Entrepreneurs who wish to transform their business dreams into reality will one way or another reach out for the external finance. Many new entrepreneurial start-up businesses do not obtain start-up financing (Gruber, 2004; Mason & Harrison, 2004b). Private individual investors with a high net worth, known as business angels, represent the largest source of start-up financing for new entrepreneurial businesses (Aernoudt, 2005a). Establishment of new businesses is vital to the development and growth of the country’s economy (Reynolds et al., 2003). Since the first publication on a business angel was published by (Wetel, 1981), many authors have researched on the informal investment market and studied closely monitoring business angels’ characteristics, investment criteria and issues related to an investment. According to (Masons & Harrison, 2000), it is cited that over the past generations many researches have been carried out in different countries and compared with each other.
This dissertation will discuss about the mind of an investor and how they operate in terms of investing their financial assets in a start-up business they believe in succeeding. The main reason is to broaden our understanding of investment aspects of a business angel and how an entrepreneur should respond to it. To find out information sources on business start-ups, refer (Appendix 1).
Many business entrepreneurs do not have the luxury of initial capital that’s needed to start-up a new business as it requires a vast amount of finance equity (Clarke, 2005; Sohl, 2006). How do entrepreneurs find the initial capital and which investor will trust the business ideas and fund the company? What is the difference between a good investment and a poor decision? What are the requirements of a business angel? These are the main issues SME business starters go through in the initial stages of a business (Wiltbank & Boeker, 2007). The answers for all these issues vary depending on several criteria. For example, it could vary due to the type of the business the entrepreneur wish to start, the capacity of the risk involved, the return of investment period and especially the preference of the entrepreneur working alone or with the influence of the investor (Kaplan & Schoar, 2005).
The dissertation tries to reach active business angels’ view points on the issues of SME entrepreneurs and investment aspects. The researcher is confident that this thesis will benefit both the business angels and entrepreneurs.
Introduction Of The Research Subjects
According to a survey conducted by the (EIRO), the government’s Bolton Committee in its 1971 report clarified that there is no single definition to explain Small to medium enterprises because of the wide diversity of businesses that operate in the United Kingdom. The report also explained that small to medium business varies according to the type of sector it operates. However section 249 of the Companies act of 1985 affirms that a small company will have to attribute at least two of the following characteristics;
- Turnover less than GBP 2.8 million
- Total balance sheet less than GBP 1.4 million
- Employees less than 50
And a medium sized entrepreneur should operate under the following regulations;
- Turnover less than GBP 11.2 million
- Total balance sheet less than GBP 5.6 million
- Employees less than 250
However in real practice, business functions that operate under small to medium terms, take on a range of working definitions depending on their business objectives (Leedy & Ormfod, 2001).
EIRO – European Industrial Relations Observatory
Formal And Informal Venture Capitalists
Venture Capital is also known as “risk investment” (Langberg, 2004). Risk investment is invested as shares and the financier expects a superior “rate of return” to recompense for the amount of risk invested (Kelly & Hay, 2003). There are 2 main types of venture financing in the UK and they are; formal venture capitalists (large financial institutions) and informal venture capitalists (wealthy private investors commonly known as “business angels”).
The UK Formal Venture capitalism began in the 18th century (Harding & Bosma, 2007). During that time Entrepreneurs found affluent individuals to get support for their new businesses. This informal tradition of funding eventually formed a business trade by a number of venture capital firms created by many wealthy. Currently there are over 120 venture capital establishments in the UK, which fund billions of cash annually to the UK SME market (Frielinghaus et al., 2005).
Informal venture capitalists are mainly recognized as Business Angels who are wealthy individuals with a high class reputation of managing well run businesses (Masson & Harrison, 2004). As investors business angels bare a larger risk than venture capital firms as they have to be liable for the loss of the investment incase the business they invest lose out. On the other hand venture capital firms have many investors who can be hand in hand to one another in a bad situation (Masson & Harrison, 2004). Business angels are more common in UK where they tend to invest more on SME businesses where banks and venture capital firms decide not to, which will be further discussed under evidence analysis (Madill et al., 2005).
