July 11, 2007
Barbara Black on Ibrahim's Angel Investors
Posted by Christine Hurt

First, I want to thank Christine Hurt for extending me an invitation to participate in the Conglomerate Workshop for Junior Scholars. I greatly enjoyed the opportunity to read and comment on Darian M. Ibrahim’s paper. I learned a great deal about angel investors and look forward to learning more as I read others’ comments.

Before there is venture capital, entrepreneurs need angel investors -- wealthy individuals who personally finance high-risk ventures that present both high-growth potential and great risk of loss. In this very interesting and informative paper, Professor Ibrahim provides illumination into the secretive world of angel investing. Angel investors act as the "conveyor belt," providing the funding as the start-up moves from the initial entrepreneurial stage to the point where venture capitalists are willing to invest and, in turn, move the venture toward an IPO or private sale. Professor Ibrahim sets up two distinct prototypes – the angel investor, who made his money running a business and is comfortable with his own ability to screen, monitor and control his investments, on the one hand – and the venture capitalist, who frequently does not come from an entrepreneurial background, invests other people’s money, and relies on corporate financing techniques to manage the risks.

In this way, Professor Ibrahim sets up his first puzzle. The conventional wisdom is that no one gives anyone a blank check; if you’re turning over a large sum of money, you want to maintain some control over it or at least protect yourself from opportunistic behavior. This played out in earlier days in the cases and literature involving limited partnership interests and minority shareholders in close corporations. Yet, Professor Ibrahim asserts, angel investors do not avail themselves of the kinds of protective measures that venture capitalists routinely employ. What accounts for this behavior? Professor Ibrahim first presents a solution to that puzzle and then presents us with another one – if it makes sense that angel investors do not bargain for protective measures, then why are we now seeing angel investors that are, in fact, acting more like venture capitalists? Professor Ibrahim explains this by describing how the formerly distinct categories of angel investor and venture capitalist have evolved into a third, hybrid category – the angel investment organization (AIO).

A great strength of this paper is its specific focus on the nature and the role of the angel investor. (A quick search on SSRN and Westlaw for law review articles with "angel investor" in the title turned up very little that was relevant on this topic.) Professor Ibrahim illustrates the distinctions between an angel investor and a venture capitalist, to make us recognize that an angel investor is not simply a first-stage venture capitalist, but a distinct prototype.

To frame it as a question familiar to securities lawyers, is the angel investor a "sophisticated investor"? The answer is certainly yes, based on the individual’s wealth and track record as a successful business person. On the other hand, the angel investor is

arguably behaving in an unsophisticated manner – he is (over?) confident of his own ability to select and monitor his investment, he does not bargain for contractual protections, and in many instances he does not diversify his portfolio. Professor Ibrahim describes some of the factors that could contribute to irrational behavior – the angel investor’s emotional attachment to the business venture, an altruistic desire to give back, the importance of trust. There may be others as well. How many investments by angel investors are motivated, at least in part, by family and friendship considerations, the excitement of being the first to invest in a new technology? What is the likelihood that contractual protections are passed up because of a disdain for lawyers? Professor Ibrahim allows for these non-financial considerations, but principally argues that angel investors’ foregoing protective devices is rational. They do not bargain for protective measures, because they understand their place in entrepreneurial finance and the need later on for venture capital. "Although venture capitalists recognize the importance of angels in entrepreneurial finance, they are hesitant to invest in start-ups where an aggressive angel’s preferences must be ‘unwound’ for venture capitalists to receive their standard preferences….The rational angel recognizes that she is the first, but not the last, source of outside investment and acts accordingly." Perhaps this is the case, but I am not sure if this very rational explanation is sufficient to account for the restraint to resist the very human tendency to demand what the reasonable investor could obtain. Angel investors may be yet another example of how reasonable or even sophisticated investors can act in non-rational ways, although, in this case, the non-rational behavior achieves a result that is logically defensible.

I appreciate the limited information available on angel investors and the difficulties in studying them, but I am left with a desire for more information to answer this conundrum. So the strength of this paper exposes a weakness. Professor Ibrahm provides a plausible explanation for angel investors’ behavior, but more empirical data would help to resolve satisfactorily the puzzle. In the absence of empirical data, more anecdotal evidence could shed some light on these questions. Do we know why, for example, twelve angel investors made the decision to fund Amazon.com, or why Andy Bechtolsheim invested in Google? There may be some great insights in these anecdotes.

Professor Ibrahim sees the rise of AIOs as the answer to the second puzzle – if angel investors behaved rationally in not demanding more protections, then why are they abandoning this model? I found the answer to the second puzzle less successful than the first. In part, this is because Professor Ibrahim was so persuasive that angel investors were a different kind of animal that it was deflating to find that they may have evolved into just another subspecies of venture capitalist. More fundamentally, the key question, as he identifies it, is what to make of the shift toward venture capital-like contracts in AIO investments? Professor Ibrahim has sketched out some plausible explanations for this development to demonstrate that it is not inconsistent with the answer to the first puzzle, but I think they require amplification to counteract the argument that the rise of AIOs is, as he puts it, "an overdue corrective for traditional angel naivety." He does not fully account for the inconsistency – if angel investors do not bargain for protective measures because they recognize the importance of later venture capital, why is not the same restraint present in the case of AIOs. His explanation – that venture capitalists may accept aggressive contract terms from AIOs because they view them as the equivalent of early stage venture capitalists – is incomplete, given the importance of the rational explanation for non-aggressive provisions in his argument in the first part of the paper. I recognize that here again Professor Ibrahim is confronted with a lack of empirical data to answer sufficiently the questions presented by the increasing popularity and visibility of AIOs. Professor Ibrahim’s conclusion may be that AIOs, despite their name, are really variations on the theme of venture capitalist and not really angel investors, in which case the link between the two puzzles becomes somewhat attenuated.

I have two smaller points that may simply reveal my ignorance of this field. First, the assumption throughout is that angel investors and venture capitalists are investing in corporations (references to common vs. preferred stock, board representation). Are LLCs not used in these start-up situations? Second, there are two references to the common complaint by venture capitalists that angel investors overvalue the enterprise. I would have liked a fuller explanation of why this is the case and how venture capitalists deal with it.

Congratulations on a job well-done!

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