No network, no venture
Myall Consulting's senior consultant on Business Angels Czech Republic (BACZ) and the case for networks of this sort
Business angels are private, wealthy individuals with an appetite for getting involved in growing entrepreneurial firms – either to realize a lucrative return, to complete their existing investment portfolio or to satisfy their entrepreneurial ambitions. Because business angel funding represents the only alternative available to companies in the initial "start-up" stage, the creation of a favorable environment for both parties is essential. This is where business angel networks come in.
What are business angel networks?
Business angel networks (BANs) create an environment where local entrepreneurs can present their projects to a range of private investors, and if successfully matched, can raise the funds required to realize them. Because both groups (entrepreneurs and investors) are informal in nature, their opportunities are usually limited to those found amongst their own network of contacts. BANs serve the useful function of bringing these two sides together, helping them to overcome limitations and to expand their possibilities. BANs can also provide professional advisory in the areas of business planning, market analysis, project evaluation, due diligence, and other critical matters.
How do BANs operate?
The operational procedure of a typical BAN is quite simple. On one side is the entrepreneur, who presents his project in the form of a business plan. Often, these business plans are structured according to guidelines or templates provided by the BAN itself. On the other side is a wealthy individual, motivated by expectations of high reward, but also by the fun and satisfaction of being involved in an entrepreneurial firm. A BAN's role is usually limited to matching the two parties based on their specific needs, arranging a meeting and advising them on the recommended approach (based on industry experience) and on the risks involved in this type of investment.
The fees involved in the process include: a membership fee charged for access to the network and including all basic services such as registration, submission of templates and project revision; a "success fee" charged at the end of the process (once the deal is closed) and set as a percentage of the amount raised; and additional fees for specialized services, such as professional advisory, project preparation, due diligence, etc.
What are the weak points of the process?
Based on research performed by the European Commission and the European Business Angel Network (EBAN), there are some fundamental weak points that can create bottleneck and lower the overall success rate of the process. From the entrepreneur's point of view, having to execute the business planning constitutes a significant barrier. Since the majority of entrepreneurs are people without business backgrounds and experience, their projects are often not presented clearly and usually contain a significant information gap. Moreover, business plans written by entrepreneurs tend to focus more on technical aspects and are neither objective nor accurate enough to rely on. As such, BANs often "screen-out" a number of potentially successful projects.
From the investor's point of view, the research points to poor quality business plans (around 80% of the total), a limited variety of projects to choose from and the entrepreneur’s inability to run the business once financed. Add to this the high failure rate of start-up businesses (estimated at 60-80% during the first year of operations), and the result is often a hesitation by business angels to recognize such investment opportunities as a viable option.
Combining both sides, it's easy to spot the vicious circle where inadequate business planning cuts the wings off entrepreneurs’ plans, while a lack of good projects cuts off the capital supply.
Business Angels Czech Republic - what makes them different
Business Angels Czech Republic (BACZ- www.bacz.cz) is a non-profit association inspired by the growing interest in the concept of business angel networks and the increasing number of them emerging across Western Europe. What makes this network unique throughout Europe is that it is geared specifically to overcome the weak points mentioned above. Established in 2001, its founders, struggling with how unprepared the local environment was on both sides of the market, recognized the need to reorganize the network's operations and to address the encountered issues. BACZ was designed to take the burden of planning off the entrepreneur and to shift it to a professional, external entity capable of casting an objective eye on the project and constructing an appropriate plan.
To do this, BACZ has introduced an additional level of financing called "seed funding," which is required to cover the costs of planning, and which benefits both entrepreneur and investor. Additionally, BACZ removes all initial barriers such as entrance fees (membership) and other formal obstacles that could slow the project inflow. And finally, the business failure rate was addressed by partnering with a consulting firm (Myall Consulting) that offers a range of start-up services designed to help new businesses succeed (for more information, please contact: firstname.lastname@example.org).
Why are BANs so important?
