors would seem to be very important, there is evidence in poorer pockets of the country and during significant times of financial market distress when informal investing still seems to be high.

3.2 Competitive Rivalry

In many industries, the most important of the forces defining the industry is the jockeying for position amongst the various industry participants. Their strategies depend on their competitors' actions and the resources any one player may be willing to devote to retaliating or reacting. Generally rivalry intensifies when: the number of competitors increases; demand for the product is growing slowly; customer switching costs are low; competitors are dissatisfied with their market position; or when it costs more to get out of a business than to stay in and compete. As an example, there was evidence of competitive rivalry in the formal venture capital industry when a flood of venture capital funds caused the Canadian government to suggest that there were too many venture capitalists seeking too few proposals. Formal venture capitalists attempted to differentiate themselves by the quality of the valued added service they provided, their ability to take ventures to IPO, by the sector in which they specialised, and other specific services.

3.2.1 Number of Competitors – Regionalism and Secrecy

In attempting to gain information about reports, research and the activities of trade associations and chambers of commerce regarding angels, contacts were made with the directors of these associations from across the country. Few offered any published or other information about the topic except the significant efforts of the Newfoundland and Labrador Chamber of Commerce. The Newfoundland and Labrador Chamber of Commerce hosted a four-location detailed seminar series with well-developed materials, speakers and substantial promotion ("Venture Financing Seminar Series" 1995)^{Footnote 7}.

Unfortunately, in some locales, the appreciation for angels' roles in financing new and expanding SMEs has generated a proprietary sentiment. In a perverse reaction to the supply of angels, some of the communities where angels work have taken to guarding the angels as well as the provision of any published information about them. Some community associations which were contacted as a matter of course, in an attempt to identify publications for the literature review, reacted protectively and secretively about the knowledge or presence of angels in their communities and were reluctant to talk to 'outsiders' seeking previously published information.^{Footnote 10} This took researchers by surprise.

That requests for previously published materials were met with suspicion illustrates the protectiveness with which some associations guard their informal investors. There are two hypothesised explanations for this reaction. Firstly, the local association may be attempting to protect the identity of its known angels as the issue of anonymity has been widely publicised. The second, and more likely, reason for their protective reaction is a desire to keep their angels' future capital placements within the community by limiting their angels' exposure to the 'threat' of proposals from outside the community. Proprietary reactions by those who would attempt to protect their community and angel interests hinder research and development of better understanding as well as the angels' prospects for finding good investments. These types of reactions suggest there are still many un-funded entrepreneurial opportunities within a particular locale. The reverence with which angels are treated supports regional secrecy. It is unknown what reactions to expect to the possible introduction of new angels to these areas. It is suspected more new angels would be welcomed as more is preferred to less.

3.2.2 Demand Growing Slowly – Few Good Entrepreneurial Proposals

Currently, a plethora of entrepreneurial proposals are in circulation. The increased requirements for fully developed business plans has precipitated the ease with which entrepreneurs can disseminate ideas. Prior to the widespread recognition of the importance of business plans, entrepreneurs with proposals to finance would have had to contact people in person, a more daunting task for most.

Though there are many business plans, what appears to be scarce are good business plans. In their analysis of the marketplace, Riding et al. (1993) suggested that there are many angels who want to invest but suffered from a lack of adequate proposals. A number of studies identified a considerable excess of additional funds possible to invest in Canada (Riding et al. 1993; Suret et al. 1995; Lionaise and Johnstone 1999). Riding et al. (1993) concluded that there was not a shortage of investors, but a shortage of good investments. As well, entrepreneurs are often unprepared for entitlements expected by equity capital (Suret et al. 1995). Furthermore, entrepreneurs who advance business plans without due consideration for the returns expected by angels are not just demonstrating their managerial inability to successfully commercialise a product and manage the investors' money, but actually advertising it (Riding 1998).

The Canadian, U.S., and British literature refer to lack of confidence in managements' abilities (Bochove 1993) to successfully bring the product to market as the predominant reason why business plans are rejected. The importance of the managerial talent of the entrepreneur is very important to angels. Angels use their selection of capable entrepreneurs to limit their exposure to market risk (Fiet 1995). Their concern for the proper selection of the entrepreneur (focus on agency risk) arises from their inability to wrest control over the investments if necessary because of limited share holdings and lack of contractual control mechanisms such as equity ratchets, strict monitoring and inability to replace the entrepreneur. Angels limit their exposure to market risk by selecting entrepreneurs who they believe to be expert in the product/market environment and who can manoeuvre the company within the marketplace to take most advantage of opportunities and limit industry, market, and competitive risk^{Footnote 8}.

The large number of informal investments taking place (Riding 1993; Farrell 1998) suggests that many angels are able to find large numbers of investments that do meet their individual criteria. In Quebec, Suret et al. (1995) suggest that the wealthiest angels are in competition with formal venture capital investors – an issue which is further exacerbated by the government's promotion of formal venture capital investments.

In theory, when there are more industry players (angels) than customers (good entrepreneurs), rivalry between industry players intensifies as competitors jostle with one another to compete for market share. If one expects rivalry amongst angels to increase as angels compete for proposals, why then does there not appear to be any rivalry? In fact, to the contrary, there appears to be a great deal of co-operation amongst angels. The answer may be in the popularity of syndication and the lack of informational efficiency in the market place. First, let us deal with syndication.

3.2.3 Syndication

Syndication is the term used to describe the co-investment of more than one investor in a project. Syndication is a means of providing greater amounts of capital for entrepreneurs by pooling the investments of a variety of individuals. Syndication is a risk reduction mechanism for angels providing benefits in two ways. Firstly, one angel does not have to provide all the funds, so angels can invest in ventures that require more funds than they are able, or care, to devote. Secondly, it spreads the knowledge base about market and agency risks amongst the group. "I can't spend $100,000 on lawyers and technology expertise for due diligence. But if three of us are looking at a deal, we have a broader pool of knowledge and contacts. One will be an engineer who knows someone in a related field who can check things out.^{Footnote 9}" (Sheldon 1999 p.28).

The wider literature provides evidence that syndication increases the anticipated holding period as well as decreasing angels' expected returns (Aram 1989), both of which are consequences which are advantageous to the investee. The practices of syndication and referrals from one firm to another are well entrenched in the formal venture capital industry (Sweeting 1991; Tyebjee and Bruno 1984) and some firms have been shown to invest in opportunities they had previously rejected when other venture capitalists had since chosen to invest (Steier and Greenwood 1995).

