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The analysis that follows focuses on the supply side of the angel capital market. We are interested in what motivates people to help young companies get established, how they go about identifying the appropriate companies to back, how they enter and exit those investments and what expectations they have.

This section also examines some important developments in the angel capital market in New Zealand and key issues facing suppliers of capital and expertise to young companies.

Motivations

What motivates people to become angel investors, to provide capital to help transform people's ideas into sustainable businesses?

The over-riding consideration for angel investors is to get adequately rewarded financially for the risks they take in investing in early stage businesses. In the majority of cases that reward will be in the form of an increase in the capital value of their investment rather than an ongoing cash yield. It follows that there must be a prospect of them exiting the investment in a manner that allows them to realise a capital gain.

There are at least four other possible factors underpinning people's willingness to invest in start-up businesses:

• Wealth or high disposable income enables and encourages individuals to allocate some of their investment funds to high risk ventures
• An appetite for risk and adventure encourages some people without significant wealth or income to invest in new ventures
• Extensive business or technical experience that can be applied to add value across more than one company
• Altruism persuades some people to become angel investors

The more altruistic an investor, the less weight they are likely to give to financial returns over and above the return of their capital. In contrast, risk-takers may be more focused on substantial returns rather than maintaining their capital. "Lotto-type" investors (see below for a more detailed discussion of angel types), for example, are likely to take the view that their initial investment will either be worth nothing or a very great deal - they are not looking for average returns.

The MED survey asked early-stage investors what the main reasons behind their investment were. The overwhelming reason (89%) for investing is for financial gain; implying around 10% of investors are not motivated primarily by returns. Around half of all respondents indicated that less tangible factors also inspired their investment in young businesses (see Figure 4).

Respondents were asked to mark all that apply

Survey respondents indicated "other" reasons for investing. Again the reasons were predominantly social, or philanthropic including assisting others to grow ("because NZ needs business growth"; "see others succeed"); regional economic development; and fun ("fun - no corporate structure/games"). Other reasons included:

• control - a desire to have a more direct influence over their investment;
• portfolio diversification; and
• professional development and networking.

How they Invest

How do potential angel investors go about identifying companies to invest in? A high proportion of angel investors work on their own - 58% do their own identification and f invest alone. However, the majority tend to identify investment opportunities from a range of sources: family and friends, brokers and professional services firms, and referrals from business contacts. Only around a fifth of survey respondents indicated that business angel networks and investment clubs provided them with deal flow suggesting that the networks that exist have limited reach (see below for more detailed discussion of networks).

Respondents were asked to mark all that apply

Over half the survey respondents indicated that they spent half a day or less per month searching for investment opportunities, and roughly the same proportion spent less than half a day evaluating those opportunities. However, there is significant number of angel investors (about 15% of survey respondents) that dedicate more than four days a month to searching and evaluating opportunities.

Syndicates

Although the MED survey indicates that a significant proportion of angels (37%) invest alone, the majority appear to have a mixture of independent investments and ones completed via syndicates or groups. A fifth of angel investors operate exclusively through syndicates or groups (see question 20 of the survey). The latter is confirmed by question 24, which asked if investors were a member of a syndicated group for investment purposes. Again roughly 20% responded positively.

The incidence of syndication is much higher in Denmark with two thirds of angels co-investing in Denmark, and a higher proportion again in the US.¹¹

Evidence from our interviews with stakeholders in the angel capital market suggests that a significant number of investors act in conjunction with others. Formal and informal networks are common, though not necessarily particularly visible.

Networks

In Europe and America networking of business angels appears to be much more established than is the case in New Zealand. Formal business angel networks (BANs) and angel investment clubs (AICs) are both more common and conspicuous, and in some cases are assisted by central and local government organisations.¹²

The limited number of BANs in New Zealand reflects two things:

• Firstly, the private, low-key and unstructured nature of such networks in New Zealand means they are difficult to identify, but are not necessarily absent.
• Secondly, business angel networks tend to become more common as the angel capital market matures - the New Zealand market is probably still relatively young by comparison to the situation in many other developed economies.

