Developing Time Series Data on
 the Size and Scope of the UK
   Business Angel Market.


      Colin M Mason                       Richard T Harrison
Hunter Centre for Entrepreneurship   Queen’s Univer...

       Executive Summary                                             1

       Author biographies              ...


This Report was comm...

    1.       In view of the importance of business angel investment in supporting an
c. Undertake administrative changes to the process in of 88(2) forms by
        Companies House to address the limitations...
as the Annual Small Business Survey) to minimise the otherwise high set-
     up costs.

7.   With a CFDI-type survey at t...

Colin Mason

Colin Mason is Professor of Entrepreneurship and Head of Department in the Hunter Centr...
development). Second, policy analysis and advice directed at the more effective mobilisation
of early stage risk capital, ...

A simple definition of a business angel is an individual, acting alone or in a formal or
informal s...
1.1 Role of Business Angels

Business angels play a critical role in the creation of an entrepreneurial climate for
three ...
However, since most business angels are current or former entrepreneurs they are
likely to be most common in regions with ...
government interventions and other changes in the external environment on informal
venture capital investment activity. Eq...
restricted to situations in which there is a family or friendship connection
         between the investor and the busines...
and devolving the investment decisions to the syndicate leaders. This model is
         much more common in the USA than i...
•   Establishing criteria that will define which informal investment activity will be
       classified as business angel ...

2.1     Introduction

The UK business angel market ha...
subscription-only magazine containing information on businesses seeking finance,
one response came from questionnaires sen...
•       Around one-third of investments involve other angels – however, the majority
           of investors invest on the...
The Mason and Harrison study has stimulated further research. Subsequent studies
have been of two types. The first type ar...
The study was based on a sample of nearly 500 investors and 467 investments
(involving over 200 investors) – a much larger...
a later study (Mason and Harrison, 2002a) this led them to argue that policy needed to
address the issue of ‘investment re...
majority of investments were within 50 miles of their home or work. Investments
were typically sourced through personal ne...
the UK that had been emerging over the ten years since publication of Mason and
Harrison’s initial study.

      •   Predo...
sources of information and more on their own private sources from an extensive base
of contacts developed as a result of b...
The landmark studies by Mason and Harrison (1994), Coveney and Moore (1997) and
van Osnabrugge and Robinson (2000) all exa...
Subsequent analysis of this data by Harrison et al (1997) interpreted the business
angel’s reaction to investment proposal...
•   Most of the equity investments were in ordinary shares – only 16% involved
       complex instruments (e.g. preference...
were. This highlighted ‘serving as a sounding board to the management team’,
‘monitoring financial performance’ and ‘assis...
attitudes and intentions. Studies that explicitly attempt to measure the scale of the
market as a whole are far fewer in n...
Enterprise initiatives have made a particular contribution to the funding of smaller
investments and younger companies, an...

In the two ...
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  1. 1. Developing Time Series Data on the Size and Scope of the UK Business Angel Market. FINAL REPORT May 2008 Colin M Mason Richard T Harrison URN 08/1152
  2. 2. AUTHORS Colin M Mason Richard T Harrison Hunter Centre for Entrepreneurship Queen’s University Management School University of Strathclyde Queens University Belfast Glasgow G1 1XH Belfast BT7 1NN Scotland Northern Ireland Tel: 0141 548 4259 Tel: 028 9097 3621 0141 548 3482 028 9097 5025 Fax: 0141 553 7602 Fax : 028 9097 5156 Email: E-mail:
  3. 3. CONTENTS Executive Summary 1 Author biographies 6 1 Introduction 8 2 The UK business angel market: an overview of previous 15 studies 3 Developing a time-series dataset to measure business angel 30 activity in the UK: definitional issues 4 Data sources for measuring the investment activity of business 34 angels: a critical review 5 Recommendations 60 References 67 Appendix 1. Questionnaire used by BANs to report on the 73 investments that they had facilitated.
  4. 4. DEVELOPING TIME SERIES DATA ON THE SIZE AND SCOPE OF THE UK BUSINESS ANGEL MARKET EXECUTIVE SUMMARY This Report was commissioned to identify the importance of business angel investment in the UK, summarise previous approaches to mapping the scale and scope of the business angel market, identify new approaches to measuring business angel activity and assess the implications for policy. A business angel is defined as an individual acting alone or in a formal or informal syndicate who invests their own money directly in an unquoted business in which there is no family connection, and who, after making the investment, takes an active involvement in the business (as an advisor or board member, for example) directly or via a co-investor. There is an important distinction between a business angel per se (‘pure’ business angel investment) who is, generally, commercially motivated and driven by expectations that there will be a financial return on the investment (although some angel investors do on occasion trade-off commercial returns for other social or altruistic motivations). These meritocratic investors are distinguished from informal investors, a broader category that includes business angels but also includes investors motivated by primarily non-commercial motives (particularly family connections), described as ‘love money’ or affinity investing. While both are important, only ‘pure’ business angel money is potentially available outside family and personal connections and is the primary focus of public policy interest. Business angel investment is important to the development of an entrepreneurial economy. However, in the absence of directories of business angel investors their invisibility makes difficult the development of accurate estimates of the scale of the business angel investment market and the identification of trends in that market. Based on a detailed review of previous research on business angels in the UK and internationally, the report concludes that research-based knowledge of the business angel market is ad hoc: i. it is cross-sectional rather than longitudinal, and as such offers no evidence on establishing trends in investment activity with any degree of robustness or reliability; ii. it is often based on small-scale samples, which creates problems of generalisability to provide estimates of overall market activity levels; iii. these samples are more often than not samples of convenience, raising issues of the extent to which extrapolation can be undertaken when the representativeness of the sample is unknown; iv. research is characterised by different definitions of business angel activity, raising the problem that comparative analysis is not based on a like-with- like comparison; v. international comparisons are problematic; vi. as a result policy decisions are based on partial information. 2
  5. 5. Recommendations 1. In view of the importance of business angel investment in supporting an entrepreneurial economy, the Enterprise Directorate should develop improved time series data on business angel investment activity. 2. Data collection should be based on a consistent rigorous definition of business angels. The Report defines a business angel as an investor who: invests their own money, makes their own investment decisions1, is driven largely by commercial considerations (although some investors may trade off part of the commercial return for non-financial considerations), is not making within-family investments, and has a hands-on involvement with the investee company either themselves or through a co-investor. Separate data collection and analysis is appropriate to scope out the non-‘pure’ informal investment activity in the UK to provide an overall assessment of the availability of risk capital. 3. Identifying business angels and the amounts they report to have available for investment is extremely problematic. Accordingly, the focus of data collection should be on investment activity – the investments made by business angels – rather than on the investors themselves. Data should be collected on both the activities of business angel investors and on the companies in which the investments are made. 4. The business angel investment market is evolving and the Report notes in particular the emergence of business angel syndicates as a key part of this market. Given the increasing significance of angel groups and syndicates, therefore, the Enterprise Directorate should instigate a regular (annual or twice a year) survey of angel groups and syndicates to collect information on their investment activity. As similar information is being collected in the US and is to be collected in Canada, there is scope for developing international comparisons in investment levels and trends. 5. Data collection on the business angel market can build on data that already exists, working with existing data sources so that they can be used to generate estimates of business angel investment activity. The Report recommends action on five fronts: a. Seek changes to the questions in GEM (Global Entrepreneurship Monitor) about informal investment to include questions about the investments themselves b. Encourage BBAA (British Business Angel Association) to increase the range of data collection from members: while to some extent this represents the ‘tip of the iceberg’ in terms of market coverage, there is potential to capture data not otherwise available from other sources (for example, on valuations, deal structures, co-investment activity). 1 This includes investors making decisions through a syndicate or upon the recommendation of a lead investor (or “archangel”) but excludes collective investments through Venture Capital Trusts. 3
  6. 6. c. Undertake administrative changes to the process in of 88(2) forms by Companies House to address the limitations of this as a source of data on market activity. These changes would include: enforcing the requirement to file; ensuring the completeness of records; requiring the disclosure of both loan and equity investments; speeding up the timescale for filing; classifying the investors to identify ‘insiders’ and ‘outsiders’ and ‘connected’ and ‘unconnected’ investors; and timely publication of a list of 88(2) filings. d. Undertake a one-off survey of business angels to identify the proportion that are members of business angel networks, the proportion of their investments that are made through these networks, and the extent to which such investments are distinctive from those made without using such networks. With this information it would be possible to extrapolate from data on investment activity through networks (as reported by BBAA, for example) to generate overall ‘headline’ market estimates. e. Undertake a one-off survey to estimate the total share of business angel investment activity that is accounted for by EIS (Enterprise Investment Scheme) and use this information to scale up EIS investment statistics to provide overall market estimates. This would require surveys of both business angel investors and EIS investors. f. While efforts to improve the utility of GEM, EIS and BBAA statistics could generate much improved information on business angel activity at relatively little cost, each of these data sources has limitations that preclude using them in isolation. Accordingly, a multi-method approach to generating consistent reliable time-series data on the business angel market is recommended. In addition to improving the utility of the 88(2) date, we recommend that consideration is given to: i. Pressing the GEM research coordinators to change the questions they ask about informal investment; ii. Collecting more comprehensive data through BBAA on their members’ investment activity; iii. Scoping a project, based on an appropriate sample, to asses the overlap between EIS and ‘pure’ business angel investment (this could also provide information on business angel network membership to permit scaling up of BBAA data). 6. Data collection on the business angel market can also be based on new data collection, going beyond existing data sources, to develop a more accurate, consistent and comprehensive estimate of angel investment trends. The Report recommends that the Enterprise Directorate invests in a company survey modelled on the Canadian Financing Data Initiative (CFDI). This is methodologically rigorous in its approach and can generate estimates of both the stock and the flow of business angel investments on an annual basis, and could build on existing surveys (such 4
