No one got the word out about the product, and without customer education, sales came to a grinding halt, recounts Adams. If institutional money had been backing his company at the time, he posits, he would have been out of a job. He believes that angel investors put a lot more trust in management than VC firm managers would have allowed. "VCs are much less forgiving of strategic errors," but it's those kind of errors that help entrepreneurs grow and succeed, says Adams, whose company has been operating for five years.
Devil's in the Details
Still, companies backed by angels don't always have a heavenly experience. Shunning institutional funding often leaves new companies with a dearth of start-up cash, as angel investors don't often have the wherewithal to supply extra padding, such as working capital, on top of their initial investment. That often leaves a nascent business with insufficient reserves to survive market slumps. "You have to be a bit more conservative in your risks," says Yves Schabes, co-founder and president of Teragram Corp., a search software company based in Cambridge, Massachusetts. In hindsight, Schabes says he could have reinvested more of his revenues into his business in the first three years, but at the time, the lack of a financial cushion from his investors held him back.
Small-business owners also need to keep an eye peeled for potential legal snares related to angel investors, says OkCupid's Yagan, who also founded study-aid company SparkNotes. "Don't go cheap on lawyers. A cheap lawyer costs more than an expensive lawyer," warns Yagan, who learned that lesson the hard way when he sold his first company.
A clause in the agreement between SparkNotes and its angel backers gave the investors the option to sink more money into the company at any point, thereby increasing their stake in the company. Yagan, a 22-year-old college student at the time, wasn't sure the company would need to raise more capital beyond the initial investment, so he reached a verbal agreement with his investors that the option to increase their stake would be exercised only if SparkNotes required additional funding.
But the following year, the day before the company was sold to Barnes & Noble, the angels exercised their right to up their stake, increasing their investment by 10 percent. Yagan, his partners, and employees who already held a stake in the company lost 10 percent of what they would have made on the sale.
Speed may be another problem for companies backed by angel investors, mainly because organic growth takes longer than acquired growth. For example, a VC firm often decides to purchase companies, products, brands, or technologies that complement existing portfolio companies, thereby helping the existing business expand.
Adams says he understands the limitations of angel investment, and already has plans to move beyond this type of capital raising. He concedes that having autonomy over his business was good in the beginning, but when it's time to sell the company, "my investor is going to be zero help. My time to pay the fiddler is coming." When that happens, Adams says, he will hire an adviser to help with valuation and other tasks to prepare the business for sale.
Once company owners are ready to take the next step and accept VC funding, they will find that choosing the right angel investor at the start was important. Companies should be looking for angel investors who have been through the VC process as a CEO or who have ties to a VC firm, says the NVCA's Taylor. In that way, the VC firm knows the company has been through "a very good farm system," he notes.
Attracting VC money, when the time is right, will also depend on how angel financing was structured. Business owners should avoid terms that grant ownership percentages or liquidation preferences to investors that could repel VCs, says Taylor. (A liquidation preference gives investors the right, if the company is sold, to collect a set return on their investment before anyone else receives a payout.) "If the terms are too favorable to the early investor, it will poison the company," says Taylor. "We see that all the time, especially with inexperienced angels."
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