The fact that the MED was able to gather over 2,000 names of early-stage investors for its survey from regional Economic Development Agencies (EDAs), as well as IGrow, MINE and others confirms the existence of angel networks. However, the impression from interviewing those active in the market is that while there are a number of networks most are casual and relatively inactive. The number of formal networks (specific framework of processes and well-defined membership) could be as low as 20 ranging from those hosted in association with individual EDAs (Aoraki Development Trust); incubators (IceAngels); legal/accounting practices; to individual active-astute investors (IGrow, Renouff Corporation, Sparkbox).

Networking amongst angel investors could be thought of as one aspect of the type of collaboration/business networking the government is looking to foster amongst firms as a means of enhancing business performance. Analysis of inter-firm collaboration¹³ suggests that a number of conditions are important to securing the benefits potentially available from networking. To a large degree these conditions are applicable to effective networking amongst business angels:

• a champion to drive the process;
• a social network that underpins investor collaboration;
• the presence of an extensive knowledge base that if shared raises the benefits to all;
• specific infrastructure that attracts investors;
• scale - as the number and size of deals increases there are greater opportunities for specialisation and co-operation, and hence a strong incentive to work with other investors and indeed other networks.

In many cases time is required for these conditions to develop and enhance the effectiveness of individual networks and the market as a whole. This is particularly relevant to the last condition.

Although New Zealand's early-stage capital market appears to be under-networked by comparison with other countries, the process of developing networks is underway. Governments in Europe have taken steps to accelerate the development of business angel networks implying that it can be done (see Danish Business Angels Network [external link] for details of the Danish government's initiatives to encourage the establishment of BANs).

Whether and how the government could intervene to encourage angel networks in New Zealand is a substantial topic for investigation. We address it to some degree in the final section of this report, but at this point we simply note that there is no single recipe for networking and that participants who will be responsible for sustaining networks are probably best placed to decide the nature of the networks that suit them. There are already a number of models in New Zealand that are quite different from each other, including, amongst EDAs.

MINE is a reasonably well-established model for networking angel investors, but has not been highly active. The model could be adopted and adapted by regional or industry specialist investing groups to help establish more, and more effective, BANs. The ICEHOUSE's angel investment club could be a model for other groups around New Zealand. While attached to an incubator the ICEHOUSE's network has also seen external deal flow. The fact is, the more BAN models or recipes there are the more likely the market will develop an appropriate range of networks that will meet the needs of investors and young companies searching for funds.

Selection Criteria

An important part of the process of investing in start-up or early-stage businesses is the investment selection criteria used.

At what stage of the business development process do investors want to invest and, at what stage do they invest in practice? Responses from the survey indicate that most prefer to invest at the start-up and early expansion stage. Around a quarter have no particular preference, perhaps indicating that other factors are more important than the stage at which they invest in a company. In practice, a much higher proportion of investment occurs at the seed stage than is indicated by those expressing a particular preference.

Respondents were asked to mark all that apply

Generally investors will want to be satisfied about two fundamental aspects of the business they are looking to become involved with:

• The character, attitude and competence of the entrepreneur and his or her management team; and
• The business case - the competitive advantage of the product/ idea.

From question 21 of the MED survey it is clear that investors place a great deal of weight on the quality, personality and attitude of the owner and management team, as well as the competitive advantage or point of difference in a commercial sense the entrepreneur's idea possesses. More weight was given to the international potential of the product than the domestic market potential, implying that most investors were looking for the business to be competitive internationally either to ensure growth or to appeal to a much larger pool of future investors.

*not important, very important

The most common reason for rejecting a potential investment opportunity was excessive risk. Question 5 of the survey asked angel investors what were the main reasons for not investing in businesses they had looked at. Almost half (49%) said when the risk was too high. Other reasons for not investing included: the business did not fit investment preferences (40%); the business plan was not acceptable (37%) and the management team lacked expertise or experience (36%).

