Business angels are crucial to the start-up ecosystem, says BMI Executive Institute affiliated professor Rudy Aernoudt. They have proven to be crisis resilient. However, we see a shift from seed financing to a follow-on financing round of start-ups in which business angels were present in a first round. As a result, less money is available for start-ups, and this could lead to a new start-up gap. To prevent this, business angel networks, such as the Lithuanian Business Angel Network (LitBAN), have a crucial role, as without business angel investments, the whole pipeline for venture capitalists would dry up leading to a devastating impact on the economy.
A second equity gap
Inflation, COVID-19, volatile valuations, valuation cuts and down rounds are amongst the major reasons why venture capitalists are increasingly investing closer to the market where the risk is reduced and the average return is higher. Moreover, as European funds become bigger, mainly through US funding, the fund managers prefer to look at big deals where the potential carried interest is much higher and the cost of due diligence, expressed as percentage of the amount requested, is lower. This creates a new funding gap for which other financiers are not immediately available. To illustrate, during the past six years, the proportion of late-stage capital for mature VC-backed companies in Europe has increased significantly: in 2021, a record €69.6 billion was invested into late-stage rounds, equivalent to 67.3% of the total. By comparison, five years ago, 48.0% of the aggregate figure in 2016 was from late-stage rounds (data pitchbook 2022).
Incidentally, this is a perfect example of market failure defeating the ‘risk-capitalist’ avoiding risk, in contradiction to what their epithet might suggest. This trend was reinforced by the successive crises. As the NVCA Venture monitor 2022 concludes: “first-financing capital could become more difficult to raise should volatility persist”.
Preliminary research confirms this analysis. In the United States business angel follow-on deals increased by 26%, but investment in new start-ups fell by 12% (Angel Capital Association data, 2021). Analyses of the Scottish and Irish Business Angel (Colin Mason, 2022) came to analogous conclusions, being a shift in which business angels mainly invest in companies in the second round of financing where they previously financed the earlier rounds and invest only very limited amounts in new start-ups. In Scotland, 90% of the amounts invested by Business Angels went to follow-on investments. After all, the COVID-19 crisis, and to a lesser degree, the energy crisis, led to lower cash flows for starters and hence to liquidity problems. These were absorbed by, often government-supported, bridging loans and additional cash injections by business angels. As a result, the business angels are tapping into their reserves, or building up reserves for the second round, which means that less money is available for new starters.
Indeed, business angels who finance a start-up in the first round have to consider the next financing round as it might still be too early, for the above-mentioned reasons, for a venture capitalist to step in. When business angels want to avoid the broken chain phenomena, in order to overcome a potential valley of death, they have no other choice than to assure the next financing round. And although this second round might be less risky and less expensive (except for the down-rounding cases), it often requires larger amounts of money which are not always compatible with the investment capacity of the business angel.
The role of Business angel networks
Business angels will therefore build up reserves for the second round and invest possibly together with a few other angels in order to increase their investment capacity. Therefore, syndication must be encouraged, as the second round of financing requires larger amounts, albeit by lower risks, than the earlier rounds. Business angels therefore increasingly need to step into the same projects together and this syndication can be facilitated by business angel networks.
Secondly, potential business angels – the so-called virgin angels – must be further mobilized. There is no shortage of money, but transmission to start-ups remains a problem despite the liquid financial markets. Business angel networks have a crucial role here as well, and should be further, and increasingly, supported. Particular attention could be given to female business angels as this is still a largely untapped potential.
Finally, cross-border investment should be promoted. Collaboration amongst business angel networks could in this context be an interesting tool. Besides, tax benefits associated with the investments should not be limited to national investments. Business angels who invest in cross-border projects – and second round financing often implies international expansion – should also be able to enjoy such tax benefits. This is already the case in France, for example and should be considered as a benchmark for other countries.
By way of exit
We need to consider the financing of the market as a whole. Without business angels, the pipeline for venture capitalists will run dry. Without properly functioning and unfragmented financial markets, there are insufficient exit opportunities for both business angels and venture capitalists in Europe, obliging them to go transatlantic. Based on a sample of investments by business angels in Europe, it appeared that for 81% of the investments, no exit had yet been realised. Anyone who sees no exit prospects will be reluctant to step in.
Business angels sow the seed while venture capitalists invest closer to the harvest. Business angels are responsible for the start-up financing for 90% of start-ups in Europe. In other words, without business angels there would be virtually no start-ups and the venture capitalists would therefore have no candidate companies. Yes, business angels are at the core of the European ecosystem and business angel networks are the trigger for the necessary syndication allowing business angels to be capable of investing their smart money until the venture capitalists can step in. If business angels do not step in, the entire start-up ecosystem will be jeopardized. If this happened, the start-up ecosystem, much needed in crisis and post-crisis times, would be jeopardized.