Download Equity for Rural America: From Wall Street to Main Street

Equity Capital and Entrepreneurs
Stephen Prowse
ow do small- and medium-sized firms
raise external equity capital? In this paper,
I describe two markets that entrepreneurs of small- and medium-sized enterprises
use in the United States to raise equity: the
organized private equity market and the market
for angel capital. Both markets are important
sources of equity capital for small- and mediumsized firms. However, until recently, not much
was known about how the organized private
equity market operated, while the market for
angel capital still operates in almost total obscurity. In this paper, I try to shed some light on how
these markets operate, and discuss some of the
major issues that surround these markets today.
In doing so, I draw on ongoing and new research
done by others and me into the operation of
these markets.
H
SOURCES OF EQUITY FINANCE
FOR SMALL- AND MEDIUM-SIZED
FIRMS
Issuing public equity is usually not feasible
for small- and medium-sized firms because of
their small size, lack of a track record, or
inadequate growth prospects. Such firms must
usually issue private equity to meet their financing needs. Two sources of private equity are the
organized private equity market and the market
for angel capital.
Defining the organized private equity
market
The organized private equity market consists
of professionally managed equity investments
in the unregistered securities of private and public
companies. Professional management is provided by specialized intermediaries and, to a
limited extent, by institutional investors. Private equity managers acquire large ownership
stakes and take an active role monitoring and
advising portfolio companies. In many cases
they exercise as much control as company
insiders, or more. As of year-end 1995, the outstanding capital in the organized private equity
market totaled $175 billion, with new commitments to the private equity market running around
$30 billion. Of this total, about one-quarter goes
to venture capital, and three-quarters to nonventure capital. The venture capital sector of
the private equity market typically finances
smaller firms—sometimes start-ups—with very
high growth prospects. The nonventure sector
of the market typically provides capital to larger,
middle-market firms with slower growth prospects but a need to finance expansion or a
change in ownership.
Defining angel capital
Angel capital refers to investments by
wealthy individuals in the unregistered equity
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securities of small, closely held companies. It is
a much more informal market than the organized private equity market, and little is known
about how this market operates. However, what
we do know about it suggests that angel investors may play quite an important role in the
financing of small, private businesses. By some
estimates the angel capital market is several
times larger than the venture sector of the organized private equity market, and angel capital in
particular is regarded as a critical source of seed
capital.
I will discuss the operation of each of these
markets in turn.
OPERATION OF THE ORGANIZED
PRIVATE EQUITY MARKET
The organized private equity market (or private equity market) is an important source of
funds for start-up firms, private middle-market
firms, firms in financial distress, and public
firms seeking buyout financing. Since 1980 it
has been the fastest growing market for corporate finance, by an order of magnitude over
other markets such as the public equity and bond
markets and the market for private placement
debt. Today, the private equity market is roughly
one-quarter the size of both the commercial and
industrial bank loan market and the commercial
paper market in terms of outstandings. In recent
years, private equity capital raised by partnerships has matched, and sometimes exceeded,
funds raised through initial public offerings and
gross issuance of public high-yield corporate
bonds.
Limited partnership
Until the late 1970s, private equity investments were undertaken mainly by wealthy
families, industrial corporations, and financial
institutions investing directly in issuing firms.
Stephen Prowse
By contrast, most investment since 1980 has
been undertaken by professional private equity
managers on behalf of institutional investors.
The vehicle for organizing this activity is the
limited partnership, with institutional investors
as limited partners and investment managers as
general partners.
Advantages of limited partnerships. The
emergence of the limited partnership as the
dominant form of intermediary is a result of the
extreme information asymmetries and potential
incentive problems that arise in the private
equity market. The specific advantages of limited partnerships are rooted in the way in which
they address these problems. The general partners specialize in finding, structuring, and
managing equity investments in closely held
private companies. Partnerships are among the
largest and most active shareholders with significant means of both formal and informal
control, and thus are able to direct companies to
serve shareholders’ interests. At the same time,
partnerships employ organizational and contractual mechanisms that align the interests of
the general and limited partners.
