Non-financial roles of informal investors

(1)

Non-financial roles of informal investors

A study of informal investors and non-financial value added

Master thesis, MSc BA specialization Small Business & Entrepreneurship University of Groningen, Faculty of Economics and Business

Name: Gertjan Herder

Student number: 1457810

Date: 18th of July 2010

Address: Grote Belt 51

Zip code and City: 9933 GG Delfzijl (the Netherlands)

Phone: +31 (0)6-21531289

(2)

(3)

3

Preface

The master thesis project is the last step in the Master’s of Business Administration with specialization in Small Business & Entrepreneurship at the University of Groningen. One of my supervisors, Dr. Lutz made me aware of informal investment as a topic. When I undertook the first research steps, it became clear that informal investment is a poorly studied area of research. I sincerely hope that this study has made a contribution to the existing research.

I desire to express my thanks to the persons who were prepared to participate in an interview. Without them this thesis would not have achieved this result. I would like to thank all the persons who were prepared to consult their network to find the relevant participants for my study. Special thanks to my supervisors, Dr. Lutz and Dr. Streb for their tips and advice and I especially appreciate the extensive e-mail discussions with Dr. Streb.

I hope that by reading this thesis you will experience and enjoy the interesting world of informal investment.

Gertjan Herder

(4)

4

Executive summary

The summary consists of two parts. In the first part the most important key issues found in the literature are discussed. The second part consists of the findings from the case studies. The research question that has to be answered in this study is: What are the different roles

of informal investors? In this summary the findings are discussed globally.

Key issues taken from the literature

The literature research acknowledged some valuable findings. Firstly, there seems to be a huge discussion in the venture capital literature about the exact definition of an informal investor. The literature study made clear that many authors use their own definitions. There are authors who make no distinction between informal investors and business angels while others do. Authors use their own interpretations of informal investors and a great number have their own, slightly different definition of business angels. This is only a definitional issue but all these contradictions have significant implications on the comparison of research findings as well as on the companywide comparison between informal investors. Avdeitchikova et al. (2008) made an important contribution with a map of the different (in)formal capital market investors. Although this is only a starting point the grey areas which Avdeitchikova et al. (2008) discovered underpin the huge problems that researchers experience at the moment. From this viewpoint the interest is to find an overall definition that describes an informal investor and a business angel. The literature suggests that these two concepts are the most difficult ones to distinguish and almost all researchers have difficulties with it. If it is possible to agree on overall definitions, the problem of grey area 2 will be tackled. Furthermore, if researchers have a common definition better comparisons can be made between studies. However, this research is not conducted to come up with overall definitions. Concerning the definitional issues, these are discussed as part of the literature study to get an understanding of the problems in this area. Nevertheless, this key issue can support the research question because the literature made it clear that only several types of investors want to invest more than only financially.

(8)

8 supervising and monitoring role, resource acquisition role and the mentoring role. The question is if these different roles are limited or not.

Thirdly, a key issue noted in the literature is that informal investors mainly perform strategic and networking activities. Surprisingly, for example, operational activities (day-to-day management and active planning) and mentoring activities were not mentioned much in studies. However, one should expect that informal investors are busy with these kinds of activities because they are deeply involved with their companies. It is interesting to examine if informal investors prefer certain activities above others. For companies who search funds this is a huge benefit. Before a company/entrepreneur decides to contact an informal investor they can already look what roles most of the informal investors want to perform. In deciding to contact an informal investor he or she can take this into account. In addition, the report of Bureau Bartels (2003) made clear that there are discrepancies between the activities performed by informal investors, and what entrepreneurs actually receive on the Dutch informal capital market. It can also be expected that the same discrepancies occur in other countries. Therefore, it is interesting to investigate the mutual satisfaction between the three types of informal investors earlier mentioned and the entrepreneurs. According to the report of Bureau Bartels (2003) not all entrepreneurs are satisfied with the input of informal investors in several management areas.

Findings from the case studies

The cases revealed that active informal investors, besides the money they invest, provide non-financial value added. The valued added is exercised in various non-financial roles that informal investors play. The most discussed role was the networking role. In the entrepreneurs’ view networking seems to be very important. Informal investors usually have a valuable network which can be beneficial for entrepreneurs and their businesses. The more frequently mentioned roles revealed were the roles of coach, adviser in different management areas, strategist, sounding board, commissioner, and a credibility role. Presumably informal investors want the role of commissioner in order to be in charge of their investee businesses but not every informal investor wants the role to serve on the supervisory board. The commissioner role was not yet discussed in the literature. Other less mentioned roles were the recruitment role, serving on the board of directors, sharer of life experiences, the demanding role, performer of operational activities, supervising and monitoring role, and the complementary role. The demanding role and the complementary role are additions to the existing literature. In one case two new types of roles were revealed: transferor of creativity and adding ‘positivity’ which are also not discussed in the literature. Above all, most roles could be found in the existing literature. To summarize, the five new roles/activities that were discovered are the role of commissioner, the demanding role, the complementary role, transferor of creativity, and adding ‘positivity’.

(9)

9 network is familiar with the informal investor. If the investment is worthwhile to consider the informal investor will invite the entrepreneur for a first contact. This contact is for the informal investor and entrepreneur to get to know each other and for the informal investors to learn more about the opportunity. This is the first contact stage. If there is a ‘click’ between the two parties they will enter the screening stage. This is the stage where the entrepreneur sometimes has to present his business concept in a pitch or a presentation. Next, they progress to the decision stage were the informal investor will decide to invest. When they enter the investing stage the relationship between the two parties unfolds. At the start of the investment process most informal investors do not consider a possible exit but there comes a time when the informal investor decides to leave the company.