Business angels tend to be get more closer to the entrepreneur with a higher level of involvement in the firms operations, which shows that their choice of target firms are somewhat different than venture capital firms’ requirements and business angels’ investment decisions are made solely on the basis of the relationship between the entrepreneur and the investor (Masson & Harrison, 2002). Although entrepreneurs could use formal & informal investors at different stages in the business as shown in the (figure 1), it shows where business angels are needed where we will further discuss later on (Aernoudt, R., 1999).
Figure 1: Financial sources and their involving stages
Source: (VENTURE CAPITAL, 1999, VOL. 1, NO. 2, 187 – 195)
- Understand a business angel, an entrepreneur and their relationship in a SME start-up businesses in UK
- Identify detailed requirements of business angels when it comes to an investment
- Determine how different countries & cultures undertake investments
This literature review is concerned about the academic groundwork of the research objectives which inquires about investment categories business angels tend to invest in a small to medium sized business sector. It also looks at how different authors have elucidated about the investment natures of different countries like New Zealand, Denmark, Sweden & etc.
In order to give a clear structure of this academic review, it will be categorized into subsections to converse different authors’ views about the research objectives. First the review will discuss about the academic Theories of investments. Then it looks at Business angels and entrepreneurs in the UK. Finally the review will investigate different countries’ nature of investments in their own markets.
2.1 Theories of Investment
There are several investment theories defined and compared by many authors. This thesis mainly focuses on informal investors who wish to invest on SME start-up businesses. Although Stock market related investment theories are irrelevant for our objectives it will be impolite to ignore discussing all investment theories. Therefore let’s investigate the theories and in the later chapters discuss the practical concepts (evidence) used currently by successful investors.
Among the following theories, Efficient Market Theory will be related to investment in stock listed companies and “principal-agent, prisoner’s dilemma framework & resource based theory” will be about business angels investing in SME businesses.
2.1.1 Efficient Market Theory (EMT)
According to (Burton Malkiel, 1973), the stock values that show in the stock market almost define where the company is in its territory and how well it performs compared to its competitors. He suggests that stock prices may not always be accurate but it can be correct most of the time. On the other hand few business managers disagree, explaining that there company’s values are priced unfairly and stock prices do not accurately replicate the performance of their companies (Burton Malkiel, 1973). The following discussion will communicate what efficient market theory is about and explore the arguments against it. According to (Michael Firth, 1975), it is stated that there were many academic researches carried out to monitor the share price behavior by investment advisory firms and investors to obtain profitable investment strategies.
What is EMT or EMH?
(Burton Malkiel, 1973) explained that Efficient Market Theory (EMT) is also known as Efficient Market Hypothesis (EMH) on a more technical term. This theory is a method of defining how stock values behave the way they do in terms of investment decisions. (Eugene Fama, 1965) later categorized EMH into three sub assumptions and they are as follows;
1. Weak form (EMH)
This method assumes that current stock values replicate all past information about the specific company such as performance measurements, returns & etc. By analyzing the stock’s price chart, it can help the investors verify as to what the future holds for the company’s stock values (Eugene Fama, 1965).
2. Semi strong (EMH)
The assumption built on this method is that all the publicly available information and historical information replicates the values of a company’s stock prices in the market. So the investors could gain more knowledge and confidence through a company’s financial statements and recent developments. It will enable the investors to judge the company future performance (Eugene Fama, 1965).
3. Strong form (EMH)
This method expressed that, other than publicly available information, the investors get an inside look into the company which largely reflects the stock value (Eugene Fama, 1965).
Principal Agent Theory
In general terms Principal Agent theory is defined as a business management framework to observe the behavior between employer & contractor or employer & employees (Spence and Zeckhauser, 1971; Ross, 1973). So here this theory can be applied to the business angel & entrepreneur relationship and discuss its implication on the investment process (Jenson and Meckling, 1976; Harris and Raviv, 1978).
