What Is The Key To Angel Investment?

We all know that if you want to raise Angel finance, you have to first prove your business concept! This means you have to have an established business with real product and real customers and be able to show how the business will generate significant revenue and profit in the future. One might argue that if you could do all that, you wouldn’t need the investment.

There can be no doubt that understanding your business concept and being able to articulate how the business makes money is an essential precondition to raising external investment. One also must accept that for the last few decades the criteria used by VC and Angel investors centered on the business concept. Investments were made in higher growth ventures which could produce a harvest through an Initial Public Offering (IPO). Since an IPO business is a stand alone business which must achieve relatively high growth in revenue and profit, this was not an unreasonable request. The problem is that this entire approach was flawed.

What is the 'right' business concept?

It is not a proven business concept which the Angel investor should be seeking, it is an attractive investment opportunity. While there is a close alignment between the two, they are not the same. A business which has good growth prospects does not necessarily make a good Angel investment. Given that less than 5% of Angel investments are harvested through an IPO, the normal exit path is via a trade sale. If you look at the historical data and exclude the IPO exits in boom market conditions, what you see is only a very rare IPO, perhaps less than 1 in 100 investments. This leave the trade sale as the normal investment exit objective. Angels are not in the business of collecting dividends on their investment. They want to see their investment back and achieve a profit on the funds employed and that means the investee firm will be sold. So an attractive investment opportunity is actually one which has a very good potential high value exit. Clearly, that is not the same investment criteria as the proven business concept.

The reason why the business concept is important is because that is the place where the Angel investment analysis starts. The Angels wants to know how the business makes money and what its growth potential is to see if it would make a good exit candidate. The best exits are based on strategic value where the investee firm is sold at a premium to a large corporation who can better exploit the underlying potential. The business concept will show the market potential of the venture’s product or service. If the business has products or services which a large corporation could rapidly scale or replicate to generate large short term revenue – you have the basis of a strategic sale.

Strategic sales are less problematic

What is often overlooked by business advisors who assist firms to raise external equity finance is that it is not the firm’s business concept which is critical in a strategic sale, it is the business concept of the strategic buyer. If the acquiring corporation already has the distribution channels, the supply chain logistics capability and the funding to exploit the acquisition, the capability and capacity of the selling business may be entirely irrelevant. A strategic buyer wants something which they can exploit, like a great product or service which can be sold back into their existing customer base. Whether the acquired firm has customers, distributors, revenue growth or even a profit may make no difference to the value which they put on the firm. Their estimate of value is based on what they can do with the underlying products and services not what the selling business has done.

Historically, Angel finance has been seen as external funding to help an entrepreneur develop and grow their business. Because the conventional wisdom of Angel and VC finance had developed in the boom markets and especially for an IPO harvest, investments went into firms with high growth potential. However, experience has now proved that the IPO was an unrealistic exit strategy and that investment need to be focused on trade sale exits. This fundamentally changes the investment criteria. When you then review the trade sale exits, what you see is that growth firms sold on the basis of their own revenue and profit generating capabilities generate far lower investment returns than strategic trade sales. A venture which can produce a good strategic exit is often a very different investment proposition to a conventional high growth business. It is this realization which has moved Angel investors away from the proven business concept investment criteria to those based on strategic value.

Are you a candidate for a strategic sale?

The critical question to ask is - What does a strategic buyer need in my business to make it an ideal acquisition? The strategic buyer is looking for something which will generate significant revenue by taking advantage of the resources which already exist within the buyer. They want a proven product which targets their existing customers, solves a compelling need and has good sustainable competitive advantages. If you can satisfy those needs, you have the basis of an attractive investment opportunity. Of course, it would greatly help your case with potential investors if you could set out the case for a strategic sale, including identifying the potential buyers.