(10)

10

1 Introduction and problem statement

This chapter starts with a brief introduction of the topic. In the first section the research question and the specific sub-questions are formulated and examined to ascertain whether a proper answer on the research question can be found. This is followed by an overview of the study.

1.1 Brief introduction of the topic

In the economic literature informal investors are described in many different ways. It is said that especially business angels are of huge importance in the entrepreneurial economy. However, not much is known about informal investors and their exact role in the economy. Why is it then possible for informal investors to exist? There are already banks that can offer (financial) resources to small businesses. There must be good reasons for informal investors to invest in small businesses in the Netherlands. Do they have better methods than the banks? This is interesting and worth investigating. With this research a start is made to unravel the market of informal investors and to look for developments and possible gaps in the economic literature about informal investors. One of these gaps is that it is suggested that informal investors play many different non-financial roles, besides the financial role. However, literature states that it is not yet clear if all these different non-financial roles are discovered (Politis, 2008). Another gap is the lack of information on the matching process between informal investors and entrepreneurs. It will be interesting to research and ascertain how these two actors decide on the roles that informal investors should play in their investee companies and if there is some relational development over time.

(11)

11 and there are interesting questions that need to be answered. If the market for informal investors is unravelled, further research can be done on how different resources delivered by informal investors add value to starting companies and in what manner they deliver value. With this research an important step is taken to support economic literature in the future.

In the Dutch market informal investors (still) play an important role to finance not listed starting companies (Bureau Bartels, 2003). They play an important complementary role towards banks and venture capitalists, especially around the pre-starting phase, the starting phase, and directly after the starting phase. On the Dutch market informal investors are a funding source for starting companies when other parties such as banks and venture capitalists are not prepared to fund these companies. Informal investors are more prepared to invest in innovative starters. This study also acknowledged that informal investors invest more than only money, they have other important roles such as giving advice, accompaniment and the input of contacts and networks. Next, the study showed that the Dutch market of informal investors is not functioning optimally yet because there are people who want to operate as informal investors but have not succeeded. These are the so-called virgin angels. Furthermore, the real investors who already invested, and the investee companies experience bottlenecks during the investment process. These bottlenecks are cyclical (the economic situation) and structural. For example, one of the structural problems is in the search process. Informal investors experience problems to search the right companies and to know how to judge the quality of entrepreneurs and business plans (Bureau Bartels, 2003).

The conclusion of this report is that the Dutch market of informal investors needs further development. The following four recommendations were made to help the Dutch market.

1) Better functioning networks (for example between banks, venture capitalists, and informal investors).

2) Setting up an industry association for informal investors. 3) Stimulating the investments of informal investors.

4) Keeping informal investors and companies informed about the Dutch informal market.

(12)

12

1.2 Research question and sub-questions

The introduction acknowledged some interesting gaps to research which resulted in the following research question:

Research question: What are the different roles of informal investors?

This research question is divided into four sub-questions that all contribute to answer the research question. The first and second sub-questions are developed to set a focus for the literature research. The third and fourth sub-questions are developed from the literature research and focus on some key themes.

The first sub-question is developed because we first have to identify the concept informal investor. An overview of different players on the informal capital market is needed to get a clear picture of this broad market. Characterizations of different players are needed to understand the differences between these players. The main function of this sub-question is to present a global overview of the informal capital market. Therefore, the first sub-question is:

Sub-question 1: What are informal investors and how are they characterized?

In this study we are especially interested in the specific roles that informal investors play besides the financial role and which roles are already discovered. If there is a map is of these different roles, research can proceed to look at some other rolls in greater detail. Therefore it is most important to study the literature for the rolls that informal investors perform. The second sub-question is:

Sub-question 2: Which roles do informal investors have in the economic literature?

(13)

post-13 investment behaviour. The roles that are found will be checked and verified with the roles found in sub-question two. Therefore, an interesting third sub-question is:

Sub-question 3: What exactly for non-financial roles do these different types of active informal investors contribute to their investee companies and how do these types differ from each other (in the case of differences)?

How do the entrepreneur and the informal investor decide which roles an informal investor will perform? The activities of active informal investors are sometimes differently perceived by entrepreneurs (Bureau Bartels, 2003). This leads to discrepancies between informal investors and entrepreneurs. It will be interesting to look at how informal investors and entrepreneurs find agreement about the activities that informal investors will add to the business of an entrepreneur and how they handle this if they disagree. Both, entrepreneurs and informal investors, have mutual expectations of each other and the matching process is relevant to investigate because information is limited about this process. Another issue is if there is any relational development between entrepreneurs and informal investors who have participated with each other for a long time. For example, do roles change over time? Therefore the fourth sub-question is:

Sub-question 4: How does the matching process between the mutual expectations of active informal investors and entrepreneurs unfold and is there some type of relational development?

In the table below a link is made between the different sub-questions and the specific literature leading to the sub-questions.

Sub-question 1 (literature research) Mainly Avdeitchikova et al. (2008), Van Osnabrugge & Robinson (2000), Sørheim & Landström (2001) and Paul et al. (2003). Sub-question 2 (literature research) Mainly Politis (2008) and Madill et al. (2005). Sub-question 3 (qualitative research) Avdeitchikova et al. (2008), Sørheim & Landström (2001), Paul et al. (2003), Politis (2008) and Madill et al. (2005).

Sub-question 4 (qualitative research) Bureau Bartels (2003).

