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Angels Give Wing to Entrepreneurs’ Ideas-Though cautious in light of downturn, wealthy investors still finance and often mentor young, risky companies.
When PhatNoise Inc., a Los Angeles-based maker of digital jukeboxes for cars, decided to seek expansion capital from a group of so-called angels last year, Chief Executive Sharon Graves admits she initially thought she might have made a mistake.
By Josh Friedman
LA Times Staff Writer
At first glance, the wealthy Southland investors listening to her pitch seemed like an unlikely group of backers for PhatNoise.
"They tend to be an older crowd, and our technology is geared toward younger people, but I guess they asked their kids about it," Graves said, chuckling. After a series of presentations, she found a receptive audience.
"It was refreshing," she added, "that an older group of white guys was able to embrace what we’re doing."
To the tune of nearly $1 million, no less. Members of the three-county Tech Coast Angels network and the Pasadena Angels, a smaller investing group that meets in the San Gabriel Valley, recently invested that amount in PhatNoise, and the company also landed $2 million from a New York venture capital firm.
Angels, the nickname for individuals who finance and often mentor risky young companies in exchange for equity stakes in the businesses, invested about $30 billion last year, according to an estimate by the University of New Hampshire’s Center for Venture Research.
That’s down by a third from 2000, the height of the technology investing bubble, the center says. But it was a larger total investment than the $21 billion that professional venture capital firms dished out last year, as they cut their cash outlays more than 80% from 2000 levels.
Except during the bubble era of 1999 and 2000, the center notes, U.S. angel investing has outpaced venture investing every year over the last decade.
Even so, early-stage companies are finding that angel investors, like venture capital firms, are much more cautious about where they will put their money these days. That’s true in the Southland and nationwide.
For instance, angels are trying to limit their risk by investing smaller amounts per company and by shying away from entrepreneurs with a promising concept but a shaky business plan.
"It’s a predictable reaction to being spanked so many times over the last three years," said Dave Berkus, who started and sold two Southern California companies before becoming a full-time angel in 1993. "There isn’t much money for a raw idea now, other than ‘friends and family’ financing."
In fact, a business often will begin by securing money from relatives and companions. Some entrepreneurs then seek angel financing when something in the range of $200,000 to $1 million can get them to the next stage, such as a finished product or a major contract. That deal size is usually too small to attract established venture capital firms, yet too big for the in-laws.
Individual angels, who make their own decisions but sometimes operate within a network such as the Tech Coast Angels, typically will commit $25,000 or so per company, so an entrepreneur might be able to get $250,000 from a group of 10 investors, for example.
Most angels are high-net-worth investors with at least $1 million in liquid assets, according to the Center for Venture Research. It estimates that there are 300,000 U.S. angels — about 90% of them men — and 125 formal networks nationwide, down from 180 groups during the height of the tech boom.
"It’s the not-ready-for-prime-time angels who have fallen by the wayside," said Jeffrey Sohl, director of the Center for Venture Research. "What we not so affectionately call the ‘doctor and dentist money’ is gone, and most of the angels still in the game are cashed-out entrepreneurs."
Like venture capitalists, angels hope for returns of at least 10 times their investment over a five-to-seven-year period, typically if the company is sold or goes public. But that kind of gold strike is the exception rather than the rule, angels say. They count on one or two big hits to make up for the likelihood that many of the companies in their portfolios will fare poorly or flame out completely.
Disasters for the Tech Coast Angels have included 1-800 Wedding, an Orange County bridal registry business. The Angels invested $1.2 million in 1998, Berkus said, and lost everything when the company was shut down three years later.
The Angels also have enjoyed their occasional bonanzas. Some in the group got back more than 100 times their original investment in Internet services company Sandpiper Networks when it was acquired by Digital Island Inc. in 1999. They had put in $135,000, Berkus said, and walked away with $18.7 million.
Sohl pointed out that amid the frenzy for new business ideas in 2000, angels funded about one in four companies that made formal pitches to them. Now, he said, one in 10 companies that pitch themselves to angels can expect to be funded, which is back to the historical norm.
The due-diligence process of vetting companies after an initial screening also has gotten "more realistic" of late, Sohl said. The review period, which had accelerated to an average of 2 1/2 months during the heyday of high-tech, now takes four months.
Still, many angels — a term first used for financiers who rolled the dice by backing Broadway shows in the early 1900s — say they haven’t lost their fervor for finding exciting new business ideas. And because they write their own checks, they don’t have the worries that venture capitalists often face in terms of answering to institutional investors.
"We don’t have to report to somebody. We’re not afraid of making decisions," said Berkus, current chairman of the Tech Coast Angels, which has about 200 members in its L.A., Orange County and San Diego chapters — a number that has risen slightly since 2000.
In the group’s surveys, at least, members say networking and educational opportunities are as much of a draw as investment ideas.