  7. 7. as the Annual Small Business Survey) to minimise the otherwise high set- up costs. 7. With a CFDI-type survey at the core of a data collection strategy, reinforced by modifications to GEM, BBAA, EIS and 88(2) sources as discussed above, there would be a strong basis for collecting consistent and robust time series data on the UK business angel market. This would give the UK the best statistical information on business angel activity and would provide policy makers with and effective ‘instrument dial’ for monitoring the early stage risk capital market and providing the basis for evidence-led intervention in the market. Given the diversity of data sources available and to be developed, and the importance of adopting a multi-method approach to market estimation and tracking, the Enterprise Directorate should commission and publish an Annual Report on the UK business angel market. 5
  8. 8. BIOGRAPHICAL DETAILS Colin Mason Colin Mason is Professor of Entrepreneurship and Head of Department in the Hunter Centre for Entrepreneurship ( at the University of Strathclyde in Glasgow. He was previously a Professor of Economic Geography in the Department of Geography at the University of Southampton. His research is concerned with entrepreneurship and venture capital, particularly in the context of regional development. He has published extensively on topics such as the new firm formation process, the geography of new firm formation and growth, the impact of small business policy, and venture capital in both the academic and practitioner-oriented literature. Over the past twenty years his main research, undertaken jointly with Professor Richard Harrison (Queen’s University of Belfast), has been concerned with the availability of venture capital for entrepreneurial businesses - they are recognised as leading academic authorities on the informal venture capital market. He has been closely involved with government and private sector initiatives to promote informal venture capital in the UK, including undertaking several consultancy projects for the Department of Trade and Industry, Small Business Service and Scottish Enterprise, compiling an annual guide to sources of business angel capital and investment activity report on behalf of the British Venture Capital Association, and undertaking research on behalf of the National Business Angel Network. He is an honorary member of the British Business Angel Association (BBAA). Professor Mason was a member of the Governor of the Bank of England’s small business finance forum and the Treasury’s Enterprise Panel which examined the role that business incubators might play in stimulating technology-based businesses in the UK. He has also advised the Australian Government and various Finnish and Argentinean organisations on strategies to increase the supply of informal venture capital and has been a consultant to the OECD and the European Union on issues associated with innovation and venture capital. He serves on the editorial boards of six entrepreneurship/small business journals and is founder and co-editor of Venture Capital: An International Journal of Entrepreneurial Finance (Routledge). He teaches courses on New Venture Creation and Entrepreneurship and Regional Development and has also lectured on raising venture capital on several MBA courses in the UK and abroad. In addition, he teaches on a Masters Degree in Industrial Economics with Particular Emphasis on Small and Medium Sized Enterprises at the Universidad Nacional General Sarmiento and Universidad Nacional de Mar del Plata, Argentina and has also taught at universities in Canada and Australia. He has also been involved in several workshops for entrepreneurs on how to raise finance and participated in the Fit4Finance Programme that was run by Hertfordshire Business Link throughout the South East and Eastern regions of England from 2002-6. Richard Harrison Richard Harrison took up the position of Professor of Management and Director of Research at Queen’s University Management School at Queen’s University Belfast in January 2006 (, and assumed the role of Director and Head of School in September 2006. He was previously Dixons Professor of Entrepreneurship and Innovation, and Director of the Centre for Entrepreneurship Research, at the University of Edinburgh Management School, and has held professorships in entrepreneurship, strategy and executive development at the Universities of Aberdeen and Ulster. Professor Harrison’s primary research over the past twenty years has been in the area of venture capital and business angel finance and encompasses three sets of studies. First, analyses of the operation of early stage venture capital markets (both business angel markets and formal venture capital markets) and their role in stimulating and supporting business development (and hence economic 6
  9. 9. development). Second, policy analysis and advice directed at the more effective mobilisation of early stage risk capital, including assessment of public sector/state interventions in the supply of capital at local, regional, national and international level. Third, international studies of the emergence and development of risk capital markets in emerging economies – much of this research is currently focused on East Asia (China, Malaysia, Singapore, Taiwan) and concentrates on the analysis of (a) the internationalisation of the venture capital industry and (b) the governance and regulatory issues in the development of an indigenous venture capital industry in emerging economies. He is founding co-editor with Colin Mason of Venture Capital: An International Journal of Entrepreneurial Finance (Routledge) – now in volume 10, this is the only refereed academic journal that specialises in the publication of research and policy papers on all aspects of venture capital and entrepreneurial finance, including business angel finance. Professor Harrison’s teaching at Masters level (full time and executive MBA programmes) has focussed on a range of Entrepreneurship and New Venture Creation courses, with the emphasis on developing both knowledge of the entrepreneurial process and the application of the principles of entrepreneurship in practice in start-up and corporate contexts. Much of this teaching is focused on opportunity identification and exploitation. Additional teaching lies in the area of Business Strategy for Entrepreneurial Ventures and Leadership Theory and Practice, and courses have been run for participants from major financial institutions and small business owners in a wide range of sectors, including the education sector. He has also contributed widely to MBA and doctoral education programmes in the US, Argentina and Sweden. Professor Harrison has served as adviser/consultant/speaker on venture capital, business angels and financing innovation to, inter alia, UK Department of Trade and Industry (Small and Medium Enterprise Policy Directorate; Innovation Unit; Small Business Service); Scottish Financial Enterprise/Scottish Enterprise; Welsh Development Agency; British Venture Capital Association; European Union DG XIII (EIMS Financing Innovation workshops); European Seed Capital Fund Network (Liege workshop); Forbairt (Ireland); Enterprise Ireland; Fraunhofer Institut, Karlsruhe (Germany); Six Countries Inter- Governmental Programme; OECD; EURADA; European Business Angel Network; Swedish Forum for SME Research; LINC(Local Investment Network Company) (UK); LINC Scotland, CONNECT (Denmark), CONNECT (Sweden), and to advisors, policy makers and local development interests on venture capital and informal venture capital (including advice on the funding of technology based businesses and the role of technology rating services in particular) in the UK, Ireland, USA and Europe. He has undertaken research on behalf of the National Business Angel Network and is an honorary member of the British Business Angel Association (BBAA). He has recently undertaken two major reviews of the early stage risk capital market in Scotland for Scottish Enterprise (see <http://www.scottish-> for the most recent), and prepared the background paper making the case for the Scottish Investment Fund (renamed the Scottish Venture Fund), recently launched by Scottish Enterprise (see <> for details of the Harrison/Peters report). He was an invited participant in an Industry Canada experts roundtable on improving statistical information on the informal venture capital market in Canada (2002), and was an ad hoc member of the Finnish delegation to a US-Finland roundtable on developing the venture capital market in Finland (2004) as part of his association with the Emerging Business Research Centre at Tampere University of Technology and University of Tampere. He is also a member of the International Advisory Board of the CIRCLE (Centre for Innovation, Research and Competence in the Learning Economy) interdisciplinary research project at Lund University, Sweden. He has recently been appointed to the International Advisory Group for the Management of Rapid SME Growth 2006-2010 research project at McGill University Montreal and Helsinki School of Economics. 7
  10. 10. 1. INTRODUCTION A simple definition of a business angel is an individual, acting alone or in a formal or informal syndicate, who invests their own money directly in an unquoted business in which there is no family connection and who, after making the investment, takes an active involvement in the business, for example, as an advisor or member of the board of directors. There is an inference that such individuals are likely to have a high net worth in order to have sufficient disposable wealth to make such high risk investments. Business angels make up what is often termed the informal venture capital market. This contrasts with the formal, or institutional, venture capital market which comprises professional investors – venture capital firms – who invest ‘other peoples’ money’, typically raised from banks, insurance companies and pension funds, but also non-financial companies, wealthy families and charitable trusts. Their investment activity is recorded and reported by their national venture capital association (e.g. the British Venture Capital Association).2 Some researchers include investments by family (‘love money’) and friends (affinity money) as part of informal venture capital. However, business angel investment is conceptually distinct from investment by family and friends. Angel investment is primarily commercially oriented3 – in terms of both the expectations of the investor for capital gains and other financial returns and the terms and conditions governing the investment - whereas love money is not. Thus, an angel investment can potentially be made in any business whereas ‘love money’ is restricted to situations in which there is a family or friendship connection between the investor and the business owner. The Global Entrepreneurship Monitor (GEM) project has suggested that family investment is more significant than disinterested or unconnected business angel investment – in the UK; for example, around 12% of reported informal investment is sourced from business angels, the remainder coming from family and friends. However, for the purposes of this report the terms business angels and informal venture capital will be used synonymously to refer to this ‘pure’ angel investment. 2 There is a tendency to assume that national venture capital statistics are an accurate measure of investment activity in the formal venture capital market and therefore to use them uncritically. However, a study of the membership Swedish Venture Capital Association challenged its representativeness – and hence the accuracy of its statistics - noting that it includes some firms that are not proper venture capital investors and excludes some important investors. The effect is to understate the amount of early stage investments (Karaömerlioglu and Jacobsson, 2000). 3 However, this does not preclude non-commercial motivations. Both Wetzel (1981) and Sullivan (1994) have noted that some angels invest for less than fully commercial reasons, for example because the product/service has social benefits, to support particular types of entrepreneur, or to support their local community, and are willing to trade-off some financial return against these altruistic considerations. Nevertheless, these investments remain distinct from those made by family and friends. 8