In the corporate business, the principal (Business angel) usually appoints the agent (manager) or else make sure the entrepreneur works according to the principal’s ideas in the business (Jenson and Meckling, 1976). The principal usually make sure that the agent’s business intentions are as similar to him/her (www.financemind.com).
In other words, the principal wishes to make sure that the business runs well and succeed the way he/she believes best (Eisenhardt, 1989). But on the other hand, over an informational advantage the agent could think otherwise for the business. This is where the problem of shared risks arises as (Eisenhardt, 1989) explains, where the Investor (principal) and the agent (manager) could end up having different opinions towards the business.
The agency theory is widely used in venture capitalism (Bruton, Fried & Hisrich, 2000a). Having conflicts due to differences in interests, it is essential to minimize these risks as (Bruton, Fried & Hisrich, 2000b) agrees with Eisenhardt. To reduce these risks investors make sure that they actively monitor the companies they invest and build a better and close relationship with each other (Busenitz, Fiet & Moesel, 2004). According to (Sweeting & Wong, 1997), using a principal agent theory to evaluate a business angel investment is not highly recommended anymore. It is much better to have a mutually agreed relationship. The agency theory shows that money motivates both the principal and the agent (Busenitz, Fiet & Moesel, 2004). But financial motivations or economic factors do not relate business angel’s relationship with the entrepreneur in this theory (Wijbenga et al., 2003).
Prisoner’s Dilemma Framework (PDF)
This is yet another theory that can be used in an investment study. In this framework there can be either a conflict or a development between the two parties involved (Cable & Shane, 1997). In this theory, both parties can either go in their separate interests and gain a certain pay off or co-operate with each other and achieve a higher pay off (Bruton, Fried & Hisrich, 2000). The prisoner’s dilemma framework promises better fitting for the business angels and the entrepreneurs because it does not presume a hierarchical relationship between the two parties (Bruton, Fried & Hisrich, 2000; Cable & Shane, 1997). Still the PDF theory only focuses on the investor – entrepreneur relationship and not any of the business angel investment activities or impacts. It concludes that the theory is not suitable enough to define a business angel & entrepreneur relationship (Cable & Shane, 1997).
Resource Based Theory
The resource based theory has many influences on the entrepreneurship. Business angels can contribute many resources other than cash it self. According to Freear, Sohl and Wetzet (2002), angel investors can contribute five types of resources to an entrepreneur: Human, physical, social, organizational & financial.
Human capital can be taken as angel investors’ contribution of business knowledge, skills and business experience to the firm (Erikson & Nerdrum, 2001a). Social capital can be gained when business angels provide their business contacts (Angel networks). By this, the entrepreneur has the opportunity to meet other investors and extend the funding possibilities to the business. Physical resources can be machines or factories and organizational capital can be described as the influence and advice the investors can give for the business for an example making the business improve on its experience (Erikson & Nerdrum, 2001b).
Financial capital consists of the funding provided in the beginning of the start-up phase (Cassar, 2003). By far this presumed to be the best suited theory to define a relationship between a Business angel and an Entrepreneur where all aspects are covered (Rose, 2005).
Summary Of Theories
Looking back at the efficient market theory, Agency theory, Prisoner’s dilemma framework and Resource based theory; it seems to be that the “Resource based theory” is the most suitable theoretical framework for the Business angel investments. However the Resource based theory has to be amended with few assumptions: Human capital should be taken as the (knowledge, skills & business experience) investors contribute with (Ardichvili et al. (2002).
Although we discussed the above theories, many researchers have described and tried to apply other similar theories to the investor – investee relationship [Example: Procedural Justice (Busenitz, Fiet & Moesel, 2004), learning and knowledge-based view (De Clercq & Sapienza, 2002), resource exchange theory (Gomez-Mejia, Balkin & Welbourne, 1990)].