Ninety-one percent of Ottawa-Carleton area angels liked investing with others and had invested with a consortium, a venture capital company or a government agency (Riding and Short 1987b). This is in contrast with Cape Breton where investors co-invested 50% of the time and alone 35% (Lionaise and Johnstone 1999). Preferences for co-investing received a rating just slightly above indifference. This may be a result of a less sophisticated capital market (fewer players and fewer types of players), less information about the market, or fewer habitual investors who may have multi-player experience. There may be variations as a result of the economic disparities between the two examples as well, Cape Breton being a more economically challenged region than Ottawa.

There is little known about syndication and lead investors, and yet the implications of syndication could improve sectoral gaps in angel investments. For example, where there is a lack of investment activity – such as the high tech sector in Cape Breton – syndication could provide a solution by involving several investors even though there is only one individual well versed in the technology^{Footnote 11}.

Angels tend to be more co-operative than competitive. The co-operative nature of their activities suggests an industry in its infancy whereby the co-operation benefits the individual players more than competitive actions.

3.2.4 Informational Ineffiencies

In some industries, rivalry is focussed on price competition. In other industries, performance features, product innovation, quality, durability, after-the-sale-service, or brand image are the key determinants by which competitors differentiate themselves. In the formal venture capital market, the VCs' specialisation and ability to successfully contribute and add value are features by which they attempt to differentiate themselves. There are no similar differentiating qualities amongst informal investors.

There are few avenues by which angels can systematically exchange information. Other than infrequent media coverage and some word of mouth, angels have no way of knowing what competitive practices other angels are employing. Angels do not know about the offerings of other angels, their deal structures, expected returns or governance practices. Therefore, lack of an information transmission system, irregular angel communication and the resulting lack of knowledge of other angels' activities works to keep rivalry at a minimum.

One of the most important new features regarding information transmission and informational inefficiencies is the proliferation and impact of the Internet which is revolutionising established powerknowledge relationships. Literally hundreds of matchmaking services and angel intermediaries are available on line from the US, the UK, Europe and Australia. The Internet has web sites offering matching services, advice for entrepreneurs, venture advertisements, advice on where to find business angels, and sites advertising angels themselves.

One of the most surprising findings is that the ubiquity of computers, and exponential growth of all things Internet-related, has not manifested in a proliferation of Canadian-based, angel related web sites. There are very few angel-related Canadian web sites. At a government level, this may be a natural result of difficulties arising from the Canadian Opportunities Investment Project failure, yet there appear to be many CCIP sites which do not have web sites. Regardless of the funded sites, one would expect more match making sites to have developed at the local or private level. Of the sites that were found, a few were related to angel activity amongst other information, a few were specific to angel information, and three Canadian sites had a matchmaking motive in mind. The three matchmaking sites are: 1) the "angel banker club" with Banakor Swisse and had a Toronto telephone number; 2) the Mount Pearl CCIP site, describing their matchmaking responsibilities and activities; and 3) the Ste-Therese de Blainville CCIP site, http://www.carrefour-capital.com/.

Other Canadian sites which offered limited general information about angels and the nature of their investments were: The Canadian Council for Small Business and Entrepreneurship, Industry Canada, Macdonald and Associates, Ventures West Inc., VC Firm, and the Canadian Venture Capital Association. Their web sites appear in Section 6.3.

The review of Internet web sites and the dearth of much Canadian activity adds further evidence to the informational inefficiency argument. Groups of individuals from associations and industries around the world occupy 'chat lines' on thousands of subjects, but angels choose not to invest in information with other angels. The ease with which angels could use the Internet to meet other angels, trade information, compare prices, contractual arrangements and exits would facilitate their activities – but still nothing exists. With the exception of their co-investors, theirs is a very solitary endeavour.

3.2.5 Summary

The protective and secretive sentiments of trades associations implies that there are not enough angels to meet the demands of their local entrepreneurs. Yet angels report not being able to find enough demand (good entrepreneurs) to satisfy their supply. The industry and market are at odds on this matter. The lack of angels' activities to take advantage of new information technology to learn about the actions of others in their own industry suggests informational inefficiencies are still at work. As they are unaware of one anothers' activities, rates of return, investment criteria and venture opportunities, there is little room for rivalry.

3.3 Threat of New Entrants

Factors important to the threat of new entrants embody elements that would lead to an increase in the number of competitors in an industry. The threat of new entrants attempts to isolate competitive factors that causes there to be more players conducting the same activities and competing for the same market. For most industries, a high threat of new entrants spells increased rivalry and more competitive reaction required. When industry factors combine to produce high profit margins and few barriers to entry, new competitors can flood the market making operations and profitability more difficult for existing competitors. A variety of forces act to discourage new players from entering an industry. They include: high capital costs to enter; requirements for detailed and specialised knowledge; the presence of learning and experience curve effects; specific resource hurdles or requirements; limited access to distribution channels; or regulatory and government actions. The presence of a number of these factors can inhibit the entrance of newcomers to the industry (Thompson and Strickland 1998).

3.3.1 Capital Requirements to Enter

There is a significant total dollar investment needed by an individual to enter this market either successfully or unsuccessfully. In the absence of government tax incentives, the investments are made in after-tax dollars making them almost twice as expensive given the income brackets of many of the kinds of individuals investing (Riding et al. 1993). Though a number of provincial and federal tax incentives apply, clearly, a minimum level of wealth is necessary to enter the market.

The height of the market entry barrier, however, may not be as high as convenience sampling implies. Hand picked, non-random samples tend to have few investments with large values. When large numbers of angels appear in samples that have a more random approach, however, (Farrell 1998) suspicions build that extreme wealth and high incomes may not be prerequisites for angel investing. Farrell's work did not request income or wealth information, but the numbers of angels appearing in the data suggest rates of informal investing that may go well beyond the numbers having extreme wealth in the provinces. As well, the same study showed investment ranges from $1,000 to $500,000. Though small by comparison, some individuals are exhibiting the excitement of new ventures involvement at a minimal level of entry barrier.

3.3.2 Access to Distribution Channel – Business Introduction Networks

Angels are not obvious and finding them is an elusive pursuit at best. Their invisibility and the difficulty entrepreneurs face in finding angels represents a "giant game of hide and seek with everyone blindfolded" (Gaston 1989, p 4). The entrepreneurs' best chances at finding one is still thought to be through their own network of colleagues and acquaintances (Yarr 1999, Sharwood 1996). In Atlantic Canada, the number of novices out numbered the number of habituals so entrepreneurs, in searching for angels, may be best advised to look to individuals who have never previously invested (Farrell 1998).

