Bear market has clipped the wings of angels - Funding retrenched

Mark Evans, Financial Post

As the high-tech industry struggles to rebound, an important issue is receiving little attention: Who's going to fund the next generation of hot startups?

Traditionally, that role has been played by wealthy individuals -- otherwise known as angels.

For backing entrepreneurs who often have little more than an idea or a prototype, angels have been willing to accept large amounts of risk in return for the potential of high rewards. It is a function that has been a key part of the private-equity ecosystem.

This, however, is increasingly no longer the case. The decline of tech stocks, disappointing investments and the scarcity of initial public offerings and acquisitions have left many angels with smaller portfolios and, not surprisingly, a growing aversion to risk.

It means startups looking for seed capital of $125,000 to $1-million are receiving scant interest from angels.

What today's conservative angels want is a commercially ready product, customers, sales and even profits -- a checklist that startups do not have and cannot attain without early-stage investment.

In other words, expectations are sky-high but in a different way from the late-1990s when investors believed that startups with modest sales were worth billions of dollars.

"Right now, I would say the angels that I am in contact with are behaving more like VCs [venture capitalists] and VCs are behaving more like bankers," said John Arnott, president and chief executive with Kronitech Systems Inc., a Toronto-based startup developing software to help manage the treatment of chronic diseases.

Mr. Arnott's frustration is widespread. After you get past bubbly elevator pitches about target markets and revenue potential, many entrepreneurs will quietly talk about their inability to get the time of day with angels and VCs; the discouragingly low valuations being discussed, and the alarming sense of conservatism within private equity markets.

"What's happened over the last couple of years is that their thresholds have changed," said Neville Tencer, head of international business development with Calgary-based Sonic Mobility Inc. "They have become a bit more risk adverse and their thresholds for investing in companies are higher."

Even more significant is the impact this risk-aversion could have on Canada's high-tech sector and the country's ability to compete globally. If the country's private and public equity markets fail to support high-tech entrepreneurs, there will be fewer home-grown companies and fewer jobs for Canadians.

Imagine Canada's economic prospects without high-tech powerhouses such as Nortel Networks Corp., Research in Motion Corp., Cognos Inc. and ATI Technologies Inc. Canada's high-tech sector employs nearly 600,000 people, generates more than $125-billion a year of business, and it has joined pulp and paper, natural resources and automobiles as the country's biggest source of export sales.

The importance of angels in jump-starting the high-tech industry should not be understated. While it is difficult to track their activity, it is estimated that angels are more active than VCs. Angels are willing to go into places where VCs do not have the resources or interest to pursue. When an entrepreneur needs $150,000 to flesh out an idea for a new chip, software or telecom equipment, it is angels who supply the capital.

Adam Chowaniec, chairman of the Information Technology Association of Canada and Tundra Semiconductor Inc., said despite the technology sector's downturn, the industry will continue to play an important part in Canada's economic future.

"The reality is that technology is cyclical," he said. "We will drive into a major new cycle, and Canada is extraordinarily well positioned to take advantage of it. This is absolutely the time where we should help angels and stimulate investment in early stage companies because we are just at the beginning of the next [technology] wave."

While entrepreneurs are troubled by the angel community's cautious investment approach, they are also alarmed by the terms demanded by angels who are willing to invest. Valuations have tumbled even though high-tech stocks have rebounded, and angels want a big equity stake while unwilling to make a large enough investment to jump-start a company's growth. For companies desperate for cash, it is akin to making a deal with the devil. If they want to survive, they take the cash.

The downside, however, for entrepreneurs and angels is that the money invested is not enough to make a real difference. By adopting a cautious approach at low valuations, investors leave companies without the resources they need to build the right team, create strong marketing and sales organizations, and have enough cash for working capital issues.

Even if a company does manage to subsequently attract venture capital, the stake of entrepreneurs and angels can be so diluted, there is no incentive/financial reward left for them in the long run.

