A slowing economy is making the question of "How do I finance my business?" more relevant than usual. Many small-business people, or those who want to start a business, are on the lookout for an angel investor—a person who is not a friend or family member of the business owner who provides capital to that business from his or her own funds. But who are these small-business saviors? And can your average small business get hold of them? Scott Shane, a professor of entrepreneurial studies at Case Western Reserve University, has a new book that attempts to answer those questions and many more, Fool's Gold?: The Truth Behind Angel Investing in America. We talked to Shane about his book, due out next month. Excerpts:
You distinguish angel investors from the most common type of small-business investors—friends and family. But how does angel investment differ from venture capital investment?
The main difference is where the money comes from. Angel investors are using their own money to put into another person's business. For a venture capitalist, the investment is an institutional one. The venture capital firm creates a pool of a capital and then deploys that capital that it raises from partners. One of the most important revelations in your book is that angel investing is not as large of a phenomenon as many people might think.
The angels aren't a big portion of the providers of capital to new businesses. Of all the informal investments, only about 8 percent is angel investments. About 92 percent is friends and family investments. It [also] isn't that large compared to what entrepreneurs themselves invest. In comparison to venture capital markets, in terms of dollar value, they're roughly the same size. Less than 1 percent of adult Americans made an angel investment in the last three years and less than 1 percent of start-ups get the money, so we're talking small numbers. Is it rare enough that entrepreneurs looking for angel investments should be concerned?
One of the things that come up with my students is the question of "How should I finance my business?" They talk about going to venture capitalists all the time and going to angels all the time. But if these things are not very common, then there's a big cost to saying I should go to an angel. If I'm unlikely to get it, I'm wasting a large amount of my time. I'd be better off saying I'm going to get a bank loan, or I'm going to have to bootstrap my business, as opposed to endlessly trying to raise money from angels. A second reason is that there are a lot of myths out there about angels being a special kind of investor. People say friends and family are dumb money, angel investing is smart money. The implication is that if you get money from angels, you're going to get a lot more in addition to the cash. There's a lot of evidence that says that's not true if you get money from the typical angel. The typical angel does not have a lot more experience in running start-ups than friends or family. It's true that a person's grandma and a top angel group are going to be different, and a top angel group is going to add more value, but a person's grandma is not going to be the typical family investor and a top angel group isn't going to be the typical angel. When you look at both a typical angel and a typical family investor, angels are not that special.
So if it's so rare and so hard to get, are there any advantages to angel investing?
What people might want to think about is—do I have the right kind of business to get money from an angel group or an accredited angel investor? Do these people have a track record of making successful investments and advising entrepreneurs? If you can get money from an experienced, successful angel investor, it's probably very beneficial to do it. But to give you some numbers, there are only about 20 percent of the people who make these angel investments who would be accredited. The angel groups are only making investments in about 500 or 600 companies a year. And about 40 percent of the people in those groups have not made money in those investments. That other 60 percent—those people are probably really helpful if you have a high-growth business. Otherwise, it's all about getting cash.
Corrected on : Corrected on 10/29/08: An earlier version of this article incorrectly reported what Dr. Shane meant by the term “common angel.” He was referring to a specific angel group called Common Angels. Also, less than 1 percent of adult Americans have made an angel investment in the last three years, not the last 20.