Berkus, 62, said he had an entrepreneurial spirit from boyhood. After winning a prize for selling the most pinyon nuts in a Cub Scout fund-raiser, he launched a neighborhood photography business, snapping pictures of adults and then selling them the 8-by-10s.
As a junior at Pasadena High in 1957, Berkus launched his first venture, Custom Fidelity Co., which made vinyl records of high school and college musical performances from around the U.S. and Canada for pen pals he met after writing to a hi-fi magazine.
That company, which he said financed his education at Occidental College as the business grew to include weddings and other customized recordings, went public in 1971. Berkus sold his stake three years later to launch a hospitality-industry software company, which he in turn sold for $9 million in 1990 to MAI Basic Four Inc.
In the early days, before angel investing became fashionable and angel networks sprouted up in the mid-to-late 1990s, Berkus considered himself a "resource capitalist."
Many angels, like Berkus, are considered "serial entrepreneurs." Some are former corporate executives. Either way, they often rely on their own business experience when evaluating investments.
As an audiophile, Berkus took a liking to PhatNoise, whose jukebox for cars is best known as the Kenwood Music Keg. At prices ranging from $500 to $800, it can store and play 2,500 to 10,000 songs, or as many as 800 CDs, according to Graves, the PhatNoise CEO.
Graves said she anticipates being able to call on Berkus and other angels for advice as the company grows, noting that one of the Pasadena Angels involved in funding PhatNoise had worked previously with a radio technology firm. Proximity to the angels is an advantage as well, Graves said, because PhatNoise’s venture backer is based on the East Coast.
Having angels and venture capitalists invest alongside each other is becoming increasingly common. Tech Coast Angels counts 21 venture firms as "affiliate members," meaning potential deals may be referred back and forth between the network and the VC firms. Venture firms took part in the majority of the Tech Coast Angels’ 11 financing rounds last year.
With a venture firm participating, angels get the security of knowing that a start-up company has a deep-pocketed backer as well.
"In the past, angels may have thought of themselves as a bridge toward further financing, but too many times that bridge turned out be just a pier leading into the ocean," said William Collins, a former tech company executive who cashed out in 2000 and joined the Tech Coast Angels.
Berkus said experienced angels have learned the hard way about going it alone.
"If we don’t think VC interest is probable we won’t make an investment anymore," he said. "No more leaps of faith."
For their part, venture firms appreciate having access to the expertise and investment ideas that angels can provide — not to mention the cold cash they bring to the table in a difficult money-raising climate.
"Tough times make strange bedfellows," said Joel Balbien, managing member of the VC firm Smart Technology Ventures in Century City.
From the entrepreneur’s standpoint, angels typically have shallower pockets than venture firms, but they can offer the entrepreneurs more coaching.
"We can’t necessarily write the big checks or multiple checks," said John Morris, head of the Tech Coast Angels’ L.A. chapter. "But an angel’s time is as valuable a resource as his money."
For example, the Angels recently financed L.A.-based Language Weaver Inc. after what turned out to be a two-year mentoring project. The investors were intrigued by the company’s initial pitch in December 2000 but considered the start-up too iffy to make a financial commitment.
Angel Richard Morganstern, a former patent lawyer and investment banker who headed the investors’ due-diligence process for Language Weaver, said the concept was compelling: Two USC professors and a grad student were creating an innovative software system for automatically translating material from one language to another.
But the company lacked experienced management, a business plan and a clear idea of what the product would look like and who might buy it, Morganstern said. In other words, it needed heavy mentoring.
So Morganstern hired a consultant experienced in language translation software to review the entrepreneurs’ platform and recommend whether it was even worth pursuing. After receiving her thumbs up, the Angels recruited a chief executive, a head of product development and software developers.
After the Sept. 11 terrorist attacks, U.S. government security agencies became the obvious first customer for Language Weaver, and the company now has $3.5 million in government contracts, Morganstern said. In December, Language Weaver received a $750,000 "seed" round of financing from angels and a venture firm.
Angels never set out to lose money, of course, but the mentoring process provides a degree of "psychic income" for the investors regardless of whether the businesses they fund ultimately pay off, Sohl said.
"It’s for people who want the excitement of working with a start-up but not the sleepless nights of worrying about payroll and everything else," he said.
Echoing Berkus and others, Morganstern said that when he joined the Tech Coast Angels four years ago, "I was at the point in my life where I wanted to do the one thing that made me the happiest: Putting companies together and getting them started correctly."
Local (LA)Resources for Young Firms
Several California "angel" investing networks consider business plans submitted by entrepreneurs. Among them:
* Tech Coast Angels. Chapters in Los Angeles, Orange and San Diego counties.
http://www.techcoastangels.com
* Keiretsu Forum. Chapters in Northern and Southern California.
* Pasadena Angels. Focus on San Gabriel Valley-area companies, but not exclusively.
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