John Roberts is learning this lesson first-hand as he tries to raise capital for Simmic.Net Inc., which is developing wireless hardware. In raising $750,000, the Ottawa-based company will sell 50% to a group of angels and a small VC.

This is an expensive proposition given that Mr. Roberts has a three-decade track record as an entrepreneur and co-founded SiGe Microsystems Inc. Furthermore, the valuations being forced upon entrepreneurs such as Mr. Roberts seem to be out of touch with reality given that Nasdaq Stock Market, which is dominated by high-tech stocks, has climbed 44% since October.

If angels are not stepping up to the plate, where will venture capital firms find new investment opportunities? Until relations between angels and VCs get better and/or market conditions improve, a steady stream of high-quality investment opportunities will be uncertain.

Mary Macdonald, president of Macdonald & Associates, which tracks venture capital investment, said this problem is being exacerbated by "friction" between angels and VCs. While it is widely accepted that angels play a critical role in the early stages of a company's development, many angels have seen their equity staked sharply diluted or washed out completely when a VC deal is completed. When this happens, it creates yet another reason for angels to stay out of the market.

"My sense is there has been some friction right now between the angel community and institutional community. It is difficult to see the pay off for angels in this environment," says Ms. Macdonald.

For their part, VCs concede that many angels have been squeezed because the current investment environment means that the new deals being completed are done at lower valuations. But, they point out, the rules also apply to VCs who have to accept lower valuations when doing another private equity round.

David Ferguson, managing director with VenGrowth Capital Management, said angels have also been hurt by the fact many do not have the deep pockets to invest when an early-stage company needs more money.

"This is not unique to angel investors," he said. "It is really anyone coming in at an early stage of a company's development. Generally, anyone who does early-stage investing or did early stage investing is faced with this kind of environment."

Despite the economic uncertainty and low appetite for risk, there are companies attracting seed investment. One angel, who asked not to be identified, said it is a "fantastic" time to invest because valuations are low and there are plenty of attractive opportunities.

In an interesting twist, the most enthusiastic angel investors are not individuals but investment firms that have seen a void in the market as VCs and angels move upstream. Yaletown Venture Partners, for example, recently raised $30-million for early-stage investments in energy and high-tech companies in British Columbia and Alberta, while the Business Development Bank of Canada has a seed fund that will invest $50-million to $80-million over the next five years.

Vancouver-based Yaletown will focus on making initial investments of $1-million to $3-million in startup companies that are pre-revenue or even pre-product. Yaletown partner Kirk Washington said the fund was created because a window of opportunity was created in recent years as angels shied away from the market.

"There has been a significant correction in the technology market," he said. "It means valuations are attractive and entrepreneurs have gotten much more resourceful. We also find $5-million is a great deal of money again and people are stretching those dollars ... It is a very good value."

Among Yaletown's investors are a dozen wealthy individuals, who have become the investment firm's quasi-angels in residence. By teaming up with Yaletown, Mr. Washington said they are able diversify their holdings and have a vehicle to review investment opportunities.

Another firm tackling the early-stage space is BrightSpark Venture Partners, which focuses on nurturing its own startups with initial capital of about $250,000. If an idea flies, it gets more funding; if it sinks, BrightSpark quickly moves onto the next idea. It is a high-risk proposition but BrightSpark only needs one or two successes out of every 10 investments.

The formula hit pay-dirt last month when Think Dynamics Inc., a two-year-old company with sales of less than $1-million, was acquired by International Business Machines Corp. for US$50-million. It was a deal that heartened startups and investors by illustrating that early-stage deals can produce huge returns for those with an appetite for risk.

It is unclear that Think Dynamics is enough to bring angels back to the game. Burned by the end of the dot-com bubble, the collapse of high-tech stocks and worries about their portfolios, too many angels are happy to sit on the sidelines until the market becomes less risky.

The problem, Mary Macdonald contends, is that they risk missing out on the next Think Dynamics and many other promising start-ups desperate for growth capital. "The guys doing the early stage stuff now are most likely to make a good whack of money when the markets turn and the exit options are there again in three, five years time."