Table 1.1 Sub-questions and supportive literature

(14)

14

1.3 Overview of the study

The first part of this master thesis is a literature study. This study is needed to ascertain what informal investors exactly are and the specific roles they perform. We have to look at this before we can move on with the case studies. Since the eighties a whole stream of economic literature on the informal capital market has been generated. This literature will be examined to discover how the literature describes informal investors and how they are characterized. The second part of the literature study focuses on the roles of informal investors. What is written in the literature about the roles that informal investors perform? This literature study was done as follows. First, I used relevant search terms to look for significant literature in the large database of Business Source Premier. After that, I searched (with the same relevant terms) the databases of the most important current entrepreneurial journals. The journals incorporated in this literature study are the journals of Entrepreneurship & Regional Development; Entrepreneurship Theory & Practice; Journal of Business Venturing; Journal of Small Business Management; and Small Business Economics. These are the most important entrepreneurial journals as noted by the SSCI Impact Factors 2008. I will also search in the journal, Venture Capital. Venture Capital has been proven a valuable journal because it describes many useful articles about this study topic.

This literature study serves as an input for the case studies that are discussed in the second part of the thesis. The case studies are held by different entrepreneurs who obtained financing from an informal investor operating in the Netherlands, and active informal investors. Hopefully, different roles of informal investors are discovered in these case studies. Maybe there will also be discrepancies because an entrepreneur experiences the role of an informal investor very different than the informal investor. In the same case studies the matching process and relational development between entrepreneurs and informal investors will be researched.

After the descriptions of the case studies1, findings and results will be discussed to verify the literature with the reality, and the findings will be analyzed for patterns (looking for similar and contrasting descriptions). The descriptive analysis of the interviews is discussed in a separate chapter. After the descriptive analysis another chapter is added in which the cross-case findings and analysis of the different cross-cases are discussed. The findings and results are not only used to check the literature but it is possible that new roles are discovered which are not mentioned in the literature. Besides, in the descriptions of different cases the roles that companies expect informal investors to play can be notified and if informal investors and companies are aware of this, expectations between them can improve in the future. This is also of benefit for companies who have never obtained financing from an informal investor and visa versa. For example, companies who search for an informal investor are now able to select an informal investor on behalf of the roles they deliver.

Next, the results are interpreted and important issues are discussed in the discussion and conclusion part. Besides, in answering the different sub-questions an answer can be given on the research question. Afterwards, suggestions for future research are given and

1

(15)

(16)

16

2 Overview of definitions and characterizations

2.1 Introduction

This chapter presents an overview of definitions and characterizations of the actors operating on the informal capital market. First, the introduction of the capital market and the agency problem are discussed. This is followed by the examination of the definitional issues and definitions of different actors. Third, the different actors on the informal capital market are analyzed separately. This chapter is concluded with an overview of all actors on the informal capital market.

2.1.1 Introduction of the capital market

Before investigating the interesting world of informal investors, a few things have to be clarified to place the concept of informal investors in the right context. Informal investors support small, growing, and attractive businesses with venture capital. Venture capital can be defined as finance that is provided on a medium- to long term basis in exchange for an equity stake. Investors will share in the upside, obtaining their returns in the form of a capital gain if the business is sold to another company or as the business goes to the stock market. The investors will lose their invested money if the business fails. Therefore, most investors (both informal and formal) will invest only in businesses that have the potential to achieve rapid growth and achieve a certain size and market position, because only in these circumstances investors have a great chance to get a return on their investments (Carter & Jones Evans, 2006).

It can be extremely difficult for starting companies to find external funding in the early stages (Wetzel, 1987). The equity gap that exists in the entrepreneurial finance market is defined by Mason (1996a) as ‘the absence of small amounts of risk capital from institutional sources for companies at the seed, start-up, and early-growth stages which arises because the fixed costs of investment appraisal and monitoring make it uneconomic for venture capital funds to make small investments, and also because of the reluctance of banks to make unsecured lending’. In other words, the gap exists between where the entrepreneur’s internal funds are exhausted and the funds provided by venture capitalists are not reachable because it is not profitable for the venture capitalist to invest in small starting companies. This so-called equity gap is partially filled by business angels and they can assist entrepreneurs who need to fill this gap. Although this is a very helpful source, business angels cannot fill the whole gap.

A study done in the Netherlands also acknowledged the importance of the informal investor market. This study shows that informal investors in the Netherlands have an important role in the starting phase of companies as well as a complementary role concerning venture capitalists and banks (Bureau Bartels, 2003).

2.1.2 Agency problem

(17)

17 entrepreneur is still largely busy with executing the daily operations. Because the investor has an equity stake, in this relation he is the principal and the entrepreneur is the agent. There is a problem if the principal and the agent have different opinions about how to run the company in the best manner. The entrepreneur could use the invested money in his own personal interests instead of in the best interests of the company. For the investor it is difficult to monitor whether the entrepreneur uses this money in the correct manner. This results in information asymmetries which occur when the entrepreneur knows much more about the running of the business than the investor. That is why investors and entrepreneurs use contracts to align the interests of both parties. Not all things can be written in a contract and therefore the information asymmetries stay and with it the agency problem (Van Osnabrugge and Robinson, 2000).

2.2 Definitions of actors

Nowadays various authors who are interested in the field of informal investors have shed their light on this topic and give definitions of the informal investor and business angel. Research on business angels was a very difficult domain and there were a few obstacles to overcome. One of these obstacles was the very inconsistent use of definitions (Avdeitchikova et al., 2008). Avdeitchikova et al. (2008) state that researchers within the field need to be more stringent in the way they use definitions. The work of Avdeitchikova and colleagues is the most up-to-date in definitional issues. A study by Farrell et al. (2008) has focused on definitional issues which will be discussed further on in the chapter. In this thesis the work of Avdeitchikova et al. (2008) plays a very important role because they present an overview of the different actors on the (in)formal capital market. This is also one of the few scientific papers that discussed the definitional issues of actors on the informal capital market in a quite narrow manner. Taking all this in consideration, the work of Avdeitchikova et al. (2008) is an excellent starting point to compare with previous literature on this topic.