Need for limited partnerships. The development of limited partnerships arose from the
need for greater institutional participation in
private equity. Few investors had the skills necessary to invest directly in this asset class, and
those that did found it difficult to use their skills
efficiently. Partnership growth was also fostered by regulatory changes that permitted
greater private equity investment by pension
funds. The results of these changes are telling.
From 1980 to 1995, the amount of capital under
management by the private equity market
increased from roughly $4.7 billion to over
$175 billion. Limited partnerships went from
managing less than 50 percent of private equity
investments to managing more than 80 percent
(Chart 1).1 Most of the remaining private equity
Equity Capital Markets—The View from Wall Street
13
Chart 1
PRIVATE EQUITY CAPITAL OUTSTANDING, BY SOURCE OF FUNDS
AND TYPE OF INVESTMENT, 1980 AND 1995
Billions of dollars
Billions of dollars
200
200
Type of Investment
Source of Funds
180
Limited
partnership
160
160
Nonventure
143.2
140
180
132
140
120
120
100
100
80
80
Venture
60
Other
40
60
44.3
40
33.2
20
0
20
2
2.7
1980
3
1995
stock is held directly by investors, but even
much of this direct investment activity is the
result of knowledge that limited partners have
gained investing in and alongside partnerships.
The expansion of the private equity market
has increased access to outside equity capital for
both classic start-up companies and established
private companies. Venture capital outstanding
increased almost fifteenfold from 1980 to 1995,
from about $3 billion to just under $45 billion
(Chart 1). Nonventure private equity outstanding, meanwhile, grew from less than $2 billion
to more than $130 billion. Thus, the growth of
the private equity market has made it easier not
only for start-up companies to acquire adequate
financing through successive stages of growth,
but also for middle-market private firms to
acquire financing for expansion.
1.7
1980
0
1995
Components of the organized private
equity market
The organized private equity market has
three major players and an assortment of minor
players. Figure 1 illustrates how these players
interact with each other. The major players are
private equity issuers, intermediaries, and
investors.
Issuers. Issuers in the private equity market
vary widely in size and in their motivation for
raising capital as well as in other ways. Table 1
illustrates the various types of firms that issue
private equity. They do share one common trait,
however: because private equity is one of the
most expensive forms of finance, issuers generally are firms that cannot raise financing from
the debt or public equity markets.
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Stephen Prowse
Figure 1
ORGANIZED PRIVATE EQUITY MARKET
INVESTORS
INTERMEDIARIES
Limited partnership
Corporate pension funds
Dollars
Public pension funds
Endowments
ISSUERS
Limited
partnership
interest
New ventures
• Early stage
• Managed by independent
partnership organizations
• Managed by affiliates of
Dollars,
monitoring
consulting
financial institutions
• Later stage
Middle-market private
companies
• Expansion
Foundations
- Capital expenditure
- Acquisitions
Bank holding companies
Wealthy families and
Other intermediaries
Dollars
individuals
Insurance companies
Equity claim
on intermediary
• Small business
investment companies
• Change in capital
Private equity
securities
(SBICs)
structure
- Financial restructuring
- Financial distress
• Change in ownership
• Publicly traded
- Retirement of owner
investment companies
- Corporate divestitures
Investment banks
Nonfinancial corporations
Other investors
DIRECT INVESTMENTS
(includes direct investments of both BHC-affiliated SMICs
and venture capital subsidiaries of nonfinancial companies)
Dollars
Public companies
• Management or
leveraged buyouts
• Financial distress
• Special situations
Private equity securities
Investment advisers
Placement agents
Placement agents
to investors
for partnerships
for issuers
• Evaluate limited partnerships
• Locate limited partners
• Manage “funds of funds”
Issuers of traditional venture capital are
young firms, most often those developing innovative technologies that are projected to show
very high growth rates in the future. They may
be early-stage companies, those still in the
research and development stage or the earliest
stages of commercialization, or later stage companies, those that have several years of sales but
are still trying to grow rapidly.
• Advise issuers
• Locate equity investors
Since the mid-1980s, nonventure private
equity investment has outpaced venture investment. Middle-market companies, roughly
defined as companies with annual sales of $25
million to $500 million, have become increasingly attractive to private equity investors.