  11. 11. 1.1 Role of Business Angels Business angels play a critical role in the creation of an entrepreneurial climate for three reasons. First, they invest largely in those areas in which institutional venture capital investors are reluctant, or unable, to invest. Because business angels do not incur the transaction costs of venture capital firms they are able to make smaller investments, well below the minimum deal sizes considered by venture capital firms. Investments by business angels are also relatively more concentrated at the seed and start-up stages, whereas venture capital firms tend to provide finance for growth and development. This is best illustrated by Freear and Wetzel (1990) in their study of the sources of finance used by new technology-based firms in New England in the 1980s. They found that while business angels invest across the full range of business development stages, they “are the primary source of funds when the size of deal is under $1million” and “provide more rounds of seed and start-up capital than venture capital funds.” For larger amounts and later stages venture capital firms dominated. Replication of this study in the 1990s confirmed these relationships (Freear et al, 1997; 1998). It therefore follows that the informal venture capital market is the largest external source of early stage risk capital, substantially dwarfing the institutional venture capital market.4 Robert Gaston’s estimate for the 1980s was that business angels in the USA were providing capital to over 40 times the number of firms receiving institutional venture capital, and that the amount of capital they invested almost exceeded all other sources of external equity capital for new and growing businesses combined (Gaston, 1989a). A ‘back of the envelope’ estimate for the UK in the late 1990s suggested that the informal venture capital market provided almost twice as much early stage finance as the formal venture capital market (Mason and Harrison, 2000a). Recent research in Scotland, tracking all identifiable investment deals over the past five years, has demonstrated that business angel investment significantly outweighs institutional venture capital investment (Harrison and Don, 2004; 2006). Indeed, business angels are often the only source of external seed, start-up or growth finance available once businesses have exhausted personal and family sources and sources of ‘soft’ money (e.g. PYBT, government schemes such as Proof of Concept and University Challenge) funds. Second, business angels are much more geographically dispersed than venture capital funds, which are overwhelmingly located in just a small number of major financial technology centres and concentrate their investments in a relatively small number of locations (Mason, 2007).5 In the case of the UK, BVCA statistics for 2006 reveal that London and the South East attracted 42% of all venture capital investments and 60% of the amount invested. Early stage investments are equally geographically concentrated, with London, the South East and the East of England attracting 49% of such investments and 54% of the amount invested by value. This is in marked contrast to business angels which, Gaston (1989b) has suggested, “live everywhere”. 4 However, as noted earlier, recent evidence from the Global Entrepreneurship Monitor (GEM), which is discussed in detail later, notes that capital supplied by family members substantially exceeded the amounts raised by business angels. 5 See Mason and Harrison (2002c) for an analysis of the regional distribution of venture capital investments in the UK. 9
  12. 12. However, since most business angels are current or former entrepreneurs they are likely to be most common in regions with a thriving entrepreneurial climate. The only analysis of the geography of business angel investing has been undertaken in Sweden where Avdeitchikova and Landström (2005) show that both investments (52%) and the amounts invested (77%) are disproportionately concentrated in metropolitan regions (which has 51% of the total population). However, this is a less geographically concentrated distribution than is the case for institutional venture capital fund investments. Furthermore, business angels tend to invest locally, making the majority of their investments in firms located within 50-100 miles of where they live (Harrison et al, 2003). This is largely a reflection of the superior information available on investment opportunities close to home and the ‘hands on’ nature of their investments. So, from a regional development perspective the informal venture capital investment process helps to retain and recirculate wealth within the region that it was generated, counteracting the effect of most investment mechanisms which act as a conduit through which personal savings flow out of regions to the nation’s financial centres for investment in core regions and abroad.6 Third, informal venture capital is ‘smart money’. Business angels are typically ‘hands on’ investors who seek to contribute their experience, knowledge and contacts to the benefit of their investee businesses. The opportunity to become involved is a major reason for becoming a business angel. The analogy is with being a grandparent – being a business angel enables an entrepreneurial individual to become involved with and contribute to the start-up and growth of a new business but without the 24-7 involvement of the entrepreneur (or parent). It is also a way in which investors can reduce agency-related sources of risk (the availability of information to one party in a relationship – in this case the business owner – that is not available to the other) and increase the prospects that the business will be successful. Since most business angels have an entrepreneurial background this involvement can also be expected to benefit the businesses in which angels invest – although to date research has failed to identify a positive relationship between involvement and business success despite the reporting of such benefits (or the perception of benefits) by owners (and investors) in successive surveys.7 1.2 Measurement Issues Given the importance of a thriving informal venture capital market for the creation and maintenance of an entrepreneurial economy it is important that Government is able to measure the number of business angels and the level of their investment activity. Measurement is important to monitor any decline in the number of business angels, drop in their investment activity or change in the nature of their investments, any or all of which could threaten the ability of businesses to access finance for start- up and growth. Measurement is also required in order to assess the impact of 6 For example, see Martin and Minns (1995) for a regional perspective on the effect on pension fund flows and Mason and Harrison (1989) who show that the flows of investment generated by the Business Expansion Scheme favoured the ‘south’ over the ‘north’ – this example demonstrates the impact of the institutionalisation of what was intended to be a development of the informal investment market, as it is the pooling of funds (the imposition of an intermediary between the investor and the investee business) that is associated with this regional concentration in investment flows: it is likely that direct investments in BES-eligible businesses were less subject to this north/south leakage. 7 See the paper by Macht (2006), presented at the 2006 ISBE conference for a review of the literature on the post-investment impact of business angels on their investee companies. 10
  13. 13. government interventions and other changes in the external environment on informal venture capital investment activity. Equally, any evidence for an increase in the number and investment activity of business angel investors has implications for the development of additional market interventions to increase the supply of capital. However, measuring the number of business angels and their investment activity on either a cross-sectional (static) or time-series basis is extremely problematic. There are two main problems: identification and definition. Identification First, as William E Wetzel Jr observed in his pioneering research on business angels, the total population of business angels “is unknown and probably unknowable” (Wetzel, 1983: 26) on account of their invisibility and desire for anonymity and the undocumented nature of their investing. From a practical standpoint this means that, unlike the institutional venture capital market, there are no lists or directories of business angels. The consequence has been that research on business angels has had to identify business angels through a variety of imperfect sources with no way in which to test for the ‘representativeness’ of the samples that have been generated. Indeed, many studies have been based on ‘samples of convenience’, such as angels who are members of business angel networks, or arising from snowball sampling methods8, both of which are likely to generate biased samples, not least because they will under-estimate the number of angels who are ‘lone wolves’, acting alone on their own initiative, or are one-time or infrequent opportunistic investors9. Furthermore, the difficulty of finding business angels has meant that most samples are small, which adds to the representativeness problem and makes it problematic to extrapolate from sample results to derive population estimates of activity with any degree of robustness. Definitions Second, there is definitional ambiguity. In order to gain a robust and accurate understanding of the size and temporal dynamics of the business angel market, data collection protocols will have to address the issue of how to differentiate between what we refer to here as ‘pure’ business angel investment and the wider informal investment market. There are four dimensions to this issue. • First, the term ‘informal investment’ is increasingly used, notably by GEM, to describe non-institutional risk capital investments in unquoted businesses. As noted above, this includes investments made by family, friends and business angels, with business angel investment being the smallest category. However, business angels have to be seen as conceptually distinct from ‘love money’ invested by family and friends. Angel investment is primarily commercially oriented (subject to the caveat that there is a sub-category of socially motivated investment) whereas love money is not. Moreover, an angel investment can potentially be made in any business whereas love money is 8 In this approach, a small number of angels are identified and they are asked to identify other angels that they know in order to expand the sample. 9 Previous research (e.g. Mason and Harrison, 1992) has suggested that these investor types will be common in a random sample of angel investors. 11