Avdeitchikova et al. (2008) presented an overview of the so-called grey areas in definitions of actors on the risk capital market. This is discussed first to get an overall picture of the risk capital market.

(18)

18 The figure above illustrates the four general players on the capital market. Avdeitchikova et al. (2008) make use of other authors in formulating their definitions. They assume these definitions to make a clear separation in the capital market. First, the four actors on the risk capital market will be described. The explanations of these actors are used in the same way by Avdeitchikova et al. (2008).

- Institutional venture capitalists: Investors who carry out professional investments of

long-term, unquoted risk equity finance in new firms, where the primary reward is eventual capital gains supplemented by dividends.

- Business angels: High net worth individuals who invest a proportion of their assets in

high risk, high-return entrepreneurial ventures. Apart from investing money, business angels contribute their commercial skills, experience, business know-how and contacts, and play a hands-on role in the company.

- Informal investors: Private individuals who invest risk capital directly in unquoted

companies to which they have no family connection. Thus, informal investors include business angels as well as private investors who contribute relatively small amounts of money and do not take an active part in the object of investment.

- All non institutional venture capitalists: Investors who make investments in start-ups

not founded by the investor him/herself, i.e. including family investments, investments by friends, colleagues, etc., but excluding investments in stocks and mutual funds.

It is important to see the difference between the definitions of the business angel and the informal investor. Avdeitchikova et al. (2008) clarifies that business angels contribute their skills and play a hands-on role in the company in which they invest. On the contrary, informal investors are not actively involved in the companies in which they invest. Another difference is that informal investors contribute relatively small amounts of money. On the other hand business angels invest a proportion of their assets in a company. Proportion means not a small amount but much larger amounts.

There are three grey areas between these players:

Grey area 1: This grey area concerns the channeling of the invested capital. Avdeitchikova et

(19)

19

Grey area 2: This grey area is about the level of investment activity and hands-on

contribution given to the company invested in. With the level of investment activity the authors mean the amount of capital invested in a company. They argue that it is very different if an investor invests, for example, 1000 euro or 100 times this amount. There should be some requirements on the level of investment activity and when to classify an investor as an informal investor or a business angel. The authors argue that this is difficult because each country is different. Researchers are uncertain when to use the word business angel and when to use the word informal investor for hands-on contribution given to the company. This is because currently a large number of business angels are investing through angel syndicates. In some of these angel investments business angels are more active and in others less active. This creates a methodological problem that has to be addressed since co-investing business angels could easily be mistaken for less active informal investors.

Grey area 3: The last grey area concerns the different relations between the investor and the

entrepreneur. Some definitions used by authors include investments from friends and family, the so-called ‘love money’. Others exclude friends and family from their definitions.

As mentioned before, another study about definitional concerns was made by Farrell et al. (2008). They argue that definitional concerns arise because of two problems such as, a lack of a common definition and definitions being narrowly prescribed. The first problem hinders generalization and the second problem hinders theory and policy development. Farrell et al. (2008) argue that the differences in definitions used by several authors are made up of six key issues:

1. Timing: Some definitions take not into account angels who made an investment long ago but do not invest at the moment, others do.

2. Debt: The exclusion of angels on the basis of the use of debt-type instruments would seem to be in response to the private equity component of risk finance. Some authors exclude business angels in their definitions on the method they use to structure their deals.

3. Virgin investors: Including investors who have never made an investment before is

good for the response rate of studies. That is why several authors include virgin investors in their studies.

4. Corporate angels2: There are researchers who include corporate angels in their definitions to reach higher response rates.

5. & 6. Family and friends: Some authors include family and friends in their definitions

while others exclude them. This issue is one of the grey areas in the research of Avdeitchikova et al. (2008).

2

(20)

20 This study of differences used in definitions of business angels, highlights one important point which also is an issue in the work of Avdeitchikova et al. (2008). These are point five and six, the use of family and friends in the definitions. The work of Farrell et al. (2008) only highlights some key issues, but does not come with hands-on solutions. On the other hand, Avdeitchikova et al. (2008) tackled this problem of the use of definitions and came up with definitions of different actors. Further, the study of Farrell et al. (2008) does not add much to the study of Avdeitchikova et al. (2008)3.

We now turn to an overview of definitions given in the economic literature. I will first discuss the business angels and afterwards the informal investors. The definitions presented will be compared with the definitions given by Avdeitchikova et al. (2008). In this way similarities and differences can be detected.

2.3 Business angels

One of the first authors who acknowledged the importance of the informal capital market was William Wetzel. He concluded that business angels were the most likely source of funds for small technology-based companies looking for start-up and growth capital. In his article he stated that the informal capital market is invisible, inefficient and often misunderstood. He also stated that the informal capital market is very heterogeneous (Wetzel 1983). During the fifties and the sixties researchers discovered this market, but it was Wetzel who put the informal capital market on the research agenda. In the eighties when he conducted his research, little information was available about the precise functioning of this informal capital market and at that stage there was no general definition of the word informal investor4. Wetzel showed that business angels share some common traits, they are:

 wealthy individuals

 self-made and man

 highly active investors

 investing in close geographical proximity to their home

 relying heavily on their network of friends and business associates.

Lerner (2000) describes a business angel as follows: A wealthy individual who invests in entrepreneurial firms. Although angels perform many of the same functions as venture capitalists, they invest their own capital rather than that of institutional or other individual investors. So, the most important point taken from this definition is that it is about individuals who invest their own capital. Lerner’s definition does not exclude the possibility

3

For this thesis it is important to show other new literature. That is the reason why I have incorporated the study of Farrell et al. (2008).