Many of these companies are stable, profitable
businesses in low-technology manufacturing,
distribution, services, and retail industries.
Equity Capital Markets—The View from Wall Street
They use the private equity market to finance
expansion—through new capital expenditures
and acquisitions—and to finance changes in
capital structure and in ownership. The latter is
increasingly the result of private business owners reaching retirement age.
Although not the focus of this paper, public
companies also are issuers in the private equity
market. Public companies that go private issue a
combination of debt and private equity to
finance their management or leveraged buyout.
Indeed, between the mid- and late-1980s such
transactions absorbed most new nonventure private equity capital. Public companies also issue
private equity to help them through periods of
financial distress and to avoid registration costs
and public disclosures.
Intermediaries. Intermediaries—mainly limited partnerships—manage an estimated 80
percent of private equity investments. Under the
partnership arrangement, institutional investors
are the limited partners, and a team of professional private equity managers serves as the
general partners. In most cases the general
partners are associated with a partnership management firm such as the venture capital firm
Kleiner, Perkins, Caufield, and Byers or the
buyout group Kohlberg, Kravis, and Roberts.
Some of the management companies are affiliates of a financial institution, such as an insurance
company, bank holding company, or investment
bank. The affiliated companies are generally
structured and managed no differently than independent partnership management companies.
Limited partnerships typically have a ten-year
life. During this period, investors forego virtually all control over the management of the
partnership, creating potential conflicts between
investors and the partnership managers. These
conflicts are addressed by two types of inventive mechanisms that align the interests of the
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general partners with those of the limited partners (Table 2). First, if partnership managers are
to raise new partnerships in the future, they
must establish favorable track records. Second, they receive a significant amount of their
compensation in the form of shares of the partnership’s profits.
Partnership managers must solve the incentive and information problems that exist when
investing in small, private companies. They do
this primarily by using a number of direct control mechanisms: in many cases they gain
voting control, and they have substantial means
of exercising nonvoting control, including seats
on boards of directors, and providing needed
capital only in well-defined stages (Table 2). In
addition to monitoring the companies, partnership managers assist in matters ranging from
designing corporate strategy to locating suppliers. Because being active in management
requires a high level of expertise, many partnership managers specialize by investment type, by
industry, or by geographic region.
Investment companies not organized as limited partnerships—Small Business Investment
Companies (SBIC), publicly traded investment
companies, and other companies—today play
only a marginal role as intermediaries in the private equity market. SBICs, established in 1958
as a means of encouraging investment in private
equity, can leverage their private capital with
loans from, or guaranteed by, the Small Business Administration. In the 1960s and 1970s
they accounted for as much as one-third of private equity investment, but today they account
for less than $1 billion of the $175 billion market. Their reduced role has resulted in part from
their inability to make long-term equity investments when they themselves are financed with
debt. Publicly traded investment companies
also played a role in the past, but today fewer
than a dozen such companies are active, and
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Stephen Prowse
Table 1
CHARACTERISTICS OF MAJOR ISSUERS IN THE PRIVATE
EQUITY MARKET
Middle-market
Public and
private firms
private firms
Early-stage
Later-stage
and corporate
in financial
Characteristic
new ventures
new ventures
divestitures
distress
Public buyouts
public firms
Size
Revenues
between zero
and $15 million
Revenues
between $15
million and
$50 million
Established
with stable cash
flows between
$25 million and
$500 million
Any size
Any size
Any size
Financial
attributes
High growth
potential
High growth
potential
Growth prospects vary
widely
May be overleveraged or
have operating
problems
Underperforming
Depend on
reasons for
seeking private
equity
To finance
a required
change in ownership or capital structure
To effect a
turnaround
To finance a
change in management or in
management
incentives
Reason(s)
for seeking
private
equity
Major source(s)
of private
equity
Extent of
access to
other financial
markets
To start
operations
To expand
plant and
operations
To cash out
early-stage
investors
Angels
Early-stage
venture
partnerships
For more
mature firms
with collateral,
limited access
to bank loans
Later-stage
venture
partnerships
Other
High levels of
free cash flow
To expand by
acquiring or
purchasing new
plant
Later-stage
venture partnerships
To ensure confidentiality
To issue a small
offering
For convenience
Because
industry is temporarily out of
favor with
public equity
markets
“Turnaround”
partnerships
Nonventure and
mezzanine debt
partnerships
Nonventure
partnerships
Very limited
access
Generally,
access to all
public and private markets
Generally,
access to all
public and private markets
Nonventure
partnerships
Access to bank
loans to finance
working capital
Access to bank
loans
For more
mature, larger
firms, access
to private
placement
market
Equity Capital Markets—The View from Wall Street
17
Table 2
MECHANISMS USED TO ALIGN THE INTERESTS OF PARTICIPANTS
IN THE PRIVATE EQUITY MARKET
(Most important mechanisms are in bold)
Partnership - Portfolio Companies
Limited Partners - General Partners
Direct means of control
Direct means of control
Voting rights
Partnership covenants
Board seats
Advisory boards
Access to capital
Performance incentives
Performance incentives
Managerial ownership
Reputation
Managerial compensation
General partner compensation
together they manage less than $300 million.