Regional

International studies of the angel capital market suggest that investment is strongly regional and/or industry oriented. Although the interviews with angel investors supported the international tendency to invest in local businesses (within roughly 100km), over 40% of respondents rated physical location as not particularly important (see Figure 7). The latter perhaps reflects the size of the New Zealand economy and the lack of depth regionally in particular sectors. However, it may also reflect the small geographic size of New Zealand (you can get almost anywhere in 2 hours from an urban location) or the fact that industry is relatively concentrated geographically.

The logic behind a regional focus revolves around:

• a desire to give back to their local community
• investors are most likely to discover investment opportunities from local contacts
• the need to have close contact with the emerging business either as a board member or a more hands-on manager means the business is ideally within one or two hours by car from where the investor lives;
• the benefits of community contacts/relationships in building a clear understanding of the business founder's character (very important to deciding whether or not to go ahead with an investment);
• can help reduce transaction costs;
• and in small communities can impose a reputational discipline on the entrepreneur that might provide some added security to the investment.

In New Zealand, local economic development agencies (EDAs) are playing an active role in stimulating or leading local angel capital networks - some EDAs much more than others. Most EDAs hold a Securities Act Exemption Notice which enable businesses to list their investment opportunities via EDA publications without having to comply with all the requirements of the Securities Act. That encourages businesses and investors to operate through their local EDAs.

There appear to be important differences between how the early-stage capital market operates across the regions. In the smaller centres the market tends to be focused around one or two individuals who have the money, acumen and respect to lead other wealthy individuals into early-stage investments. In larger communities a number of individuals and organisations will be active providing depth and diversity to this part of the private capital market.

Although some people interviewed as part of this study thought that the South Island markets were driven more by groups of wealthy people from the same social circle (old boy networks) as opposed to the more individual entrepreneurial style in Auckland, the differences may well be more about perception than substance. Similar social groups exist in Wellington and Auckland, but bigger markets will be more diverse suggesting a different overall character.

Industry

Angel investment is often regarded as particularly important in nurturing the growth of so-called new-economy businesses (information technology, design intensive businesses). Technology companies certainly account for a high proportion of the businesses that angels invest in (around 60% have one or more investments in technology businesses according to responses to question 9 of the MED survey).

In other countries sector specific angel networks are relatively common probably because the number of start-up firms in any particular industry and region is far greater than is the case in New Zealand. Software, telecommunications and biotechnology are amongst the higher profile networks in other countries reflecting the greater likelihood that companies in such activities will require outside equity and business skills to commercialise ideas quickly - speed-to-market is critical to such ventures.

UK, Swedish and Norwegian studies¹⁴ however, indicate that hi-tech businesses are not the only ones targeted by angel investors: retail trade, consumer services, finance, manufacturing, and real estate all feature as potential investment areas.

In New Zealand investments in manufacturing and agriculture account for just under a third of most angel investors' portfolios. The question in the survey relating to industry allocation of investments provided respondents with a very broad selection of industries, which for many did not allow them to properly indicate where they were investing (27% answered "other").

Respondents were asked to mark all that apply

Those who answered "other" were asked to specify which areas they invested in. It is clear from these more detailed responses that the majority of "other" investments are in technology, IT, biotechnology, software, and electronics. By implication a significant proportion of investments in manufacturing and agriculture are probably technology related.

Angel investors surveyed were asked whether they had invested in companies spun-off from Crown Research Institutes (CRI) or that had emerged from business incubators. Less than 3% had invested in CRI-originated businesses and just over 10% had invested in incubator-related businesses. Given that incubators are a relatively recent phenomenon in New Zealand we would expect a growing proportion of angels to invest in incubated businesses over time.

Exits

The MED's survey of angel investors suggests that 340 people currently have around 880 investments. According to survey question 26, investors have exited 466 deals in the last five years. The pool of investments from which the 466 exits have come from is probably larger than the 880 current investments given that the average age of investments is probably between four and seven years.

Mason and Harrison¹⁵ argue that the average life of profitable angel investments in the UK is four years, two years for unprofitable investments, and six years for "living-dead" investments.

