angels at woRk

Bridging the Funding Gap

A Task Force on Early Stage Funding, led by UBC’s Sauder School of Business and sponsored by the National Research Council, stated in 2005 that Canada suffers a $5-billion “funding gap.”

This funding gap is the financing shortfall for new initiatives that lie between the research stage, where government funding and grants are often available, and the growth stage, where traditional venture capital (VC) may be available to innovative businesses.

Furthermore, since 2005, venture capital has virtually abandoned early-stage investment in Canada. Ontario, for example, experienced one of the most substantial declines in VC activity in Q3 2008, with a total of $163 million invested in 36 companies, 43 per cent less than the $283 million of Q3 2007. Although VCs are looking more active now that the market is improving, the fact that they pulled in their horns over the past couple of years has widened that $5-billion funding gap.

In a related trend, possibly exacerbating the shortfall even more, the Conference Board of Canada (CBC) reports that over the past four decades, Canada’s ranking with respect to global inward investment has steadily dropped. In essence, Canada has lost some of its traditional advantages; natural resources, for example, are now more costly to explore and exploit, so foreign investors have been steering clear.

In sum, the financial crisis and economic recession led global investment in Canada to fall by an estimated 20 per cent in 2008, according to CBC.

So our VCs have been focused on supporting their existing ventures (when they have money to invest at all) and outside investors have been keeping their cash in their pockets. Although recent reports have indicated that Canada is now, once again, becoming a haven for astute foreign investors because of the strength of our economy and the stability of our banking sector, not much of this money is going towards early-stage, growth companies.

The most parched of Canada’s thirsty start-ups are those involved in biotechnology and related areas. These sectors have been identified as key by federal ministries – federal MPs, in June of last year, even formed a ‘BioCaucus’ to promote the new economic opportunities associated with biotechnology in Canada. This group, which included our Minister of Industry, Tony Clement, recognized the emergence of biotechnology companies as “engines of growth,” but offered few solutions to bridge the funding gap. The group’s focus was pouring money into research and educational facilities in order to develop new technologies. Well, this is possibly useful, but here’s a newsflash – we already have superlative technology. Canadians are really, really good at innovation, engineering, research, and invention. What we don’t have as readily is the funding and expertise that enables companies to commercialize that technology. Especially in biotech, where the path from idea to finished product is long and frequently painful, early-stage companies can wind up with everything in place for success – except the money. How then do smaller, fast-growth companies in this sector access capital? Traditionally, business angels, individuals who invest their own money in early-stage companies, have bridged the gap between the “triple F” investors – Families, Friends, and Fools – and institutional investors such as VCs and purveyors of public equity, who invest OPM (other people’s money) in start-ups. Often serial entrepreneurs, angels usually invest between $10,000 and $250,000 of their own capital for the pleasure of helping a company grow and the hope of involvement in a play that generates lots of cash.

Overall, angels’ contribution is not inconsiderable. In Canada, angels have historically invested more than twice what VCs are putting into growing companies. In the recent, desert-dry past, angel investment has totaled, by some estimates, more than four times institutional investment. The most up-to-date studies indicate that Canadian angels have invested about $2.2 billion per year in upwards of 25,000 companies.

Moreover, as the gap between family-and-friend investors and the bigger institutions has widened, angel investors have increasingly banded together, both to protect their investments and to provide greater amounts of capital to their investees. Bands of angels can invest as much as $5 million if the three Ts are aligned in their investment target: • Team – 60 per cent of angels’ focus is on management

• Traction – the company’s product or service is already proven.

This gets a weight of about 30 per cent in angels’ evaluation • Technology – a unique, patent-protected technology will have a weight of about 10 per cent in the overall evaluation of the company

Management is by far the most important element for angels. Where VCs sometimes have complex financial models at the basis of their judgment about whether to invest, angels – who may nonetheless use sophisticated financial modeling – will look much more closely at management.

