Heavenly Returns

You hear the stories. Ken Brenner, CEO of the Private Bank of the Peninsula in Palo Alto, Calif., had a friend who plunked $25,000 of seed money into a start-up that blossomed into a software giant. "At one point his stock was worth $7 million," says Brenner.

Then there's this tantalizing statistic. An average annual return of between 30% and 40%, realized over an average holding period of five to seven years, was achieved by angels who exited investments during the first half of 2007, even when factoring in the deals that tanked, according to the Center for Venture Research at the University of New Hampshire (www.unh.edu/cvr).

But that's on average. The Center's data also show that any single angel investment-which might be defined as very early-stage financing beyond friends and family-has a one-in-three chance of going belly-up. At Brenner's private bank, "We've seen people lose a lot of wealth." His buddy with the lucky strike? "He held it too long."

Total loss? The investment of a lifetime? Something in between? Whether an angel investment soars or crashes isn't entirely an accident. It could even hinge on the advice you give. "To simply talk a client out of angel investing is disingenuous at best and a breach of professional duty at worst," says wealth advisor Rick Ashburn, principal and chief investment officer at Creekside Partners Investment Counsel in Lafayette, Calif., who builds angel portfolios for his more sophisticated clients. Even if analyzing private equity deals is beyond your expertise-and you should tell the client if it is-there is plenty of assistance you can lend.

A good first step is understanding something about the 234,000 accredited investors who the Center for Venture Research estimates made $25.6 billion of angel investments in 2006. According to the Angel Capital Association, a professional association of North American angel groups, the average investor in these groups devotes 10% of investable wealth to the asset class. Usually these individuals have retired (early in many cases) from successful business careers.

Various motives fuel the drive to become an angel, including of course the high-risk, high-return potential and diversification benefits. Ashburn says, "We believe the best investment opportunities are in the entrepreneurial economy, not the securitized markets, and that their returns are non-correlated."

A very common motivation is the desire to give back by providing expert advice. Grateful for their own success, these angels enjoy mentoring nascent enterprises, sometimes because they too had a helping hand along the way. An angel might sit on the board of directors, serve on an advisory panel, or merely have a sounding-board relationship with the company CEO. Regardless, investing provides a venue for remaining actively engaged in the business world. To these investors, the activity's non-financial rewards are critically important.

Ian Rogoff is this type of angel. He began investing partly to get involved with technology transfer, or the commercialization of technology developed in university, nonprofit and government labs. "For me, angel investing is a wonderful opportunity to bring out technology and to help small companies grow and create jobs," says Rogoff, who has gone on to become a general partner in a buy-out firm, Sierra Nevada Partners in Lake Tahoe.

Other investors take a hands-off approach. Investing may be a way to stay abreast of the latest developments in hot industries they are interested in-clean technology for instance. "Or a client might decide he can make the world a better place by investing $100,000 in a company that's trying to build a business in solar collectors, rather than spending it on solar panels for just his house," says Chicago attorney Jonathan Wasserman, a partner in the private wealth services practice group at Neal Gerber Eisenberg.

Yet another reason the affluent turn to angel investing is for training the next generation. One of Wasserman's client firms is a prominent family office. "Some of the kids are going to business school," he explains. "Angel investing gives them a chance to learn the process, lead a deal and work with accountants and lawyers inside and outside the family office. It can be a transitional mechanism."

Against that backdrop, here are some ways the private wealth advisor can assist angel clients.

Even the ultra-wealthy sometimes harbor misguided expectations about angel investing, thanks to the urban legend of spectacular profits. Ever hear about losers? Plus, every entrepreneur's pitch for funding comes brightly packaged in contagious enthusiasm. "You need to make clients really appreciate the 33% probability of losing all their money on any particular investment," Wasserman says.

Next, mention the commitment necessary for proper diversification. Ashburn tells clients, "If you don't have the capital to do ten different angel investments of $50,000 each, you probably don't belong in the asset class."

The funds aren't deployed all at once, though. Typically it takes two to three years. Interesting deals must be located and they may go through subsequent financing rounds that require follow-on investments if the angel is to avoid having his participation in the company's growth diluted. "If you don't re-up, you won't see the return that you're looking for," Rogoff says. "The investor needs to keep money in reserve as dry powder." Rogoff initially invests half of what he expects a deal to require.

"YOU NEED TO MAKE CLIENTS REALLY APPRECIATE THE 33% PROBABILITY OF LOSING ALL THEIR MONEY ON ANY PARTICULAR INVESTMENT."-Jonathan Wasserman

For the aggressive client who shrugs off these concerns and proceeds with becoming an angel, Ashburn tones down the conventional portfolio's risk profile. Instead of an 80-20 equity-bond mix, it might be 40% stocks and 60% short-term debt.

