Faculty of Economics and Business MSc Business Administration
MSc Thesis Small Business & Entrepreneurship
Informal Venture Capital Investments in the Netherlands:
Matchmaking between Business Angels and Entrepreneurs in the Presence
of Information Asymmetries
Name Maurits H.L. Olde Meule
1 Abstract
This thesis examines the business angel market in the Netherlands, with a special interest to the efficiency of matchmaking initiatives which act as matchmaker between business angels and entrepreneurs. This efficiency is assessed on the basis of information asymmetries which exist in the matchmaking process between both parties. The thesis concludes that (1) matchmaking initiatives can reduce or overcome the following information asymmetries: (a) the quality of the idea or business model of the entrepreneur, (b) the interest of the business angel, (c) the type of control mechanism in the investee business and (d) the identification of the business angel and that (2) matchmaking initiatives can reduce, but are unable to overcome the following information asymmetries: (a) the quality of the entrepreneur, (b) the quality of the business angel, (c) the interest of the entrepreneur and (d) receiving sufficient investment opportunities.
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Summary
The content of the thesis is about the extent of efficiency of the business angel market in the Netherlands. Business angels are high net worth individuals who invest private money directly in an unquoted business and generally take an active involvement in the business. The motivation of the subject of this thesis is based on the current situation of the business angel market in the Netherlands. The business angel market suffers a matchmaking problem between business angels and entrepreneurs. These matchmaking problems are the cause of the inefficiencies in the business angel market. These market inefficiencies are: high search costs, inability for business angels to invest as frequently as they would or as much as they want and entrepreneurs are renouncing business angel funding because of the difficulties in finding a suitable business angel.
Information asymmetries are the cause of the matchmaking problems between business angels and entrepreneurs and are the underlying sources of the inefficiencies in the business angel market. The thesis is based on four sets of information asymmetries which exist in the process of matchmaking. These sets are: the quality of the investment partner, the interest of the investment partner, the control mechanism in the investee business and the identification of the investment partner. The first three information asymmetries stem from problems in the agency relationship between business angels and entrepreneurs. In the agency relationship the business angel (principal) invests capital to obtain a return and the entrepreneur (agent) is expected to exert effort to put the invested capital to the best possible use. Agency theory is concerned with resolving problems that occur in relationships with the presence of asymmetric information between both parties.
Matchmaking initiatives of Business Angel Networks or intermediaries which act as matchmakers in the business angel market are analyzed, based on the information asymmetries, in order to determine the extent of effectiveness. Six respondents who hold a position of manager in a matchmaking initiative are interviewed for obtaining qualitative data and information about the extent to which the matchmaking initiative can reduce or overcome the information asymmetries.
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Content
1. Introduction ...5
2. Problem statement & research questions ...7
3. Sources of venture capital ...9
3.1 Institutional venture capital ...9
3.2 Corporate venture capital ... 11
3.3 Informal venture capital ... 12
3.4 Comparison ... 14 3.5 Conclusion ... 17 4. Business angels... 19 4.1 Definition ... 19 4.2 Characteristics ... 21 4.3 Investment strategies ... 22 4.4 Active involvements ... 25
4.5 Matchmaking with entrepreneurs ... 27
4.6 Conclusion ... 29
5. Matchmaking process : Information asymmetries ... 31
5.1 Quality of the investment partner ... 32
5.1.1 Quality of the investment opportunity ... 32
5.1.1.1 Quality of the entrepreneur ... 33
5.1.1.2 Quality of the idea or business model ... 34
5.1.2 Quality of the business angel ... 35
5.2 Interest of the investment partner ... 37
5.3 Control mechanism in the investee business ... 37
5.4 Identification of the investment partner ... 38
5.5 Conceptual model ... 40
6. Methodology ... 41
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6.2 Sample ... 41
6.3 Data collection ... 42
6.4 Data analysis ... 42
7. Results of the interviews ... 43
7.1 Interview 1 ... 43 7.2 Interview 2 ... 47 7.3 Interview 3 ... 50 7.4 Interview 4 ... 52 7.5 Interview 5 ... 55 7.6 Interview 6 ... 58 8. Analysis... 61
8.1 Quality of the investment opportunity ... 61
8.1.1 Quality of the entrepreneur ... 61
8.1.2 Quality of the idea or business model ... 62
8.2 Quality of the business angel ... 64
8.3 Interest of the entrepreneur ... 65
8.4 Interest of the business angel ... 66
8.5 Type of control mechanism fits investee business ... 66
8.6 Receiving sufficient investment opportunities ... 67
8.7 Identification of the business angel ... 68
8.8 Next generation of matchmaking initiatives ... 69
9. Conclusion ... 72
9.1 Suggestions for further research ... 75
9.2 Limitations... 75
References ... 76
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1. Introduction
The history of the term “business angel” comes from Broadway at the end of the 19th
century. Individual investors starts providing funds for directors to invest in the production of new musicals. Besides the financial benefits, the motivations to invest came from the investor’s love for the theatre and the opportunity to meet and socialize with famous actors, writers and producers. The investors were motivated by something larger than money and due to this fact they secured high risk capital (Ramadani, 2009). Business angels became a critical source of financing in the start-up phase of some risky, but promising ideas and projects beyond Broadway. A couple of examples of promising and historically successful start-up projects are the funding of Bell Telephone by Alexander Graham Bell in 1874 and the funding of $40.000 of five business angels to Henry Ford in 1903. Also the founding of Apple Computers was funded ($91.000) with the help of business angels in 1978 (Van Osnabrugge & Robinson, 2000).
