2. The Informal Capital Market
The informal capital market covers a wide range of investors, from founders, families and friends through to business angels. It is generally distinguished from the formal capital market by the fact that the investment is done by individuals directly rather than via a specific entity (normally a company, such as a venture capital fund).
This report focuses specifically on angel investors - people who invest directly, either as an individual or as part of a group, in a privately owned businesses where there is no close family or other connection between themselves (the investor) and the business owner.
What are the typical characteristics of an angel capital market?
- Angel capital is a subset of the private equity market.
- It is generally accepted that this market lies somewhere between the capital provided by founders/families/friends and venture capital.
- It comprises high net worth and high income individuals with a high tolerance for risk, investing alone or in informal groups or syndicates.
- It is a key source of seed and start-up capital to entrepreneurs with a specific and commercially promising idea.
- It is less structured than the venture capital market, but angels are probably more objective than the friends and family capital providers.
- It provides relatively small amounts of capital to new businesses and is frequently supplemented with human capital (the latter may be business, technical, or marketing advice that will be provided in exchange for equity). It is colloquially known as smart money.
The angel capital market can be defined by the stage of a company's development at which the capital is applied. The following diagram is consistent with international studies of the informal capital market, with some modification to reflect what we understand to be the situation in New Zealand (see question 7, page 52 in Appendix I for details of the various segments/stages of capital market).
Figure 1: Private Capital Market
There is considerable overlap between the main sources of informal capital. "Founders and families" are the first source of funding for new ideas or ventures and often that funding will come via mortgage finance. "Friends" potentially cover a wide range of people from close family friends to acquaintances who may already be investing in start-up businesses and therefore could more strictly be described as angel investors. Angel investors tend not to have any previous relationship with the entrepreneur and therefore take a more objective approach to determining whether or not to invest. Angel investors range from those taking a passive approach (backing others' judgements), through to hands-on investors providing advice or direct management input to help the business become established. In many cases the latter group of angel investors will take as rigorous an approach to their investing as some venture capitalists. A key difference between angel and venture investors is that angels tend to invest as individuals (often as part of a group) operating part-time, whereas venture capital generally comes via a company or fund with full-time managers and a board, using formal analysis and investment procedures.
There is some blurring in New Zealand between angel and venture investors, which may reflect the relative immaturity of the angel and venture capital market in New Zealand - the market is still segmenting and specialising. Even at maturity, though, there will be a reasonably close link between angel and venture investors as firms look for larger funding rounds and more sophisticated management and marketing input.
Size of the Market
Any attempt to define the size and scope of one part of the informal capital market (angel capital, for example) is fraught with difficulty. Firstly, because it is hard to determine precisely where this particular part of the market begins and ends, and secondly, it is a fragmented and un-reported part of the capital market.
The Ministry of Economic Development has commissioned Statistics New Zealand to conduct a "Business Finance Survey" in August 2004. The results of that survey are likely to provide a more robust estimate of the stock of angel capital invested in New Zealand.
It is important for this study that we establish some measure of the relative size of the angel capital market in terms of money invested, number of active investors and recipients, and geographic and industry spread. Determining the size of the market is important for the government and industry to get a good understanding of how important the various components of the early-stage capital market are and how it compares to similar markets in other countries. Our approach is to identify broad boundaries that we can be confident capture angel investment activity and then try to tighten those boundaries.
In simple terms the household sector owns the business sector either directly via equity in businesses, or indirectly through loans to businesses from household deposits at banks. In practice this simple picture is complicated by foreign investment both in and out of New Zealand. But it is unlikely that many foreign investors could be regarded as genuine angel investors in New Zealand given the difficulty of contributing in any practical way to a business from a distance.
According to Wespac's Household Savings Indicators1 report, total household assets stood at around $350bn as at the end of 2003. The majority of these assets were tied up in real estate ($234bn) with the rest ($117bn) in financial assets - deposits at banks, investment in the stock markets and "other". The "other" category accounts for around $25bn and probably represents a broad measure of the stock of informal capital - it includes owners' equity in private businesses.2
If we assume the "other" category is a reasonable measure of the maximum potential size of the informal capital market then we are left with the challenge of dividing the amount up between venture capital, investment by founders, family and friends, angel capital, and other.
In their 2003 venture capital monitor Ernst & Young3 estimated that the stock of venture capital/ formal private equity in New Zealand was $1.12bn, with $568m available for investment (around $550m invested). These numbers suggest that later stage private equity (including venture capital) accounts for a very small proportion of total "other" household assets.
Studies in the US4 and Scandinavia5 suggest that the angel capital market is probably about ten times the size of the venture capital market. That would imply around $10bn of angel capital in New Zealand. But that still leaves over half of "other" household assets attributable to founders (owner equity), families and friends. The latter group also owns a considerable share of all the retained earnings (and shareholder current accounts) in New Zealand's unlisted companies - retained earnings are regarded as one of the biggest sources of equity for small businesses.6
Mason and Harrison (2000) estimate that informal venture (angel) capital investment in the UK is broadly equivalent to the amount of institutional venture capital provided to start-up and early stage ventures.7 If the same held true for New Zealand then the informal capital market would be less than $500m (by no means all of the $550m venture capital invested is start-up or early stage). Mason and Harrison also point out that the smaller average size of investments in the informal venture capital market is reflected in the fact that eight times as many businesses raise finance from business angels than from institutional venture capital funds. As we show below New Zealand angel investors tend to do considerably more deals per annum than venture capital firms suggesting that many more businesses (probably more than 8 to 1) turn to angels than venture capitalists for equity finance.
