When is an Angel Investor Like a Bank, Only Better?

Bringing on debt at the start of a business is difficult and risky. It can put an undue burden on the cash flow of the business and impact the balance sheet in how the investors view the whether or not their investment will go to grow the business or relieve the debt. Further, there are many risks involved when Early-Stage companies begin seeking loans from a bank; however, in order to understand the risks involved, one must understand what a bank really is. A bank is defined as a financial institution that accepts deposits and channels the money into lending activities. The Federal Reserve regulates institutional banks such as Bank of America, Wachovia, local banks etc. With the recent collapse of the banking industry, bank practices regarding loans are even tougher. Even though the SBA has offered many incentives to get the banks to start releasing funds to small business owners, the flow through has been stymied by the bad debt from both the private and commercial borrowers plaguing banks’ balance sheets. Most people believe that debt financing only comes from banks like these, or institutional lenders, and that equity financing comes from private or institutional investors. The alternative lending market has increased lately and is eagerly making loans available to companies with the need for inventory, contract and PO financing, and invoices to be collected.

Private investors can provide capital in a debt vehicle. This allows private investors to play the role of a bank, but without the fiduciary restrictions of operating under Federal Reserve Regulations. Sometimes the loans are simply negotiated and contracted one on one. The investor generally will guarantee the loan against some collateral or personal guarantee. Unless the investor is more like a “friend and family” investor and loans money based on the good will with the entrepreneur. Most times the investors participate in a convertible note along with other investors as part of a private offering that is regulated by the SEC as an unregistered offering of securities. In this type of loan, interest is typically accumulated and the entire amount is converted into shares of the company at a future date and a predetermined discount against the then value of the stock.

The benefit of a convertible note vs straight equity investment when the company is still private is two fold. The investment amount is accumulating value and is discounted so the amount of equity purchased with the original investment amount is greater than just a stock purchase. Second, it avoids the biggest obstacle to early stage companies attracting capital from individual investors-arguments over the value of the company when there aren’t revenues and the business model isn’t fully vetted.

When a young company seeks traditional commercial loans early on, then important revenues and profit margins are used to service the loan instead of fueling the growth of the company. In fact, many Early-Stage companies can’t even qualify for loans due to an unanticipated shortfall of capital. Therefore, it’s very important for Early-Stage companies to funnel all of that capital towards the growth of the business instead. If this is not done, then the consequences impact negatively on the company who is trying to grow and reach new milestones in its trek to attract private equity investments. Private investment in the form of convertible debt can earn a return of 10 to 40 percent or even a multiple, which works out incredibly well for the entrepreneur and the private investor. It is a better ROI for the investor than any other type of investment, even real estate. Also, it is a better type of capital for a growing business that doesn’t have the cash flow to service debt and with high growth potential can produce great wealth for the founders and investors.

Of course, finding an angel investor to provide early stage venture capital isn’t like finding a “sugar daddy” that is just going to write blank checks. The entrepreneur is accountable to that investor to produce a result, a return on investment as best he or she can. And, the entrepreneur must understand that the cost of the angel investor money is significantly more than the cost of any debt…long term. It is the difference between a fixed interest charged vs the multiple on the value of the stock from when it was bought to when it was sold. Investors are rewarded with that high return, and the entrepreneur needs to be grateful for it, because the investor is taking a huge risk that they could lose everything if the company fails to execute effectively. The investor is “loaning” their money to the entrepreneur with the expectation that it will be returned with a big reward for the risk they are willing to take by “betting” on that team being the best at bringing the product to market and generating revenue and value to the company and shareholders.

Karen Rands is a Venture Catalyst, a Compassionate Capitalist- and a dominant force in the entrepreneur and investor markets with her blogs, published articles, frequent speaking engagements and her weekly radio show. Entrepreneurs are helped through expert knowledge and strategic services offered by Launch Funding Network (LAUNCHfn), and investors join the Network of Business Angels & Investors (NBAI) to learn, collaborate and prosper (2009 Top 50 Angel Groups by Inc Mag). Entrepreneurs sign up for free investor tips, ezine and notices of opportunities to meet with investors at http://GetInvestorMoney.com. Investors sign up for free excerpts of the Learn to Be an Angel Investor handbook at http://HowToBeAnAngelInvestor.com

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