Wednesday, August 23, 2006

We Need More Angels in Pittsburgh

Future economic growth in the Pittsburgh Region depends on increasing the rate of creation of startup firms that commercialize technologies coming out of the region’s universities, medical center, and corporate R&D centers.

An essential step in the growth of a startup technology firm is finding seed-stage capital – investments that enable the company to refine its business plan, create and test its product, build its management team, and prepare for sales to initial customers. These investments can range from $100,000 to $2,000,000 per company, depending on the type of business.

Although in the 1990s, a number of venture capital funds across the country made seed and early-stage investments in startup companies, very few do today. As venture funds have grown larger, it has become impractical for them to make many small investments, and so they seek larger investments in fewer companies. As a result, however, a company that ultimately needs venture capital may never reach the point where it can qualify unless it can find seed-stage funding from another source.

Innovation Works has estimated that out of the estimated 150-200 new technology companies formed in the Pittsburgh Region each year, about 12-18 will ultimately have an enterprise value of $20 million or more, and about 6 will reach a size of $50-$100 million or more. Of these, almost all will need significant seed-stage funding, and the smaller firms may never need larger venture capital investment. Consequently, without an adequate supply of seed-stage investment, the majority of potentially successful firms may die for lack of capital.

If the region is successful in increasing the rate of formation of new companies, the need for seed-stage funding will also grow dramatically.

Local economic development agencies have attempted to fill the seed-stage capital gap, particularly Innovation Works, which has invested $28 million in 82 technology startup firms over the past 7 years. But the public funding for seed capital is limited, and the more an organization like Innovation Works invests in any one company, the fewer companies it can help, particularly at even earlier (pre-seed) stages.

The Role of Angel Investors

What’s the answer to the seed-stage capital gap? Angel investors – high net-worth individuals making investments of $25,000 to $250,000 in startup companies.

Some angel investors have the money, time, and expertise to make well-informed seed-stage investments on their own, but most do not. That’s why many angels choose to join an angel network – an organized group of angels, perhaps with a professional staff, that helps perform due diligence on startup firms and carries out the necessary legal and financial steps to close and monitor investments. Members of an angel network don’t invest in every company that the network invests in – they can pick and choosewhich subset of deals they will invest in. Having an angel network is also good for entrepreneurs, because it makes it much easier for them to find angels, rather than trying to locate them one by one through networking.

There is also a growing trend toward creating angel funds – these funds enable individuals who don’t have the time or interest to actively participate in an angel network to make an upfront investment, which is pooled with the investments of other high-net worth individuals and invested in a diversified portfolio of early-stage companies. These pooled funds can either be managed by a professional fund manager, or can be structured as a “sidecar” fund that invests along with an active angel network. Eitherway, these funds expand the amount of seed-stage capital available to promising companies, thereby creating the equivalent of a larger network of angels.

Angel investors have been a critical part of the Pittsburgh Region’s economic development for over a century. Alcoa, for example, is here in Pittsburgh because 118 years ago, Pittsburgh had angel investors willing to invest in an entrepreneur with a new technology, and Ohio didn't. When Charles Martin Hall invented an inexpensive method of smelting aluminum, he came to Pittsburgh from his home in Oberlin, Ohio because he was unable to find investors in his home state. Alfred E. Hunt and a small group ofinvestors provided the $20,000 in seed capital that gave Alcoa its start.

The Need for More Angel Investors in the Pittsburgh Region

The Pittsburgh Region is fortunate to have one professionally-managed angel network – Blue Tree Allied Angels. Blue Tree has 43 current angel members, and has invested $3.8 million in 10 companies to date.

However, the most successful angel networks around the country have at least 80-100 members, and several regions of the country have two or more angel networks. Moreover, there is no active angel fund in Pittsburgh. Although Innovation Works is currently working to develop one, its success willdepend on the ability to recruit individuals to invest in the fund.

The relatively small number of active angels and the lack of an angel fund in the Pittsburgh Region creates several problems:
  • Fewer angels means that each angel has to make larger investments in each company in order to meet its capital needs. That increases the angels’ level of risk, reduces their ability to fund more companies, and reduces their ability to invest in companies needing large amounts of seed capital.
  • Because it typically takes 5-10 years to receive a return on an angel investment, once angels become fully invested, the network’s ability to invest in new companies decreases, unless new angels join.
  • The ability to evaluate deals depends heavily on having angels or fund managers with expertise in the technologies and industries being pursued by startups. Fewer angels means some companies may be rejected simply due to lack of understanding or comfort with the technology and its potential market.

Currently, there are many signs of an acceleration in technology-based entrepreneurship in the Pittsburgh Region. Fourteen new companies were started in the past year using technologies developed at Carnegie Mellon, the largest number ever. The University of Pittsburgh ranked sixth in the nation in the number of start-up companies created in 2004. However, without a sufficient pool of angel investment for these startup companies, they may fail or move to other regions.

Once angel investing reaches “critical mass,” it can become self-sustaining, since the founders of angel-funded companies can themselves become angel investors. But the Pittsburgh Region needs to “prime the pump” to create enough successful startups to reach that point.

How Much Money Does an Angel Need, and How Much Can They Make?

Although someone could become an angel investor in a individual company with as little as $25,000, they will need to be able to make multiple investments in order to find the one or two successful companies that will offset losses from the unsuccessful ones. A typical angel investor might expect to invest $150,000 to $250,000 over a period of several years. (The individual will also need to have sufficient net worth to meet SEC requirements as an accredited investor, and the amount they commit to angel investingshould represent 5% or less of their investable assets in order to insure good portfolio diversification.)

How much can they make? Data from the National Venture Capital Association show that seed- and early-stage investments can have the best return potential of any private equity investment. The most recent report says early/seed capital funds had a 41.4% 10 year internal rate of return, compared to 10.7% for later stage venture capital, 8.9% for buyouts, and 7.2% for the S&P 500.

If you have an interest in the region's future and enough assets to invest, consider becoming an angel investor. If you know someone like this, encourage them to become an angel investor. You can learn more and get a downloadable summary of the needs for and benefits of angel investing here, and you can contact Blue Tree Allied Angels or Innovation Works for more information on becoming an angel investor.


Anonymous Anand said...


Given this post on angel investment, we thought this analysis of Pennsylvania's startup and investor community would be of interest to you.

A Deeper Dive into Pennsylvania's Startup, Venture Capital and Angel Investment Community

We also linked to your blog at the conclusion of the post as a resource that those interested in PA startups could visit/use as a resource.

If any thoughts, comments, etc, don't hesitate to be in touch. Have a great day.

co-founder, ChubbyBrain

3:27 PM  

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