Informal venture capital-equity investments and non-collateral forms of lending made by private individuals (business angels) play a key role in the financing of start-ups and emergent companies. Business angels invest their own money, directly in unquoted companies in which they have no family connection. The key role of business angels in financing emergent companies can be divided into three parts. Firstly, business angels occupy a critical position in the growth firm financing spectrum, filling the ‘capital gap’ between founders, family and friends and the institutional venture capital funds which normally do not invest in start-ups and emergent business, because of their high transaction costs. Secondly, the market for informal venture capital is substantially larger than the institutional venture capital market, in terms of both the amounts and number of investments made in businesses in their start-up and early growth stage. Thirdly, business angels are ‘hands on’ investors, contributing their knowledge, skills, expertise and contacts in a variety of informal and formal roles in their investee businesses. Business angels contribute more to a business than just to the money, because of their entrepreneurial backgrounds (Harrison & Mason, 1999).
The public equity market and the institutional venture capital market are visible and well understood. The informal venture capital market, on the other hand, is often misunderstood. It is composed of a virtually invisible populations of individual investors who provide equity financing for entrepreneurial ventures of all types. Several studies investigated the problems and methodological obstacles with defining the population and sampling the invisible informal venture capital market (Avdeitchikova et al., 2008; Farrell et al. 2008; Harrison & Mason, 2008; Wetzel, 1987). In much writing about the informal capital market, business angels and informal investors are even used interchangeable (Riding, 2008). In the first part of this thesis, the defining and sampling problems of business angels, informal investors and the area of the informal venture capital market will be researched.
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capital markets is a matter of fundamental concern to entrepreneurs, venture investors and to public officials. Venture capital falls into the category of either formal/ institutional venture capital, which is invested by venture capital funds or corporate companies, or informal venture capital investors, which is directly invested by private individuals. However, the market for informal venture capital and business angel investments suffers from a matching problem. Large amounts of business angel capital are available in the market, but entrepreneurs and emergent businesses face great difficulties in accessing these financial resources, because they cannot find the right angel. On the other side, it is also possible business angels are not able to find attractive investment opportunities (Harrison & Mason, 2000).
Business angel networks (BANs) which act as financial intermediaries between business angels and entrepreneurs, are a means to overcome the matching problem as discussed above. In reality, most North American and European BANs are relatively unsuccessful in (1) matching business angels and entrepreneurs and (2) offering services that provide members (business angels) who want to invest in entrepreneurial ventures. According to Knyphausen-Aufseß & Westphal (2008), BANs operate in a paradoxical situation with market need or inefficiency on one side and the lack of success of BANs on the other side. BANs face problems with financing their activities and depending strongly on governmental subsidies. As discussed above there is a lot of research in North American and European countries about business angel (networks) and informal venture capital. The scientific research and scientific usefulness of information about the business angel market in the Netherlands is lacking. The Dutch magazine ‘Brookz’ of June 2011, which is a magazine for professional investors and entrepreneurs in the Netherlands, pays attention to the informal venture capital market in the Netherlands and the introduction of the first Dutch BAN in September 2009. Brookz magazine highlights the current situation of the Dutch informal venture capital market: ‘Despite the increase in supply and demand of informal venture capital the market of informal investments in the Netherlands is functioning poorly and invisibly. Due to the lack of knowledge and dysfunctional matching, the available informal venture capital in the market is not able to find the way to entrepreneurs. On the other hand, entrepreneurs are not sufficiently aware of the possibilities of informal venture capital.’ Bernd Mintjes -board representative of the Dutch BAN- exemplifies this as follows: ‘In terms of informal investments and business angels, the Netherlands is considerably behind internationally. In England, on 3400 inhabitants one individual makes informal investments, in the Netherlands, only one individual is making informal investments on 17000 inhabitants. We must bridge this gap.’
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2. Problem statement & research questions
In the business angel literature, sampling difficulties are often cited alongside varying definitions of informal venture capitalists, business angels, private equity investors and micro-angel investors (Farrel et al. 2008). In order to research the market of business micro-angels, the definition of a business angel is an important element in the design of this thesis. Defining the population of business angels is necessary for the determination of an appropriate sampling methodology.
This thesis is developed in order to research the informal venture capital market in the Netherlands and especially the contribution of business angel networks in the process of matchmaking between business angels and entrepreneurs. This thesis will contribute to the creation of an efficient business angel market in the Netherlands. The thesis will give conclusions and recommendations about the current status of efficiency in the Dutch business angels market. As described, the market of informal investments is invisible, inefficient and different terms into the spectrum of informal investments are used interchangeably. The lack of (scientific) information on the Dutch informal venture capital market makes this thesis a challenge. The results of this thesis should lead to a base and foundation of research on the informal investments market in the Netherlands.
Before researching the informal venture capital market in the Netherlands we need to analyze the sources of venture capital and the structure of the informal venture capital market. It is necessary to develop specific research questions in order to define the different parts of venture capital and the position of business angels in this spectrum. With research based on these research questions the different populations into the spectrum of venture capital and business angels can be defined in trying to solve the definition problems of informal investments and business angels before we start the empirical research on matchmaking initiatives in the business angels market. This research content will be covered in the following main question of this thesis:
What distinguishes business angels from other venture capital investors and what are the most efficient initiatives for matching business angels with entrepreneurs?
As discussed above, this thesis is divided into a literature study and an empirical part. The theoretical part is about developing knowledge of definitions, structures, attitudes, behaviours and characteristics of the venture capital market. The first sub question is developed in order to gain knowledge about the venture capital market and the structure of this market with the different actors. The term informal venture capital implies a position of informal investments within the market for venture capital. Researching this position leads to the following sub question:
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After defining the venture capital market and informal investment possibilities, the focus must be narrowed to business angels to determine the definition of a business angel compared to other possibilities of informal investments and venture capital. The investment strategy and the active involvement of the business angel is crucial in the process of business angel investments. Dividing business angels on the base of involvements and investment types is reflected in the following research question:
(sub2) What is the definition and the characteristic of a business angel and which investment strategies and active involvements are applied by business angels?