The long-term nature of private equity investing
appears not to be compatible with public investors’ shorter term investment horizons.
Two other types of private equity organizations are SBICs owned by bank holding
companies and venture capital subsidiaries of
nonfinancial corporations. Both types were
extremely important in the 1960s, and they still
manage significant amounts of private equity.
However, these organizations invest only their
corporate parents’ capital. In this sense, neither
is really an intermediary, but rather a conduit for
direct investments.
Investors. A variety of groups invest in the
private equity market. Chart 2 provides information on the relative importance of the different private equity investors at year-end 1995.
Public and corporate pension funds are the largest groups, together holding roughly 40 percent
of capital outstanding and currently supplying
close to 50 percent of all new funds raised by
partnerships. Public pension funds are the
fastest growing investor group and recently
overtook private pension funds in terms of the
amount of total private equity held. Pension
funds are followed by endowments and foundations, bank holding companies, and wealthy
families and individuals, each of which holds
about 10 percent of total private equity. Insurance companies, investment banks, nonfinancial corporations, and foreign investors are the
remaining major investor groups.
Most institutional investors invest in private
equity because they expect the risk-adjusted
returns on private equity to be higher than those
on other investments and because of the potential benefits of diversification. Bank holding
companies, investment banks, and nonfinancial
corporations may also choose to invest in the
private equity market to take advantage of
economies of scope between private equity
investing and their other activities.
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Stephen Prowse
Chart 2
INVESTORS IN THE PRIVATE EQUITY MARKET, BY HOLDINGS
OF OUTSTANDINGS AT YEAR-END 1995
(Billions of dollars)
Investment banks
$8.60
Other
$16.00
Nonfinancial corporations
$7.50
Public pension funds
$39.50
Insurance companies
$12.70
Commercial banks
$10.93
Corporate pension funds
$34.70
Individuals
$10.31
Endowments and foundations
$20.00
Operation of the market for angel capital
Who are the angels?
The market for angel capital—where individuals provide risk capital directly to small,
private, often start-up firms—operates in almost
total obscurity. Very little is known about the
market’s size, scope, the type of firms that raise
angel capital, and the types of individuals who
provide it. In this section, I report information
on the angel market gathered from two sources.
The first is my field research that involved interviews with more than a dozen angel investors in
the Dallas/Fort Worth area. The second is an
empirical study of over 100 firms which
attempts to document the importance of angel
investors in their financing prior to going public
(Fenn, Laing, and Prowse, 1998).
An angel investor is a provider of risk capital
to small, private firms. By risk capital, I mean
equity capital (or near-equity capital such as
loans or loan guarantees provided by investors
that also have an equity position in the firm).
The provider is a wealthy individual, not an
intermediary such as an SBIC or a private equity
limited partnership. Such individuals are not in
the top management of the firm to which they
provide capital nor are they employees, nor in
the immediate family of a member of management or an employee. Angels are arm’s-length
investors in the firm. Indeed, angels are often
perceived as the second round of financing a
start-up goes through, after the entrepreneur has
Equity Capital Markets—The View from Wall Street
19
exhausted all his family and friends’ money, but
before he approaches formal venture capital
partnerships. Angels often (but not always)
have entrepreneurial backgrounds and tend to
invest in start-ups and other small, closely held
companies.
hard data from a recent empirical study George
Fenn, Nellie Liang, and I are conducting. It is on
the importance of angel investors and some
characteristics of their investment patterns in a
sample of high-tech firms that went public in the
early 1990s.