Business introduction agencies are agencies which try to match angels with entrepreneurs. Significant efforts at developing business introduction agencies have been initiated. Business introduction networks, match making bureaux, and networking services are seen as desirable and important as a type of channel mechanism bringing buyers and sellers together. Access to channels of distribution – in this case, finding suitable manners and means of matching angels with adequate entrepreneurial pursuits – is a matter of significant discussion, study and public effort in Canada. Intermediaries, national, local, sponsored and private match making initiatives have been established. Surprisingly, initiatives have met with extremely variable reception and results.

Earliest reports of investor interest run hot and cold on the idea of match making networks in Canada. Riding and Short (1987b) found that about 30% of informal investors had no, or almost no, interest in matchmaking networks and about 45% were only moderately interested in the idea. The message, though not strong, seemed to be that they were not interested and would prefer to find deals on their own. They either did not want, did not trust, nor did not feel the necessity for the services. At that time, there may have been less acceptance for the intermediaries as a consequence of less knowledge about the services. Why some (possibly many) angels do not prefer such services has yet to be discovered.

A number of matchmaking services have been launched in the past decade. In 1990, the Foundation for the Advancement of Canadian Entrepreneurship (FACE) launched the Enterprise Funding Corporation as an information, opportunity, networking and resource subscription database where opportunities could be reviewed and listed for sale (DeJordy 1990 a; 1990b). The then Ottawa-Carleton Economic Development Corporation has maintained an office for the Special Investment Opportunities (SIO) project which has been "instrumental in arranging early-stage financing of almost $5 million for Ottawa businesses" (Riding 1998 p. ME4).

The Canadian Investment Opportunities Network (COIN) project's failure was widely reported in Riding et al. (1993). Computerised business introduction services have had limited success in Canada. Its lack of success is attributed to the informality of the database, the breadth geographically at which it tried to bring investors and entrepreneurs together, and its arms' length attempt to introduce entrepreneurs without regard for project type or quality. As well, because the investor had to contact the entrepreneur, it was felt that the anonymity issue was not handled well. The case of the Halifax Equity Group, which added personal service and much cultivation of entrepreneurs before presentation to investors, was also a failure though not as widely known nor publicly evaluated. It is probable that there are other efforts to provide business introduction services which exhibited similarly poor results.

In the U.K., the apparently more successful business introduction services are generally funded by subscription memberships and little due diligence is performed on the deals. The investors receive newsletters with the details of entrepreneurial activities included. Investors contact entrepreneurs if they are interested. Though surprisingly similar in practice, the U.K. efforts appear to be more successful than COIN was in the Canadian context.

No benchmarks have been established by which one determines the success of such a service, however, examples of relatively more successful Canadian operations include the now defunct St. John's Board of Trade Investment Opportunities Project (IOP) and the currently operating University of Calgary MBA student credit system. The former, the St. John's Board of Trade IOP was funded by ACOA and brought together investors to view screened opportunities, organised forums, and conducted education and information seminars. Twelve matches (from 90 entrepreneurs) over three years produced acceptable results. The University of Calgary ("CCIP Conference Report" 1999) gives MBA students credit towards their degree program to conduct due diligence for entrepreneurs^{Footnote 10}. If the year's efforts produce ventures which look favourable after the students' analyses, a number of angels are invited to the University to hear the entrepreneurs' plans. They have had a number of noteworthy successes over the past 15 years, but unfortunately, like the formal venture capital model, their experience has shown that angels are more likely to favour the larger deals (greater than $500,000)^{Footnote 12} short changing the younger, more immature seed deals for which it was thought informal investment was ideal.

More recently, under the Canadian Community Investment Plan (CCIP), a comprehensive investment skills development program ("Steps to Growth Capital" 1997) and 22 demonstration sites across the country are developing databases and networks, organising investor forums, screening entrepreneurial proposals, and coaching entrepreneurs in an attempt to facilitate access to capital. A formal analysis of best practices will be developed and disseminated following the program's completion in 2002 ("Canada Community" 1995).

In 1998, the merchant banker, Banakor Swisse, launched an 'Angel Investment Club' via Chase Global Capital whereby investors with as little as $1,000 can partake of group investments reviewed and analysed by Banakor Swisse specialists ("Angels are organising" 1998). Unlike the average expected returns on angel investments, Banakor Swisse pays the going rate on a savings account. Three months after announcing the product, bank officials met with potential investees in Nassau ("Looking for returns" 1998b), and ten months later were referring to the club as "a unique organisation of international elite, sophisticated and astute venture capital investors." The target seems to have evolved considerably from the initial prospects who were the $1,000-investors ("Banakor Swisse Financial" 1998c).

Reports have indicated that because of the difficulty in finding good entrepreneurial opportunities (Riding and Short 1987a), it is important for the business introduction agency to weed out the 'lemons' (Blatt and Riding 1993). Some reports from the U.K. suggest that business introduction services only attract lemons (Harrison, Dibben and Mason 1997) because only lower quality entrepreneurs seek these sources of funding (Amit Glosten and Mueller 1990). Angels who desire networking opportunities prefer presentations and informal private investment circles (Lionaise and Johnstone 1999). Sufficient funding would appear important as a direct correlation has been established between sufficient money for publicity and advertising and a continuous flow of new entrepreneurial opportunities and angels (Brown and Stowe 1991).

At present, opportunities for matchmaking services are ripening, but the perfect equation to woo investors and satisfy entrepreneurs has not yet been found. In theory, market inefficiencies would seem to be improved by introducing angels and entrepreneurs and facilitating the free flow of information, but the lowest ability entrepreneurs are expected to take advantage of these services (Amit Glosten and Mueller 1990). In practice, the interest of investors is thin at times and over-zealous entrepreneurs are unhappy with the results after weeks or months of anticipation and no capital forthcoming.

Business introduction services are intermediaries and play a role in the introduction of entrepreneurs and angels. As Internet technology is engaged by issuers, the competition for good proposals may increase and cause a greater shortage of suitable opportunities. Fewer and fewer intermediaries need be involved in transactions. Langevoort (1998) provides an analysis of the US situation that poses thoughtful questions about the more direct channels – from angel to entrepreneur – and their consequences. As well, as industries engage in more business practices using the Internet, it is expected that 'questionable' offerings will be more readily available.

In an attempt to untangle forthcoming issues related to the ease with which angels may meet entrepreneurs via the Internet and questionable 'offerings' which may result, a studious examination of the role of intermediaries and the effects of possible disintermediation are called for by Langevoort (1998). He calls for broad empirical study of investor practices regarding how they learn about opportunities, how truly 'sophisticated' investors really are, and who else they rely on for investment information in making decisions. He also calls on researchers to take up the cause for similar study about start-up firms. Given the nature of advances by Canadian intermediaries, or lack there-of, these calls for advances seem timely.