According to Harrison & Mason (2000), the market for informal venture capital and business angel investments suffers from a matching problem between business angels and entrepreneurs. Business angel networks are a means to overcome this matching problem, but how do they overcome this matching problem? The problems in the process of matching business angels with entrepreneurs makes the business angel market inefficient. Both parties face matching barriers which stem from information asymmetries (Kotler et al., 2004). Researching these information asymmetries leads to the following research question:
(sub3) Which information asymmetries are the cause of the matchmaking problems between business angels and entrepreneurs?
The empirical part of this thesis is based on the outcomes of the literature study. The literature study should result into the information asymmetries in the matching process between business angels and entrepreneurs which hinders the effectiveness. Before an investment, business angels and entrepreneurs develop an individual profile in which they create the conditions which the potential investment opportunity must meet in order to achieve the most suitable business angel – entrepreneur relationship. These conditions are the underlying sources for the resulting information asymmetries. When these conditions are known by other parties, the information asymmetries can be reduced or overcome and will result in more investment relationships. In order to research the current matching initiatives and its effectiveness in reducing or overcoming the information asymmetries the following research questions is developed:
(sub4) To what extent can current matchmaking initiatives reduce or overcome the information asymmetries between business angels and entrepreneurs?
The results from sub question four should give more insights in the effectiveness of several types and categories of current matching initiatives. With these results the business angels market in the Netherlands can be analyzed. In order to improve the efficiency of the business angel market in the Netherlands the following question is developed:
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3. Sources of venture capital
Before starting the research about the definition and sampling problems of the informal venture capital market, the broad spectrum of the venture capital market should be identified. In order to get a total view on the global venture capital market including the market for informal investments. This chapter elaborates on the first research question:
How is the venture capital market structured and where is informal venture capital positioned in this market?
This part of the thesis explains the different submarkets in the venture capital market and will give a first insight into the financing possibilities of entrepreneurial ventures and emergent businesses.
The market for venture capital is a specific form of industrial finance. Venture capital is a part of a more broadly based private equity market. In the private equity market, institutions, firms and wealthy individuals can make investments (with private equity) in ventures that are not quoted on a list of stock markets and which have the potential to grow and become a significant player on the international market (Harrison & Mason, 1999). Venture capital investments can usually be regarded as an active and temporary (five to ten years) partner in the invested venture and they are normally minority shareholders. The achievements in rate of returns are mainly in the form of capital gain through exit rather than by means of dividend income. According to Landström (2007), the venture capital market consists of three different submarkets and these are: the institutional-, corporate-, and informal venture capital market. In the next paragraphs of this chapter, the three different submarkets will be explained.
3.1 Institutional venture capital
Institutional venture capital firms act as intermediaries between financial institutions (large companies, pension funds, wealthy families and trusts) and unquoted businesses that need capital (Landström, 2007). According to Wright and Robbie (1998), investments of institutional venture capitalists are professional investments of long-term, in unquoted and risk equity financing in new firms where the primary reward is supplemented by dividends. The definition of Mason & Harrison (1999) includes also the different organizational forms which institutional venture capital firms can take: ‘The institutional venture capital market comprises full-time professionals who raise finance from pension funds, insurance companies, banks and other financial institutions to invest in entrepreneurial ventures. Institutional venture capital firms can take various forms: publicly traded companies, captive subsidiaries of large banks and other financial institutions, and independent limited partnerships.’ Depending on ownership structure, the different organizational forms of institutional venture capital consist of:
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Independent limited partnerships, in which the venture capital firm serves as the general partner. As general partner they raise capital from other limited partners, such as institutional investors (pension funds, insurance companies and banks).
Government venture capital organizations. These are financed and controlled by government institutions.
Since the 1980s, the independent limited partnership form has emerged as the most dominant organizational form in the market for venture capitalist. In an independent limited partnership form, the venture capitalists are general partners and control the fund activities, where the individual investors acts as a limited partner who is not involved in the daily management of the investment fund (Landström, 2007). Figure 1 shows the investment process of the venture capital market.
Figure 1: The investment process of the institutional venture capital market
The institutional venture capital market differs from country to country and also the characteristics of the venture capital industries in the US and Europe differ. The substantially difference between the US and Europe is illustrated by Bygrave & Timmons (1992). They make a distinction between two types of venture capital:
Classical venture capital funds, which raise capital from patient investors, for example, wealthy individuals and families. The investment funds are managed by investors with entrepreneurial experience and industrial knowledge, who invest in start-ups and early stage ventures and these investors actively operate in the businesses in which they invest.
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Bygrave and Timmons (1992) show that due to the growing dominance of institutional investments in venture capital funds in the US and Europe, merchant venture capital funds have taken over at the expense of classic venture capital. In Europe institutional venture capital is usually considered synonymous with the market for private equity in a more general sense. Institutional venture capital investments in Europe include investments in terms of early and expansion stage financing as well as investments covering a range of other stages such as funding of management buy-outs, consolidations and turnarounds. On the other hand, in the US, institutional venture capital investments is narrower and refers to early stage investments in growth-orientated businesses.
3.2 Corporate venture capital
A significant part of the institutional venture capital market (paragraph 1) is the corporate venture capital market. This capital is funded from ‘captive’ venture capital organizations. Corporate venture capital are equity or equity-linked investments in young, privately held businesses, where the investor is a financial intermediary of a non-financial corporation (Maula, 2001). The main difference between institutional venture capital and corporate venture capital is the fund sponsor. In corporate venture capital the fund sponsor is a corporation, or a subsidiary of a corporation which is the only limited partner. In institutional venture capital the fund sponsors are individual investors which act as limited partners.