4

(21)

21 that business angels may invest in companies owned by families and friends. Mason and Harrison (1994) give a slightly different definition of a business angel. They invest their own money, make their own investment decisions, consider commercial aspects, are not involved with family investments and take an active role in the company in which they invest. It is significant that this definition excludes investments made in family businesses and business angels play an active role in the company in which they invest. Concerning the definition of Lerner, Mason and Harrison use a slightly narrower definition. It is stated by Freear et al. (1994) that business angels are high net worth individuals who invest a proportion of their assets in high-risk, high-return entrepreneurial ventures. Again, it is suggested that business angels are wealthy. This has affinity with the definition of Lerner (2000). Prowse (1998) defines a business angel as a provider of risk capital to small, private firms. Following Prowse (1998) a business angel has certain characteristics. He is a wealthy individual, that often has entrepreneurial backgrounds and who tends to invest in small start-ups. They can have ownership stakes and may be active in advising the company. Another difference is made between ‘active angels’ and ‘passive angels’. Active angels are angels who actively monitor the firm in which they invest, they sit on the board and advise the firm. Passive angels only contribute money to the firm and rarely monitor the firm. These passive angels often belong to an informal network where active angels perform the deals for them and manage their investments (Prowse, 1998). Wiltbank et al. (2009) also give a broad definition of the word business angels. Their description is: ‘a wealthy individual who acts as an informal venture capitalist, placing his or her own money directly into early stage new ventures’. This definition has much in common with the definition of Lerner (2000). According to Elitzur and Gavious (2003), angels are wealthy individuals who provide financial resources to the company in early stages. They argue that business angels could be relatives of the entrepreneur or individuals from the industry who were successful entrepreneurs themselves and now willing to help young companies. This definition is basically broad because the authors also take into account that business angels can invest in companies of families and friends.

In general Mason and Harrison (2008) argue that the definition of the word ‘business angel’ has become increasingly fuzzy. But they have found robust key features of business angels that distinguish them from other informal investors:

 Business angels invest their own money

 They make their own investment decisions

 Financial rewards dominate the investment decision

 Excludes within family investments

 Business angels have hands-on involvement in the investee company

The authors conclude that all definitions of business angels have to possess these key features.

(22)

22 1) Business angels concentrate on the provision of capital in small investments in the

start-up and early stages of the company.

2) Business angels are more accommodating to the needs of the small business owners by having lower rejection rates, longer exit horizons and target rates of returns that are similar to those of venture capitalists even though they assume more risk.

3) Business angels invest mainly in their own local economies.

Interesting is the fact that business angels, when they invest in a small business, stay longer in the firm compared to, for example, venture capitalists. It can be acknowledged that business angels want to know what goes on in the small businesses in which they invest. Carter and Jones Evans (2006) state that business angels are high net-worth individuals who invest their own money directly in unquoted companies in which they have no family connection in the hope of financial gain, and typically play a hands-on role in the business in which they invest. They often have an (entrepreneurial) business background and invest on their own or with a group of other angels in new or started companies with growth potential.

The table below shows the different definitions of authors about business angels. Next, similarities and differences are discussed with respect to the definition of a business angel given by Avdeitchikova et al. (2008).

Author Definition

Wetzel (1983) Business angels are wealthy individuals, self made and man, highly active investors, who invest in close geographical proximity to their home and rely heavily on their network of friends and business associates.

Mason and Harrison (1994) Business angels invest their own money, make their own investment decisions, consider commercial aspects, are not involved with family investments and take an active role in the company in which they invest.

Freear et al. (1994) Business angels are high net worth

individuals who invest a proportion of their assets in high-risk, high-return

entrepreneurial ventures.

Prowse (1998) A business angel is a provider of risk capital to small, private firms.

(23)

23 institutional or other individual investors. Elitzur and Gavious (2003) Business angels are wealthy individuals who

provide financial resources to the company in early stages. They could be relatives of the company or are individuals from the

industry.

Carter and Jones Evans (2006) Business angels are high net-worth individuals who invest their own money directly in unquoted companies in which they have no family connection in the hope of financial gain and typically play a hands-on role in the business in which they invest.

Wiltbank et al. (2009) Business angels are wealthy individuals who act as informal venture capitalists, placing their own money directly into early stage new ventures.

Table 2.1 Chronological overview of definitions of business angels

Similarities and differences

Most definitions acknowledge that business angels are wealthy individuals. This is also described in the definition of Avdeitchikova et al. (2008). Furthermore, the definitions of

Mason and Harrison (1994), Freear et al. (1994), Lerner (2000), Carter and Jones Evans (2006), and Wiltbank et al. (2009) suggest that business angels invest their own capital. In the definition of Avdeitchikova et al. (2008) this term is also acknowledged. They mention it: ‘investing with a proportion of their assets’, in line with Freear et al. (1994). Only the definitions of Mason and Harrison (1994) and Carter and Jones Evans (2006) acknowledge that business angels play an active role in the investee company. It is striking that none of the other definitions mention the active role of business angels. Avdeitchikova et al. (2008) have applied this active role in their definition which is very important.

(24)

24 investments in the definition of a business angel given by Avdeitchikova et al. (2008). I suggest putting in the definition ‘not taking part in family investments’.

Overall the definition given by Avdeitchikova et al (2008) is the most compelling. Except from adapting some light nuances to the definition, the definition is clear and narrow.

2.3.1 Characterizations of business angels

Carter and Jones Evans (2006) describe that business angels have both economic and non-economic motivations, such as fun and enjoyment and social responsibility. An important characteristic is that business angels do not seek a controlling interest or management position, but take an advisory role and want to give their opinion on major management decisions. In general they invest in a range of £10,000 to £250,000.

Carter and Jones Evans (2006) conclude that a business angel has a common profile: - In 95% of the cases business angels are male.