As Figure 9 shows, more than a third of investors have not exited any investments in five years and another quarter indicate they have exited only one investment. At the other extreme more than one in ten investors has exited four or more investments over the last five years implying a small pool of relatively active investors.

Figure 9: Number of Exits (Last 5 Years)

Figure 10: Return on Exited Investments

Interestingly, around a fifth of exited investments in New Zealand have generated returns greater than 30%pa according to the survey responses. We would be cautious about interpreting the survey responses on returns too literally. In some cases several funding rounds may have been required and considerable unpaid time will have been invested. Nonetheless, the results are roughly in line with what most angel and private equity investors would be looking for - one to two "gushers" out of every ten investments.

Almost one in 10 investors don't know what return they made on their exited investments, and another 18% lost some or all of their investment. Many more investors realised low returns (0-10%pa) than were expecting them. That was an experience that came through from those investing in start-up and early-stage companies.

From our interviews there did not appear to be a significant number of angel-backed companies going on to attract venture capital. There appear to be at least two reasons for this lack of transition:

• generally venture capital companies are not interested in providing an exit for existing investors; and
• angel-backed companies often remain too high a risk for venture capital investors.

Respondents were asked to make all that apply

A significant proportion (around 40%) of all exits are involuntary - the business either ceases operations or is liquidated. That is consistent with recorded returns from the survey with around 45% of realised returns being less than 10%pa. UK data¹⁶suggest that 40% of informal capital investments are written off as a loss, and one in five produce returns of 50% or more.

Around 40% of angel investors exit by selling out to existing shareholders or to other private investors (possibly venture capitalists). Just one in ten angel investors exit via a public listing, which is not surprising given their focus is on establishing the business rather than later stage growth. Around a quarter of exits are achieved via a trade sale.

Angel Investor Characteristics

Analyses of the angel capital market in Europe and North America generally conclude that the archetypal angel investor is a high net worth individual who provides risk capital and expertise to one or more start-up companies. Angel investors are almost invariably male, generally aged between 35 and 55 and more often than not invest in businesses close to where they live and in industries with which they are familiar. While financial return is an important motive, angel investors are also driven by non-financial factors such as a desire to contribute and a wish to reinvest or leverage their expertise.

The MED's survey provides some empirical evidence confirming that the above general description of angel investors also holds true for New Zealand. The information outlined in the graphs below relates to those who responded to the survey, and who invested in companies where there was no prior relationship with the owner (i.e. it excludes those investing in businesses owned by family members or friends).

Figure 13: Age Distribution

Figure 14: Wealth Distribution

Figure 15: Income Distribution

Angel investors from the survey fit the archetypal definition of an angel investor: aged between 35 and 55, high net worth ($2m+) and high incomes.

We noted above that, consistent with overseas results and according to the MED survey, only 5% of New Zealand angel investors are female. The MED survey also indicated that around 85% of angel investors are European/Pakeha. Asians accounted for just under 4% of investors and more than 8% did not specify an ethnic group.

The survey also shows that 82% of angel investors have founded and run their own business and around half (47%) of these had received angel capital (from people other than friends and families). In other words, a large number of angel investors have been on the "other side of the fence" and therefore can appreciate some of the tensions and difficulties that can arise.

Angel Types

There is a considerable body of research that has focused on categorising angel investors as a means of better understanding the supply side of the market - what drives it, and who the important players are. The research highlights two important characteristics of the angel capital market: it is difficult to define, and there is no such thing as a typical angel investor - it is a very heterogeneous market.

Nonetheless, numerous studies have attempted to define categories of angel investors, in some cases in such numbers as to defeat the usefulness of categorisation. Although grouping investors into a small number of categories runs the risk of over-simplifying the types of angel investors that exist in the market, it delivers a clearer picture of the main groups and their characteristics.