Venture capital is used in order to develop new businesses and into the area of corporate venture capital Maula (2001) distinguishes two types: (1) internal corporate venture, in which innovations and new businesses are developed at various levels within the boundaries of the firm. (2) external corporate venture, in which semi-autonomous or autonomous organizational entities will be created that reside outside the existing firm. Within the frame of external corporate venture, corporate venture capital is used, as a tool, for strategic considerations and business development together with tools as venture alliances and acquisition possibilities.
Table 1: Corporate venture capital
Type of investment Externally managed Internally managed
Investment via independently Direct subscription for minority managed venture capital fund. equity stake.
Investment vehicle Independently Independently In-house corporate Ad hoc/one-off managed fund managed captive managed fund investments,
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In addition to the theory of Maula (2001), MacNally (1994) states that corporate venture capital can have two main forms: externally- and internally managed investments (see table 1). In externally managed investments, large corporations finance new firms alongside independently managed venture capital funds. Internally managed investments make investments through their own internal organization.
3.3 Informal venture capital
Another source of the venture capital market includes the market for informal investments of wealthy private individuals in entrepreneurial ventures. In this paragraph the first introduction will be given about the main subject of this thesis, informal venture capital and business angels. The first part of the explanation of the venture capital market was particularly focussing on the institutional and formal side of venture capital in order to get a broad view of the venture capital spectrum. From this point, the focus will be placed on the informal side of the venture capital market and a first start is made to solve the definitional and sampling problems within the market of informal venture capital and especially to the business angel market.
For many years, the informal venture capital market has been associated with and regarded as equivalent to business angels. The term ‘angel’ was originally used to describe individuals who helped financing theatre productions on Broadway, called ‘theatre angels’. These angels invested in theatre productions mainly for pleasure and making contacts with their favourite actors. These investment were based on high risks. The individual investors lost their money if the production was a flop, but shared the profits of the investment if the production was successful (Benjamin & Margulis, 2001).
In the beginning of the 1980s, William Wetzel (1983) was one of the first who introduced the term ‘business angels’ for people providing the same kind of risk investments in young entrepreneurial ventures. In recent years, we saw broadening of research into the informal venture capital market with the introduction of a broader range of private investors making equity investments in entrepreneurial ventures (Sorheim & Landström, 2001). A common definition of ‘informal investors’ is based on Mason & Harrison (2000): ‘private individuals who make investments directly in unlisted companies in which they have no family connections’. This definition of informal investors is not only including investments made by business angels but also those investments made by private investors who are less active in the ventures in which they invest as well as private investors who invest smaller amounts of capital in unlisted businesses. An important argument in the definition of informal investors is that investments made by family and friends and other close relatives are based on other considerations and investment criteria than those of informal investors.
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Narrow definition Business angels High net worth individual, acting alone or in a formal or informal syndicate, who invests his or her own money directly in an unquoted business in which there is no family connection and who, after making the investment, generally takes an active involvement in the business (commercial skills, experience, business know-how and contacts), for example as an advisor or member of the board of directors (Mason & Harrison,
1995 / 2008).
Informal investors Comprised of private individuals who invest risk capital directly in unquoted companies in which they have no family connection (Mason and Harrison, 2000). Thus, informal investors also include business angels as well as private investors who contribute relatively small amounts of capital and do not take an active part in the business.
Informal investors, Defined as any investments made in start-ups including family other than the investors’ own businesses,
and friends including family investments, investments by friends, colleagues, etc., but excluding
investments in stocks/ mutual funds (Reynolds et
Broad definition al., 2003).
Figure 2: Actors and their definitions of the informal venture capital market.
One main conclusion from previous research has been that the informal venture capital market is very heterogeneous and needs classifications for informal investors. Sorheim & Landström (2001) (see figure 3) divided the informal venture capital market in accordance with the informal investors investment activity and competence of founding and running entrepreneurial ventures in four classifications:
‘Lotto investors’ are characterized by a low investment activity level and a low competence in founding and running entrepreneurial ventures. This means that they make very few informal investments and have only limited knowledge and skills for adding value to the firms in which they invest.
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‘Analytical investors’ have a low investment activity level, but possess a fairly high competence. They are labelled as ‘analytical’ because they seems to posses the competence, but they are either not able or not willing to commit themselves to substantial investment activities in the informal venture capital market.
‘Business angels’ are characterized by a very high investment activity level, in addition to possessing high competence. Business angels can contribute both knowledge and skills to the firms in which they invest, and they generally engage in many informal investments.
Competence in founding and running entrepreneurial ventures Low High Investment activity High Traders 24% of the investors Business angels 25% of the investors Low Lotto investors 30% of the investors Analytical investors 21% of the investors Figure 3: Categorization of informal investors (Sorheim & Landström, 2001)
Empirical findings show considerable differences between the four categories of informal investors. These are differences regarding information sources used, the level of firm involvement, co-investing, investment horizons, geographic preferences etc. The market for informal investments could be more effectively analysed by using these classifications.
3.4 Comparison
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Table 2: Characteristics of the three sources of the venture capital market
Characteristic Institutional Corporate Informal venture capital venture capital venture capital
Source of funds Primarily institutional Investing corporate Investing their own investors who act as funds money
limited partner
Legal form Limited partnership Subsidiary of a Private individuals large company
Motive for investments Equity growth Equity growth Equity growth and strategic Intrinsic rewards Investment Experienced Experience within Experience varies
investors industry/technology
Large investment Large investment Limited investment
capacity capacity capacity
Extensive due Extensive due Limited time for
diligence diligence due diligence
Monitoring Formal control Corporate control Informal control Source: Mason & Harrison (1999), De Clercq et al. (2006).
