July 11, 2007
George Dent on Ibrahim's Angel Investing
Posted by Christine Hurt

Darian Ibrahim’s paper, The (Not So) Puzzling Behavior of Angel Investors, is well-informed, thoughtful, well written, and extremely useful. I have several comments on it, but they are all minor, friendly amendments.

It’s an old saw that a minority equity investment in a closely held business is worthless. (See, e.g. Donahue v. Rodd Electrotype.) Venture capitalists make such investments valuable by a complex, ingenious package of protections, including staged financing, senior securities, board representation, vetos and exit rights. However, angel (or seed) investors often finance even riskier start-up companies without most or any of these protections. Ibrahim seeks to explain this seemingly reckless behavior.

Bravely (see infra) Ibrahim eschews any neat model. He posits that several factors influence angel investors’ conduct, including reliance on trust (based on personal contact and reputation) and close monitoring. He also deduces that that many angels invest with little formal protection because they are interested not only in financial return but in the joy of the entrepreneurial game and the prestige from backing exciting new ventures. He also suggests that the dichotomy between detailed venture capital contracts and casual angel investments is fading as the angel industry matures.

I say that Ibrahim’s avoidance of any neat model is brave because the result is that the paper does not pretend to any dramatic theoretical breakthrough. However, his description of a complex reality seems exactly right.

As he acknowledges, a major problem in studying angel investments is the lack of rigorous empirical data. This stems both from the novelty of the industry and from its informality; it is practically impossible to obtain details about thousands of individual investments in private companies. Accordingly, both his conclusions and my following comments are based more on conjecture than one would wish.

First, I think that the context of angel investments renders VC-like protections both less necessary and less beneficial in ways that the paper does not adequately recognize. For one, although angels do not formally arrange staged financing, in practice the firms in which they invest lack sufficient capital to go long without additional financing. Further, even without much contractual protection the investor can sue for breach of fiduciary duty. Even if the entrepreneurs accept the reputational damage of such a suit, its financial impact on the venture is likely to be fatal. In sum, the angel may have more power to force the firm into bankruptcy than the paper acknowledges.

Second, Ibrahim concludes that angels are either financially rational or are consciously pursuing non-financial interests. Here again more and better data would be helpful, but I suspect that there’s quite a bit of hubris here. Successful business people tend to assume that they are financial wizards when their success may stem from one good idea or entirely from luck. They think they know a winner when they see it, but I bet that the batting average of angels is pretty low. (Their incaution is probably reinforced by the typical entrepreneur’s dislike of lawyers and contracts.) Of course (as Ibrahim recogizes), those who get burned probably become either more cautious or simply drop out of angel investing. However, there’s always a new crop willing to play the same game.

Finally, I think the paper could give a little more attention to the future of the current trends that it discusses. Although there have always been wealthy individuals willing to finance a neighbor with an interesting business idea, only recently has there evolved something that could be called an angel investment industry. As the paper describes, this industry is already mutating with the appearance of angel investment organizations, whose members often eschew the casual approach of traditional angels in favor of stronger contracts that lie closer to the venture capital model. If this trend continues, the dichotomy between angel and venture capital investments may diminish further; only unsophisticated (foolish?) angel investors will persist in the casual approach.

Again, these comments are minor; the paper is excellent. I recommend it to everyone who teaches business associations as a fine, cutting-edge description and analysis of an increasingly important field.

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