  14. 14. restricted to situations in which there is a family or friendship connection between the investor and the business owner. Adding to the definitional confusion is the fact that whereas a clear distinction can be made between family members and others, the definition of a friend is much more problematic: surveys of ‘pure’ business angels have consistently identified social, as well as business, networks as sources used to identify potential investment opportunities. A further confusion is that the same individual can be a source of both angel finance and love money. • The population of business angels is not fixed or static. Rather, being a business angel is a transitory state. A ‘virgin’ angel is someone who is looking to make their first investment – but as the experience of business angel networks in the 1990s attests, many of these individuals never make any investments. Another problematic category are individuals who have made one or more investments but are not currently looking to make new investments, either because they have no further liquidity (but may become active investors again once they realise proceedings from a successful exit event) or because they have invested and have withdrawn from the market on the basis that this activity is ‘not for them’10. Counting either category of individual as a business angels risks exaggerating the total number of active angels in the market and hence the investment capital potentially available. A final category is latent investors – individuals who would not describe themselves as active investors but who will invest opportunistically if suitable deals ‘pop up’. The implication is that approaches which use the business angel population as a source of information on investment trends (i.e. supply side measurement) must address the issue of how to identify these various components of the angel population in order to generate reliable estimates of the availability of finance from business angels. In practice it may be conceptually clearer to focus on actual business angel investment flows rather than the amount of capital that business angels say they have available for investment. • The angel market is evolving, notably with the creation of angel syndicates and other angel groups. These groups operate in two ways. First, they may act as formal or informal syndicates in which each member of the syndicate takes an active role in the investment opportunity identification, screening and investment processes. Typically such syndicates will be relatively small. Second, they may operate on the basis of a small group of active investors offering passive members of group the opportunity to invest in deals that they are offered but had no role in identifying, evaluating or negotiating and will not play any hands on role in the investee businesses. This second group might be considered to have broken some aspects in the conventional definition of a business angel. Nevertheless, as the members are investing their own money on a deal-by-deal basis and making a basic investment decision (yes or no) they can still be considered to be business angels. Rather more problematic are those angels groups that operate on the basis of pooling their investment funds 10 One example of a successful entrepreneur who exited from his business, initially set out to be a business angel investor and ceased to consider further activity after two unsuccessful investments convinced him this was not something he could undertake successfully is given in Mason and Harrison (2006). 12
  15. 15. and devolving the investment decisions to the syndicate leaders. This model is much more common in the USA than in the UK, where such investments are not eligible for tax relief under the Enterprise Investment Scheme. The reality of angel investing is therefore that it operates on a spectrum, occupied at one end by the solo investor who makes his or her own investment decision to invest directly, and at the other end by investors who are part of angel syndicates who simply say ‘yes’ or ‘no’ to the investment opportunities that they are offered and play no direct hands-on role in the investee company. The hands-off investor who invests in a pooled fund, and delegates the decision on which investments to make, would not be considered to be a business angel on the basis on the definition adopted here. • There is a final definitional issue which has become important in economies such as the UK. Since the introduction in 1981 of the Business Start-up Scheme, and the later replacement of this with the Business Expansion Scheme and the Enterprise Investment Scheme (EIS) (discussed below), and the introduction of Venture Capital Trusts (VCTs), there have been tax- efficient vehicles designed to encourage and leverage private capital into unquoted businesses with a view to closing the equity gap. However, while schemes such as EIS allow for direct investments by individual investors and business angel syndicates (to make their investments tax efficient), there is a problem with pooled investments under EIS and through VCTs, where individuals commit investment, to take advantage of the tax breaks available, to fund managers, who make the investment decisions and undertake the post- investment monitoring. This divorces the investor from the investment decision-making process, and would not qualify as business angel investment as we define it here. It is a moot point as to whether the introduction of pooled EIS funds and VCTs has diverted investment funds that would otherwise have come to the market as business angel investment.11 While much EIS investment in particular will meet our definition of business angel investment, some will not, and most VCT investment will not meet this definition. Given that EIS investments are captured and reported by Inland Revenue one key question is the extent to which it is a useful approximation for overall business angel investment activity?12 The Project The project specification defines the objective as being to lay the foundations upon which a robust time series dataset can be developed to measure business angel activity in the UK. The ability to measure and monitor changes is seen as being beneficial both to government in developing policy to increase access to finance by small businesses, and to stakeholders and finance providers. The specification sets out four key elements in the study: 11 The extension of VCTs to allow investment into AIM-quoted companies takes this investment channel beyond the business angel market and make it impossible in any case to rely on VCT data as a trend indicator in the business angel market. 12 It also raises the issue of the extent to which the development of a time series should be based on capturing data on the investment activity of a specific group of actors in the market (‘business angels’) or on scoping out the commitment of investment to a specific set of circumstances (defined variously as start-up/new ventures, equity gap issues, technology ventures etc). 13
  16. 16. • Establishing criteria that will define which informal investment activity will be classified as business angel activity; • Reviewing data sources currently available on the business angel market; • Developing a methodology to collect robust time series data on the size and scope of the UK business angel market; • Address data collection issues. In Section 2, as background, we provide a comprehensive overview of studies that have examined the UK business angel market, noting in particular the approaches used in these studies to identify and define business angels. Section 3 offers a definition of business angels and their investments. Section 4 reviews the research literature to provide a critical assessment of data sources that have been used in the UK and elsewhere to identify business angels and measure their investment activity. Based on this review, Section 5 makes recommendations on the most appropriate approach to develop a robust time series data on: • The number of active business angels in the UK; • The characteristics of business angels; • The number, size, sector and characteristics of their investments. 14
  17. 17. 2. THE UK BUSINESS ANGEL MARKET: AN OVERVIEW OF PREVIOUS STUDIES 2.1 Introduction The UK business angel market has been the subject of research for nearly 20 years. This section provides a review of our current knowledge of business angels and the operation of the informal venture capital market. The review is in three sections. It begins with a summary of the first ever study of business angels in the UK by Mason and Harrison (1994) that was conducted between 1989 and 1991. Second, it identifies subsequent in-depth studies that sought to extend the Mason and Harrison study. Third, it examines studies that have sought to examine specific aspects of the investment process. We pay particular attention in this review to the approaches used in these studies to identify and define business angels. 2.2 Mason & Harrison (1994): ESRC Small Business Research Initiative Study The first ever study of business angels in the UK was undertaken by Mason and Harrison between 1989 and 1991 as part of the ESRC’s Small Business Research Initiative. At that time awareness of business angels in the UK was extremely low. However, a report by the Advisory Committee on Science and Technology, a Cabinet Office committee on barriers to the growth of entrepreneurial businesses which was published mid-way through the research, did emphasise the importance of business angels, arguing that “an active informal venture capital market is a pre-requisite for a vigorous enterprise economy” (ACOST, 1990: 41). Mason and Harrison’s study was hugely influenced by US studies, notably Wetzel’s pioneering study of business angels in New England (Wetzel, 1981; 1983; 1986a; 1986b) and the subsequent studies funded by the US Small Business Administration’s Office for Advocacy, notably Arum Research Associates (1987), Gaston and Bell (1986; 1988)13 and Haar et al (1988).14 Its aim, following Wetzel (1986a: 132), was simply to put “some boundaries on our ignorance”, its approach to identifying business angels was based on the approach used by Wetzel and the questionnaire was modelled on the one used in the US SBA studies, in part to facilitate UK-US comparisons. The study had five objectives: (i) to identify the characteristics of UK business angels and compare them with their US counterparts; (ii) to document their investment activity; (iii) to identify the characteristics of their investment portfolios; (iv) to examine their involvement with the companies in which they invest; and (v) to identify their motivations and factors which they take into account when evaluating investment opportunities. Following the approach of US studies, questionnaires were sent to individuals on selected mailing lists which appeared to target individuals with the characteristics of business angels (business owners, high net worth individuals). This generated 47 completed questionnaires from over 4000 questionnaires. A further 12 questionnaires were completed by subscribers to Venture Capital Report, a 13 This research is accessible as Gaston (1989b) 14 Visits in the late 1980s and early 1990s by Harrison to the SBA and by Mason and Harrison to Wetzel and his colleagues at the University of New Hampshire gave them access to the reports and survey instruments and an understanding of the methodological issues involved in finding business angels. 15