A study¹⁷ of the Norwegian angel capital market used cluster analysis to identify four main groups of angel investors:

• Lotto investors (gamble with a small amount invested with the possibility of high returns)
• Traders (high activity, low competence)
• Competent investors (good analytical skills, cautious, low activity)
• Business angels (often lead investors, engage directly with target companies, multiple investments, relatively long time horizons)

A recent US study¹⁸ also had four categories of angel investors based on interviews with 26 angel investors, 12 angel groups and 15 related professional service firms. The following categorisation is based on the experience of angel investors along two axes - relevant industry experience and relevant entrepreneurial experience:

• Guardian angels (considerable technical and managerial skills that are actively applied to the start-up business)
• Professional entrepreneur angels (investing outside their area of expertise and tend to invest alongside guardian angels they trust and respect)
• Operational expertise angels (experienced executive in target company's industry, brought in to help other angel investors with due diligence and direct involvement with the firm)
• Financial return angels (rich individuals with capital but no particular technical or business experience to offer start-up businesses, and therefore looking for a return rather than involvement in the company)

The above two attempts to categorise angel investors highlight the sponginess of any particular set of descriptions, but they identify some of the dimensions along which it might be useful to categorise investors. The definitions are likely to vary between countries and possibly also by the maturity and size of individual capital markets. However, there are some approximate match-ups between the two studies groupings:

In the absence of a detailed study of angel investor types, but drawing on interviews with people with a good overview of the angel capital market in New Zealand, we suggest there are three broad groups of angel investors:

The three groups identify themselves largely by their degree of involvement, but also their experience, either as an entrepreneur or as an investor in the seed/start-up end of the private equity market. The following categorisation has been informed by the interviews carried out as part of the environmental scan as well as extensive filtering¹⁹ of the survey results. The econometric analysis (including principal components analysis) reported on below is detailed in Appendix IV.

Passive-Dabblers

Passive dabblers tend to have fewer informal investments than angels as a whole and such investments are likely to represent a small proportion (probably less than 5%) of their investment portfolio excluding property. The great majority of these investors would not regard themselves as angel investors, and may not even be aware of the concept.

Passive-dabblers are likely to have a higher appetite for risk than more active angel investors. They will be prepared to invest without a detailed knowledge of the business, relying instead on the reputation of other investors, and in some cases may even invest on "tips" (or punts) from business colleagues. They are more likely to be young to middle aged, rather than old - they are better placed to recover losses incurred in investing in high risk ventures. They are relatively casual investors, relying on the word or judgement of others rather than their own detailed analysis.

This group of investors is characterised more by high incomes than by high net worth, reflecting the fact that younger people are generally still accumulating their wealth. It will include professionals - lawyers, dentists, doctors, company executives, accountants, etc - who generate high earned incomes, but are generally fully committed to their careers/practices and therefore have little time to rigorously analyse individual investments.

Although many passive dabblers will act on their own, the majority of investments they make are likely to be alongside others with a more detailed knowledge of the investment (either through personal contacts, through their professional involvement with the business or via accounting/legal firms).

Passive-dabblers probably account for a relatively small proportion of those covered by the MED survey because, almost by definition, they would not elect to join investor networks. However, if we consider that the broad population of angel investors is possibly as high as 20,000, then the majority of them would be passive dabblers.

Angel Investors

The archetypal angel - high net worth individual, more often than not a person who has founded, run and sold their own business, or who has extensive senior executive experience and is keen to continue applying their skills in a slightly less hands-on role. They will tend to be amongst the older private equity investors (most often retired or semi-retired) and in addition to capital will typically contribute knowledge, experience, contacts and judgement. They normally become a director of the business(es) they invest in.

They will more often than not act alone and be motivated by a desire to coach/mentor young entrepreneurs rather than simply to maximise the return from their investment. In some cases they will be attracted by the entrepreneur's idea and will want to help turn it into a reality. In these senses they are more likely to be focussed on the success of the business rather than their share of the spoils.

In contrast to the passive-dabblers, angel investors undertake a more thorough analysis of the idea, company and person before they invest. They are more likely to restrict their investments to local businesses, though some will invest in companies within easy reach of where they live (a direct air connection or up to a two hour car journey). As a result of this more rigorous approach to investing they are likely to achieve higher returns than passive dabblers.

Active-Astute

There is a small group of early stage private equity investors who are active and professional. They dedicate most of their working hours to identifying potential investments, preparing the ground to invest, and often allocate a significant amount of time to developing the businesses they invest in.