3.3.3 Detailed & Sp ecialised Knowledge or Learning & Experience Curve Effects of Habitual Investors

The literature beyond Canada highlights concern about the actions of habitual angels, those who have made more than one investment, because it is thought that as a group they administer the largest portion of investment funds. As habitual investors, there may be economies of scale or learning efficiencies. But economies of scale and the need to sustain high levels of investment activity may not be the barriers to entry that had previously been thought since there are a proliferation of novice investors, first-time or one-time investors, in some studies. In a study of newly incorporated firms, Farrell (2000 forthcoming) identified 50 percent novices and 50 percent habitual angels. In previous works, high rates of habitual investors have been more likely to occur due to convenience sampling. Members of informal investment clubs or associations may have been more likely to be habitual investors since their higher level of activity would precipitate association with such groups. Therefore, when they identified other investors for interviews, the odds of finding more habitual angels was likely. More representative methods of sampling have shown a larger proportion of novice informal investors.

Advances in habitual entrepreneurs' activities, serial and portfolio entrepreneurs, have prompted similar interests in angel investors. It is not hard to hypothesise that experience and learning curve effects have a place in informal investments^{Footnote 11}. Angels are known to lament about conducting better due diligence were they to have their chance again (van Osnabrugge 1998). A critical mass, or gentle upward curve, as regards numbers of investments and learning might influence angels' ability to assess entrepreneurs who angels feel are the key to controlling market risk (Fiet 1995). On the other hand, angels who achieve substantial gains in their first investment will find it hard to duplicate their success as simple statistics states that subsequent occasions of any activity will regress to the mean.

3.3.4 Exits as Barriers to Entry

The exit is a precarious situation for informal investors because of difficulties in locating buyers. This is a serious industry exit impediment. Regardless of investment criteria and viability, lack of an exit or harvest opportunity renders the investment illiquid. Fewer efforts have been made to encourage the development of exit opportunities as compared to efforts made to encourage introduction opportunities. The focus of developmental efforts have been at the beginning of the investment process where the investees are the major beneficiaries rather than at the end of the investment process where investors may be unable to exit. When the focus is constantly applied to the front end of the investment process, the emphasis is on the recipient of the funds, namely the entrepreneur. Were the focus to shift to the end of the investment process, namely the exit, more attention would be applied to the investor. The lack of interest or attention to the angels' needs for returns and exits is demonstrated by the incredulity that entrepreneurs express at the anticipated expected returns of informal investors.

In Atlantic Canada, 18% of informal investors sold an investment but no details were provided as to the nature or manner of these exits (Farrell 1998). Another one-third of investments went bad implying that about 50% have never tried to sell their investments. In 1986, "attempts to create secondary markets for privately held shares" and to "improve access for junior- and medium-sized companies to the computerised automated trading system (COATS)" met with little response from securities commissions (DeJordey 1989b, p. B3).

3.3.5 Rates of Return

Industries associated with high rates of return are often susceptible to new entrants as other companies and players attempt to acquire some of the industry profits. Returns have two key components as regards the provision of venture capital; namely, the harvest amount received at exit and the length of time the investment has been held. The length of time the investments are held directly influences the returns achieved by the investor. In reviewing returns, the reader must be aware of the difference between anticipated returns and actual returns. The former signified what investors hope to achieve and the latter refers to actual calculations based on successful exits.

Internationally, the formal venture capital industry has grappled with developing methods of adequate and transparent reporting of returns. In a perverse reversal of the general risk return relationship associated with finance, the returns of early stage, high risk, investments have shown dismal results (Bygrave 1994; Wright, Robbie and Chiplin 1997). As these early stage investment returns have been calculated based on investments of venture capital firms, there are good reasons to expect poorer returns by angels because of their less diligent pre-investment investigation. On the other hand, is it possible that better returns should be expected because of a greater inclination for an angel to know the investee in advance, or because angels take less equity than formal venture capitalists (Farrell 1998) and firms tend to perform better than average as the entrepreneur's percentage ownership increases (Amit, Brander and Zott 1997).

The informal venture capital literature has little to report as regards detailed actual returns^{Footnote 12}. Canadawide, the average anticipated holding period expected by investors is more than six years (Riding et al. 1993). Investors in the Ottawa-Carleton area expect to hold their investments from five to eight years (DalCin et al. 1993). Actual investment holding periods may be heavily influenced by exit opportunities and the failure rate of young ventures.

Informal investors anticipated after-tax, non-compounded rates of return of 32% which is comparable to findings of greater than 50% annually found in other studies when consideration is given to the 51% tax bracket under which most informal investors would be classified (Riding et al. 1993). After tax returns of 30 to 40% per annum were reported in the DalCin et al. (1993) study. Riding and Short's (1987b) habituals were generally happy and indicated they would invest informally again. Farrell (1998) made fleeting mention of it in her study as few investors were prepared to discuss the matter. Those that did respond reported returns in the vicinity of 20 to 50%^{Footnote 13}. More startling, however, is the report that more than one-third of informal investors identified randomly indicated having lost their investment entirely (Farrell 1998). As the overall losses incurred by a number of significant investments increases, the group of investments as a whole must improve considerably to keep expected returns at a reasonable level. The lack of even many highly successful anecdotes suggests that investors are not receiving the quality of returns for which they had hoped. The best information as regards angels' return on average suggests one need not worry about a deluge of new entrants to the industry.

3.3.6 Serial Angels and Corporate Angels

The distinction between various types of private equity capital may seem precise, but there are considerable grey areas. As interest and research progress, two new groups of angels are making advances into the angel investment mindset. (They have been there all along, we are just now categorising and studying them.) They are angels who are investing the gains of previous informal investments, or successful entrepreneurs who are investing the gains of their current or previous profitable ventures. In this discussion, they are referred to as serial angels and corporate angels respectively (Farrell 2000 forthcoming).

To investigate each of these let us digress to the origins of private equity capital terminology. The two criteria that help to create categories of distinction for venture capital are:

• the sources of the funds, either personal or corporate, and
• whether the investment decision makers are paid management or the funds' owners.

Notice that the stage of the investee is not one of these criteria. Any formal or informal venture capitalist can invest at any stage of a venture's development. Types of venture capitalists are determined by the source and management of the investor's funds.

Firms that have funds provided by corporate sources and which have professional managers, exhibit more qualities of formal venture capital than informal venture capital regardless of what stage of development the investee occupies. These groups are seen along the top of Figure 1. For example, the Royal Bank's Primaxis Technology Fund is a single company fund which, as a corporate subsidiary, has professional managers investing on the corporation's behalf. As a corporate subsidiary, the professional nature of its investment management makes it a formal venture capital firm even though it is intended to invest in early stage ventures. Primaxis would occupy the upper right side of Figure 1. Angels, on the other hand, invest personal funds and make their own search, diligence and investment decisions. These occupy the lower left hand corner of Figure 1.