  18. 18. subscription-only magazine containing information on businesses seeking finance, one response came from questionnaires sent to individuals who placed adverts in the Financial Times seeking investment opportunities in unquoted companies, and 13 came from investors who were either known to the researchers or referred to them by a third party. This gave a total of 86 responses. The key findings were as follows: (i) Personal characteristics • UK business angels are predominately male (99%), predominantly in the 45-65 year age group. • They are experienced entrepreneurs, two-thirds having started at least one business, and 70% of these being serial entrepreneurs. Half of the entrepreneurs were cashed-out. • The occupational classification is dominated by business-owners, self- employed and consultants (a description often used by entrepreneurs who had sold their business). • Relatively high incomes and net worth but not as rich as might have been expected (only 16% were millionaires). (ii) Investment activity • High rejection rate – invest in only 8% of all opportunities that they consider. • Median amount invested is relatively small (£22,000 at 1990 prices). • Only a small proportion of their wealth is committed to such investments (typically under 10%). • There is considerable diversity amongst investors in the number of deals considered and investments made. • Most angels are infrequent investors and nearly one-third reported making no investments in the three years prior to the survey (Nb. all respondents self- defined themselves as ‘business angels’). • Information on investment opportunities largely comes from business associates and friends and the investor’s own search – these were also the ‘best’ sources in the sense of being most likely to receive investment. Formal sources (e.g. accountants, lawyers, bankers) provide relatively few referrals and have low conversion rates. • Most angels (70%) cannot find sufficient investment opportunities and have funds available to make more investments. (iii) Investment characteristics • Investments are concentrated in start-up and early stage businesses. • Investments occur in all industry sectors but there is a strong bias to technology businesses (self-defined) (33% of the total). • The average size of individual investments is £10,000 – only 12% of investments exceed £50,000 (of course, deal sizes were often larger because some angels invested with others). • Provide a mix of equity and loan finance. 16
  19. 19. • Around one-third of investments involve other angels – however, the majority of investors invest on their own. • Most investments involve a minority equity stake in the investee business. • The majority of business angels are ‘hands on’, although only a minority join the board. However, nearly one-third are passive, merely receiving shareholder information and attending shareholder meetings. • Investments tend to be local, with two-thirds in businesses located within 100 miles of the investor’s home or office. (iii) Investment motivations • Business angels are motivated primarily by financial considerations, notably the opportunity for high capital appreciation. However, non-financial considerations also play an important role, notably to participate in the entrepreneurial process. (iv) Investment appraisal • The key factors which angels take into account are the management team and the growth potential of the market. • The vast majority of angels rely on their own evaluation, either exclusively or supplemented by outside advice. Comparison with US business angels (Harrison and Mason, 1992a) reveals few differences in demographics, although those in the UK tend to be older. However, there are significant contrasts in the operation of the market. In comparison to US investors, those in the UK • have more investment opportunities brought to their attention, seriously consider more opportunities but invest in a smaller proportion. • are more likely to invest independently. • are less likely to be approached by entrepreneurs seeking finance. All of this suggests that the informal venture capital market in the UK may be operating less efficiently than its counterpart in the USA, particularly with respect to information flows on information opportunities. Landström (1993) added evidence on business angels in Sweden to enable a three-way comparison which suggested that Swedish investors operated in ways that are closer to the US than the UK – for example, the ratio of opportunities considered to investments made, investment activity, time spent in evaluation and syndication. However, it is unclear the extent to which differences between these studies in the identification of business angels contributes to this variation. In parallel, Mason and Harrison also undertook a survey of investors registered with LINC, a federation of local business angel networks (or business introduction services as they were originally known). Usable responses were obtained from 53 current and previous members. LINC investors were distinctive from the respondents to the ESRC survey in three respects: they were younger; they had higher incomes and lower net worth, and made larger investments (Mason and Harrison, 1996a). This raised the possibility that business angels who join business angel networks may be distinctive. 17
  20. 20. The Mason and Harrison study has stimulated further research. Subsequent studies have been of two types. The first type are further large, comprehensive studies of the UK informal venture capital market which have sought to extend, qualify or challenge the profile of the UK informal venture capital market presented by Mason and Harrison (1994). However, the profile of business angels presented by Mason and Harrison (1994) has proved to be remarkably robust. The second type is a set of studies that have sought to add detail to the broad-brush profile of business angels presented by Mason and Harrison (1994) and subsequent researchers. This has mostly involved a shift away from what has come to be termed the ‘ABC’ studies of investor characteristics and investment activity in favour of in-depth studies of particular investor types and specific aspects of the investment process. One implication from this research is the difficulty of identifying business angel investors, and the significant resource costs incurred in trying to build up a sufficient sample for analysis and extrapolation. Accordingly, as in this and other subsequent studies, market estimates, even in cross-sectional terms, are hard to come by, and the logistics of the research preclude easy elaboration of the survey approach into the basis for time series analysis. 2.3 Beyond the initial Mason and Harrison study The first major study of the UK informal venture capital market following Mason and Harrison’s (1994) pioneering exploratory study was research undertaken by Patrick Coveney at the University of Oxford for a PhD which was repackaged as a ‘how to’ book for businesses seeking to raise finance (Coveney and Moore, 1998). However, the key findings had been published some time earlier as Stevenson and Coveney (1994; 1996). The key contribution was to document the heterogeneity of business angels by developing a six-fold categorisation: • Virgin angels – individuals with funds available looking to make their first investment but have yet to find a suitable proposal. • Latent angels – rich individuals who have made angel investments but not in the past three years, principally because of the lack of suitable investment proposals. • Wealth maximizing angels – rich individuals who invest in several businesses for financial gain. • Entrepreneurial angels – very rich, very entrepreneurial individuals who back a number of businesses for both the fun of it and as a better option than the stock market. • Income seeking angels – less affluent individuals who invest some funds in a business to generate an income or even a job for themselves. • Corporate angels – companies which make regular and large angel-type investments, often for majority stakes. For each group the study sought to identify the funds available for investment, demographic and financial characteristics, investment criteria and, where relevant, barriers to investment. 18
  21. 21. The study was based on a sample of nearly 500 investors and 467 investments (involving over 200 investors) – a much larger sample than used by Mason and Harrison15 and achieved by working in collaboration with Venture Capital Report, a monthly investment opportunity magazine with a subscriber base of over 700 who paid a subscription, at that time, of £350 per annum. Over 90% of respondents were either VCR subscribers or had made enquiries about subscribing. It might be expected that the requirement to pay a significant subscription would have biased the subscribers to the largest and most active investors. The most significant difference from the Mason and Harrison study was that Coveney found a much higher level of investment activity, which is not surprising in view of the sample frame used. Investors invested more frequently, made much bigger investments (median investment of £40,000 per investment) and had bigger investment portfolios. The proportion of passive investors was also lower. However, these differences are likely to have arisen on account of the approach taken to identify business angels which is likely to have favoured more active and bigger investors, and the inclusion of corporate investors (9% of all respondents) which will also have biased investment amounts upwards (see Mason and Harrison, 1997 for a full critique). Other findings, such as the inability of angels to find sufficient investment opportunities, friends, family and business associates being the main referral sources, and the dominance of investments in start-up and early stage businesses are all consistent with those reported by Mason and Harrison (1994). The second major study in the wake of Mason and Harrison was by Mark von Osnabrugge, another Oxford University PhD student. This was a more theoretically- based study. The emphasis was to compare the investment approaches of business angels and venture capital funds: the focus was therefore on the investment process rather than the size and scope of the informal venture capital market. Major issues examined included the following: deal flow, screening, investment criteria, due diligence, contracting, and post-investment monitoring and control. The research was based on 262 questionnaire responses from business angels and venture capital fund managers and 40 personal interviews. Findings were published in academic papers (e.g. Van Osnabrugge, 1998; 2000) and integrated into a book which reviewed the entire investment process (Van Osnabrugge and Robinson, 2000). Mason and Harrison have undertaken two further significant studies. The first of these was based on funding from the DTI to undertake a follow-up of their ESRC study which investigated other aspects of the informal venture capital market that remained shrouded in mystery. So here again the study was not particularly interested in issues associated with the size and scope of the market. The methodology involved questionnaires being distributed by 19 business angel networks to their investors: 127 usable responses were obtained, mostly from this source.16 This research led to the publication of three papers. Mason and Harrison (1999) provided a critical review of the impact government intervention to stimulate the informal venture capital market, looking specifically at the use of tax incentives (EIS, roll-over relief and VCTs) and business angel networks. They concluded that policy was too supply oriented and needed to address deficiencies on the demand side. In conjunction with evidence from 15 However, the size of the questionnaire, and hence the detail in the data collected, was much smaller. 16 Some questionnaires were also sent to business angels who had been identified through informal contacts and recommendations. 19