All the investment theories have a common characteristic that have only a few relevant investment features in them to the investor-investee concept. To make it applicable for the Business angels and entrepreneurs all these theories should have few amendments and adaptations (Sapienza, Manigart & Vermeir, 1996).
Small And Medium Enterprise (SME)
William Kendall, the Chief Executive of Whole Earth Ltd stated, “SME business is a fantastic place to work. You have to think innovatively to be an entrepreneur. It’s thrilling and it’s enjoyable.”
According to (European Industrial Relations Observatory) there is no general definition for SME. But the (Government’s Bolton Committee, 1971) cited that the characteristic of a SME firm is a self-sufficient business being owned by a single owner with a small market share. The report also stated that the size of the SME changes in different industries.
Although it is hard to give one specific definition for SMEs, it can be measured and classified by numbers (employees & revenue rates). The defining measurements are as follows:
Definitions: (The Department for Business, Enterprise and Regulatory Reform – BERR, UK) has defined SME with 3 types of measurements and those are based on amount of employees:
Micro firms: 0-9 employees;
Small firms: 0-49 employees and
Medium firms: 50-249.
The (European Commission) changed the definition of the SME to increase the partnerships and innovations. The definition which took affect on 2005 is: “ A Micro, Small and Medium-sized enterprise (SME) is made up of firms which employ less than 250 employees and have yearly revenue less than 50 million euro”.
Importance Of SME In The Uk
The country has raised the level of growth productivity in the last era reducing the competition gap between other countries like US, France & Germany (BERR, 2008).
Currently UK is reacting well to the global prospects and challenges. The growth of the SME market increases each year promising to boost the economy of the country. According to (European Business Angels Network (2007) Dissemination Report on the Potential for Business Angels Investment and Networks in Europe), the employment and annual revenue contribution of the SME industry as a whole is more than 50 percent of the total.
The UK government provides necessary support for people to step up and start their innovative business to increase the competition level of the country (www.berr.gov.uk).
Earlier it was discussed that previously recognized agency theories explains that the investor, ensuring a healthy relationship is highly regarded as a successful investment aspect in an investment (Kelly & Hay, 2003). Therefore exploring more about what authors have studied about entrepreneurs and investors is vital.
The difference between a formal venture capitalist and a business angel is that a venture capitalist invests looking at the company and its ability to perform (Schramm, 2004). On the other hand the business angel focuses mostly on the entrepreneur to make sure there can be a good business relationship (Mark and Robinson 2000, p138). The entrepreneur is the only key to get the funding needed for a start-up business. As an entrepreneur, it is vital to gain the investors trust and confidence in the business idea. According to (Osnabrugge & Robinson 2000, p123), it is cited that during a business start-up there is a high percentage of entrepreneurs failing to make good management decisions in the initial stages. It is very sensible for an entrepreneur to seek a business angel as they pay special interest on the business they invest in with all their resources including non-financial contributions. It could help fill all the management weaknesses of an initial stage of the business and save huge amounts of consulting and managerial costs (Mason and Stark, 2004).
(Osnabrugge & Robinson, 2000) had explained that entrepreneurs should be aware that the investor not only pays attention on the business proposition but also the entrepreneur himself to ensure the safety, confidence, enthusiasm and the ability to depend on the entrepreneur. Trust is something investors work hard to find in an entrepreneur, because they invest large amounts of financial resources on a person they met in a short period of time (Osnabrugge & Robinson 2000, p125). According to a study conducted by Stedler and Peters; entrepreneur’s capability to convince the business angel to invest is very important and showed that 81% of business angels has expressed that a positive first impression established in the first meeting as important (Stedler and Peters, 2000).
When it comes to angel investment decisions being made, business angels need to ensure that the entrepreneur should be a proficient manager (Gerald and Joel, 2000).
Loyalty, leadership, reliability and personality are important characteristics that angel investors look into when they evaluate entrepreneurs. An entrepreneur should be able to have those qualities to gain an influence of the investor (Aernoudt 1999 & Sappa 2006). The characteristics that separate a good ownership from a poor is, that if the entrepreneur is able to establish trust and leadership skills with confidence and make the employees follow him/her (Micah Baldwin 2007).