They take a more hands-on approach than angel investors and therefore have a much better understanding of the risks they are taking and look to actively manage those risks. They will tend to have capital invested in a number of businesses (certainly more on average than the other two groups) and therefore be using a portfolio approach to help reduce their risk.

These private equity investors will generally be the conduit through which a lot of passive early-stage funding flows. In a sense these individuals could be thought of as one-man venture capital companies. They follow the same disciplined approach to investing, including a comprehensive investment document setting out an extensive list of conditions and agreements. In other words the initial transaction costs are relatively high.

They are often the "lead investors" referred to in other countries. For example in Norway 40% of investors over a three year period made their investments following the initiative of a "lead investor".²⁰

The following provides some of the key characteristics of an active-astute investor operating in the New Zealand market. Although there are dangers in setting out characteristics based on interviews with just two or three active investors (the temptation is to generalise), we believe the details provide some useful specific information about active-astute angel investors.

The investor groups identified above can be used to present a more detailed picture of the early-stage investment market in New Zealand:

#Infometrics numbers
*From MED survey

Data from a study²¹of around 600 Norwegian informal venture capital investors show that the majority of investors are passive (in 65% of all investments the investors behave as they would if investing in a publicly listed company). The same report suggests that in the UK, US and Sweden 70-90% of investors play a relatively active role in their investee companies.

Econometric Analysis

Using MED survey data, we applied econometric techniques in an attempt to isolate the separate influences of various underlying factors on investment exits and returns.

While we should not ignore the possibility that there is some bias in the response rate owing to the sample selection method, the number of responses to any given question suggests that we can be reasonably confident that the answers are representative. However, cross-tabulations of more than one question at a time are likely to contain much wider error margins, depending on the number of responses to each of the tabulated questions. This needs to be borne in mind when reading the analysis described below.

Simple statistical descriptions provide a useful overview of the characteristics of angel investors; their methods, preferences, opinions and so on. From these descriptions it is always tempting to draw inferences about links between variables and possible causative influences. For example, we may observe that most successful angel investments are by investors of high net worth and simultaneously that most successful angel investments are in manufacturing. Which of these has the stronger effect on returns and to what extent might wealth be a proxy for experience, via the effect of age?

The econometric analysis undertaken cannot tell us anything about causation. It may reveal where the true correlations exist (if the models are correctly specified), but we must rely on theory and reasoning to explain why such relationships might exist.

The econometric analysis of the survey data is described in detail in Appendix IV. The analysis entails an examination of the factors that contribute to successful angel investment, using multiple regression; and principal components analysis of investment criteria and market perceptions. In each case three groups were identified: all angel investors, passive investors and active/astute investors. In effect, we viewed angel investors as being segmented along a continuum of involvement from passive to active.

With the survey having so many questions it was originally our intention to undertake some form of factor analysis or principal components analysis on the whole dataset, in order to establish whether responses exhibited any form of clustering around certain attitudes or investor behaviour. Unfortunately the survey response dataset does not support this type of analysis. There are too many different types of questions for distillation into one or even a few dominant signals without some guidance from theory or other empirical research.

Instead, we chose two approaches for the analysis of the dataset. Firstly, we defined two specific questions that seek to determine what factors contribute to a successful angel investment:

• What factors are associated with a successful exit (using the responses to Question 28 to define the dependent variable as the net number of successful exists)?
• What factors are associated with a high rate of return at exit (using the mid-points of the response options for Question 27 as the dependent variable)?

These questions are explored using multiple linear regression with a "general to specific" methodology. Sample size restrictions have forced us to omit industry type as an explanatory variable.

Secondly, in an attempt to return to the idea of a typical angel investor, we analyse two questions that ask investors about their opinions on a range of issues. Principal components analysis is used for this task. The two questions are 29, which asks about the angel investment market environment, and 21, which asks about angel investment criteria.