And by and large, the angel is not looking simply for technological brilliance. Most angels figure a good manager will hire or partner with someone who has the science locked down. Science is seen as a commodity. This is why sometimes the angel investor seems less interested in the technology story than the VC may be – and may lose patience with a lengthy technology section in a company presentation. Instead, angels will ask questions like: “has the team successfully built a company before this, what is management’s track record and who is on the board of directors or advisory board?” Angel investors look for business acumen, domain knowledge, and operational expertise in the management team, which for them includes the board.

Since biotechnology companies are most often technology driven, angels’ management focus can confuse biotech companies that come looking for financing. Presenters are accustomed to providing lots of technology detail, when what an angel generally wants to know is, “does it work, is it protected, and is there a market?”

In addition, the angel’s investment process can be lengthy. The following chart shows the stages a typical angel group might work through to complete an investment, a process that can take six months or more (although the individual angel may take less time to make a decision). Since angels do most of their own due diligence, and since most angels are volunteers rather than paid analysts, it’s easy to see why the angel group’s investment might not be delivered as quickly as company management would like:

It is clear that angels can operate from an investment template that may sometimes serve to exclude biotechnology companies, especially drug discovery companies, from their portfolios. Angels look for payback in three-to-five years, while biotech companies are frequently looking at seven years and upwards before any payout to investors. Angels want to invest in companies that are in the com-

Opportunity Submitted

Pre-Screening (Manager)

Screening (Committee)

Pitch & Group Screening Due Diligence

Final Negotiation

Investment

CoInvestment mercialization stage, where their operational expertise can aid the company to get its product to market, while biotech companies need substantial money long before they have a product ready to show the market. Angels look for investees that will hit the tipping point with investments of under $2-million, as they fear being squeezed by later, bigger, more powerful investors with little concern for the small investor who brought the company to the point of success. Biotech companies can require tens of millions of dollars to complete the research and development phase alone.

But much more compelling with this seeming lack of fit between angel investors and biotechnology is the fact that angel investors really have the perfect profile to invest constructively in health sciences, biotech and medical technology.

Angels have done it themselves. They understand the challenges of running a business, and can help technology boffins and scientistentrepreneurs with the logistical and regulatory demands of the growth-oriented company they’re running

Angels are risk-tolerant. As high-net-worth investors, they are investing their own money, and do not have to answer on a quarterly basis to fund managers and institutional investors who are driven by monthly returns and daily stock-price fluctuations.

Angels are patient money. Although they would prefer to cash out in three years, if they are motivated by excitement about a company’s or product’s potential they can spend a much longer time supporting their investee’s goals.

Angels are hands-on investors. Where biotech companies often excel at technology and falter on operations, angels enjoy helping and have real management expertise to contribute. Angels’ goals are well-aligned with those of their investees.

Angels have connections, and where they don’t have them they will generally work to develop them. Most angels will give their Rolodexes a powerful workout in support of their investees – unlike many institutional investors. Biotech companies flourish best in rich intellectual and technological environments, and angels will work to ensure that management can tap into this type of richness.

Angels are comfortable with technology. Many angels made their money in software or process technology. They are not often frightened by complex stories.

Angels need and want to diversify their portfolios. Over the last few years, there have not been plentiful biotech investments of a size appropriate for angels or angel groups. Some angels, who see healthcare, medical technology and biotechnology as key to future growth in Canada, are actively looking for opportunities in the sector.

Angels are successful investors. Angel groups have posted average internal rates of return (IRR) of 27 per cent over 3.6 years, far exceeding either money market or average exchange returns for the same period.

Such outstanding results indicate that either angels are exceptionally astute at identifying strong investment opportunities or that angel investment makes for better companies. In either case, it would seem well worthwhile to explore angel investment.

Robin M. Sundstrom is a business owner and angel investor whose firm is a sponsor of the National Angel Capital Organization. She is a founding member of the Cleantech Angel Network.

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