Vol. 11, No. 6, Pg. 26. Angel Investors: Using the Internet in the Private Offering of Securities.

• Author: By Brian C. Bonner and Laura H. Hugins

South Carolina Lawyer

2000.

Vol. 11, No. 6, Pg. 26.

Angel Investors: Using the Internet in the Private Offering of Securities

26"Angel" Investors: Using the Internet in the Private Offering of SecuritiesBy Brian C. Bonner and Laura H. HuginsIn the jargon-filled world of financial markets, "angels" are wealthy individuals who provide equity capital to start-up companies. Recent projections estimate that angels inject more than $50 billion into young companies each year-more than twice what venture capital firms contribute. Emory Thomas Jr., Bands of "Angels" Get Organized (visited February 1, 2000) www.msnbc.com/news/304203.asp? cp1=1.

While angel investing has been a vital source of capital in this country over the last century, the Internet is making access much more readily available. For instance, companies such as Garage.com, Direct Stock Market (www.DSM.com.), Nvst.com and IPOnet (www.e-IPOnet. com or www.Rule506.com) are operating Web sites that enable potential investors to connect with entrepreneurs. In essence, these sites provide a financial market dating service in cyberspace.

This expansion of angel investing through the Internet raises two issues. First, how can this method of raising equity capital benefit South Carolina businesses? Second, how can businesses lawfully take advantage of the Internet to raise equity capital?

THE CHALLENGE OF THE SEED CAPITALIZATION

Because capital is the lifeblood of any business, whether a start-up company or a more fully developed enterprise, access to capital is critical. Capital acquisition is almost always undertaken in specific stages over the life of the enterprise. The most common sequence of these stages is based on the ease of the start-up company's access to the capital source.

A start-up company typically begins obtaining funds through the entrepreneur's personal funds, then seeks funding from the entrepreneur's friends and family. As the need for additional funding arises, entrepreneurs look to wealthy and sophisticated strangers, or "angel" investors, but this avenue will only be lucrative if the enterprise is able to attract angels' interest. If unable to attract angels, the start-up company will often pursue traditional venture capital sources or possibly a joint venture with a more fully capitalized partner. Alternatively, if the entity is especially fortunate, it may have enough market promise to vault over the venture capital stage and proceed directly to an initial public offering.

As the investor audiences at each of these successive stages become further and further removed from a connection with the enterprise and its founders, being able to adequately demonstrate and communicate a compelling investment opportunity becomes ever more critical for the enterprise. However, demonstrating such an opportunity can be difficult to accomplish without a record of performance that is traditionally only developed and realized over time-usually several years. For this reason, a start-up enterprise is rarely able to skip more than one of these stages in its capital evolution.

Public Offerings. Regardless of the zeal exhibited by many entrepreneurs conceiving of an initial public offering, a public offering is almost always impractical for a start-up company. Because a public offering involves the offer of securities to a very large number of investors without regard to their individual levels of sophistication, the success of the offering invariably depends on the ability of third party selling agents (typically one or more investment bankers) to sell the company's securities, either on a "firm commitment" or "best efforts" basis.

The selling agent's success, in turn, depends on whether the company's investment potential is attractive enough to make investors part with their money. As noted above, the absence of any track record makes communication of the compelling investment opportunity very difficult for the start-up enterprise. Public

27 offerings are also very expensive and time consuming, requiring the services of accountants, attorneys and selling agents in preparing registration and disclosure documents that must pass a rigorous review by the U.S. Securities and Exchange Commission (SEC), typically involving the filing of several amendments over the course of several months. Consequently, start-up companies are limited in their ability to successfully pursue this avenue of equity capital until much later in their capital evolution.

Friends and Family. Although family members are often the first individuals that entrepreneurs contact for capital, the pool of friends and family is frequently quite limited and offers insufficient funding to meet the ongoing needs of many start-up companies. Furthermore, embroiling friendsand family in a risky, fledgling company can often aggravate the already stressful operating atmosphere of the enterprise.

Traditional Venture Capitalists. The start-up enterprise that has either abandoned or exhausted its capital opportunities from friends and family, but still finds itself not quite ripe enough for an initial public offering, is basically left with the choice between

28 pursuing traditional venture capital sources or wealthy and sophisticated "angels."

In most cases, these alternatives can present a very unattractive choice or no choice at all because traditional venture equity capital is often not readily available for start-up companies. This lack of access is due, in part, to the venture capital firms' minimum annual revenue requirements for the start-up enterprise and the gravitation of these firms to offerings larger than the typical $500,000 to $1 million seed capitalizations of start-up companies. In addition, although venture capital firms provide a network of contacts for entrepreneurs, many start-up companies are not willing to relinquish the managerial control or substantial ownership of the company that venture capital firms almost always require.

"Angels." The "capital gap" between friends and family and the traditional venture capitalist (or the initial public offering) is littered with the remnants of many, if not most, start-up companies. Applying the term "angel" to the group of investors willing to help bridge this gap is consequently apropos.

Because the ability to reach these angel investors in many cases means the difference between the success or failure of the enterprise...