Investors find it comforting to know that the entrepreneurs have invested partly on the business before seeking external investment. This gives the investor the idea that the entrepreneur has given all the effort in the involvement of the process and that the financial value of the business is appreciated (Osnabrugge & Robinson 2000, p127).
According to (Sappa 2006), business angels take lots of time and effort into finding out background information on the entrepreneur to ensure that the owner has the right expertise to manage the business he proposes. (Haines and Riding 1998) corroborates furthermore by adding that the entrepreneur sharing his/her previous business experiences and being much more practical about the business brings more information and confidence to the investor.
Finally all the above characteristics that were discussed are very important for a new start-up entrepreneur to influence investments from professional business angels.
As we have gone through the theories of business angels it is important to know who business angels are in the minds of researchers. A business angel is a highly prosperous individual who can be a business person and willing to invest part of his/hers finance on a promising entrepreneur who has a potential to succeed (Isakssin 2000, Helle 2004).
According to (Harrison & Manson, 1999), there are three eras of business angel researches conducted in the investment business:
First era of business angel research was conducted by United States of America in early 1980s. Authors like; (Landstrom, 1993) from Sweden and (Harrison & Manson, 1992) from United Kingdom repeated the same work by giving out similar results. In this era it was solely concentrated on business angels’ thoughts, activities and characteristics (Freear, Sohl & Wetzel, 2002).
Second era enabled researchers to go deep into business angels by investigating their post investment involvements. Theory building up and applying for business angels began in this era. Although there were theories built for business angels, it wasn’t developed enough to be completely suitable for the activities of angel investors (Connolly et al., 2006).
Third era will be the era about the future researches of business angels. There were many faults in the previous researches done and they need to be taken in a new direction to make sure the researches investigated will produce good results (Arenius & Minniti, 2005). This would finally make us understand the minds of business angels and match the Business angel – Entrepreneur relationship under changing economy, culture & competition (Connolly, O’Gorman & Bogue, 2006). By the help of (Harrison & Mason) & Swedish researchers like (Sorheim 2005) will enable to investigate on the changing environment of Business angels. This also mean that the theories being found in the previous eras could finally be developed enough to apply on the business angels’ current investment methods and get positive results (Gompers & Lerner, 2007).
Characteristics Of Business Angels
Almost all the business angels who actively invest on new businesses have few common characteristics. They all have the main motive to increase the potential of their financial capital (Duxbary, Haines & Riding 1996). But (Landstrom 1993, Osnabrugge and Robinson 2000) explained that all business angels should not be profiled in a similar way because cultures and person to person could make them different to each others ways in terms of making a personal investment decision.
Although there could be many differences between business angels, (Osnabrugge and Robinson, 2000) also stated that there are general motives behind all business angels when it comes to a certain result they expect out of an investment. When Venture capitalists and business angels are taken together it is wide clear that Business angels are individuals who prefer to invest less financial capital than of the formal investors who invest large amounts. Business angels also prefer to invest their money mainly on initial stages of a business (Osnabrugge and Robinson 2000). When it comes to formal investors, they are selective in industries they invest on depending on a lot of information and research. But the Business angels invest on the entrepreneur regardless of what industry sector the business idea would succeed on. They do little research on the industry but heavy research on the entrepreneur they expect to build a trust worthy relationship, because they depend on the entrepreneur much more than the venture capitalists that only rely on the market and the performance of the company (Osnabrugge and Robinson 2000, p63). Furthermore a research conducted in the Norwegian angel market and studies conducted in the US have identified several angel categories.
There could be cultural and economical differences among countries like (UK, Sweden & Singapore) but angel investors do have likely investment standards in those countries (Landstrom 1993). (Freeny, Haines & Riding 1998) explained that the markets which business angels are currently active are where they are wiling to invest more on.