An angel who contributed $10 million to start up a brokerage firm received 40% of its common stock. The other principals put up comparatively little capital. They worked at the business for a short time, then shuttered it. Because the angel owned 40% of a $10 million company, he received $4 million in the liquidation. The other guys kept 60%.

Had this star-crossed gentleman instead demanded preferred stock with a preference on liquidation distributions, he could have prevented his wealth from being siphoned, says Burton Wiand, the Tampa attorney who the investor brought in-too late.

Wiand, who is a partner at Fowler White Boggs Bank, has also seen cases where an investment hits pay-dirt yet the angel isn't appropriately enriched because he invested at unfavorable terms, having eschewed legal help. "Control is a lot of what the client should be thinking about," says Wiand.

A key issue is dilution of ownership. At a minimum, clients should ask for pre-emptive rights so that they are able to invest in later rounds and maintain proportionate ownership as the company grows.

Having a board seat can keep an investor informed about the company's progress but it can hardly guarantee control. "I've seen instances where a majority shareholder appointed the board members, they turned against him, threw him out and brought in new management," says Wiand.

When the client can not truly consolidate control, a better strategy might be to put money in as convertible debt. It gives the investor an equity interest if the company does well. "If not, you have the company by the handle because it owes you a legal debt," Wiand says.

As angels seek protections, they need to be careful not to create conditions which might repel the professional investors the company will ultimately need, warns Wasserman, the Chicago attorney. Demanding warrants that allow buying a stated percentage of the company at a fixed priced as it blossoms, or extensive "blocking rights" that require the business to obtain an investor's permission before taking certain actions, can be turn-offs to the big boys. Regardless of what the angel bargains for initially, though, he must be prepared to re-negotiate if the fledging enterprise indeed advances to the professional money round. "Some of the rights that earlier investors have will usually be stripped away," Wasserman says. How much is a function of relative bargaining position.

For instance, it is not to the angel's advantage if the company is floundering and has little prospect of survival without a substantial capital infusion. On the other hand, consider this case of Wiand's. A particularly avaricious angel had amassed so much control that it strangled the company. He eventually yielded to the professionals when they came a knocking, but he fared well. "This investor's control gave him considerable negotiating power when good things were about to happen for the company," Wiand says.

The Angel Capital Association knows of approximately 265 angel groups in North America. Possibly the best advice you can give a client is that they join at least one of them. "The most important thing in angel investing is the quality of the deal-flow," says Rogoff, "and joining an angel group improves the quality dramatically."

These organizations invite early-stage companies to make presentations at their meetings. This effectively creates competition for investors' capital-competition that stiffens as the angel group's reputation becomes larger-which in turn spawns a far better investment opportunity set than whatever deals an angel might discover on his own. "The right community of angels, with the right process for reviewing deals, the right amount of capital and mentorship (capabilities), and a record of past investment success is an attractive vehicle for entrepreneurs to come to," says Rogoff.

He actually belongs to two groups, each of which attracts a somewhat different deal-flow. Some angel groups have begun forming networks to give their members access to a broader range of opportunities. For instance, California-based Keiretsu Forum (www.keiretsuforum.com)has chapters in London, Barcelona and Beijing.

Another very valuable benefit of joining an angel group is sharing the due diligence, that painstaking process of vetting potential investments. "Even if the deal is in a space you know, you may not have the time or inclination to delve into every aspect of the business," says Rogoff.

Angel groups are comprised of experts from an array of disciplines, and they are able to field savvy investigative teams. Consider the typical deal in which Ashburn places his clients' funds. There will be a dozen due diligence committee members. One examines the patent for the product. Someone else, the company's financials. Others contact customers and suppliers. "The end result is a collective report, and then each investor makes his own investment decision," Ashburn says.

Because group members' contributions are such an essential component of the investing process, Rogoff cites the quality of the angel group as the second most important ingredient for success in this investing genre.

Still another key benefit of angel groups is the post investment mentoring given to the companies invested in. The expertise helps boost the baby business's odds of survival, Rogoff says.

Beyond these advantages, many angel groups sponsor investor education seminars for their members. They provide networking opportunities as well, says Colin Wiel, president of the Keiretsu Forum's San Francisco chapter. "Our members go on ski and golfing trips, and many of them have started outside business ventures together. There is this wonderful element of 'community.'"

Like other non-marketable assets, angel investments can be nettlesome for the planner during incubation.

You could show their value at basis on portfolio reports like Rick Ashburn, a San Francisco Bay Area advisor, does. But that means potentially l-o-o-o-ng stretches of zero return dragging down the client's total portfolio return, not to mention the performance your firm can advertise, he says. Some firms exclude angel investments from performance reports for this reason.

Advisors who evaluate deals face a compensation conundrum. Ashburn might spend 20 hours examining a company that a client invests in-and another 20 on rejects. For 100 bp on a $25,000 investment, it's not exactly worth it. So in addition to his usual AUM fee, Ashburn charges a performance fee of 10% of the client's profits, if and when a liquidity event occurs.