By William S. Podd, Executive Director, Landmark Angels Inc.

As angel investors confront the realities of the current recession, they must implement strategies to weather the downturn and ultimately profit. Investors have to assess early stage venture opportunities with other capital market opportunities, such as those in the public equity and real estate markets, on a risk/reward basis. Leading angel groups are reassessing how they source, choose, value and structure early stage investments. Angel investors need to limit their investments only to those companies that demonstrate a clear path to a substantial exit and they must also be prepared to provide additional capital infusions when required for their investments.

To attract capital, early stage companies are offering substantial reductions in their valuations. Angel investing, with its historical high risk/high reward strategy, can provide an opportunity for significant returns for high net worth investors as part of an asset allocation strategy. Individual investors and wealth managers who are interested in the rewards angel investing can offer, should consider joining an angel group with experienced members, who can help to identify “best of breed” companies and help to assess and reduce risks.

Historically, early stage venture investing involves significantly greater risk than investing in any number of other capital market opportunities, since the primary risk has been that of losing the entire investment in the venture. Early stage companies may lack an experienced management team, key customers and significant revenues and may have little assurance of raising additional capital. This risk can be offset by significant returns, in a possible range from 5x to 10x the equity invested, when the company reaches a successful exit.

"Best of Breed" Deals

So how does an angel investor source deals and choose the best ones—those most likely to lead to a successful exit?

Angel investor groups have relied upon informal networks, comprised of their members, attorneys, accountants and venture capitalists to source opportunities. And while these local and regional networks will remain vitally important, angel groups must have access to the highest quality deals. Currently, many groups will only invest in companies within an hour’s drive of their location and many have hard caps on valuations, rejecting deals over a certain limit. Yet angel groups must be willing to change these restrictions and be flexible in the search for future market leaders, which will ultimately provide strong exit returns.

If angel investors are receptive to invest in companies which are further along, they may encounter less risk as these companies will often have greater revenue, key customers and stronger management teams. In fact, as venture capitalists have largely migrated to larger, later stage deals, angel groups can exploit the opportunities they have left behind. In the current recession angel investors can find quality companies offering deeply discounted valuations. Investors making relatively modest capital commitments can obtain substantial equity positions.

In addition to pursuing a strategy of mitigating risk and maximizing rewards, angel investors must adhere to the basic investment fundamentals, including seeking companies with strong, experienced management teams operating in attractive markets where their competitive advantage is clear.

Partnering with Investors and Wealth Managers

Insufficient capital is one of the major risks of early stage investing. Angel investors are beginning to fill this gap, essentially providing Series A institutional equity rounds, previously funded by venture capitalists.

However, to ensure the availability of additional capital to protect their initial equity investments if institutional money is not available or attractive, angel groups must expand pools of capital by partnering with a new class of investors - family offices and wealth managers. These asset managers have greater liquidity than the typical individual angel investor, who may face more acute capital constraints.

By working with an experienced angel group, wealth managers and their high net worth investors can utilize the research capabilities and industry connections of the angel group and the group’s expertise in selecting “best of breed” deals. In addition, wealth managers and their high net worth investors can partner with the angel group and its syndicate to minimize its future capital contributions.

Angel groups can partner with affiliates and other angel groups to form syndicates on a deal by deal basis, like venture capital firms. Syndicating investments with other groups of angel investors can fill out larger investment rounds and provide partners for subsequent equity rounds. In addition to providing capital, syndication allows for the sharing of the due diligence process and access to better deal flow.

Importantly, syndication can also provide angel groups with greater diversification allowing them the ability to invest the same total amount of capital in a greater number of companies.

Evaluating Exits

Angel groups also are spending more time evaluating the future exit opportunities of potential investments prior to committing equity. With the likelihood of initial public offerings as an exit opportunity substantially diminished, angel groups have focused on the merger and acquisition strategy as crucial to realizing returns.

Investors are now placing greater importance on the number of potential acquirers in a company's market segment and the relationships that the company may have with these acquirers, to determine the likelihood of a future acquisition. Angel groups must also rely on relationships with venture capitalists to help assess the strengths and weaknesses of a deal and to determine if company is an attractive prospect for institutional funding in subsequent rounds.

A New Investment Climate

Changes in strategy for angel investing are the result of both the dramatic downturn in the economy and a desire for improvement upon past returns on investment. As a result of substantial losses in the public equity markets, the majority of investors have less capital to commit to early stage ventures. Nevertheless, they can find attractive opportunities in angel investing at deeply discounted valuations which allow for potentially substantial returns.

Angel investors need to adapt strategies to the current economy. They must focus on the fundamentals of each potential investment-strong management, innovative products, sizable markets, healthy cash flow, little competition and viable exits. They can also benefit from ongoing trends in angel investing that provide opportunities to find higher quality deals across geographic sectors, to partner with wealth managers to access additional sources of capital and to syndicate investments to achieve portfolio diversification and ensure the availability of follow on funds.

Although angel investing continues to have its risks, its rewards will continue to be attractive if these strategies are implemented.