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investment will be made. In comparison to the institutional and corporate investments, the experience varies between the individual informal investors. Due to the informal structure of the investments and variety of private individuals there exist a lack of uniformity of the experience level. Institutional and corporate investors showing more experience with investments and corporate investors also show individual experience in typical industry or technology investments. The capacity of capital is larger at institutional and corporate investments compared to the limited investment capacity of an private individual. The time and ability to do a extensive due diligence valuation is a very common process into the markets for institutional and corporate investments. Special in-house knowledge of industries and specific investments is an advantage of the institutional and corporate venture capital market compared to the individual investor in the market for informal investments. The informal investor is more likely to invest in a venture with a familiar feeling of the product, venture and the skills of the entrepreneur. Due diligence is also more important for institutional and corporate investment due to the risk of losing capital and the desire for stable future returns. The ability for monitoring and accounting control is higher into the markets for institutional and corporate investments, because these types of investments are made by firms with extensive knowledge and the capacity for doing research and to add and monitor accounting controls based on financial, management, customer satisfaction and market figures. Informal investors are often less capable to add extensive monitoring and control mechanisms, because of the lack of receiving specific market information and the time and ability for doing extensive research. This research should be done on the shoulders of an individual private person.
The types of investors into the spectrum of venture capital investment take their own place in the venture capital investment cycle (figure 4).
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The stages of the company development explains the place where different types of investors can contribute to business growth. The four development stages: concept, start-up, growth and later-stage can be divided with three factors of growth. These factors: investment, risk and sales are focus areas for investors to invest in businesses. In the concept stage, where the factor risk is very high, it is very difficult for entrepreneurs to gain financing from investors, because the business makes no revenues and is not able to draw from resources. Due to this fact entrepreneurs can only gain finance from family, friend and love money and in some cases business angels will invest because the concept of the business and the entrepreneur has a great potential in the perspective of the business angel. The expected investment momentum for business angels to invest is the start-up phase of a business. The risks are reduced compared to the concept phase and the business is starting up the sales and the investment capacity of the business is growing. The informal venture capital has influence in the stages of concept and start-up of a business. Informal investors and business angels can make investments in exchange for shareholding in the business with a relatively high risk. After the investment of informal investments in the early stages of the business development, the need for higher investments and sales figures increases. In these stages, growth and later stage, the institutional venture capitalist invest in business. The risk is further reduced compared to the first two stages and the venture capitalists are able to make return forecasts and introduce control mechanisms. In the later stage, the business can go public and can be traded on the stock markets and lose its unquoted status. From this perspective it can be concluded that business angels and informal investments are very important in the emergence of new business, economic growth and new developments.
3.5 Conclusion
As discussed in the paragraph of informal venture capital, the market for informal investments can be divided into: lotto investors, traders, analytical investors and business angels. Figure 4 shows the total spectrum of the venture capital market, including the separate sources and actors of venture capital. In bold, the position of business angel investors is highlighted within the total spectrum. It makes clear that business angels are a form of informal venture capital (informal investors) and informal venture capital is one the three sources of the total market for venture capital.
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Venture capital market
Institutional Corporate Informal venture capital venture capital venture capital
Individual Corporation, Private individuals institutional investors or a subsidiary of a who invest their own
who act as limited corporation which is the money. Types of informal partners in an investment only limited partner in an investors:
investment - lotto investors - traders
- analytical investors - business angels
Figure 5: Business angels positioned into the total spectrum of the venture capital market
From the perspective of the company development lifecycle the place and influence of informal investments is shown. In the early stages of business development, business angels and informal investors play a vital role in funding young business. The high risk factor hinders the investments of bigger institutional venture capitalists, but without informal investments, who invest in more risky (early stage) businesses, there are few new developments of businesses.
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4. Business angels
After researching the total spectrum of venture capital the next step is the investigation of the existing research about business angels. The business angel is investigated on the base of his characteristics as a person and his personal/ investment behaviour in the process of involvements in the business in which they invest. The second research questions elaborates on this chapter of the thesis.
What is the definition and the characteristic of a business angel and which investment strategies and active involvements are applied by business angels?
4.1 Definition
To get a clear view of the business angel and its activities the definition of a business angel according to Mason & Harrison (2008) is the further base of this thesis. The distinction between an informal investor and a business angel is made in paragraph 3.3 where the business angel is defined into the terms of Mason & Harrison (2008). This definition is the most recent definition which covers the subject within the research about informal venture capital. According to Mason & Harrison (2008), a business angel is a high net worth individual, acting alone or in a formal or informal syndicate, who invests his or her own money directly in an unquoted business in which there is no family connection and who, after making the investment, generally takes an active involvement in the business, for example as an advisor or member of the board of directors.
Several aspects of this definition need to be emphasized in order to get a distinction of the business angel as a type of an investor.
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Acting alone or in a formal or informal syndicate. The way in which business angels operate has changed over the past years. Business angels can act alone in an investment or can invest with other business angels in an investment syndicate (structured angel groups) . Operating in this way offers business angels and the business in which they invest a couple of advantages. These advantages are based on spreading risks by operating with other business angels and from the entrepreneurs perspective, a syndicate can offer a greater added value through the collective experience and knowledge of the members (Paul & Whittam, 2010). As a result of this acting alone in investing in a syndicate phenomena, the business angel market is transformed from a ‘hobby’ activity to an increasingly professional market place for business angels. This professionalism is reflected into the published routines of accessing deals, screening deals, undertaking due diligence, negotiating and investing (May, 2002).
Investing his or her own money. A characteristic of a business angel is accessibility to private capital and investing this privately owned capital into unquoted business. The fact that business angels are investing their own money distinguishes them from institutional and corporate venture capital whose investment funds come from sources as pension funds and banks and have a legal duty how to invest in such investment funds. Firstly, business angels do not have to invest in business if they do not find appropriate investment possibilities whereas venture capital funds have to invest with a fixed investment life cycle from investment to exit, typically ten years. And secondly, business angels can make quicker investment decisions (Freear et al. 1994). Thirdly, business angels need less capacity for financial specialists and legal due diligence, so the costs for the investee business are lower. Business angels can also adopt their own investment criteria whereas venture capital funds have to invest in specific types of business and have to follow specific investment criteria.
