Venture Debt - Angels Take Flight to Safety

Paul J. Marino, Founder, Paul J. Marino & Associates and COO Young Venture Capital Assn.

As a follow up to an article on venture debt financing that first appeared in the June 2006 edition of the Intelligencer, this article will take a look at a new phenomenon in the venture debt community: the Angel investor. Early stage investors (often referred to as the angel) are comprised of two groups: (i) friends and family and (ii) an angel investor and the investment usually takes the form of an infusion of cash into the Company for common stock. For the purpose of this article, we will refer to the foregoing two groups as an "Angel"-as in an Angel answered my prayers-for capital. This article will concentrate on professional Angels and Angel groups.

Traditionally venture debt is used for the purchase of hardware and infrastructure equipment, finance inventory and other non-SG&A costs, thereby enabling venture backed companies to reserve the equity capital investments for business critical activities such as research and development, marketing practices, and hiring. Today, however, companies are using venture debt as a means of creating and/or obtaining liquidity while not giving up (at least initially) an equity piece in the company.

Why Early Stage Venture Debt is Important

Although Angel's account for a majority of initial startup capital, they only represent a fraction of venture dollars that flow into companies. In fact, over the last ten years, angel investing accounts for only approximately 3.8% of invested capital[1]. While in total dollar amounts Angels make up a small percentage of capital deployed, they play a significant role in the development of an early stage company. With that being said, the foregoing statistic does not account for the increasing volume of venture debt placed by Angel groups. This increased volume of debt deployed at the Angel level is creating liquidity at the seed level; thereby creating greater access to capital and liquidity(whether debt based capital is cheaper or costlier is dependent on the deal documents and of course the company's ability to attract venture financing-which lead them to debt in the first place).

Why Angel Debt Deals are Increasing

As stated, Angel debt is playing a greater role in emerging companies' financing for a variety of reasons; however anecdotally, it seems the two biggest reasons are (i) the lack of a clear and discernable exit strategy (or at the very least a palatable exit strategy-one that an Angel could stomach) and the lack of competition in early stage deals (probably the overriding factor).

In the not so distant past, an Angel investor would invest its money into a startup with hopes of returns in the 10x to 20x range (despite severe dilution over the next rounds of financing) and the timing for the investment period usually lasted 3-5 years. Today, however, an Angel investor might see a return of 7x to 12x with an estimated investment period of 5-7 years prior to a substantive liquidity event[2]. Further compounding the pain, since most venture backed company's rarely pay dividends an expected return on an Angel investment is so far out that it becomes difficult to model any type of quantitative return - thus your investment strategy goes from assumed returns based on historical data to throwing darts (which has always been a component).

Filling the Void

Since most investors (especially East Coast investors) are in a flight to quality, many are reluctant, if not a down right opposed, to investing in an early stage company. Observing this trend, many Angels realized that they could fill the void left by a venture shop-and fund the Angel round using the same deal terms and asset protection terms usually reserved for institutional investors. Traditionally, most Angel's received common stock for their investment (common stock offers the least amount of protection to an investor); however, now Angel investors are deploying convertible promissory notes that carry conversion premiums, cumulative dividend and often times a kicker (usually allowing the investor to a much larger chunk of capital then it would have received in a traditional common stock or preferred stock scenario).

Lack of Competition Breeds Better Terms

Today, early stage companies (excluding Silicon Valley) are finding that most early stage institutional investors have moved up the capital food-chain and are no longer interested in seeding or investing in pre-revenue companies. As a result, many Angel groups (and family offices) have reacted, like any disciples of Adam Smith would warrant, by demanding better pricing and terms for their capital.

Many companies seek debt as a means to stave off valuation decline, as a bridge to the next round of financing or as expansion capital. Unfortunately, many companies take the capital without understanding either the deal documents and/or the debt servicing obligation associated with the borrowing of capital. With this burden comes the risk of default.

Nonetheless, deals where Angel's issue debt are more prevalent then they have ever been before. Instead of debt being used to ease a liquidity crunch prior to a funding event, it is now used at the seed and early stage investment levels. The questions that a company needs to ask are (i) whether it can pay the debt service on the obligation, (ii) whether the Angel (lender), in an effort to pick up cheap capital, is making the loan in hopes of default, and (iii) most importantly, whether there is an alignment of interest between the Angel (lender) and the company-does the Angel really believe in the company and want to help it succeed or does it want to pick up the assets and/or gain control of the company at a substantially reduced price.

Angel debt like any other financial product has its place in the capital market food chain-and while it has risen in prevalence and occurrence, it is still debt financing-carrying with it all of the upside and all of the downside of leverage.

[1] Price WaterhouseCoopers Money Tree National Aggregate Report through Q4, 2007.

[2] The window between the Angel investment and the next investment might be lengthier (at least compared to historical standards) or never materialize (see, East Coast West Coast, YVCS Newsletter of June 2006).

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The Young Venture Capital Society, (YVCS), is a not-for-profit educational organization, created for young professionals under the age of 35. Specifically our goal is to help educate and equip the next generation of venture capitalists with: Technical knowledge, Financial astuteness, Industry perspective, Network of contacts, and Knowledge of the venture capital industry as a whole.

Paul J. Marino, Chief Operating Officer and Co-Editor of Visionaries Newsletter, practices law at Marino, P.C. where he focuses on representing startup and mid sized corporations. He assists his clients in all areas of corporate law including merger and acquisition, shareholder, private placement, and other corporate agreements. Dovetailed with his transactional experience, Mr. Marino advises clients in matters concerning corporate governance, financial privacy, acceptable use policies, and preparation of financial disclosure statements. He has a considerable knowledge base in information technology law with a special concentration in telephony which has allows him to lend his experience in matters concerning regulatory and compliance issues at both the state and federal level.