Results

Based on the discussion in the previous section we examine the above questions for three different groups of investors:

1. All angel investors - those who answered "yes" to Question 1.
2. Passive investors - those who reported "no other roles" under Question 23.
3. Active/astute investors - those who reported "board member" under Question 23 and reported net household wealth above $2m under Question 36.

The regression analysis suggests that passive investors are a mixed group, with successful investors comprising both hobbyists and those desiring the challenge of building a business; those who secure their opportunities through business contacts and those who secure them from friends and family. They place more importance on evaluating proposals, than searching for opportunities.

Successful astute/active angel investors prefer to invest at the expansion stage and in businesses that are consistent with their own expertise and experience. Referrals from family and friends has a positive effect; the group may be astute, but this does not mean that they shun informal networks. Astute investors also attach importance to research and to achieving a financial return.

In relation to investment criteria and perceptions about the angel investment market, principal components analysis reveals a high degree of uniformity amongst angel investors as a whole, but rather less when investors are categorised as passive or astute.

While passive and astute investors are different in some key respects, (such as reasons for investing) it would seem that investment criteria and market perceptions are not amongst the main differentiating factors.

Detailed results are set out in Appendix IV.

Significant Developments and Market Issues

The angel capital market is maturing as investors gain experience, a market profile is established, and there is a better understanding of the market and the context within which it operates - this study is a contribution to the latter. The following sections outline some of the key developments.

Market Evolution

Markets typically evolve in response to experience, outside influences and the demonstration of different strategies, with successful (unsuccessful) ones being identified and adopted (dropped) by market participants. New Zealand's early-stage capital market is evolving - the following comments from at least two experienced stakeholders highlight what they see as important developments:

• The capital market at each stage (seed, early-stage, expansion) is more sophisticated (rigorous, organised and experienced) than it was five years ago. That partly reflects the establishment of the government's venture investment fund (VIF) with quite formal criteria, but also the emergence of active business angel networks. For example, the ICEHOUSE's recently established angel investment club (ICE Angels) has clear investment process and membership rules.
• The angel capital market's profile is growing, with more deals being reported in the media and angel investors such as Stephen Tindall, Sparkbox and IGrow receiving publicity. More articles are appearing in business magazines highlighting the angel capital market and web searches on the subject are likely to bring up more New Zealand references to the angel capital market than would have been the case five years ago.
• There is a better understanding of how to make money out of new ideas - professional services firms have accumulated more experience of businesses trying to commercialise ideas and that knowledge is available to potential angel investors. Over time investors will be expanding their own understanding of how to commercialise ideas and manage companies through their formative years.
• More professional investors are participating in the market and that is bringing more rigor to the investment process. The fact that returns have generally failed to meet expectations has been an important incentive for some angel investors to be more rigorous about how they go about investing, who they invest with and what type of businesses they invest in.

The government's Investment Ready Scheme, now the Escalator scheme, as well as numerous studies looking at firms' access to capital have helped build a better understanding of the angel capital market. The more analysis and information there is about the market the easier it is for people to identify and participate in the market, and the better informed existing players can be. Part of the intention of the current study, and especially the MED survey of angel investors, is to expand market knowledge for the benefit of policy makers and market participants.

More investor groups, syndicates, networks and investment clubs are emerging, which enhances the flow of information and knowledge about the market. Whether the rate of growth in this important component of the capital market is too slow because of specific market failures, or is proceeding at pace consistent with logical market evolution is unclear. We suspect that the evolution of networks has more of a geometric than a linear development curve - the pace of growth will accelerate over time as more examples of successful networks establish a track record.

From interviews with those active in the angel capital market, the general consensus was that investments take longer than expected to complete (entry to exit). The time taken appears to range between three to five years and it is not uncommon for the investment cycle to be around seven years.

Although the survey indicates 466 exits over the last five years by those surveyed, it is not clear from what sized pool of investments they come (we know that respondents had 880 current investments). In light of experience in the venture capital market it would be surprising if the angel capital market has established a firm track record of performance. On the basis of the 466 exits noted by the MED survey, the estimated average return in the angel capital market is 16.9%pa.