Unquoted business. As opposed to investing in companies that are listed on stock markets, business angels invest in businesses which are not listed on stock markets (unquoted). By the fact that business angels want to play an active role in the company in which they invest the most appropriate way to invest in businesses is unquoted business. Business angels can help these business to grow whereas stock market investments are passive (Mason, 2006).
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angels, the means of risk reduction and the information asymmetries will be discussed in the final section of this chapter.
With the investment of own money and the active involvement of the business angel in an unquoted company we can highlight the major characteristics of a business angel. In this paragraph the definition of a business angel is described, but from this point it is not clear how we can characterize the person who’s acting as a business angel. In the next paragraph the person behind the business angel is described on the basis of profiles from existing research about business angels.
4.2 Characteristics
The profile of a business angel is researched in the literature and one of the striking features is the remarkable consistency in the profile of characteristics of business angels in different countries (Mason, 2006). The business angel can be characterized in a typical profile of its person. The typical business angel is a male, in the age group of 45-65, well educated and a successful cashed-out entrepreneur. These characteristics of the person behind the business angel need some explanations to understand why these characteristics belongs to business angels.
Male. Research in various countries are consistent in finding that at least 95% of the business angel is male (Freear et al. 1994; Gaston 1989; Morrissette, 2007). This can be attributed to the relatively small number of women who have built up a successful entrepreneurial business or hold senior positions in large businesses. However, according to Harrison & Mason (2007), the small minority of women’s (5%) who act as business angel have the similar characteristics to those of their male counterparts. Well educated. The level of education is influencing the economic success of a person
and business angels are typically educated with a university degree or professional qualifications. Business angels with masters and PhDs are rare. (Mason, 2006). This fact also reflects the research of Reynolds (2007) which concludes that the relationship between education and entrepreneurship is an inverted U-shape. Individuals with too little and too much education show a hindrance in entrepreneurial behaviour.
Age of 45-65. This timeframe of the age group reflect the length of time required to build significant individual net worth and start a successful entrepreneurial venture. Cashed-out entrepreneurs in this age group become a business angel because they want to remain economically active (Mason, 2006). There are some international differences. According to Landström (1993), in the USA business angels are slightly younger compared to business angels in Nordic countries. In the years to come business angels may become slightly younger, this can be explained by the technology boom since the late 1990’s. In that period a lot of younger entrepreneurs cashed-out from technology businesses.
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positions in large business and whose wealth is derived from high income. Cashed-out entrepreneurs have acquired the kind of experience to start, manage and build up a successful entrepreneurial business. Their professional careers add value to their business know how on the business in which they invest. The remainder are successful senior managers who stop working and add value to new business with commercial skills, specialism and have experience with working with entrepreneurial ventures, such as accountants, consultants and lawyers (Mason, 2006).
The following paragraphs focus on researching the investment strategies of business angels and the description of different involvements which business angels can have. The investment strategies of business angels and the factor risk reduction is an important part of this research in order to understand the relationship between business angels and entrepreneurs. On the other hand, the fact that business angels can have different types of added value and behaviours over time implies the dynamic character of business angels.
4.3 Investment strategies
In the literature several studies can be found about the identification and categorization of business angels by dividing the population into subgroups of investors. The categorizations of business angels are based on their investment activity and competence (Sorheim & Ländstrom, 2001), entrepreneurial background (Coveney & Moore, 1998) and investment motivations (Sullivan & Miller, 1996).
In studies about business angels from the last few years, especially from the year 2008, a common share of views is presented which refers to the further development of categorization of business angels. Avdeitchikova (2008), Avdeitchikova et al. (2008), Farell et al. (2008) and Mason & Harrison (2008) conclude that studies should be conducted that have the investment, and not the investor, as the basis of analysis. Business angels can implement different investment strategies in their investment portfolios, it is of considerable importance to understand what influences this choice. The research of Lahti (2011) is the first study which contributes to this view of categorization based on business angel investments instead of their behaviours. According to Lahti (2011), a categorization that divides business angels into sub segments based on their general investment behaviour may portray a too static and simplistic picture of the market. Avdeitchikova (2008) concludes that a business angel can act more actively in one deal than in one other. Therefore, business angels may not always act in accordance with the profile assigned to them in a categorization study. The behaviour of business angels can also change over time as their investment experience increases.
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problems between the two parties: adverse selection and moral hazard. Adverse selection occurs when the business angel is unable to determine the qualities of the entrepreneur before making the investment. Moral hazard occurs in two situations. Moral hazard can occur (1) when the interests of the business angel and entrepreneur conflict and (2) when it is difficult or expensive for business angels to verify what the entrepreneur is actually doing (Lahti, 2011). Due to the fact of lacking a track record and tangible assets new ventures are involved with high levels of uncertainty and asymmetric information. Reducing the agency problems in new ventures is the basis for the framework of Lahti (2011). As mentioned before, the dimensions on this framework are: the comprehensiveness of due diligence and the involvement in the business.
Due diligence. The due diligence phase is the prime opportunity to reduce uncertainty with regard to the quality of the investment opportunity. Much research about business angel’s due diligence indicates that the entrepreneur is more important than the idea or business model. Business angels are more concerned about risks related to entrepreneurs and management, whereas formal venture capitalist emphasize market risks in investment decisions. Due to the lack of information to make an extensive investment analysis, the characteristics of entrepreneurs and management dominate the investment decision of a business angel. This dimension refers to reducing agency problems of adverse selection in determining the qualities of the entrepreneur in the pre-investment phase .
Involvement in the business. Business angels can monitor the business by taking a seat on the board of directors and through frequent interactions with the entrepreneur. This provides the business angel with the opportunity to obtain timely feedback on the condition of the business. This involvement is not only a control mechanism, but the business angel can contribute with added value by making their human capital available for the business. In order to reduce the moral hazard problems the involvement of the business angel enables the reduction of potential relationship conflicts and contribute to the verifying of entrepreneur’s activities.