Size of the angel market
Diversity of angels. Investors in the market
for angel capital appear to be extremely diverse
and heterogeneous. This is explained partly by
angels’ diverse backgrounds. Some are financially sophisticated, some are not. Some have an
entrepreneurial background from which they
derived their wealth, while others obtained their
wealth through inheritance or other means. It is
also explained partly by their motivations for
investing in the market. Most are probably
investing for return, but some may have altruistic reasons.
Some estimates of the size of the angel market
suggest that it is many times the size of the formal venture capital market. For example,
Freear, Sohl and Wetzel (1996) claim that perhaps between $10 and $20 billion is invested by
angels each year into as many as 30,000 firms.
However, an estimate from the 1993 National
Survey of Small Business Finances (NSSBF)
suggests that around 10,000 firms per year
receive a total of about $3 billion in equity from
angels (Fenn, Liang and Prowse, 1998). The
NSSBF number may well be a conservative estimate of the size of the angel market since it
samples primarily established small firms that
may not be the major seekers of angel capital.
There is clearly a great deal of uncertainty about
the importance of the angel market in financing
small firms. Compare the above numbers with
the venture sector of the private equity market
where commitments by limited partners totaled
$6.6 billion in 1995.
Interview observations of angels
The following section presents a general
description of angels activities gleaned from my
interviews with them. Or course these descriptions much be taken with a grain of salt because,
as yet, there is little data available with which to
confirm what angels tell us in interviews. In
addition, the heterogeneity of the angel market
means that it is very hard to come up with general statements about how the angel market
operates. However, I follow my interview
observations on the angel market with some
Active and passive angels. Angels also vary in
the degree to which they are active investors in
firms. By active angels, I mean those who
actively monitor the firms they invest in, sit on
the board, advise the firm on various matters,
and sometimes help the firm overcome particular operating, marketing, or financial problems.
Passive angels, on the other hand, provide only
money and rarely monitor the firm closely. Passive angels rarely exist independently. They are
usually part of an informal network of passive
angels led by one or more active angels who
find deals, perform the due diligence, informally syndicate the deal among their network of
passive angels, and manage the investments.
Passive angels often invest simply on the word
of a trusted active angel.
Active angels on the other hand are most often
highly motivated ex-entrepreneurs who are perceived to have a skill at picking good people in
whom to invest. These active angels rely heavily on their ability to pick good management
teams and good ideas.
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Active angels share some common characteristics. First, they are typically older ex-business
owners who have considerable experience
founding and managing companies—often
start-ups but occasionally large firms also. Second, they have high incomes or net worth. There
is, in fact, a formal definition of an accredited
individual or angel in federal and state securities
laws and regulations. In general, they are identified as individuals whose net worth is over $1
million and whose income exceeds $200,000
per year. Angels typically do not depend solely
on their angel investing for their current income
and so their participation in this activity often
varies widely depending on their interest and the
time they have to devote to it. Many angels do
not make more than one investment per year,
although there are a few full-time angels who
will make as many as four or more per year. It is
not uncommon for an active angel to have an
informal network of passive angels who will
coinvest with him on deals that he finds.
Financial sophistication of angels. There is
also a marked difference between angels in their
degree of financial sophistication. The more
sophisticated angels tend to insist on investment
contracts that resemble the ones written in the
private equity market, which contain lots of
incentive and direct control mechanisms to
overcome moral hazard problems and protect
them in case of poor performance. Unsophisticated angels omit even the most basic protections. In general, even the most sophisticated
angels rely less on governance mechanisms in
the investment contract versus their gut feel
about the potential success of the enterprise and
the character of management.
Business angels. Having often founded companies themselves, most angels prefer to focus
on start-up or infant-stage firms, rather than
already established businesses, although some
more successful and wealthier angels will also
Stephen Prowse
participate along with other partnership or institutional investors in middle-market buyouts.