- Are cashed-out entrepreneurs. They have had experiences with the start-up and growth of companies.

- Are in the age of 45 to 65 years. These ages reflect the length of time that is required to build a reasonable personal capital.

Carter and Jones Evans (2006) also tell us that geographical characteristics of business angels’ investments are important. They distinguish between two dimensions. First, studies show that business angels live everywhere. Second, they report that various studies indicate that the most investments made by business angels are local. Harrison and Mason (1992) have also reported this local investment behavior of business angels.

Research by Paul et al. (2006) concluded that business angels give more weight to softer factors, such as the impact made by the entrepreneur during the first meeting and that business angels work with less information than, for example, venture capitalists. Before business angels invest in a company, they want to know exactly what type of company it is and they will only invest if they have full trust in the entrepreneur.

Business angels have three common benefits that make them a more suitable financial alternative than, for example, venture capitalists. First, business angels prefer funding high-risk entrepreneurial firms in their earliest stages. Venture capitalists prefer funding in later stages, but especially business angels prefer funding in the early stages. Second, business angels prefer funding the small amounts needed to launch new ventures. Third, business angels tend to have less risk aversion and lower expectations of return than, for example, venture capitalists (Freear et al, 1991).

(25)

25 do more investments than business angels, so the venture capitalists have much more investment experience (van Osnabrugge and Robinson, 2000). A study by Wetzel (1987) made it clear that business angels in general lack investment experience and on average invest infrequently5.

As reported before, business angels have unique and varied backgrounds. Generalizing all these business angels is very simplistic, but is it possible to characterize business angels. Van Osnabrugge and Robinson (2000) have a list of ten characteristics of business angels. Business angels:

 Prefer smaller–size investments than venture capitalists.

 Usually invest in start-ups and early stage ventures.

 Make investments in virtually all industry sectors.

 Are more flexible in their financial decisions than venture capitalists. They have different investment criteria, longer investment horizons, shorter investment processes and lower targeted rates of return.

 Funding does not involve the high fees when raising funds from financial institutions.

 Are value-added investors in that they contribute their personal business skills to new young businesses.

 Operate in a market that is more geographically dispersed than the formal venture capital market.

 Account for a leveraging effect in that it makes the investee firm more attractive to other sources of possible finance.

 Are instrumental, thanks to the loan guarantees they offer their investee firms in addition to the money they personally invest.

 Are not averse to funding technology companies.

Beside the positive things of business angels, van Osnabrugge and Robinson (2000) report four disadvantages of business angels:

 Business angels are less likely to make follow-on investments in the same firm. Venture capitalists spend around two-thirds of their funds on expanding their existing portfolio firms.

 Business angels prefer to have a say in the running of the firm, which may lead to the fact that the entrepreneur has to give up some of his control. Rather, some business angels invest in firms in which they do not have much expertise. This will make the participation of the business angels less value-added in a particular firm.

5

(26)

26

 A small group of business angels can behave as ‘devils’. They can have self-serving motives instead of promoting the good things of the firm.

 Business angels do not have the reputation of a big institution, such as one of the bigger venture capitalists. This good reputation can be crucial if a successful firm seeks assistance from an investment bank for a private placement or Initial Public Offering (IPO).

Van Osnabrugge and Robinson (2000) conclude to say that the positive things outweigh the negative things. So an active informal venture market is a positive thing for the global economy.

2.4 Typology of business angels

First, typologies of different authors are discussed. After discussing a typology, I will try to fit different actors from the typologies in the definitions of Avdeitchikova et al. (2008).

Sørheim and Landström (2001) have proposed to make a classification of the informal capital market. They argue that the informal capital market can be divided in accordance with the informal investors’ investment activity and the competence of the informal investor. They came up with this classification through sending questionnaires to a large number of individuals assumed to make informal investments in Norway through the snowball method. The snowball method involves indentifying one investor and using their knowledge and contacts to identify others. Finally they identified four groups of informal investors who each have different characteristics.

1. Lotto investors: Have a low investment activity and low competence. This group makes very few investments and only adds limited value to the company in which they invest.

2. Traders: Have a high investment activity, but a low competence. This group has the will to invest, but they have limited competence with which to add value to the companies in which they invest. Primarily they are providing financial resources. 3. Analytical investors: Have a low investment activity, but a very high competence.

They are called analytical because they possess the competence but they are not willing to commit themselves to substantial investment activity.

4. Business angels: Have a high investment activity and a high competence. This group adds value to the companies and also engages in many informal investments.

(27)

27

Lotto investors can be compared with the non institutional venture capitalists. People who invest in family businesses are mainly friends or family and often have a low investment activity. They will probably invest only once in the family business. Likewise, lotto investors do not want to take active involvement in the investee company. Traders can be compared with informal investors. Traders only invest in financial resources. They have a low competence, so it can be assumed that traders do not want to participate actively in the investee company. Informal investors also participate only financially and have no active part in the investment. It is difficult to place analytical investors in any of the definitions given by Avdeitchikova et al. (2008). This is because Avdeitchikova et al. (2008) have given no definition that can be compared with an investor with a low investment activity, but a high competence. It narrows the definition of the business angel, but the problem is that most business angels have a high investment activity, an analytical investor has not. The last category business angels is the same as the definition of business angels given by Avdeitchikova et al. (2008) because in both definitions, business angels participate with financial resources and take active involvement in the investee companies.

Paul et al. (2003) presented another typology of business angels. Their typology is based on the number of investments made by an informal investor. Their study is based on a sample of companies in Scotland. They get their results through sending questionnaires to companies that were (ex)members of a well known BAN (Business Angel Network) in Scotland, named LINC (Local Investment Network Company). They distinguish four categories of business angels.