Turning now to the flow of informal capital; the MED survey records 880 current investments by the 347 angel investor respondents. Furthermore, the survey also asked (question 4) how many businesses did the respondent invest in over the past 12 months. Although the total of 255 investments will include some double counting (different angel investors will have invested in the same deal), it can be compared to 51 venture capital deals over 2003 in New Zealand and 39 the year before.8 The sums of capital involved per deal are likely to differ significantly. Our data indicates that the amount of angel capital invested by those investors responding to our survey was around $26m last year ($100,000 average deal size multiplied by 255 deals) compared to $88m of venture capital.
Informal capital investment (friends, angels and venture capitalists) appears to represent a relatively small proportion of "other" household financial assets. Below we examine in more detail the likely size of the angel capital market.
Amount Invested
Responses to the MED survey of angel investors to two questions (12 and 13) about the amount of uncommitted funds available for investing and the amount actually invested produce figures of $87m uncommitted and $90m currently invested. There were roughly 300 respondents to each of the questions suggesting that on average each angel investor has $300,000 invested in businesses.
Question 6 provides some idea of the number of investments those surveyed currently have in total (we have assumed that those who indicated they had more than five current investments have on average 7). That gives a total number of investments of 880 by those surveyed, implying that the average size of angel investments per deal in New Zealand is around $100,000. From our environmental scan that figure seems plausible. It also implies that those surveyed, with at least one investment, have on average 3 current investments.
Norwegian data9indicate that the average amount invested per deal is US$76,000. The same investors have on average 3.7 current investments, somewhat higher than our estimate for New Zealand. In other words, New Zealand angels invest proportionately more per deal in a smaller number of deals. Moreover, given that Norwegian per capita income is around 2.4 times higher than it is in New Zealand the total amount invested per investor, and average deal size, is significantly higher in New Zealand than Norway relative to average incomes in each country.
Inland Revenue Department data show that 11,160 people earned more than $200,000pa in 2002 and therefore can be approached by firms seeking equity capital informally (one criteria in the Securities Amendment Act allowing firms to avoid meeting normal reporting requirements when seeking capital is if they approach people earning $200,000 or more over two consecutive years). Not all of these people will be actual angel investors, but let us assume (simply a guess) that 65% are. That would imply around 7,300 investors - roughly three times the total number of names originally provided for the angel investor survey.
Multiplying the implied number of investors by the estimated average amount invested per angel from the survey data ($300,000) produces a figure of around $2bn of angel capital invested.
The GEM10 (2000) study estimated that 4.3% of New Zealand's adult population (2.97m people aged 15+) provide informal capital to firms other than their own (it includes investments by family and friends as well angels, as defined for the purposes of this study). Furthermore, the GEM (2004) study indicates that the average amount invested per person $23,000 per person. That implies a total amount invested of around $3bn.
But because the figure includes investments by friends and family (likely to be a significant portion of the total amount of informal capital invested), and could also include investments made via venture capital firms, it implies the size of the genuine angel capital market is probably less than $2bn.
Another statistic from the 2004 GEM study is that informal venture capital investment is equivalent to 3.5% of GDP implying a total of around $4.7bn. This figure excludes "classic" venture capital, but still includes investment by friends and family, so again is an overestimate of the angel capital market. The data suggest that the informal capital market in New Zealand is more than 10 times the formal venture capital market, whereas in Australia (presumably using the same methodology) the informal capital market is only 23% bigger than the formal venture capital market.
The general sense from the above analysis is that the angel capital market (in terms of what is currently invested) is probably around $1bn. In other words it is around twice the size of the venture capital market (invested), but probably significantly smaller than the followers, friends and family capital market.
Number of Investors and Level of Activity
The number of angel investors seems to lie somewhere between 1,000 and 20,000. The lower figure is based on the size of the survey sample and the proportion of those meeting the definition of being an angel investor. The upper limit of 20,000 is based on the assumption that 15% of GEM's estimated 128,000 (4.3% of the adult population) informal investors are genuine angel investors (the total includes friends and family investors as well as venture capital investors).
Data from Statistics New Zealand indicate that 3% of couples have combined income of more than $200,000 - that translates into around 20,000 households, and possibly individuals, that might meet the income criteria (see Appendix II) to be approached by firms seeking informal capital, and thus be regarded as potential angel investors.
We are inclined to favour a figure nearer the upper, rather than the lower end of the range, on the basis that there will be a significant number of people earning more than $100,000 (58,680 at the 2001 census) who have angel-type investments without considering themselves angel investors.
If the definition of an angel investor is confined to those who actively contribute to the development of the business they invest in then the angel investor population could as low as 2,000 and some experienced market participants put it at less than 1,000 individuals. From the environmental scan we would put the number of genuinely active or full-time (active-astute, see below) angel investors in New Zealand at less than 100.
An interesting point picked up in the 2004 GEM study is that a high proportion (58%) of New Zealand's informal investors is female. That contradicts evidence from overseas and the MED survey, which found that around 5% of respondents, who could be defined as angel investors for the purposes of this study, were female. Our view is that the GEM results are not an accurate reflection of the gender mix of angel investors in New Zealand.
Figure 2: Number of Investments Last Year
We calculated above that over the last 12 months those angel investors surveyed by MED had made 255 investments (Question 4, assuming those that made 5 or more had, on average, made 7). Most had made none or only one investment over the past year (see Figure 2). However, there was a small group (six investors, just over 2%) who had made five or more investments in the last 12 months).
Nearly a quarter of angel investors have four or more investments according to the responses to question 6 of the MED survey. Figure 3 shows that a quarter have only one current investment, and 15% currently have no active investments.
Figure 3: Number of Current Investments
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