  22. 22. a later study (Mason and Harrison, 2002a) this led them to argue that policy needed to address the issue of ‘investment readiness’ (Mason and Harrison, 2001; 2004a). The second paper from this research (Mason and Harrison, 2002b) provided the first ever evidence on the returns achieved by business angels, their time to exit and method of exit.17 A related paper found that investing in technology businesses generated an almost identical returns profile to that of investments in non-technology businesses (Mason and Harrison, 2004b). Their second study was based on a survey of investors registered with BANs that were part of NBAN (Mason and Harrison, 2002a). This supported the clear picture of business angels being self-made high net worth individuals (62% were millionaires; 71% were or had been business owners), motivated largely by financial considerations but also from the satisfaction of being involved in the entrepreneurial process, typically allocating between 5 and 10% of their total investment portfolio to angel investments. It confirmed their earlier study that the tax regime was the main macro- level influence on their willingness to make angel investments. In this study 38% of investors had used the EIS. Over 90% of respondents were looking to make further investments – no doubt this was a reason why they were members of BANs. The study therefore probed the barriers which prevent business angels from making as many investments as they would like – investment preferences (linked to industry/market knowledge, and location) and the quality of investment opportunities were both influential. However, investors did indicate that they relaxed their investment criteria in certain circumstances – notably if the management team had high credibility, if the investment amount was small, if the business was close to home and if the opportunity had been referred by a trusted source. The failure to successfully negotiate investments, typically because of differences of opinion on price and size of shareholding, was also identified as a relatively frequent occurrence. A fifth significant contribution is a study of business angels in Scotland by Paul et al (2003). Scotland has a long tradition of business angel activity. Following research by KPMG (1992) the stimulation of the business angel market was identified as a key focus for policy intervention in the Scottish Business Birth Rate strategy. This resulted in the establishment of LINC Scotland in 1992 which, under its Chief Executive, David Grahame, is one of the most respected and innovative business angel networks in the world. Scotland is also distinctive in terms its number of business angel syndicates. The KPMG study was based on interviews with 38 business angels who had made 89 investments in the previous four years involving an investment of some £4.4m, with an average of £50,000 (skewed by five investments each of over £250,000). These investments were predominantly in seed, start-up and early stage businesses. Investments were made primarily for capital gain rather than income, the investment instruments was overwhelmingly straightforward equity and transaction costs were kept low by not costing time and in most cases keeping documentation to a minimum. Some 80% of investments were less than £50,000. Investors expected to be personally involved in their investee companies. The investors were predominantly aged 40-55 and were either cashed out or disengaged entrepreneurs or experienced managers who had retired or taken redundancy. The vast 17 An earlier, unpublished version of this research seems likely to have influenced government policy, the evidence on holding period prompting government to reduce its capital gains taper from 10 years to four years and evidence on the size of shareholding prompting the abolition of a minimum qualifying equity share (Mason and Harrison, 2002b). 20
  23. 23. majority of investments were within 50 miles of their home or work. Investments were typically sourced through personal networks. Consistent with other research, investors could not find sufficient investment opportunities. Based on its survey evidence the study estimated that the size of the informal venture capital market in Scotland, in terms of both money available for investment and amounts already invested, was around £25m. The Paul et al (2003) study was based on a questionnaire survey of current and previous LINC Scotland investors and members of one angel syndicate. This generated 140 usable responses, including both virgin angels and those who had made one or more investments. For the most part the profile of angels and their investment activity reinforced the picture presented in earlier studies. Scottish angels are predominantly male and aged over 50. However, in contrast to other studies, only a minority had a SME background. They were motivated by capital gain, with interest and fun as subsidiary reasons. The entrepreneur/management team was their key investment criterion. The sample included 30% who were looking to make their first investment and, at the other extreme, 14% who had made more than five investments. This skewed distribution also emerges in terms of the amount invested, with 45% investing less than £50,000 and 6% investing over £500,000. Half invested as part of a syndicate. Echoing a constant theme in the literature, most investors were constrained from investing more by the lack of investment opportunities. There was no attempt to estimate the size of the market. Finally, it is important to highlight two somewhat obscure studies from the ‘grey’ literature which sought to profile the angel market in the UK. The first was a summary of a study of 50 business angels (and 47 intermediaries) undertaken on behalf of the National Westminster Bank Technology Unit (Innovation Partnership, 1993). This study pointed to the diversity of angel types and involvement in the market (in terms of amount invested, frequency of investment, size of investment and amount available for investment). Age (average age of 50), motivation (capital gain) and background (52% former entrepreneurs) confirmed other studies. It also confirmed that angels tended to find deals through their personal contacts. In terms of investment criteria the report confirmed that investing close to home was an important consideration for a majority of investors – however, this was influenced by the size of the investment, about of involvement required and ease of travel (“how far can I travel in an hour”). With this caveat, most investors would consider any investment opportunity on its merits: only a minority had clear investment criteria – and found it easier to express these in terms of what they would not invest it. Most investors wanted to play a hands-on role in their investee businesses. The typical investment was £20,000-£50,000 but the range extended from £5,000 to £500,000. Finally, the study noted the difficulty of getting angels to say how much money they had available for future investments. The potential amounts available for investment are subject to fluctuation, depending on an individual’s liquidity, the opportunity itself and the state of their other investments. The Investor Pulse (2003) survey, which was undertaken by C2 Ventures, was based on a web based questionnaire that the angel investment community was invited to complete. A key deficiency is that the report does not indicate the actual number of responses. However, the survey broadly confirmed the picture of business angels in 21
  24. 24. the UK that had been emerging over the ten years since publication of Mason and Harrison’s initial study. • Predominantly a business ownership and management background. • Range of investment experience from ‘yet to invest’ to more than five years of angel investment experience. • Motivations dominated by financial considerations but ‘fun’ is an important subsidiary reason. • The majority (60%) prefer to invest on their own. • Emphasis on investing in start-up and pre-revenue businesses. • Key factors considered at the initial screen: clear financials; scaleable business model with a clear marketing and sales plan; ‘must have’ (rather than ‘nice to have’) product/service; clear exit and realistic valuation; understanding that it is the team that gets the funding, not the plan. • Two-thirds of transactions in the period 2000-2002 were for less than £50,000 (average of £27,500), but a small proportion of investments were in excess of £500,000. 2.4 Adding Detail to the Operation of the Market In addition to these large scale studies have been a number of more narrowly focussed enquiries. These have been of two types. First, there have been some studies which have examined specific types of business angels. Second, there have been several studies on specific stages in the investment process. 2.4.1 Studies of specific types of business angel There are four studies in this category. Anderson (1998) studied high income workers in the City of London on behalf of LINC for his MBA dissertation at London Business School. It found that only 40% had invested in unquoted companies, with lack of information, lack of time and lack of trusted advice being barriers to investment. Kelly and Hay have published two studies which have examined active business angels. Their first study reported on what they termed ‘serial investors’ – their sample comprised eight investors who they interviewed in detail and who had made an average of five investments. The sample split into two groups: those who always invested on their own and those who invested as part of a syndicate. The key conclusion of the study was that such investors typically make investments in industries, markets and technologies where they have some familiarity and know the entrepreneur, or have the deal referred by an individual who has this knowledge. However, angels in syndicates had a greater scope for investing in unfamiliar situations or where they did not know the entrepreneur because they were able to leverage of the knowledge of their co-investors (Kelly and Hay, 1996). Their second study involved an investigation of the most active business angels, what they termed ‘deal-makers’, and others have called ‘super angels’, to examine their sources of information on investment opportunities. They concluded that these angels (defined as having completed six or more investments) rely less on publicly available 22
  25. 25. sources of information and more on their own private sources from an extensive base of contacts developed as a result of building up their own portfolios (Kelly and Hay, 2000). Harrison and Mason (2007) have provided the first-ever profile of women business angels in the UK. There are some differences in characteristics and background but the numbers are too small to test for statistical significance. Women appear to be slightly more likely to invest in women-owned businesses, but this is not because they factor gender into their investment decision. Indeed, the findings tentatively suggest that gender is not a major issue in determining the supply of business angel finance, and that the informal venture capital market is not differentiated along gender lines. However, further investigation of this topic would be worthwhile in view of the tentative nature of these conclusions. 2.4.2 Studies of specific stages in the investment process (i) The personal portfolio allocation decision Mason and Harrison (2000b) have explored in a very preliminary fashion the factors which influence how much of their wealth business angels will allocate to investments in unquoted businesses. One of the key distinguishing features of informal venture capital is that it is discretionary: business angels are investing their own money and so, unlike venture capital funds which have raised money for the purpose of investing, business angels do not have to invest. Based on responses from 56 investors attending a LINC Scotland conference18, Mason and Harrison show first of all that money which is not invested in unquoted businesses would instead be invested primarily in the stock market, property and interest-bearing cash accounts. Respondents were presented with a list of potential influences that were thought to potentially influence their willingness to invest (e.g. tax environment, economic conditions, stock market conditions). The evidence indicated that business angels were particularly sensitive to tax – the availability of tax relief on their investments was the most important factor encouraging them to invest, with lower capital gains tax being the second most positive factor, while higher rates of capital gains tax was the top factor which would discourage investment. Lower tax on dividend payments was the third most significant factor encouraging investment while higher tax on dividends was the second most important factor to discourage investment. By contrast, economic conditions are much less influential on the willingness to invest, although by no means insignificant. Stock market conditions have the least influence on investment activity. These conclusions are supported by evidence from two other studies, one of which is the Mason and Harrison DTI study (discussed earlier) (Mason and Harrison, 1999; Mason and Harrison, 2002a). (ii) Investment decision-making criteria 18 Although profiling the respondents was not an objective of the study it is worth noting that they conformed to the highly skewed distribution that had been identified in previous studies. At one extreme, 26% of investors had not made any investments in the previous two years and 28% had made one or two investments whereas at the other extreme 24% had made more than five investments. The amounts invested ranged from less than £50,000 (19% of respondents who had made investments) to £250,000 and over (32%). 23