To be complete, the four clusters of business angel investments, based on the two dimensions (due diligence and involvement), are described in order to give a view of the framework (figure 6) of Lahti (2011).
High involvement Conventional angel investments
Professionally safeguarded investments
Low involvement Gambles Due diligence driven
investments
Low High
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Gambles. The investments refer to their speculative nature. The comprehensiveness of the due diligence is low and the involvement in the business is also low. This would imply that the business angel puts limited emphasis on managing the risk in the pre- and post investment phase. In this investment, the information asymmetries are not effectively reduced and this investment resembles a gamble. These investments might be made by business angels who are unfamiliar with the investment industry. These business angels are not able to fill the information gaps in the pre- and post investment phase due to the lack of industry competence.
Conventional angel investments. These type of investments are the most consistent with the business angel style of investing. The comprehensiveness of the due diligence is low and the involvement in the business is high. The low due diligence results from the information asymmetries in the pre investment phase. The low due diligence is compensated by the post investment control mechanisms and through active involvement in the business.
Due diligence-driven investments. The focus of this investment is on due diligence in the pre investment phase rather than active involvement in the business in post investment. Information asymmetries are reduced in the pre investment phase to ensure that business angels are not investing in investment opportunities lacking sufficient quality. This style of investing refers strongly to investments of formal venture capitalists with low involvement and high comprehensiveness of due diligence in the pre investment phase.
Professionally safeguarded investments. This type of investments has a strong focus on managing risks in both phases of the investment. A high comprehensive due diligence is complemented by an active involvement in the investee business. Much emphasis is placed on reducing risks relating to agency problems (adverse selection and moral hazard). The relevance of the agency theory is very strong in reducing information asymmetries in both the pre- and post investment phase.
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The study of Lahti (2011) in paragraph 4.3 elaborates on the dimensions of investment strategies of business angels in the pre- and post investment phase in order to reduce risks. The study is based on the perspective from the business angel in order to develop the best suitable investment strategy. On the other hand, the study of Politis (2008) contributes to the added value activities (active involvement) of business angels from the perspective of the entrepreneur. Politis (2008) elaborates on the complementary value added activities for the investee business. Politis (2008) links these added value activities of the business angel to theoretical perspectives that explain why these can have a contribution to the investee business. The study of Lahti (2011) and the study of Politis (2008) connect with each other in the development of involvement activities. Lahti (2011) states that business angels need involvement to reduce risk in the post investment phase and Politis (2008) completes this approach with the actual development of four types of involvements. The literature research of Politis (2008) results into a distinction of four complementary value adding activities which business angels can contribute to businesses in the post-investment phase.
The content of each activity and the theoretical background of this activity to the potential contribution of adding value will be explained and discussed in the following overview.
Sounding board/ strategic. The business angel provides strategic advice to the entrepreneur based on business angel’s extensive know-how and management expertise of running business. From the studies it is reported that this role of adding value is the most frequent one performed by business angels. Business angels are likely to be active in this role, such as helping to formulate business strategies, reflecting on ideas, enhancing the management resources in the firm and giving advice to realize the value creation in the business. Their involvement is related to the infusion of entrepreneurial drive and values in the organization which are based on the extensive experience of the business angel of working in relation to growing ventures. The provision of business know-how and management expertise can be linked to the resource based theory, where the business internal environment in terms of its resources and capabilities is critical for creating long-term sustainable competitive advantage. The bundle of resources of the business is critical to build up competitive advantage and achieve above average returns. In this role, the business angel is the key strategic resource of the business, because the business angel is neither perfectly imitable nor easily substitutable and for that reason of great value.
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survival and success of a firm is dependent on its abilities to link with its external environment. The business should initiate and maintain control over critical relationships, assets and contacts in the external environment to reduce resource dependencies. This added value of business angels fits nicely into the context of new ventures which often face difficulties in the development of setting up stable links to important key stakeholders in their surroundings.
Supervision and monitoring. Shielding the investments of the main resource providers of the business from potential managerial misbehaviour of the entrepreneur (the risk of mixing personal and business goals) is a basis for the supervision and monitoring role of the business angel. To perform supervision and monitoring activities in a venture capital funded business, business angels can add proper accounting information systems and can serve the board of directors of the business. These checks and accounting information enable business angels to oversee operating matters, protect the assets of the business and hold the entrepreneur accountable for their actions. The involvement of business angels in the supervision and monitoring role can be linked to the agency arguments. The separation of ownership from day-to-day decision making creates a principal agent relationship and may lead to agency problems between contractual parties. The basis of agency problems is that managers may have access to superior information regarding the resources and the performance of the business. Consequently, managers can take the advantage of this information asymmetry for their own purpose while reducing the return of the other investors. Business angels can avoid non-profit activities by other investors by monitoring the managerial and business performance. To reduce the potential agency costs, investors should be actively involved in supervision and monitoring activities in order to maximise shareholders value. Business can provide added value through their involvement in supervision and monitoring activities in order to minimize the potential asymmetric information and reduce the potential of agency costs.
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relationship. This trust between business angel and entrepreneur has the potential to reduce harmful conflicts and promote cohesion and long-term commitment.
Table 3 presents a view, as conclusion, of the framework about the four value adding activities in the post-investment phase of business angels and the underlying theoretical perspectives of these activities.
Table 3: Adding value activities of business angels and underlying theories Value adding role How do business angels Underlying theory
add value
Sounding board/ strategic Building and protecting the bundle Resource based theory of valuable resources in the firm.
Resource acquisition Creating and maintaining a stable Resource dependency flow of critical resources. theory
Supervision and monitoring Minimizing conflicts of interests Agency theory by means of formal control
mechanisms.