Angels’ typical investments in start-up firms
can be as low as around $50,000 but may be as
high as $1 million. In these large deals, coinvesting with other angels or partnerships is
common.
Informal and agent deals. Business angels
rely primarily for their information on potential
deals on a very primitive and informal networking arrangement of friends, family, and other
angels and business associates. On occasion
they will also rely on formal agents or middlemen such as investment bankers and brokers.
Many angel investments are arranged by informal
matchmakers, such as lawyers or accountants
who only occasionally put deals together and
are not full-time agents.
Deals brought to the angel by agents are less
attractive than deals the angel locates himself or
through his informal network. This is because
agent-arranged deals involve additional fees for
the agent, and also because they tend to get bid
up in price by competing investors who are also
being shown the deal by the agent. In addition,
deals brought by an agent have less credibility
in the eyes of the angel because the entrepreneur
is not being vouched for by a known associate of
the angel. Finally, sophisticated angels, which
may require a lot of protections in the investment contract, often find that deals marketed by
agents are targeted at those unsophisticated
angels on a “take it or leave it” basis. They tend
not to be able to insist upon additional changes
or protections to the deal as marketed by the
agent. On the other hand, some full-time angels
do not mind working with agents because it
relieves them of some of the burden of due diligence work.
Implications of informal angel deals. Reliance on such an informal, inefficient network
Equity Capital Markets—The View from Wall Street
for gathering information about potential deals
has a number of implications. First, most angels
invest near to home, consistent with the reach of
their networks. There is another reason angels
invest close to home, which has to do with the
cost of monitoring the firm. Most angels like to
be no further than a quick plane trip from the
firm in order to keep the time and money costs of
regular monitoring visits down. Second, the sharing of information on deals with other active and
passive angels generates a lot of coinvestment
opportunities. Most angels share information on
potential deals both to get coinvestors and with
the expectation that the favor will be reciprocated
in the future. Third, most angels complain of a
shortage of opportunities in which to invest. In
particular, they complain about the information
channels currently available to find deals. Finding
deals appears to be a very hit-or-miss proposition, with a large degree of serendipity in the
number and quality of deals that an angel sees.
Criteria for choosing angel deals. How do
angels screen investment proposals that they are
introduced to? Many angels specialize by sector
depending on their expertise and background.
The primary criterion that angels use to screen
proposals is whether the entrepreneur is previously known and trusted by them or by an
associate whom they trust. This is very different
from limited partnerships that, while they also
have trust in management as a key criterion,
rarely insist upon previous personal knowledge
of the entrepreneur. Of course, most angels also
appear to require comprehensive business plans
before considering investment, including a history of the firm and its principals, relevant credit
reports, a summary statement of the purpose and
goals of the enterprise, a clear description of the
proposed financing, marketing plans, and a
clear description of the technical aspects of the
proposed venture. These appear to be given secondary status to a personal knowledge and trust
of the principals.
21
Active angels almost always provide more
than money. Angels provide assistance by helping companies arrange additional financing,
hire top management, and recruit knowledgeable board members. Angels also may become
involved in solving major operational problems, evaluating capital expenditures, and
developing the company’s long-term strategy.
They will often take a formal position as a paid
part-time or full-time consultant to the firm.
Most angels appear to have an investment
horizon of about five years for their investments, though some have horizons that are
considerably longer. The most usual method of
exit for a successful firm is an IPO or the sale to
another company. However, IPOs are rare and
considered a home run, reflecting the likelihood
that in five years the company will not be at the
stage where a public offering is feasible.
Data on angel investments in a sample of
high-tech IPOs
In Fenn, Liang, and Prowse (1998) we collected information from 107 initial public
offerings in the period from 1991 to 1993 in two
high-tech industries: computer software and
medical equipment. For each company, we collected data on the identity of its shareholders
just prior to the IPO. Questions included: how
many were formal venture capitalists and angel
investors; what their equity stakes were in the
firm just prior to the IPO; and did they sit on the
board of directors or have any other relationship
with the firm. In addition we collected data on
the firm’s size, location, age, R&D expenditures, and the primary security issued by the
company (preferred, common, or debt).