The widespread decline in the value of technology-intensive businesses between 2000 and 2003 made conditions difficult for many investors in early-stage (and later stage) hi-tech businesses. The slump in capital spending on hi-tech equipment internationally during this period has made the task of commercialising new concepts more difficult, adding significantly to the capital investment demands for new companies.

Laws and Regulations

There are three areas of legislation/regulation that have a direct bearing on the early-stage capital market:

• Exemption notices and security issuance laws
• Tax rules governing capital gains
• Tax rules relating to continuity of ownership to claim tax losses

In Appendix II we have set out the relevant legislation governing investment offers to the public. Recent changes to the law appear to have increased the scope for businesses to seek funding from investors without having the benefits of an exemption notice. A number of EDAs have been granted an exemption notice by the Securities Commission to permit them to handle investment offers outside the conditions of the Securities Act (1978).

Capital gains tax is a sensitive issue amongst all private equity investors. The rules determining whether or not taxation of capital gains apply to private equity investments revolves around the rather tenuous concept of intention at the time of investment, or how much investing one does. Until these rules are clarified some private equity investments remain vulnerable to a 33% across the board reduction in returns. The fact that virtually all high risk private investing is done with an implicit or explicit exit strategy suggests the intention at the time of investment is to sell at some stage in the near future (3-7 years).

One significant angel investor raised the problem of having to maintaining 49% ownership by at least one shareholder to ensure access to previous tax losses. The investor who raised this issue implied that they had had to compromise the structuring of some deals to maintain continuity of shareholding in order to secure tax losses. With young fast growing companies desperate for capital, shareholdings often have to change significantly to attract new capital. More mature companies tend to have relatively stable share registries and therefore do not generally find it difficult to use losses to offset future profits for tax purposes.

Investor Education

The Escalator Service, formerly the Investment Ready Scheme, was developed because the demand side of the private equity market was believed to lack sophistication. A number of interviewees argued that a similar lack of knowledge and experience exists on the supply side of the early-stage capital market. Although there are sophisticated investors in this segment of the capital market the majority are not.

Few investors undertake rigorous analysis or seek professional advice before investing. That partly reflects the need to keep transaction costs low given the size of the sums involved. However, in many cases entrepreneurs and investors underestimate the amount of capital a business will require to support growth, and a lack of pre-investment analysis and an appropriate deal structure can create major headaches when more capital is required from original or new investors.

¹¹The Danish Investment Fund, Business Angels in Denmark, 2002, see European Business Angels Network [external link].

¹²Gullander S. Napier G. Handbook in Business Angel Networks - The Nordic Case; Stockholm School of Entrepreneurship; 2003.

¹³Colin Campbell-Hunt et al; Collaboration and Linkages between SMEs in New Zealand, MED; June 2004.

¹⁴Mason C. Harrison R. "A Strategy for Closing the Small Firms' Finance Gap"; Venture Finance Research Project; Working Paper No 3; 1991. Landstrom H. "Informal Risk Capital in Sweden and some International Comparisons"; Journal of Business Venturing; 1993. Reitan B, Sorheim R; 1999; op cit.

¹⁵C Mason R Harrison; "Is It Worth It? The Rates of Return from Informal Venture Capital Investments"; Journal of Business Venturing, 17, 211-136.

¹⁶Ibid.

¹⁷Sorheim R and Landstrom H; "Informal Investors in Norway - A Catagorization and Policy Implications"; Babson College-Kauffmann Foundation Entrepreneurship Research Conference, June 2000.

¹⁸Linde L and Prasad A; Venture Support Systems Project: Angel Investors; MIT Entrepreneur Center; Release 1.1; February 2000.

¹⁹The questions used in determining the categories included: Q14, Q15, Q16, Q17, Q18, Q19, Q20, Q23, Q24, Q26, Q27, Q30, Q31, Q35, Q36.

²⁰Reitan B. Sorheim R. The Informal Venture Capital Market in Norway - Investor Characteristics , Behaviour and Preferences; a revised version of a paper presented to the Babson-Kauffman Entrepreneurship Conference; May 1999.

²¹Ibid.