Mentoring Minimizing conflicts of interests Relational governance by means of informal control theory
mechanisms.
Source: Politis, 2008. 4.5 Matchmaking with entrepreneurs
This paragraph elaborates on the matchmaking process between the business angel and the entrepreneur. This matching process is complex, because both parties lack knowledge and information about each other.
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have difficulties in identifying promising investment proposals that meet their investment criteria. Within this market, we can speak of a matchmaking problem between business angels and entrepreneurs. This matchmaking problem is the reason why researchers changed the term ‘capital gap’ into the ‘capital and information gap’ (Harding, 2002). The term ‘capital gap’ deals with the difficulties entrepreneurs face in attracting capital from institutional venture capitalists and the ‘information gap’ deals with the existence of information asymmetries between the business angel (supply) and entrepreneur (demand). These information asymmetries generate market inefficiencies: high search costs, the inability for business angels to invest as frequently as they would or as much as they want and entrepreneurs are renouncing business angel funding because of the difficulties in finding a suitable business angel (Kotler et al., 2004).
To reduce these information asymmetries, policy makers have sponsored the birth and development of various types of matching organizations with the specific aim to reduce the information asymmetries between business angels and entrepreneurs (Aernoudt, 1999; San José et al. 2005). These matching organization, referred to business angel networks (BANs), have grown significantly in the past years in various countries in Europe. The role of BANs is to create a channel connecting between business angel and entrepreneur, which is able to reduce the search costs for both parties and ensure a sufficient flow of proposals for business angels (Sohl, 2007).
The statistics of the European business angel network (EBAN) (2010), report a decrease in both the number of deals per angel and the average size of the deals over the last few years. This indicates that the European BANs are ineffective in the development of the informal venture capital market. The study of Kelly & Hay (2000) contributes with an interesting insight into the members of BANs. They argue that, as compared to business angels outside BANs, business angels who become members of BANs are less experienced investors who can leverage less structured commercial and financial networks. This means that business angels in BANs are much more likely to be inexperienced and underdeveloped business angels, which might explain the relative performance of BANs in relation to the number and average size of deals.
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deal flow, but also to exploit the potential of the market and converting potential business angels into active business angels who contribute to market efficiency.
Policy makers have not only established BANs to reduce the market inefficiencies, but have also established support programmes to stimulate risk capital financing and thereby foster economic growth (Cumming, 2007). The market inefficiencies: high search costs, the inability for business angels to invest as frequently as they would or as much as they want and entrepreneurs are renouncing business angel funding because of the difficulties in finding a suitable business angel who are addressed by directly increasing the supply of risk capital or by increasing expected returns to investors through decreasing taxations, improving exit markets, or reducing barriers to entrepreneurship (Collewaert et al., 2010).
4.6 Conclusion
The characteristics of the business angel and its significance to the development of young businesses and economic growth is explained in this chapter. However, the business angel market suffers a matching problem and BANs are established to overcome this problem. These matching problems occur due to the fact that both parties, business angels and entrepreneurs, face problems with information asymmetries. These information asymmetries are the cause of the inefficiencies which occur in the business angel market.
The first part of this chapter elaborates on research question two and discuss the definition, characteristics and the involvements of business angels in the investee business. According to the definitional problems with the investors in the informal venture capital market and the interchangeably used definitions of informal investors and business angels the definition of a business angel is researched. A business angel must be defined as: ‘high net worth individual, acting alone or in a formal or informal syndicate, who invests his or her own money directly in an unquoted business in which there is no family connection and who, after making the investment, generally takes an active involvement in the business, for example as an advisor or member of the board of directors’. The personal characteristics of a business angel is important for the entrepreneur in order to identify the kind of person a business angel is. In the literature different kinds of characteristics of business angels are researched but in general the business angel can be characterized in this typical profile of its person: The typical business angel is ‘a male, in the age group of 45-65, well educated and a successful cashed-out entrepreneur’.
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involvement in the investee business in order to obtain timely feedback on the condition of the business and contribute with their human- and social capital.
The added value of business angels in the business can be contributed with personal human capital or social capital from the network and relationships of the business angel. Business angels can contribute with the involvement of four different types of adding value act ivities and these are in general based on the building, creating, protecting and maintaining of valuable resources (resource based theory) in the business and minimizing conflicts due to formal- and informal control mechanisms (agency and relational governance theory) (Politis, 2008).
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5. Matchmaking process : Information asymmetries
Analyzing the underlying sources of the inefficiency in the matchmaking process and the lack of knowledge and information will be researched in line with research question three:
Which information asymmetries are the cause of the matchmaking problems between business angels and entrepreneurs?
In order to research the efficiency of matching initiatives in the business angel market in the Netherlands, the information asymmetries which occur between business angels and entrepreneurs must be defined. These information asymmetries are the cause of inefficiencies in the market. These market inefficiencies are: high search costs, inability for business angels to invest as frequently as they would or as much as they want and entrepreneurs are renouncing business angel funding because of the difficulties in finding a suitable business angel.
Table 4: Information asymmetries between business angels and entrepreneurs in the matchmaking process
Business angel Entrepreneur
Table 4 reports the concepts of the four sets of information asymmetries between business angels and entrepreneurs. These information asymmetries are the relevant theoretical concepts which occur in the process of matchmaking. Overcoming or reducing these information asymmetries will lead to a higher efficiency of matchmaking. The information asymmetries will be the underlying components of the model which will be researched in the next part of this thesis (see paragraph 5.5 for the conceptual model). In the next part matching initiatives of organisations and institutes will be assessed based on the information asymmetries. The concepts of the four sets of information asymmetries are defined in the following paragraphs.
1. Quality of the investment opportunity
2. Interest of the entrepreneur
3. Type of control mechanism fits the investee business
4. Receiving sufficient investment opportunities
1. Quality of the business angel
2. Interest of the business angel