The biggest issue we faced was clearly how
to identify angels. Our definition of an angel
investor is any individual that acquires an equity
stake primarily in consideration for capital
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Stephen Prowse
Chart 3
INCIDENCE OF ANGEL AND VENTURE CAPITAL INVESTORS
Percent of sample
Percent of sample
45
45
40
40
35
35
30
30
25
25
20
20
15
15
10
10
5
5
0
0
Angel
Venture capital only
Angel and venture capital
Note: The sample includes 107 firms in the medical instruments and computer software industries that went public from 1991
to 1993.
contributions to the company, excluding past and
present employees of the company or their
relatives.
Our results, in brief, are as follows:
1) Virtually all of the firms in our sample
raised external equity capital before going public. Only two were able to “bootstrap” their way
to an IPO without raising any equity capital at
all. Of the 105 that did raise equity capital, most
raised it from either formal venture capitalists
or angels. Only four firms did not raise equity
from either venture capitalists or angels, but
solely from corporate or institutional investors.
Thus, 101 out of 107 firms in our sample raised
external equity capital from angels or venture capitalists or both. Over 20 percent of the
sample (23 firms) raised equity only from
angels, while an additional one-third (36 firms)
raised equity from angels and venture capitalists (Chart 3). Thus while venture capital is
more frequent it appears that angels clearly play
an important role in financing the firms in our
sample.
2) Angels are much more likely to structure
their investments with common stock than with
Equity Capital Markets—The View from Wall Street
23
Chart 4
PRIMARY SECURITY ISSUED BY FIRMS
(Common, convertible preferred, or debt)
Percent
Percent
100
100
Debt
90
90
Preferred
80
80
70
70
60
60
50
50
40
40
30
30
20
20
Common
10
10
0
0
Angel only
preferred (Chart 4). Angels purchase common
in 75 percent of the firms in which they invest,
while venture capitalists purchase preferred in
75 percent of the firms in which they invest.
3) Angel-only backed firms are smaller, younger,
and less R&D-intensive than firms financed exclusively by venture capitalists (Table 3).
These empirical results support the notions
that angels are important suppliers of capital to
start-up firms, and that they invest at earlier
stages than do venture capitalists, confirming
some of the issues raised in the interviews.
Whether these characteristics extend to startups in other high-tech industries, or, in particular, to start-ups in non-high-tech industries, is an
issue we are currently investigating.
Venture capital only
ISSUES IN THE OPERATION OF THE
TWO EQUITY MARKETS
In this section I discuss two issues that have
been raised with regard to the operation of the
private equity and angel markets. First, is there
a developing venture capital gap for start-up
and seed firms in the private equity market?
And second, how should we best address the
search problems that firms and angels face in
the angel capital market?
Is there a venture capital gap for start-up
firms?
There has been much discussion within the
private equity industry about an alleged shift in
the flow of funds from start-up and early-stage
24
Stephen Prowse
Table 3
FIRM CHARACTERISTICS
The sample includes all firms in the computer software and medical instruments industries that went
public from 1991 to 1993.
Angel only
Venture capital only
$1.3 million
$11.1 million
Research and development/
assets
13.0%
27.3%
Age at first angel or
venture capital investment
1.1 years
1.8 years
-.4%
1.3%
Total assets
Net income/assets
investments to later-stage deals. One reason
often given for such a shift has to do with the
fixed costs of due diligence across all deal sizes
and the increasing size of limited partnerships’
investment pools. Thus, the motivation is to
want to write bigger checks, and move to laterstage deals. Another reason often given is the
increasing presence of large institutional investors that are risk-averse and have short
investment horizons.
