Investment capital: the rise of 'angel' investors

Angel investors are stepping up to larger, more complicated investments as the venture capital industry consolidates. But there are drawbacks to accepting their investment capital.  

In 2009, Steve Woda and his brother Tim dreamed up a new company: an Internet-based service that would help inform parents about how to protect their children in today's high-tech world. The motivation was personal: In early 2009, a child predator had been caught stalking one of Tim's children via social media.

An experienced entrepreneur, Steve planned to seek seed funding in stages while he and his brother worked out the company's early kinks. The happy results so far: Since late 2009, their Arlington, Va., company, uKnow.com, has already attracted about $1 million from a progression of about 20 "angel" investors (individuals and groups who invest in start-up companies).

"Timing was on our side," says Steve, uKnow.com's chief executive officer. "Unfortunately, there's a rising risk for kids online. But fortunately, we found a growing number of angels available to help us address this problem."

While the venture-capital industry continues to consolidate, making it hard for some entrepreneurs to get investment capital, angel investments are on the rise. Angel investors are typically wealthy individuals who, like venture capitalists, make high-risk investments in fledgling companies in hopes of reaping exceptional returns. The difference is that the money they typically provide is much less than what venture capitalists offer, so angels usually have funded very early stages of new businesses. But even that is changing.

"Angels have become emboldened in the last 18 months and have been funding a larger number of companies than they historically have," says Paul Kedrosky, a senior fellow of the Kauffman Foundation, based in Kansas City, Mo. "They're picking up the slack as venture capital has pulled back."

Some have banded together, forming angel groups to bolster their investment capabilities and gain access to more deals. Some groups have also invested together in syndicated deals. In 2010, some 265,400 individuals were active angel investors – up 33 percent since 2002, according to the Center for Venture Research at the University of New Hampshire (UNH) in Durham.

The growth of angel investing – which often targets high-potential areas such as the Internet, social media, medical devices, biotech, and the like – is good news for entrepreneurs. Recipients get not only needed money but also mentoring from these angels, who often choose companies in sectors where they have a special interest.

Moreover, because angels and angel groups have been springing up all over the country, even in smaller cities, they can aid entrepreneurs that venture capitalists might overlook. "We don't have venture firms in our town," says Dick Reeves, executive director of the seven-year-old Huntsville (Ala.) Angel Network, which has invested in nine Alabama start-up companies. "Venture capitalists are in big cities, where you find higher traffic potential for them."

Not surprisingly, many entrepreneurs laud the benefits of angel funding. Among the allures: "If you're not 100 percent certain of your business model, angels can give you the money while you figure that out," points out Healy Jones, marketing vice president of the four-year-old OfficeDrop, based in Cambridge, Mass., which produces a highly accessible digital filing system for small businesses. Another attraction: Angels typically "take a smaller stake in your company than venture capitalists would," says Mr. Jones.

The venture-capital industry is undergoing its own problems. After peaking at 1,006 in 2006, the number of venture-capital firms had fallen to 791 by 2010, according to the National Venture Capital Association in Arlington, Va. Firms raised less money in the third quarter than in any quarter in the past eight years. And while more dollars remain invested in venture capital in the first nine months of 2011 than in the same period in 2010, investment in seed-stage companies fell by 56 percent from the second to the third quarter, and the number of deals declined by 26 percent.

Of course, angel investing isn't about to replace venture capital. Wealthy individuals can't match the funding from pension funds and university endowments that participate in venture-capital funding. Typical angel funding "rounds are much smaller in size, more like $250,000 to $400,000, compared with, say, a $2 million venture-capital round," points out Mr. Kedrosky.

Angels have other drawbacks. They are "much more fickle" investors than venture capitalists, Kedrosky says. "They have a history of dropping out of sight when times are bad because they're investing their own money."

Some question whether the firms backed by angel investors are efficient job creators.

UNH's Center for Venture Research reports that angel investments accounted for 370,000 new jobs last year – or six jobs per angel investment. But many start-ups aren't staffing up as quickly as in the past, and they're "also adding fewer workers as they grow," according to the Kauffman Foundation.

"Angels are picking up the slack at a time when entrepreneurs can do more with angel financing than ever before," Kedrosky says. With today's technology, you can "now sell your product over the Web and postpone hiring. That's very different from historical patterns when start-ups needed more people from their outset."

"Ultimately, these companies could be job creators, but if they do [create jobs], it will take longer" than it has in the past, he says.