Recently, a number of notable highly successful firms have become engaged in 'angel-type' investments which are recognised in the media. These firms are led by successful entrepreneurs. The most visible and obvious example is Terry Matthews whose estimated net worth exceeds $1 billion and who is spearheading investments in employees and other entrepreneurs via the medium of his own highly successful Newbridge Networks and Celtic Investments Inc.^{Footnote 13}. The former is the technology company where he made his initial success and the latter is the venture investment company established by him to allow investments in companies outside the control of Newbridge. Matthews is reported to have invested in almost 30 high-tech start-ups ("ITF Sets its Sights" 1999; "Small Pleasures" 1995).

Some successful entrepreneurs have had considerable success in backing and supporting entrepreneurial endeavours of their employees using their companies as investment vehicles. Newbridge Networks is an example of note. There is no reason, however, to believe that this company is the solitary example of such exemplary informal investment activity even though there are not many reported examples of others. Entrepreneurs are recognised as a significant cohort in the group of informal investors. In Riding and Short's (1987) study, 21 of the 25 respondents had been involved as top management in a new venture start-up. In Cape Breton, 80% of angels had backgrounds as entrepreneurs (Lionaise and Johnstone 1999).

Entrepreneurs who are the embodiment of their successful entrepreneurial companies and have a history of investing are more clearly angels even though the funds they invest may have been acquired and invested through their company's activities. The investment efforts of these entrepreneurs were facilitated via the vehicle of their companies, making the source of their funds more corporate. Despite this 'corporatisation' of funds the essence of an individual using their wealth to invest in other entrepreneurs persists. Investments which are made by entrepreneurs' corporations do not fall exactly within the parameters which would normally describe informal investment. Yet, in these cases the direction of the firm's investment activities is determined by the proclivities of the CEO who is a successful entrepreneur in her/his own right.

Hence, while the investments are financed by the successful operations of a firm, the nature and type of investment are initiated by the entrepreneur. In these scenarios, the entrepreneur has come to a position of wealth and ability through their own successful entrepreneurial activities. The evolution of successful entrepreneurs into informal investors is an area of research that is expected to grow rapidly (Farrell 2000 forthcoming). There is a growing cadre of such entrepreneurs whose personal successes are being used to finance new ventures of their own (referred to as re-contracting or serial entrepreneurship in the literature^{Footnote 14}) or of others. Attempts have been made to identify these types of 'corporate angels' and to include references to them in this review. No formal research has yet been conducted regarding corporate angels, but their similarity to serial entrepreneurs is worth pursuing (Wright, Robbie and Ennew 1997).

Not surprisingly, some of the entrepreneurs that successful corporate angels finance are in industries and product groups that are part of the angels' supply chain or channel of distribution. This takes advantage of industry knowledge that the entrepreneur has had years to acquire. Therefore, the investee's products are eminently employable in, or useful to, the angels' businesses. For example, Matthew's investment in ITF Optical Technologies Inc. was not just as an angel, but as a potential customer for the fibre optic booster which now has customers such as Nortel Networks Corp. and the high tech Newbridge Networks ("ITF Sets its Sights" 1999). Cody Slater's Rig-Rat and Ron Warris's Net Shepherd Inc. were similarly financed by oil industry 'corporate angels' and an employer (Colt Engineering Corporation) servicing the energy industry respectively (Cody Slater's Rig-Rat 1999). Consumers of technology tend to support technology investments.

In other cases, the angels' investment activity is arrived at after selling their share in a substantial success story providing them with the means and time on their hands to find and finance new ventures. Creig Clark's sale of College Pro Painters precipitated his Horatio Enterprise Fund. Unlike Matthews, Clark's Horatio Enterprise Fund focuses on small start-up service companies looking for less than $750,000 such as Canadian Coin Processors and ISDN as well as manufacturing such as Page Manufacturing's flat plug (Greenwood 1994).

Denzil Doyle, referred to as the dean of "informal investment" (Riding 1998) arrived from a key management position as president of Digital Equipment Canada (Sheldon 1999). His investments are reported to vary from "equipment that measure the after-effects of dynamite blasts in the mining and construction industries to data terminals for police cars" (p.24). Having invested in 15 investments, he is certainly a significant portfolio investor (many informal investments at once), but it is not clear that he is investing the proceeds of previously successful entrepreneurial activities. As a former corporate CEO, his origins are slightly different than the other corporate angels mentioned who are largely entrepreneurs. In their case, they are entrep reneurs making their investments via their companies, while he was a former corporate executive now making investments personally.

In this industry, it is expected that more entrants into the industry will be met with enthusiasm instead of being perceived as a threat. The amount of media press associated with Matthews', Clark's and Doyle's investments have created a new kind of cultural hero, the Canadian success story who is not afraid to invest in their own employees or to seek out new and exciting initiative right here in Canada. These types of observations, were they more prevalent, would work to dispel the debilitating issues of "invisibility" and "anonymity" that, it is believed, angels prefer. By promoting similar success stories, angels may move to the forefront as publicly recognisable players in the equity markets making them more visible and available for new proposals. Similarly, the presence of serial entrepreneurs, who turn significant returns from initial activities into investments in other endeavours (Wright, Robbie and Ennew 1997), may be expected to increase the numbers of angels in the population^{Footnote 15}.

3.3.7 Summary

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. Business introduction networks represent significant efforts to bring entrepreneurs and informal investors together, but the formula has yet to be perfected. As well, 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. The poor capacity for most angels to exit as well as the poor average returns represent some of the industry's largest barriers to entry to date. More encouragingly, the presence and apparent growth of serial, and portfolio informal investors as well as corporate investors gives cause for encouragement. The growing understanding that angels are very much born of entrepreneurs fuels optimism as these areas gain research interest.

3.4 Presence of Substitutes

The presence and availability of substitutes represent alternative sources of finance and the ease with which they can be accessed by entrepreneurs. Substitutes provide other options for entrepreneurs to finance their ventures. Substitutes are other types of products entrepreneurs could use instead of angel finance. The availability of substitutes, the ease with which the entrepreneur can switch between substitutes, and switching costs are three criteria determining the effect of substitutes on industry competitiveness. Details about the other methods of finance are not part of the study framework and so are not addressed here. However, the availability, desirability, and switching costs of general classes of substitutes is addressed. The general classes of substitutes include love money, debt and formal venture capital. As well, a scenario is hypothesised that differentiates between the availability of substitutes for high ability and low ability entrepreneurs.

