Angels In the Meltdown

Wednesday, Aug. 5, 2009 | Their wings are a bit bruised and battered, but angel investors are still around to help fund start-up companies. In fact, with the economy still wobbling from the blows it suffered last year, angels are more important than ever in the worlds of early tech and biotech financing.

Venture capital, which emerged in recent decades as the dominant model for funding innovation, was knocked on its heels by the market meltdown. And though experts do not know how the model will ultimately be changed, they do know that now, and for the foreseeable future, venture firms are by and large focusing on much safer bets than they have in the past.

This means angels, wealthy individuals who traditionally have invested in start-ups only at their earliest stages, are being asked to help fill a growing gap between a company’s beginnings and the time when it can survive on its own. And angels are obliging — partly because it is the only way they have to protect their investments.

“The amount of money from VCs going into new investments is way, way, way down. And angel money is only way down,” said Mike Elconin, the president of the San Diego chapter of Tech Coast Angels, a network of angel investors in Southern California.

The new funding landscape has made angels both nervous and excited. They almost all have seen their net worth decline over the past year, a reality that has curbed their appetite for risk. But rarely have they experienced a time when there were so many potentially great deals to be had.

This new paradigm is changing not only how angels invest, but their involvement in companies they are investing in. They are more likely these days than in the past to pool their money and form syndicates so they can grow a company without an individual shouldering too much risk. And increasingly their investment is accompanied by a more hands-on approach with the company.

“Many of these would have been smaller investments for the VCs,” said Jack Florio, an angel investor and marketing director for the local angel group. “But the VCs are not investing in things in early stages like they used to.”

Angel investors have been around as long as there have been entrepreneurs. They are typically the third stop the founders of a start-up make after they have hit up their family and friends and maxed out their credit cards and mortgages. After friends and family, angels put up as much as 90 percent of start-up capital, said Marianne Hudson, executive director of the Kansas-based Angel Capital Education Foundation.

Angels played a big role in the establishment of San Diego’s tech and biotech industries, which have a multi-billion dollar annual impact on the local economy. Some of the more notable angel-funded companies in recent years include Althea Technologies, a contract drug development company, and Green Dot, a provider of prepaid debit cards.

An angel will invest anywhere between $25,000 and $2 million in a company to help get it off the ground. But few angels can afford to carry a company to the next level of development, which usually requires between $5 and $10 million. Typically, that is when a venture capital firm comes in.

But the last year or so has been anything but typical. The market meltdown not only did great damage to the portfolios of venture capital firms, but looks to have forced the industry to undergo some lasting changes. “There is no question that the VC model is under a lot of stress and (it is) unclear how long it will last or if this represents a permanent shift,” Elconin said.

The concern is based on the fact that the largest investors in venture capital firms are institutional investors like pension funds or insurance companies. Such an institutional investor might invest 5 to 10 percent of a diversified portfolio in venture capital. So when the market crashed not only did the value of the portfolios drop, but the institutional investors rebalanced their portfolios, which took even more money away from venture capital.

In 2008, venture capital investment in San Diego companies totaled $1.1 billion, 40 percent less than the total investment in 2007, according to Dow Jones VentureSource. And in the first half of this year 40 companies in San Diego have received about $400 million in venture capital funding. And the majority of this funding went to more established companies rather than true start-ups.

Keeping similar statistics for the angel investment is next to impossible because the community is a disparate group of individuals and the companies they invest in are all private. However, Elconin and others say that while angels are definitely more cautious and making fewer new investments, they have been more active than venture capitalists — especially in recent months as the stock market has rebounded.

And angels are finding themselves doing more of what are known as follow-on investments with companies that in normal times venture capitalists would do.

“Venture isn’t available so [companies] are going back to their original investors,” said Vern Yates, a long-time angel who helped found the San Diego angel group.

And, he said, the angels are agreeing in order to protect their original investment.

But in many cases, the follow-on investment from an angel is significantly less than the amount the company was planning on getting from a venture capitalist. As a result, Florio said, the angel often ends up having to in effect help company founders re-write their business plans to accommodate smaller investments.

“We have companies that need mentoring as much as they do the money,” Florio said.

But the money is still important. This is why angels, who have historically invested on their own, have been banding together into syndicates so they can provide more financing while minimizing their risk. “Individual angels are realizing that it is a way to see more and better deals,” Hudson said.

There is, however, concern that even if angels are able to raise more money through syndicates that it won’t be enough to make up for the lost venture money that may not come back, and certainly not enough to spur noticeable growth in the local tech and biotech industries, which are crucial job generators in the regional economy.

Joe Panetta, president and CEO of Biocom, the local biotech industry association, said the so-called “valley of death,” the years between when a biotech discovers a drug and when it brings it to market, continues to get longer and more expensive. The average cost of this process is now over $1 billion.

“In San Diego we have always had a scarcity of angel investors,” Panetta said. “We have a lot of innovation here, and we need more high-net worth investment.”

Please contact David Washburn directly at david.washburn@voiceofsandiego.org with your thoughts, ideas, personal stories or tips. Or set the tone of the debate with a letter to the editor.