  26. 26. The landmark studies by Mason and Harrison (1994), Coveney and Moore (1997) and van Osnabrugge and Robinson (2000) all examined the criteria used by business angels in making investment decisions. However, this evidence was generalised and retrospective. Specifically, it ignored the different stages in the investment process and the scope for different criteria to assume greater or lesser importance as the investment process proceeded. Subsequent studies have probed the investment decision-making process in much more detail. Mason and Harrison (1996b) undertook a case study of deals rejected by a private investment syndicate. This revealed that the decision-making process involves two stages: an initial review and a more detailed appraisal for those opportunities that passed the initial screening stage. Three factors dominated as reasons for rejection: characteristics of the management team, marketing and market-related considerations, and financial considerations. Most opportunities were rejected for just one or two reasons – although deals rejected at the initial review stage were more likely to be rejected on the basis of the culmination of several deficiencies rather than a single consideration. Mason and Rogers (1997) undertook a study in real time of the factors that business angels take into account in their initial screening of investment opportunities – the stage at which most investment proposals are rejected.19 This particular study was based on the reactions of 10 business angels to a particular investment proposal that appeared in Venture Capital Report. The larger unpublished study reported on the reactions of 19 business angels to three investment proposals, providing a total of 30 decisions (Mason and Rogers, 1996). Investors’ responses were taped, transcribed, coded and subjected to content analysis. The findings indicated that investors placed the most attention on market and financial considerations and the entrepreneur/management team. The study also highlighted several distinctive features in the approach of investors to the initial screen: • Investor fit: the first response of investors was to ask themselves whether this opportunity was a good fit with their personal investment criteria – in particular, did they know anything about the industry or market, how much money were they looking for, where is it located and was their scope to make a contribution? • Investor preconceptions: the previous experiences and preconceptions of investors influence their attitude to the opportunity – this was particularly influential when considering their view of the market. • Focus: investors placed a strong emphasis on the need for businesses to have a clear market and business focus. • Investor attitude: the approach of investors at the initial screening of an investment opportunity was to look for reasons to reject it. They were suspicious and cynical and looking to be convinced. 19 The research in this study was used to make the video “You Are The Product” (1997) which has been successfully used as a means of interactively teaching entrepreneurs how to become ‘investment ready’ by giving them an insight into what business angels look for when they read a business plan or investment proposal. 24
  27. 27. Subsequent analysis of this data by Harrison et al (1997) interpreted the business angel’s reaction to investment proposals in a ‘swift trust’ framework, identifying some of the key inter-personal dynamics involved in the investment process. Mason and Harrison (2003a) adopted a similar real time methodology to capture the reactions of business angels to a presentation by an entrepreneur seeking finance. This highlighted the importance of presentation in shaping investor attitudes and how a poor presentation will quickly turn potential investors off. Finally, Mason and Stark (2004) adopted the approach used by Mason and Rogers but with the difference that the same investment proposals were shown to business angels, venture capitalists and bankers in order to reveal differences in their approaches to investment evaluation. Bankers were shown to have a very different approach to that of business angels and venture capitalists, placing much greater emphasis on the financial aspects of the proposal to the exclusion of most other issues. Venture capitalists place equal emphasis on market and financial issues while business angels give greatest emphasis to the entrepreneur and investor fit. (iii) Negotiation and Contracting The first evidence on how investments were negotiated and structured was provided by Mason and Harrison (1996c) in a study based on a telephone survey of 31 investors and 28 entrepreneurs involved in investments that had been made through LINC. The majority (71%) of investors had made only one or two investments. Key findings were as follows: • Only a minority of investors (38%) and entrepreneurs (44%) identified any issues that were difficult to negotiate – the most difficult issues were the size of the investor’s shareholding and related issues of ratchet clauses and pricing. • The approach of investors to valuation was very imprecise, with the actual valuation reached by processes that were variously described as ‘arbitrary’, ‘informal’ or ‘negotiated’. • Over three-quarters of entrepreneurs sought professional advice, mainly from lawyers, in the negotiation process. The costs were fairly modest. In contrast only just over one-third of investors used professional advisers, again mainly lawyers to draw up or review the investment agreement. • The decision time was relatively short, in most cases extending over less than three months. • In only 70% of investments was a formal investment agreement drawn up. • Two-thirds of investors and entrepreneurs agreed that the investment agreement was equally favourable to both sides; 20% of investors and 15% of entrepreneurs felt that it favoured the entrepreneur while 12% of investors and 18% of entrepreneurs felt that it favoured the investor – in other words, most entrepreneurs did not feel that the process of raising finance from business angels was exploitative. • Only 40% of investments involved straight equity, with a further 29% involving only loans. However, equity dominated in those deals that involved both equity and loan finance. • The investor or investors took a minority position in 56% of the investments and a 50% stake in 19% of investments. 25
  28. 28. • Most of the equity investments were in ordinary shares – only 16% involved complex instruments (e.g. preference shares). LINC sponsored a follow-up survey of investments made in the period 1994-96 using the same survey instrument (Lengyel and Gulliford, 1997). A much more detailed investigation of business angel contracts was undertaken by Peter Kelly for his PhD at London Business School which attracted responses from 106 business angels who had largely been contracted through business angel networks (Kelly and Hay, 2003). Compared with previous studies these investors would appear to be unusually active, with an average of eight investments each. The study found that, contrary to previous studies business angels draw up contracts as a matter of course. They want to spell out quite clearly the rights, roles and responsibilities of management and investors. Five non-negotiable items are identified: • Veto rights over acquisitions/divestures; • Prior approval for strategic plans and budgets; • Restrictions of management’s ability to issue share options; • Non-compete contracts required from entrepreneurs upon termination of employment in the venture; • Restrictions on the ability to raise additional debt or equity finance. These non-negotiable give investors a say in material decisions that could impact the nature of the business and the level of their equity holding. There are also a number of contractual provisions to which investors attach relatively low importance and so may be considered to be negotiable: • Forced exit provisions; • Investor approval required for senior personnel hiring/firing decisions; • The need for investors to countersign bank cheques; • Management ratchet provisions; • The specification of a dispute resolution mechanism in writing up front. These items were included in fewer than 40% of the contracts studied. Less experienced angels include a wider array of protective contractual safeguards. But with experience angels become more focused on elements that can impact their financial returns. Finally, Kelly and Hay (2003) observe that ‘important to include’ is not the same as ‘willingness to invoke’, and suggest that angels prefer to use their relationship with the entrepreneur to manage setbacks and problems rather than using the contract to invoke their rights. (iv) The post-investment relationship The landmark studies discussed earlier provided some evidence on the ‘smart’ aspect of business angel investing. However, this aspect of angel investing has not been explored in much detail by UK scholars. Based on a survey of investors who had raised finance from either venture capital funds or business angels, Harrison and Mason (1992b) presented evidence on the roles identified by the entrepreneurs as played by business angels and their assessment of how helpful these contributions 26
  29. 29. were. This highlighted ‘serving as a sounding board to the management team’, ‘monitoring financial performance’ and ‘assistance with short term crisis/problems’ as the most valued contributions. Mason and Harrison’s study of deals that had been facilitated through LINC (1996c) looked in more detail at the post-investment experience. It confirmed that the norm was for investors to become involved, and would typically join the board. Their time input varied from at least a day a week to less than a day a month.20 Their contributions were also varied and best summarised as passing on their business experience. However, only half of the entrepreneurs regarded the angel’s contribution as being helpful (31%) or extremely helpful (19%). Nevertheless, nearly half of the investors (47%) and a majority of entrepreneurs (56%) considered the relationship to be productive and majority of both investors and entrepreneurs regarded it as consensual. The Lengyel and Gulliford (1997) study provides updated information on these issues. Kelly’s PhD study also explored the motivations of angels in becoming involved with their investee businesses. The typical anticipated involvement by the angels in his study was 16 hours per month (8 hours face-to-face and 8 hours phone calls and reading reports) and 40% of investors were employed in the business in some capacity. Kelly concluded that rather than being a means of defending their interests (i.e. for protection) business angels get involved in response to specific needs of their investee businesses. He further notes that involvement is greatest at the early stages, where the business’s need for experience is greatest (Kelly and Hay, 2003). (v) Harvest Mason and Harrison’s (2002b) study of exits was based on data on 128 investments. Returns were highly skewed: 47% of exits involved a total (34%) or partial loss, or broke even in nominal terms, while 23% generated an IRR in excess of 50%. Trade sales were the main exit route and were used both for successful exits and some that only broke even. IPOs accounted for only a small proportion of successful exits. Exits from ‘living dead’ investments were mainly through sales to other shareholders and new third party shareholders. The median holding period was four years – but this varied by investment performance. The median holding period for investments that generated a good or exceptional return was four years, rising to six years for investments that generated low positive returns and just two years for loss-making and break-even investments. The most successful investments shared few common characteristics. A separate analysis of the returns from technology and non- technology investments found no differences in the returns profiles (Mason and Harrison, 2004b). Mason and Harrison’s (1996c) earlier study of LINC deals had noted that some angels take returns in the form of directors’ fees and, less commonly, consultancy fees. 2.5 Market Based Estimates The research summarised to date has focused on the identification of business angel investors, and has collected data on their investment behaviour, demographics and 20 Mason and Harrison’s NBAN study found that on average angels commit six days a month on each investment (Mason and Harrison, 2002a). 27