3.4.1 Love Money

To date, love money has been considered to be mutually exclusive of informal equity. The bulk of research interests typically examine only arm's length relationships as part of informal investments. This may be short-sighted as there is good reason to revisit the definition and motivation of love money as informal investment. Firstly, the evolution of personal relationships may put the definition in jeopardy. While the definition of family is relatively straight-forward, the identification of a partner as an investor or a friend is a more difficult distinction to arbitrate. Consider a scenario whereby an investor becomes integrally involved in the firm and then becomes a friend of the entrepreneur. The distinction of the entrepreneur's partner as a friend or as an investor is open to considerable interpretation. What may have started as an arm's length relationship may have evolved into a friendship. Was this love money or not?

Secondly, the motivations for investing may be based on information regarding business trust, personal biases and coercion. As regards matters of business trust, first knowing the entrepreneur may give an investor important insights into the entrepreneur's credibility and integrity. There is some evidence that investments by syndicates where the entrepreneur was known to one of the members of the group had better returns and exits than those where the entrepreneur was not known by any members of the investment group (Kelly and Hay 1996). Families, friends and neighbours may be better able to assess the entrepreneurs' credibility, work ethic and stamina. On the other hand, the assessments of family friends and neighbours may be biased, perhaps depending on the nature of the relationship. Furthermore, family, friends and neighbours may feel obliged or uncomfortable by requests for, or contributions of, capital.

Including individuals of these types in angel research allows room for exploration about differences and similarities that may not have been uncovered otherwise. This is where new insights are gained.

Family, friends and neighbours have been the traditional sources of love money (Macintosh 1994a). The role of families as significant suppliers of capital has been noted (Farrell 1998; "Venture Capital in OECD Countries" 1996). "The Canadian Federation of Independent Business reports that savings or loans provided by relatives, friends and associates make up more than 90% of start-up capital in this country" (Gaudet and Leighton 1987). Savings, friends and neighbours must represent a considerable supply of substitutes for entrepreneurs because, in the Atlantic Region at least, 35% of informal investors identified indicated they had made an informal-type investment to a family member (Farrell 1998). Many of the family investments were made by habitual investors^{Footnote 14}.

It is often felt, however, that love money sources are exhausted before angel capital is sought and love money, therefore, no longer represents a reliable substitute for the new venture. On the other hand, where it is still available, it could be hypothesised that the close attention paid to entrepreneurs by the more personal relationships of family may prove to be a formidable switching cost. Anecdotal evidence suggests that this is one cost some entrepreneurs are not prepared to pay.

3.4.2 Formal Venture Capital

From an industry perspective, formal venture capital becomes more available as a substitute for angels when formal venture capital funds are plentiful. In Canada, when venture capital funds are well stocked, formal venture capitalists tend to look to more early stage projects (the traditional domain of angels) than when funds are more constrained (Macdonald 1995). Therefore, in years when venture capital is plentiful, angels may face competition from formal venture capital firms. This has been the case lately. In 1998 and 1999, the industry invested Cdn$659 million and $579 respectively in early stage ventures, up from previous years (Macdonald 1995). "When the money starts to dry up, as it did in 1991, very little is available for start-ups. Much of it goes into later stage financing of the more mature companies. With a little more money flowing into our industry today, a little more is available for our early-stage start-ups" (Pavey 1995).

When more formal funds filter down to the early stage projects, more substitutes will be available for entrepreneurs seeking funds. From the standpoint of any individual entrepreneur, however, formal venture capital will be a substitute in very few instances. Only for those who have very high abilities – or at least the capability to signal as such – will have access to formal venture capital. Safrata (1988) set the stage when he reported that 130,000 new businesses start in Ontario in 1987 while only 78 companies were funded by venture capital. Less than one-tenth of one percent qualified for formal venture capital. Seventy percent (70%) of SMEs in the Canadian Chamber of Commerce and the Canadian Labour Market and Productivity Centre's survey indicated difficulties in accessing venture capital ("It's an uphill battle" 1995).

Evidence suggests that angels are not as demanding as venture capitalists for rates of return or equity^{Footnote 15}. The rates of return required by formal venture capitalists are higher than those required by angels, and angels have not shown the 'vulture' capital approach by demanding controlling proportions of equity (Farrell 1998). Higher rates of return and larger portions of equity are the switching costs entrepreneurs have to endure to acquire finance from formal venture capitalists as opposed to angels. As well, entrepreneurs may be subject to considerably more monitoring actions by the venture capitalist than the angel.

3.4.3 Banks and Non-Traditional Debt

Banks continue to represent the largest amount of finance for SMEs^{Footnote 16}, but entrepreneurs are still concerned that banks represent a poor source of seed and start-up capital. Evidence supports their lament. While only one in five SMEs report difficulties accessing debt finance ("It's an uphill battle" 1995), the smaller, younger firms generally have greater problems since they have fewer assets and less demonstrated history of cash flows for payment. Banking representatives attribute the gap between what banks provide and what aspiring or novice entrepreneurs want to a lack of understanding regarding debt and equity and the banks' roles. (DeJordy 1989c).

Evidence indicates that the banking industry is making a policy of increasing the proportion of loans to retail customers (residential mortgages, credit cards, consumer loans) as opposed to business customers (Sharwood 1996). Wynant and Hatch (1991) examined more than 1,500 bank loan file attributes and found fewer than 10 % of loans were for companies less than one year old. Riding and Haines (1994) reviewed 1,400 files and found fewer than 5% were less than one year old.

Government-assisted, debt-type initiatives have provided help with loans by either providing guarantees for a price such as the Canadian Small Business Financing Act, or providing flexible interest and payment schemes such as Atlantic Canada Opportunities Agency's Action Loan Program. The Canadian Small Business Financing Act (then called the Small Business Loans Act) was designed to assist the asset-based needs of smaller firms by providing guarantees to traditional lenders which provided the loans. Widening the net to include projects as high as $250,000 (from $100,000) increased the number of qualified and interested applicants, but has been criticised for including projects which may have been able to find finance otherwise. Their 1997-1998 Annual Report reported that 38% of the 'loan frequency' went to new businesses. It is likely that much smaller percentage of 'total dollars loaned' went to new businesses as new ventures might be expected to ask for smaller sums on start-up (and because the number was not isolated in the report).

The Business Development Corporation's Patient Capital Project was designed for venture seeking from $50,000 to $250,000 with follow-up funds to $500,000. The terms of principle repayment were flexible, hence the name, but interest on the loans was payable from the start. Though the product was a loan, ongoing management support gave the impression of venture capital. Introduced in 1995, the product is no longer available. Loans with similar terms can be arranged through their venture capital division.