1. Nascent angels: Angels who yet have to make their first investment and are very serious about doing so.

2. Novice angels: Inexperienced angels at the start of their angel career. They have participated already in one investment.

3. Portfolio angels: Experienced angels who have made between two and five investments.

4. Super angels: Angels who are very experienced and made more than five investments.

Nascent angels are in my opinion the same as virgin angels6 . Nascent angels do not fit into any of the definitions because nascent angels are not investing. In the definitions of Avdeitchikova et al. (2008) all investors are already investing. Also novice angels are difficult to place in one of the definitions because novice angels want to take an active role in the investee company, but they have only made at least one investment and are very inexperienced. Actually, novice angels are already business angels, but Paul et al. (2003) want to make a distinction between these angels. Paul et al. (2003) argue that novice angels

6

(28)

28 are very inexperienced with regard to investing in new starting companies, for example, how to structure the deal and how to negotiate with the company. On the other hand these angels can be very experienced how to invest in particular business industries because they have worked in a particular industry themselves for many years. When discussing this experience factor this needs to be taken into consideration. Next, portfolio angels are experienced investors and can be compared with the definition of business angel given by Avdeitchikova et al. (2008). Most business angels are experienced, which also counts for portfolio angels. The last category super angels are very experienced business angels and in my opinion these are angels who form a separate class because of their experience. Avdeitchikova et al. (2008) in their definition describe the average business angels. In my opinion super angels are rare.

Gaston (1989), Benjamin and Margulis (1996), Coveney (1996), and Evanson (1998) have also made classifications of different types of informal investors. But all these studies have a couple of limitations. Firstly, none of the studies provides a comprehensive explanation or a theoretical basis for the choice of categorized variables. Secondly, the categorizations suggested in previous research are static where individuals are assigned to groups based on some general characteristics. Finally, and most important, the existing typologies of informal investors do not contribute to our theoretical understanding of why there are different types of investors and what explains the differences in their investment behavior (Avdeitchikova, 2008). In the next chapter a typology of different investment roles made by Avdeitchikova will be presented.

2.5 Angel syndicates

Over the past few years, a new phenomenon has introduced itself in the informal capital market. There are angels investing as part of an angel syndicate (also called angel alliances). This approach allows the angels to collectively make larger and more frequent investments (van Osnabrugge & Robinson, 2000). It is acknowledged that the amounts of these investments are still smaller than those funded by small venture capital firms.

The positioning of these angel syndicates is graphical illustrated below:

Informal Formal

--- Individual angels Angel syndicates Venture capital firms

---

Figure 2.2 The venture capital continuum (Van Osnabrugge & Robinson, 2000)

(29)

29 Angel syndicates do have several advantages compared to investing alone.

 Pooling money to invest in larger deals otherwise out of reach

 Diversification across multiple investments

 Leveraging and sharing of network contacts and investment expertise

 The ability to add more investments to an existing portfolio

 The ability to add further follow-on rounds to existing investments

Besides the advantages these syndicates have some running costs and may not be appropriate for those business angels who want to have a large say and active involvement in the companies in which they invest. Although there are single-deal syndicates which are formed especially for a single deal, nowadays there are also multi-deal syndicates which are organized to make multiple deals over many years. The participants in these syndicates are allowed to choose voluntary in which deal they want to invest. In this way, angel syndicates can make portfolios in which the investments made are less risky. Angel syndicate deals are more professional than a normal business angel deal and the status of these syndicate deals is much higher than a normal business angel deal. This status makes it very easy for starting companies to obtain further follow-up money in next financing rounds. Research shows that, business angels invest amounts of £10,000 to £250,000. Angel syndicates invest generally more than £250,000 (Carter & Jones Evans, 2006). Angel syndicates play a significant roll in the entrepreneurial economy because they primarily operate in the funding gap discussed earlier. Another point is that angel syndicates have much more credibility with venture capitalists. Venture capitalists often have a negative view of business angels. They are seen as amateurs who often overvalue their investments in companies. Because angel syndicates are more professional, venture capitalists are more confident about them and much more prepared to invest in follow-on rounds. Angel syndicates also reduce sources of inefficiency in the informal capital market for they are visible to the outside world and mostly not as anonymous as individual business angels. Carter and Jones Evans (2006) conclude that angel syndicates are increasingly becoming the only source of finance, other than government funds, for starting and growing businesses that already have exhausted 3F money7. With the emergence of angel syndicates, venture capital is returning to its classic roots. For quite a lot of small businesses these angel syndicates are a hole in the market.

2.6 Other types of angels 2.6.1 Virgin angels

A study by Bureau Bartels (2003) disclosed that the informal investors market in the Netherlands is not functioning optimally yet because there are people who want to be informal investors in the future, but have not had the right opportunity to invest. These possible investors are the so-called virgin angels. They have not yet invested because they think the economic situation is not appropriate these days. However, a quarter of these

(30)

30 virgin angels are going to invest in the future (Bureau Bartels, 2003). According to the study, these virgin angels want to invest directly in companies, not through angel syndicates.

Freear et al. (1994) in their research discovered three groups of investors. One of these groups where the interested potential investors with no venture investment history, but who express a desire to enter the venture capital market. This group is the same as virgin angels. The potential investor (virgin angel) invests on a smaller scale than the normal active business angel especially the amount of finance they invest. Business angels and potential investors clearly differ on the scale of commitment and the motivation for investing. Freear et al. (1994) argue that potential investors are more inclined to participate with other investors (this conclusion is the opposite of the study of Bureau Bartels) and they see venture investing more as a diversification strategy than the normal business angel.