  30. 30. attitudes and intentions. Studies that explicitly attempt to measure the scale of the market as a whole are far fewer in number. One of the few such studies is the risk capital market analysis undertaken in Scotland, which has profiled all identifiable equity investment in the unquoted business sector between 2000 and 2005 (Harrison and Don 2004; 2006). These reports presents the first comprehensive account and analysis of the early stage risk capital market in Scotland, and indeed anywhere in the UK, and with the exception of research in Sweden there are no identifiable similar analyses elsewhere. The analysis is based on a unique specially created database which records actual investments made in businesses in Scotland and identifies the investors making those investments (the methodological implications of this research are discussed in Section 4 below). The key findings of the initial report are as follows. Over the four years (2000-2003 inclusive) there has been a total of £673m of identifiable risk capital investment in 581 new and young Scottish companies. The early stage equity risk capital market in Scotland is very much larger than previously estimated – for example, figures from the British Venture Capital Association suggest that over these four years there was a total of £119m invested in start-up and early stage businesses in Scotland. There is, in other words, a large and dynamic early stage risk capital market in Scotland which channels investment capital from a wide range of institutional and other investors into start-up and growing companies, and this market is significantly larger than previous estimates have suggested. In 2003, the Scottish Risk Capital Survey identified £121m of new investment in Scottish businesses; in the same year the BVCA recorded only £7m in early stage investment and a total (including management buy out and buy in investments, which are excluded from this Survey) of £109m. Institutional venture capital investors dominate the market – in total over the four years they have invested £527m in Scotland. Much of this investment is not recorded in other market statistics (such as the BVCA data), either because the institutions are not members of BVCA or are overseas-based. Business angel investors play an important role in the market – over the four years they have invested £115m in Scottish businesses, equivalent to 27% of all risk capital investment, excluding the three largest transactions – this is a very important segment of the overall risk capital market and plays a crucial role in helping develop an entrepreneurial economy in Scotland. In 2002 and 2003, business angel investment (£44m) in Scotland was more than twice the level of early stage investment recorded by BVCA members (£19m). Co-investment by business angels and venture capital investors in the same deal has been noted as a feature of well-developed risk capital markets, particularly in the US. This Survey shows that this has occurred in around 11% of investments, but this proportion has fallen from 15% to 6% in 2003 (when most of the co-investments recorded were follow-on investments). Currently, it appears that the business angel and institutional segments of the risk capital market in Scotland are operating largely independently of one another – in part this reflects different investment preferences and exit expectations (business angel investors are, for the most part, making smaller investments and are less likely to press for early exit and returns). Hybrid investors, combining financial returns with policy objectives – are a small but important segment of the market. Some 90% of the activity of this investor group is accounted for by recent Scottish Enterprise activities (the Co- Investment Fund and Business Growth Fund). Although only contributing some £15m to the risk capital market, they have been represented in 44% of all investments recorded in 2003. The Harrison and Don reports conclude that these recent Scottish 28
  31. 31. Enterprise initiatives have made a particular contribution to the funding of smaller investments and younger companies, and this contribution has been most significant in a difficult funding environment. The relatively buoyant Scottish risk capital market in 2003 (by comparison with the national UK situation) is in part attributable to the catalytic and confidence building impact of these initiatives. The Scottish research concludes that there is more risk capital being invested in Scottish early stage businesses than previously estimated. The difficulties in raising capital reported by many companies and their advisors may, therefore, not be a function of the shortage of risk capital available in the market but a function of either a problem in mobilising and making visible the risk capital which is available or a lack of ‘investment readiness’ in the businesses seeking finance. 2.6 Summary This section has reviewed both the published and unpublished research on the UK’s informal venture capital market. Indeed, the UK, along with the USA, Canada and Sweden, have attracted the majority of research. Wetzel’s initial studies and the SBA- sponsored studies in the 1980s and Sohl’s work over the past fifteen years have contributed to a detailed understanding of business angel investing in the USA; Riding’s initial research in Ottawa and subsequent national studies have done the same for Canada (e.g. Short and Riding, 1989; Riding et al, 1993), while Landström is now building on his initial Swedish study (Landström, 2003) by directing new studies by PhD students (Månsson and Landström, 2006; Avdeitchikova and Landström, 2005). There have also been one-off studies of angel activity in a variety of other countries, notably Finland (Lumme et al, 1998), Norway (Reitan and Sørheim, 2001), Germany (Brettell, 2003; Stedler and Peters, 2003), Australia (Hindle and Wenban, 1999), New Zealand (Infometrics Ltd, 2004), Japan (Tashiro, 1999) and Singapore (Hindle and Lee, 2002). Mason (2006a) provides a review of the international literature on informal venture capital. What is clear from both the UK and international studies is that the vast majority of the research has had a ‘micro’ focus, profiling business angels, documenting their investment activity, examining various aspects of the investment process and, especially in the UK, assessing the impacts of various forms of policy intervention, notably tax incentives and business angel networks. This emphasis on studying the process has largely avoided the need to consider methodologies and sampling frames that would generate representative samples of business angels. Indeed, as this review makes clear, most UK studies have relied heavily on business angel networks as a means of identifying business angels, despite concerns about possible bias. The consequence of this accumulation of a series of micro-studies using questionnaire surveys of samples, sometimes quite small, focused on specific aspects of angel profiles and the investment process, and which have relied to a greater or lesser extent on samples of convenience (notably members of business angels networks), is that there has been very limited understanding of the development of the market in terms of scale and scope over the past 15 years. In other countries – mostly lacking business angel networks, at least until recently – researchers have had to use more imaginative approaches to identify angels. As a consequence these studies are of greater use when we come to consider how a robust time series dataset can be developed to measure business angel activity in the UK (section 4). 29
  32. 32. 3. DEVELOPING A TIME SERIES DATASET TO MEASURE BUSINESS ANGEL ACTIVITY IN THE UK: DEFINITIONAL CONSIDERATIONS In the two decades since business angels have been recognised as a focus of research and policy attention definitional issues have become more problematic. There are at least two reasons for this. The maturing of the informal venture capital market has provided more ways in which investors can make investments in unquoted companies, notably through various forms of angel groups, syndicates and networks, blurring the distinctiveness of angel investing. Research has added further confusion. Recent Nordic research, unlike earlier UK typologies (e.g. Coveney and Moore, 1998), has identified several different types of investor, some of whom deviate from the conventional definition. For example, Sørheim and Landström (2001) propose a four- fold categorisation based on the level of investment activity and investment competence (measured by entrepreneurial experience): • Lotto investors: low investment activity and low competence in business start- up; • Traders: high investment activity but low competence in business start-up; • Analytical: low investment activity but high competence in business start-up; • Business angels: high investment activity and high competence in business start-up. Avdeitchikova (2006) has also proposed a four-fold classification based around two dimensions – investment level and involvement: • Micro investors: low on both dimensions; • Fund managers: high on investment activity but low on involvement; • Mentors: low on investment activity but high on involvement; • Business angels: high on both dimensions. Infometrics Ltd (2004), which undertook a government-commissioned study of business angels in New Zealand, suggested that angels are differentiated on two dimensions – motivation (guardian, professional, operational expertise, financial return) and activity (dabblers vs. active) GEM has contributed further definitional imprecision by reporting on what it terms “informal investment” – as we have shown above, this is a ‘chaotic’ category which includes all forms of direct investment in unquoted companies and therefore includes investments in businesses of both family and non-family members. The aim in this section is to bring some greater clarity to definitional and measurement issues. This is an essential preliminary step before we can go on in the next section to consider data sets. There are four features that are fundamental to business angels and their investments and distinguish this form of investing from institutional venture capital. • First, angels are investing their own money. Because of this, they are able to make rapid investment decisions without the need to undertake extensive evaluation or third-party due diligence. No one has ever challenged this feature of angel investing, although it does occasionally arise as an issue, 30