ACOA's Action Loan Program in Atlantic Canada deferred interest for three to five years at which point higher rates of interest encouraged quick repayment (Vardy 1990). The program was designed to supplement the "disturbing gap" (p. 5) for formal venture capital in the region.

Other types of financiers are taking over the burden of business lending such as asset lenders, contractbased lenders, secured loans, and foreign financiers^{Footnote 16}. These types of lenders are little known by the average bank manager who is generally unprepared to help a small business in need of debt capital. Furthermore, many of these options are only easily available in the larger markets such as Toronto, Vancouver, Montreal, etc. The more 'equity-like' their offerings, the more expensive their products become.

Traditional and non-traditional sources of debt appear to be substitutes of limited value. At best, they may be good substitutes for specific entrepreneurs such as those with a history or demonstrated ability to pay, or those who happen to be located in major financial or urban centres. At worst, they are only available to larger firms or expose the entrepreneurs to personal financial risk ("It's an uphill battle" 1995).

3.4.4 High and Low Ability Entrepreneurs

The pecking order of finance places the various sources of finance sought by entrepreneurs in an order of preference. Entrepreneurs begin with their own resources. As they deplete their own personal funds, their desire to keep all the venture's equity encourages them to prefer debt as the next source. As high profile players in the financial system, banks are often the entrepreneurs' most obvious source and gravitate to them first (DeJordy 1989c). By employing debt as their first line of defence after they have exhausted their own sources, decision making, control and equity remain intact for the entrepreneur. If debt sources are not forthcoming, and success at the more traditional financial institutions wanes, the entrepreneur is forced to concede that selling equity will be necessary to achieve their objectives.

When equity sources are examined, the more publicly recognisable formal venture capital firms may be the first in the entrepreneurs' arsenal of equity options. (After all, a venture capitalist's phone number can be found in a telephone book.) However, most entrepreneurs have little understanding of the high hurdle rates and exponential growth expected of formal venture capital investees. They are quickly deterred as very few of the proposals formal venture capitalists review will meet the growth pattern and upside potential required of venture capital firms. Beginning to exhaust their options, entrepreneurs then turn to angels. Having read and heard about angels, but not knowing where to find them, may make angels the last resort in the pecking order of entrepreneurial finance. By this time the entrepreneur finds interested angels, s/he may not have many alternatives. At this point, ent repreneurs may have few, if any, substitutes. Sadly, with few substitutes left, there may be little 'ease' with which they can manoeuvre.

In short, entrepreneurs start with their own money, move toward sources of debt, and then seek equity (Binks and Vale 1990). Therefore, as a rule, entrepreneurs generally come to venture capital after they have exhausted all other avenues.

The scenarios may diverge depending on the ability of the entrepreneur. Amit, Glosten and Muller (1990) provide convincing theoretical analyses that high ability entrepreneurs do not need to participate in seeking venture capital; low ability entrepreneurs will look for equity and may purchase 'signals' which make it appear that they are high ability entrepreneurs. The entrepreneur knows their own ability whereas the venture capitalist does not, and only the entrepreneurs who are unsure of their capabilities will seek to risk share by pursing equity such as venture capital. The poor returns in the venture capital industry add justification to this theory. These issues of asymmetry of information and adverse selection present compelling and thought provoking grist for those involved in private equity policy.

There is also evidence that entrepreneurs who have been previously funded by venture capitalists will signal their worth by not taking the first offer made by interested equity providers. These high quality entrepreneurs will negotiate to acquire better terms, deal structure, fewer contractual obligations, reduced reporting requirements, or value added services (Busentiz, Barney and Fiet 1997). Therefore, having substitutes available to them, high ability entrepreneurs may be selected by angels early in their search for finance, possibly even before the entrepreneur begins serious search activities. Low ability entrepreneurs, having few substitutes, will be left actively looking for capital at the match making bureaux and business introduction services. Some angels have commented that the entrepreneurs who are not invested in quickly by acquaintances and friends must be low quality entrepreneurs^{Footnote 17}. Do successful angels opportunistically search and approach high quality entrepreneurs' And do other angels passively await proposals from poor quality entrepreneurs'.

Hence, not surprisingly, the ability of entrepreneurs may determine the quantity of equity substitutes available to them. The development of the theory of high and low ability entrepreneurs (Amit et al. 1990) may have less bearing on the provision of debt since loans decisions are based on more objective and, to a greater extent, historical criteria such as cash flow, ability to repay, and assets. These types of decision criteria leave less room for assessing the future potential of a currently unproven entrepreneur.

3.4.5 Summary

Family and friends may be difficult substitutes for angels as they may have been exhausted as a source of capital first, or they may be an uneasy observer, 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 requirements of venture capital. 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. The theory of high- and low-ability entrepreneurs may determine the sources entrepreneurs seek and their ability to access substitutes.

3.5 Power of Costumers

Within the Porter's Five Forces Model, customers have power in the industry-customer relationship when the customers are large and have substantial bargaining leverage in price negotiations. Other situations that may give the customer relative power in the industry-customer-relationship occur when: the customer has substitutes from which to choose; the customer's costs of switching are low; the customer is very large or particularly well informed about the sellers' products, prices, or costs; or the customer has discretion over whether or not to work with the seller. The agency concerns^{Footnote 18} of the angel-investee relationship, has been studied extensively by Fiet for a decade. From the contract law, the amount of control that the investee possesses after the relationship with the investor has been cemented with an agreement is the key determinant of the entrepreneur's power in the relationship.

3.5.1 Substitutes and Switching Costs

Low quality entrepreneurs who have been invested in by angels may have few substitutes; there are more substitutes for high quality entrepreneurs. For each, however, the switching costs are high. The considerable time and effort which goes into locating an angel represents real and opportunity costs for the entrepreneur^{Footnote 4}. To change that financier means not only do they have to find new sources of finance, the entrepreneur will have to buy out the angel were s/he to decide s/he did not want to pursue this relationship further. Knowing the expense it can be to rid yourself of an angel reduces the entrepreneurs' power in the angel-investee relationship. In some instances, where the success of the venture is outstanding, the angel may not want to leave^{Footnote 17}. Anecdotes abound about successful entrepreneurs who consider their angels to be millstones though this has not been explored empirically. It can be very hard for an entrepreneur to gain additional power once the deal is consummated and the structure and conditions established in a formal or informal agreement.