San Jose´ et al. (2005) describe a virgin angel as individuals who fulfill all the conditions of becoming a business angel but who never invested. They argue that there are about 850,000 virgin angels in Europe and about 1,75 million in the US. San Jose´ et al. (2005) propose a business angel academy for active and passive angels to teach them how to invest, and to enable them to actually invest in the future. This academy will teach virgin angels especially how to recognize and evaluate opportunities. They are aware that virgin angels would rather invest in the lower range of investments because they have a higher risk perception. To deal with this high risk perception the authors propose that virgin angels co-invest with other angels. In this way virgin angels will be more confident to make their first investment.

2.6.2 Latent angels

Another angel group is the so-called latent angels. In the economic literature there is little information available about this group. It is argued that there are millions of latent angels in the US alone (van Osnabrugge & Robinson, 2000). Van Osnabrugge and Robinson (2000) describe latent angels as: ‘those who have not made an angel investment within the last three years but have done so in the past’. Mason and Harrison (2008) describe latent investors as: ’individuals who would not describe themselves as active investors but who will invest opportunistically if suitable deals appear’. This is a slightly different definition than the former. A similarity is that in both definitions the investors are not active investors.

2.6.3 Dormant angels

(31)

31

2.6.4 Corporate angels

The next angel group is the corporate angels. Some business angels who own companies, use their own company to make investments rather than from their own personal funds. Investing in this manner reduces their personal risk (Farrell et al., 2008).

2.6.5 Technology angels

Another angel group is the technology angels. Erikson and Sørheim (2005) researched how these technology angels differ from other informal investors. They portray technology angels as business angels that invest only in technology originated companies. The study shows that technology angels differ from other informal investors in sources of deal origin, selection, phases of investments, degree of involvement, and exit expectations. Erikson and Sørheim (2005) explained that another angel group is operating on the informal capital market. The study is limited in that it focused only on the Norwegian context, which makes it unclear whether these findings are applicable to other countries.

2.6.6 Born global investors

In a recent study a special type of informal investors was investigated called born global investors. Born global investors are experienced investors who invest in companies that operate globally (Moen et al., 2008). These so-called born global investors have some key characteristics that differ from other informal investors. Born global investors:

 Are investing in a greater number of projects.

 Have more experience than managers in large firms and larger incomes.

 Are not involved themselves. They monitor their investee companies in the same manner as other informal investors.

Because more and more small businesses operate not only locally but also globally, this type of informal investor will become increasingly significant in the future.

2.7 Informal venture capitalists (informal investors)

In empirical studies it was recognized that the informal market was going far beyond individuals who are active investors who are involved in the firms in which they invest. It was seen as a broadening of the concept of business angels (Avdeitchikova 2005).

(32)

32 other informal investors, in risk capital in one or more unlisted companies. These informal investors can decide independently if they want to invest in these unlisted companies. They not only deliver financial capital, but give advice and coaching too. These informal investors invest in companies who are not led by family and friends. In this definition there is very little difference between the definitions of a business angel and an informal investor. According to (Wetzel 1983), business angels are wealthy persons but following the definition of Avdeitchikova et al. (2008) informal investors are not wealthy per se. However, they can be individuals with abundant money to set aside. Farrell et al. (2008) propose an all-embracing inclusive definition in order to capture the essence of informal capital investing. They give the following definition: ‘A business angel/informal venture capital investor/individual private equity investor should be defined as an individual, non-professional, debt/equity investor (not lender) investing their own funds in unquoted firms in which they are not the entrepreneur’. O’Gorman and Terjesen (2006) have the same opinion and their definition is: ‘Informal investors are both private individuals (termed business angels) using their own money directly in unquoted companies in which they have no family connection and individuals who invest in family members ventures’. In this definition there is no separation between informal investors and business angels and informal investors who invest in family companies and investors who will not invest in family companies.

In the definition of Bureau Bartels (2003) informal investors who also give advice and coaching are taken into account. On the contrary, Avdeitchikova et al. (2008) argue that informal investors do not take an active part in their investment. This is a difference. A similarity between the two definitions is that both exclude family investments as well as investments made by friends and colleagues. I prefer the definition given by Avdeitchikova et al. (2008) because they also mention the non-active role that informal investors perform. The definition given by O’Gorman and Terjesen (2006) is a very broad definition because these authors make no difference between informal investors and individual investors who invest in family businesses. In my opinion it is obvious to make a distinction between individual investors who invest in family businesses and those who will not invest in family businesses, because both will behave differently in the investment process. Overall, the definition of an informal investor given by Avdeitchikova et al. (2008) is the definition that is preferred.

2.8 Local differences between informal investors

(33)

33 informal investors. GEM collected all these results from different countries who are members of GEM. The results can be seen below.

Figure 2.3 Quantity of informal investors per country, OESO countries who participates in GEM (EIM/GEM, 2004)

This chart illustrates that Iceland, with 8.8% has the most informal investors of the whole population, followed by France (4.9%), New Zealand (4.8%), and the United States with 4.3%. The Netherlands with 1.3% has one of the lowest scores in this chart. The conclusion is that Iceland has the most informal investors with entrepreneurial activity. In Iceland many people show entrepreneurial behaviour, even so in New Zealand and the US. Countries with a great deal of entrepreneurial activity will most probably attract more informal investors.

2.9 Different types of informal investors

This chapter is concluded with an overview of the different actors operating on the informal capital market. In the table below some types of informal investors are taken in one definition because they mean exactly the same, but are mentioned differently by authors.

Grey area Type of informal investor Definition

Super angels Angels who are very experienced and have already participated in more than five investments.

Business angels (active angels)

High net worth individuals who invest a proportion of their assets in high risk, high-return early stage new entrepreneurial ventures and who do not take part in

family investments. Apart from investing money,

business angels contribute their commercial skills, experience, business know-how and contacts, and play a hands-on role in the company.

Non-financial roles of informal investors