Angel Investors Rethink Exit Strategies

Ellie Winninghoff, Private Wealth

“Angel investors don’t make money owning companies,” noted angel investor and former Willamette University professor Robert Wiltbank said. “They make money by selling companies.”

But what happens when nobody wants to buy?

That’s a problem that angel investors encounter more frequently than people realize, says Wiltbank, who has authored two widely consulted reports about angel investments.

Wiltbank made his comments while opening a day-long workshop in Seattle last month sponsored by Element 8 (formerly Northwest Energy Angels) about the challenges of investing in a world with few exits. Even though many companies financed by angel investors thrive, only a few go public or are sold, leaving their initial investors with an illiquid portfolio and an inability to continue investing, speakers at the conference said.

Angel returns historically have been comparable to those of professional venture capitalists—an average 2.6 times capital return, or gross IRRs of 25 percent, according to Wiltbank, whose database includes 1,600 to 1,700 exits by angel investors. It usually doesn’t take angels long to discover they invested in a lemon, he added. Although the average holding is four years, the bad news comes within three years, while wins take an average of six years to play out.

But there are diminishing returns to invested capital. Of 3,000 acquisitions looked at between l996 and 2006, only 15 percent of the companies were bought for over $50 million, he said.

“There is a complete lack of relationship between the amount of money raised and the return,” Wiltbank said. “The assumption is that if you add more water, you will get a bigger plant. But if your only good outcome is based on [the company selling for] $100 million, you should be nervous. Academic research has shown that nobody can sustain being a kingmaker, and I would not engage in that strategy at volume.”

That said, Wiltbank’s data also indicates that fast growth achieved through high burn rates results in higher returns on investments than slow growth achieved through bootstrapping.

“The jet fuel hypothesis appears credible,” he said. “But while the aggregate return on investment for burners is 53.8 percent compared to 16.3 percent for bootstrappers, the return on an annual basis is the same.”

Selling At Peak Value
Basil Peters, who wrote the first book about exits for angels and entrepreneurs, said that even a thriving and valuable start-up has a 75 percent chance of not achieving an exit, and the most likely result is that the company will ultimately fail. The problem: a general lack of strategy and planning around exits, in which timing is critical.

“The ideal time to exit is at the peak of growth, often about three years into the investment,” he said, noting that it should therefore be planned 12 to 18 months earlier. “Companies often start the exit after the peak growth and end up with IRRs of 15 percent versus 124 percent. Or more commonly, zero percent. If a company misses the ideal time to exit, there is a significant probability that it won’t just exit for less, it will never exit at all.”

One potential reason for this is intellectual property infringement, where rules in the U.S. and global attitudes and practices have turned the game upside-down, creating serious risk for small companies. To begin with, the first-to-file rather than the first-to-invent wins the patent in the U.S. now.

“If you have a good patent, sell [the company] as soon as possible after the patent is granted, or whenever you have disclosed the technology, whichever is sooner,” Peters said, pointing out that when a patent is granted, the risk skyrockets because it has been posted on the internet. “Even if a company has not filed a patent, but it has released a model, the risk skyrockets because technology can be reverse-engineered.

“If the technology is not reverse-engineerable,” he added, “some people believe you should not file a patent.”

Another challenge is that many big companies, especially those in Asia, take the attitude that they will use the intellectual property and let the lawyers figure it out later. He saw this firsthand with one of his own angel investments, when he went to Best Buy two weeks after an exit—and saw the company’s technology sitting on the shelf.

“The company had shown the technology to a big Asian display manufacturer, trying to negotiate a licensing deal under a strong non-disclosure agreement,” he said. “As near as we can determine, the big company must have put the design into their production process right after the meeting.

“I have no doubt that if this had happened a few weeks earlier, [the company] would not have had an exit,” he added.

Distributions Add Value

David Bangs of Seattle, an angel impact investor who believes that angels generally overlook companies that are being built for long-term value, has a different approach to the exit problem: getting money back along the way.

For example, his investment in Farmpower LLC recycles local farm and food waste into renewable energy using an anaerobic manure digester. When the company makes a profit, its first distributions go to cash investors, making them whole in three to five years.

“This will not be a Google,” Bangs said, pointing out that ongoing distributions give units an inherent value that enable a personal exit strategy, and that he sold units to another investor last year for a fivefold return.

“So with no exit, I got an exit,” he said.

Bangs said that while he does not like to do royalty loans, he uses them to invest in nonprofits. For example, his investment in Viva Farms, a business incubator for farmers in Mount Vernon, Wash., consists of earning 1.9 percent of revenues for nine years.

“It’s sort of a way to make an equity investment without equity,” he said.

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