As has been discussed, debt is often preferred to equity for continuation of control by the entrepreneur and because of the cost of the instrument. Acquiring debt may be the alternative when the angel is bought out. Low ability entrepreneurs will have fewer substitutes as their projects will not support the criteria for debt. For an able entrepreneur, the cost of debt would be less than the cost of equity capital as angels are anticipated to expect anywhere between 20 and 50% after tax, annually for five to ten years possibly before harvest.

An experienced entrepreneur may have power in the relationship when execution of the exit becomes imminent. The entrepreneur's perspective may have migrated towards a hold, rather than sell, strategy though the angel and the entrepreneur may have shared similar opinions at the advent of their relationship. Different perspectives evolve as time passes as the entrepreneur may have their livelihood, job, salary, retirement and equity at stake. Unless the details of the harvest criteria have been well specified in advance, the entrepreneurs' migration to a 'hold' strategy could spoil the informal investors' opportunities for successful exit and harvest if a potential buyer was in attendance.

The potential for difficulty would suggest that angels 1) massage carefully their relationships with their successful entrepreneurs to ensure an equitable parting for both of them, and 2) spend thoughtful consideration throughout the duration of the investment as to the personage and form of a potential buyer for the investment. More knowledge of exit patterns, types of exit partners, conflicts with the entrepreneur and possible exit strategies would make a meaningful contribution to existing angels and future investment patterns in Canada.

3.5.2 Large Customer or One Who is Informed About Sellers – Products, Prices, or Costs

Almost by definition, entrepreneurs who are financed by angels are relatively small organisations. Entrepreneurs who have received angel capital are highly fragmented with no associations with one another. Except for press and media accounts, which are extremely selective, they generally have no information about angels' prices, contracts, suppliers, or costs. Their naivete is glaring when entrepreneurs are surprised by the returns which angels expect.

3.5.3 Customer Has Discretion Over Whether Or Not To Work With The Seller

Most entrepreneurs, it is felt by angels, are lower quality entrepreneurs (Riding et al. 1993) whose business plans may be viable, but are not capable of producing exceptional returns. These entrepreneurs do not have discretion over whether or not to work with the angel and are fortunate to find one. Their power is low. However, if the investees are high quality entrepreneurs, they may have other opportunities available and are shopping for the best terms. Entrepreneurs who have previously been financed by venture capitalists have been shown to negotiate better deals than their less experienced firsttime venture capital seekers.

High quality entrepreneurs may be those for whom most angels would desire an opportunity in which to invest. Because of the extreme upside potential of investing in a high quality entrepreneur, it is likely that the power held by the entrepreneurs, in their relationships with their angels, is high. In this scenario, one can build an hypothesis that a high quality entrepreneur converts non-investors into investors. Meeting a high quality entrepreneur with a successful business plan may be the necessary prequalification that converts non-investors into novices. That little is known about this conversion process emphasises the many extremely important elements of angel investing which have yet to be discovered.

The high quality entrepreneur has the most opportunity to exercise power when the terms of the deal are being negotiated. After an angel has made a decision to invest, negotiations will focus on issues of price and, if the angel is not inclined towards the passive side of the scale, methods of governance that may include monitoring and control. To the extent that angels require tight control, binding contracts, high governance and observable and frequent monitoring mechanisms, entrepreneurs may have little control. The use of contractual agreements by the angel can dilute the entrepreneurs power. Constraints on salaries and the expenditure of large sums of money, regular reporting requirements, requiring seats on the board of directors, and equity ratchets are all methods for angels to exercise power over the entrepreneur. The greater the use of these tools, the more power the angel will have in the angel-investee relationship.

The exit is the final score on which the entrepreneur and the angel must settle. If contractual agreements have been decided in advance, the arrangements of the harvest may be established and the entrepreneur has less power over the final arrangements. Often, however, the specifics of exit are not pre-established and an unwilling entrepreneur can wrest a successful harvest from the angel. Experienced angels have indicated convertible debentures are their preference. "Macaulay usually takes convertible debentures as his investment. 'If the company hasn't made it in three to five years, I get my money back – provided, of course, the company is able to redeem it. If the company fails, your money is gone. But if the company is doing well, it should do an IPO, and you exercise your option to take common shares'" (Gordon 1999).

3.5.4 Summary

Entrepreneurs who have found angels may have substitutes, but will probably incur extremely high switching costs to unburden themselves of the angels. The 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 overcome their financiers is if they are high quality entrepreneurs and can adjust the terms to their greater benefit, or in refusing to execute harvest strategies which benefit the angel.

^{Footnote 7} Information acquired in conversation with Nova Scotia Equity Tax Credit program personnel in 1998.

^{Footnote 8} The research paper trail ends here.

^{Footnote 9} This experience is borne out in formal venture capital by the number of living dead, the 'six' in the so-called 2:6:2 ratio. Formal venture capitalists anticipate, on average, that two deals out of 10 will be written off, two will produce exceptional returns which will harvest nicely, and six will go on in their portfolios as the 'living dead.' The living dead are businesses that are viable and operating, capable of paying the entrepreneur a wage and profit, but will never meet the VCs' original exp ectations. The difficulty with these investments is what to do with them or how to realise anything from them.

^{Footnote 10} Specifically, requests for published information regarding angels as a part of the methodology specified for this research encountered negative reactions by some trade associations/chambers of commerce in Prince Edward Island and Vancouver.

^{Footnote 11} This suggestion was made by Johnstone at the University of the College of Cape Breton.

^{Footnote 12} APEC (1994), in agreement with critical sentiment acknowledged in the wider literature, suggests it is impossible for these operations to exist independently of public fund ing since their operators – in the search for commissions or fees – will always gravitate to the larger deals, hence debilitating the early-stage intent for which they were encouraged.

^{Footnote 13} This result may have been a function of the manner in which the question was posed in the telephone interview. Respondents may not have had sufficient time to calculate the return had they not worked it out in advance. This question has been revised in her current research.

^{Footnote 14} Mike Wright heads a group of researchers at the University of Nottingham who have been building a database of management buy-out and buy-in data which is the source for a series of papers on serial entrepreneurship and recontracting by venture capitalists of formerly backed entrepreneurs. This database has been recognised as the longest running, longitudinal collection of entrepreneurial activity in the world.

^{Footnote 15} The Federal Government 2000 budget allowing proceeds from one investment to be rolled over into new investments without tax penalty would be expected to improve this condition as well.

^{Footnote 16} For a comprehensive review of the methods of finance available to small and medium sized enterprises in Canada, see Riding's report to the Task Force on the Canadian Financial Services Sector. 1998.

^{Footnote 17} A Nova Scotia entrepreneur whose business has had exceptional success reports having attempted to make her angel "a very rich man," yet he is not interested in exiting the venture.