Data available on the venture capital market
do not provide a clear answer as to whether this is
in fact a serious problem. Venture capital partnerships have been getting bigger over time—
the average size of a partnership in 1980 was
$28 million, while it was about two and a half
times bigger at almost $75 million in 1995. In
addition, the average size of a single investment
by a venture partnership has risen by about the
same multiple (from $1.2 million in 1980 to
$3.4 million in 1995). Thus there may have been
increasing incentives for partnerships to move
to larger deals as they got bigger over this
period. However, much of this increase is simply due to inflation. In real terms, the average
size of a partnership and the average size of a
partnership’s investment have increased by
only about 50 percent. In addition, according to
the data, there is no clear associated shift in the
flow of funds away from early-stage venture deals
to later-stage venture deals (Table 4). The share
of new venture investments going to early-stage
deals was higher in 1995 than it was in 1983.
It is true that the nonventure sector has
expanded faster than the venture sector over the
last 15 years (Table 4). This could in some sense
be viewed as a shift in the flow of funds away
from the industry’s venture activity. It is important to note that while the nonventure sector has
grown the fastest, both nonventure and venture
capital have grown extremely fast, especially
relative to the growth of other corporate finance
markets over the same period. And at least over
the last six years, the share of new commitments
going to venture versus nonventure capital has
remained constant (Table 4).
Problems in the market for angel capital
Anecdotal evidence from studies on the angel
capital market suggests that there is great dissatisfaction with the information channels angels
Equity Capital Markets—The View from Wall Street
25
Table 4
TRENDS IN PRIVATE EQUITY
Distribution of new venture investments by focus of investment (in percent)
Early stage
Later stage
35
30
30
38
65
70
70
62
1983
1985
1990
1995
Stock of capital in the organized private equity market ($ billions)
Venture
1980
1995
3.0
44.3
Nonventure
1.7
172.6
New commitments to private equity partnerships ($ billions)
Venture
1990
1991
1992
1993
1994
1995
1.4
2.6
2.9
4.2
4.7
6.6
Nonventure
5.6
8.1
9.9
15.2
23.7
25.5
Source: Fenn, Liang, and Prowse (1997).
must use to find deals, and that most angels
would invest in more deals if they could find
them. Putting these two impressions together
suggests that a more efficient search process
might result in more deals being done. Of
course, it might be that the awkwardness of the
search process is an illusion. The fact that angels
have more capital than investment opportunities
could mean that all the positive net present value
deals are already being funded. However, the
search on both sides is very time consuming and
awkward.
Matching services. One proposed solution to
this problem has been the creation of a number
of localized networks of matching services. These
are all nonprofit organizations because the economics of providing networking services does
not seem to be able to provide an economic
return sufficient to provide for profit motivations to start such businesses. They collect information from interested seekers of funds (firms)
and providers of funds (angels), and provide a
computer matching service to interested parties. They also provide educational services to
26
Stephen Prowse
angel investors on how to invest in firms.
Recently these local networks have been integrated nationally via the Small Business
Administration-sponsored ACE-Net.
The effectiveness of such a system in solving
the search problems that angels face may
unfortunately be impeded by two characteristics of most angel investors. The first is that
angels put a very high premium on previous
knowledge of the entrepreneur, thus there is a
question as to how much value an anonymous
matching service will add. Angels also like to
be very close geographically to the firms in
which they invest. This might also mean that
a national network is no more effective at
solving the search problem than existing local
networks.
The most effective efforts to increase the efficiency of the angel market may well lie in the
educational efforts that are being undertaken.
Many angels are unsophisticated investors and
there appears to be a lot of room for them to
move up the learning curve in terms of the contracts they write with firms.
CONCLUSION
Evidence suggests that the organized private
equity market and the market for angel capital
are important sources of finance for small firms.
It is clear that further research into these markets is warranted, as policymakers strive to
create conditions whereby small- and mediumsized enterprises find it easier to raise equity
capital.
ENDNOTES
1 These and other figures in this section are estimates from Fenn, Liang, and Prowse (1997).
REFERENCES
Fenn, G., N. Liang, and S. Prowse. 1997. “The Private
Equity Market: An Overview,” Financial Markets, Institutions and Instruments.
Fenn, G., N. Liang, and S. Prowse. 1998. “The Role of
Angel Investors in Financing High-Tech Start-Ups,”
unpublished working paper.
Freear, J., S. Sohl, and W. Wetzel. 1996. “Creating New
Capital Markets for Emerging Ventures,” University of
New Hampshire, unpublished manuscript. Durham,
NH.