Not My Cup of Tea - Some Business Types Are A Better Fit for Angels

Adapted from an article originally published by the author in Inc. Magazine.

Angel Investing Business Models
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Why do web and software businesses seem to get investment traction while real, down-to-earth business and manufacturing-intensive companies flounder to raise capital? It has to do with the type of investor model involved. The investor model has to match the type of company.

Fact: There are different investor models, and they are attracted to different kinds of businesses

Angel investors look at business investments differently than other types of investors. For example, unlike VCs looking for outsized opportunities to put big pools of money to work, angels have more limited funds to draw on. They have to have a plan for where a company they invest in will get future capital. It might come from VCs who can be attracted down the road, or strategic partners, or other angels and early-stage investors. To an angel, not knowing where future capital will come from is a form of assumed risk (often referred to as financing risk). This sits right next to technology risk, market risk, regulatory risk and all the other risks inherent in an early-stage business investment.

Aside from identifying sources of future capital, the only other way to manage financing risk is to consider the very basic question of how much cash a business will need to stay alive (because growth doesn't produce cash, it consumes cash). Future financing risk is reduced by the less cash a business needs (or put another way, the more the business's natural contribution margin can support its own survival).

For angels, capital-efficiency matters, and margins affect capital efficiency

As a result, angels seek companies which can do something meaningful with their money--achieve milestones that will significantly de-risk the business. This mindset translates directly into investment preferences. It's a pretty straight-forward equation--higher margin businesses have the edge in terms of appeal.

Since every company makes lots of mistakes in the early days, it always takes more time than expected to achieve forecasts. Angels know that the fundamental nature of the business impacts how much cash will be consumed as it iterates. For example, for a web-based business that doesn't get the product just right, it might only take two pizzas, a six pack of beer, and a weekend to modify it. In contrast, if the business requires a factory build-out and a supply chain to crank out enough widgets to fill a distribution channel before an error can be discovered, a significant amount of funds will have burned in the process.

As a result of these unavoidable realities, angels are more careful about investing in businesses that require significant capital to test even a basic hypothesis. All things being equal, due to their more limited capital bases, angels tend to be drawn to businesses that require slightly less capital. And within that category, angels are especially drawn toward businesses that offer the potential for rapid and non-proportional margin expansion as the company grows and scales. If you manufacture a widget, the second one costs about as much to make as the first. However, if you design a software product, although the first copy of the product is hugely expensive, the second copy is essentially free. Software business offers the potential for massive margin expansion with scale.

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Software is hard to beat in terms of margins

Consider a business at the opposite end of the spectrum from software: a professional services business. Costs in people-based service businesses grow linearly with revenue because, to grow, more billable staff is needed. Costs in manufacturing companies fall in the middle of the spectrum. Because of their complex supply and manufacturing chain requirements, they have to carry inventory (or at least work in process). This has carrying costs, delays due to manufacturing and shipping, and risks due to potential obsolescence in the event of a necessary pivot. These companies also require up-front cash (or a source of credit) to pay for that manufacturing, shipping, warehousing and maybe distribution, further eroding margins.

Angels don't want to get thrown out at second base. If a business burns more money than angels can provide or source elsewhere, especially if the shortage comes before something of real value is created, it is game over. The result is either a total write-off, or a cram-down distress financing where later investors badly dilute early investors (and crush the founders so badly that they might not have enough skin left in the game to bother sticking with it).

At the end of the day, it's about leaving room for error

If you want to think about it in the simplest terms, consider it this way: businesses with expansionary margins provide more room for error. Industries with simple supply chains offer this. Distribution over the web is virtually free compared to going through tiers of distribution. Changing software products is faster and easier. Factors like these drive the powerful capital efficiency angels crave. From an angel investment standpoint, a no-asset web services company (i) consumes less capital which (ii) gives it more room for error which (iii) has a higher alpha: if it does work, it works big, its margins expand explosively and it generates a big return on the modest capital invested. And that's why software businesses vs. businesses that are manufacturing-intensive often have an easier time raising angel investment money.

About the Author

Seraf Co-Founder Christopher Mirabile is the Chair of the Angel Capital Association and also Co-Managing Director of Launchpad Venture Group. He has personally invested in over 50 start-up companies and is a limited partner in four specialized angel funds. Christopher is a frequent panelist and speaker on entrepreneurship and angel-related topics and serves as an adjunct lecturer in Entrepreneurship in the MBA program at Babson. 

Due to his combination of roles as investor, advisor and angel group leader, Christopher was named among Xconomy's "Top Angel Investors in New England."