There could be many differences in Business angels’ personalities and points of views of the whole investment process. There are studies that showed the “most regular business angel”. It is stated that the age, where successful individuals decide to invest their money on a business is when they get to their 50s. This shows that it is almost a retirement phase from a business point of view. This can be confirmed by a research carried out in Germany where it stated that 95% of BAs were male individuals, 56% were directors or owners of their businesses and 17% were individuals who were in the director board on other organizations (Stedler & Peters, 2003). Even (Osnabrugge and Robinson 2000, p156) supported Stedler and Peters by explaining that the individuals were in director posts and had good business experiences before they decide to move on into personal investments.
Most business angels involve themselves heavily during the initial stages of start-up businesses. They wish to invest near to their homes to make sure of convenience. And Business angels are well educated, wealthy beyond a certain average and expect to have a good life with their feet up on a desk holding a glass of wine, which we all hope to achieve one fine day (Freeny, Haines & Riding 1998).
Although this thesis aims to look at the characteristics of UK business angels, it was clear by all previous studies that there are common statistics about their decisions and behaviors. This tells us that, UK angel investors too are not far from what was described before in the theories. Still it is important to point out few common characteristics of UK business angels;
Common Characteristics Of UK Business Angels
According to (Ardichvili et al., 2002), Business angels in the UK have been or still are active business owners. They invest in more similar markets to what they are operating in, which saves them a lot of time trying to understand the market and the operations.
Like all business angels, UK investors are highly motivated by the return of their investments and the effort (non financial motives) they have put in to the start-up business. They do enjoy being a part of a new business hoping to succeed for the better part of the community and the country (Landstrom 1993).
Furthermore UK business angels prefers and makes sure they invest on new businesses that they could visit regularly, which means they invest in promising firms which will locate geographically near to where they reside (Ardichvili et al., 2002). BAs would rather invest in firms within their residing area, than investing in a location where they find it hard to meet the entrepreneur even though it would double their investments (Harrison, Mason & Robson, 2003). Most British angels prefer their entrepreneurs operate within 100 miles of their homes although investors who invested on technological businesses are willing to travel long distances (www.bbaa.org.uk).
According to Mason, British angels mostly prefer to invest on small businesses during its initial stages where it is not too late to put in not just their finance sources but their advice and experience to get things on the right track. This, in a way gives them satisfaction of being a part of a promising business (Mason, 2002).
After going through the common characteristics of British Angel Investors, it is quite clear that there isn’t a major difference compared with the international countries like Sweden and Denmark which will be discussed later. We discussed about Business angels and it is vital to know the categories of their investments.
Investment Aspects Of A Business Angel
One of the objectives of this thesis is to find out how Business angels in UK and other similar countries decide to invest on a certain investment they find it promising. An investor looking for good reasons to decide on an investment is known as Investment Aspects or Investment Criteria (Landstrom, 1993). It is a way of evaluating the business and the entrepreneur to ensure the security and the profitability of the business proposal.
According to the venture capitalism and angel investment comparison carried out by (Osnabrugge & Robinson 2000), it revealed that although there were similarities among their attributes in their investment standards there were a certain amount of dissimilarities which makes business angels favorites for a new start up business.
For an example, venture capitalists are prepared to invest almost in all stages of a business and therefore they look into all the past and probable financial records of the company. On the other hand the business angels much prefer to invest on a start-up phase of a new business where past financial experiences are not so important to them
(Osnabrugge & Robinson 2000).
Most business angels give similar priorities to investment aspects, when it comes to making a decision. With much researches conducted over the past years (Osnabrugge & Robinson 2000) has come up with a selected summary that illustrates the criteria of an investment. The following (Table 1) of twenty-five selective factors are prioritized by well known angel investors;
Priority factors for an investment
passion of the industrialist
Dependability of the industrialist
Sales prospective of the product
proficiency of the industrialist
Entrepreneur(s) first impression
Development prospective of the market
Quality of the product
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