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Angel Investors Get Pickier

Because angels have become more selective at every stage of the investing process, entrepreneurs are working harder to obtain financing, says Scott Shane

The financial crisis and recession have made raising capital more difficult. This is true for the millions of owners of small businesses that rely on debt from banks, credit-card companies, and trade creditors, but it is also true for the founders of high potential businesses—those hoping to reach tens of millions of dollars in sales in five to 10 years—that are trying to raise money from business angels. Although estimates based on Federal Reserve data indicate than less than 3% of young companies raise equity from external investors, the explosive growth of some of these businesses makes them an important group seeking capital. For these companies, the increased difficulty in raising money can be seen in evaluation process, known as the deal funnel, at angel groups. When seeking money from the 300 or so angel groups operating in the U.S., entrepreneurs typically first submit their business plans. The angels reject most of these but have some evaluated by a screening committee. Businesses are then further winnowed down, with only some entrepreneurs asked to present to the group. Only a proportion of those who present move on to due diligence. And only some of those on which due diligence is conducted receive an investment. While angels have always winnowed down investments in this deal funnel, the share of companies that make it through the different stages has changed over the past three years. What the Data Show

The figure to the right plots the proportion of the roughly 17,000 new submissions made to angel groups from 2007 through 2009 that made it through each of the stages in each of the past three years, using data from Angelsoft, a provider of investment tracking software for about half of U.S. angel groups. The figures show important changes in the deal funnel from 2007 to 2008 and from 2008 to 2009. From 2007 to 2008, the major shift was a drop in the share of companies that received an investment. The share of companies that made it through the screening, presenting, and due diligence stages was pretty much the same as the prior year. In 2009 angel groups appeared to adjust to this lower rate of investment by adjusting down the share of companies making it through the screening, presenting, and due diligence phases. As a result, angel groups in 2009 were more selective at every stage of the investment process than they were in 2007. The rule of thumb appears to be that the groups were positive at each stage at about half the rate in 2007. What Innovations Are We Losing?

We don't know what has happened to the entrepreneurs who sought funds from angel groups in 2009 who would have received an investment if the groups were still making investments at the 2007 rate. Some of them might have obtained other types of capital or redesigned their businesses to expand without external financing. But I suspect that others ceased to pursue their opportunities. Does this mean we will be losing out on such companies as PortalPlayer (NVDA) and DigitalThink (CVG), which were funded by angel groups and subsequently went public? We can't know. The greater selectivity of angels might mean they are concentrating their energies on the companies with the greatest potential, or it might mean they are failing to finance great businesses. We'll also never know whether those businesses that didn't get an investment from an angel group last year would have been successful if only they had received financing. The company that didn't get financing in 2009 but would have in 2007 might have ended up just fine, or it might have failed to get its products developed, its marketing plans implemented, or its key hires made for lack of capital. Even though we can't know for certain what all the effects of angel groups' greater selectivity are, we do know it's more difficult to get capital from members of these groups today than in 2007. And that's making entrepreneurs who have founded high-potential companies work a lot harder to obtain financing than just a couple of years ago.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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