Business angel networks play a crucial role in the development of the private equity market by ensuring that the capital needs of SMEs (small- and medium-sized enterprises) are properly addressed. The number of networks in Europe has been growing rapidly since the end of the 1990s, reaching almost 200 in 2003. The number of active business angels in Europe is currently estimated to be around 125,000. This is only about 12% of the estimated potential market of one million business angels.
A study carried out under the auspices of the European Commission concluded that a significant number of Europe's 20 million SMEs represent a potential target market for risk financing ranging from 60 billion euros to 240 billion euros. The direct impact of BANs is estimated to be 64.7 million euros invested in 742 businesses annually.
Business angel funding and the private equity market
As defined by EVCA (European Private Equity & Venture Capital Association), the private equity market provides capital for enterprises not quoted on the stock market. There are two subsets of the private equity market. The first is comprised of venture capital funds and is interested in large-scale deals generally worth a few million euros. The other is made up of business angels, who invest (individually or in the form of syndicates) in deals ranging approximately from 0.1 million euros to 1 million euros.
Speaking in terms of company life cycle, funding from business angels addresses the capital needs of enterprises that are in the seed phase (research, prototyping and concept development), the start-up phase (product development, initial marketing) and the early growth phase. From that point (when the company is breaking even or trading profitably but needs additional working capital) through its expansion, the business will attract the attention of venture capitalists. VCs may also resolve ownership and management issues in the form of buy-outs and buy-ins.
The importance of the business angel sector stems from its ability to meet the wide range of capital needs of SMEs – needs that other financial institutions avoid due to the risk involved. (See graphic on the right)
What influences the development of private equity?
Like any other industry, private equity is subject to the prevailing macro- and micro-economic environment. The development of the private equity market in a particular locale depends on the entrepreneurial culture of the society, the availability of long-term sources of funding, the local tax and legal environment and the overall economic climate.
Based on recent research (2004) conducted by EVCA in 21 EU countries, the most favorable environments for the development of the private equity market are in the United Kingdom, Luxembourg and Ireland. On a scale of 1 to 3, with 1 being most desirable, these countries earned composite scores of 1.26, 1.49 and 1.53, respectively. The Czech Republic (2.12) scored slightly above the average, ahead of both Poland and Slovakia, and second in the region only to Hungary. At the bottom of the list sits Austria (2.53) and Germany (2.41).
What does the Czech Republic's score of 2.12 really mean?
According to the study, the Czech Republic has plenty of room for improvement in the private equity market, placing 15th on the list in terms of favorable legislation and tax regulations. As for the positive characteristics of the Czech environment, the relatively low average tax rate (28%) for private individuals and companies will be lowered even further (to 24%) in 2006. Also, the administrative costs and capital requirements for limited liability company formations (public limited companies and private limited companies) are below average, while gains made from the divestment of shares are tax-exempt if the securities are held for at least six months.
The unfavorable aspects of the Czech private equity environment are mainly related to the regulatory framework. Firstly, there are no tax incentives for private individuals to invest in private equity and venture capital, nor is there a special tax rate for SMEs. Also, the time required to set up limited liability companies is much longer than average. In the case of mergers, the requirement of notification and the obligation to suspend the deal until the relevant authorities approve it could negatively impact the operation. Lastly, regulations regarding R&D provide no fiscal incentives on this expenditure.
A clear choice
When considering the overall benefits of business angel funding and the positive role business angel networks play in increasing this kind of funding, the clear choice is to create a favorable climate that encourages its development. Some of the factors shaping the environment – and the behavior of its players – are deeply rooted in the local culture, and as such take decades to change. However, the most important factors (which indirectly influence the evolution of the others) originate in the overall regulatory framework of the legal and tax environment.
Therefore, in order for investment conditions in the Czech Republic to improve, government officials need to embrace the enormous role they play in the advancement of industry development. With interest from the market side already demonstrated and entities like BACZ already arising, now is the critical time to create legal and tax incentives that support private equity initiatives and that allow the market to take full advantage of its fruits. In the end, this is just too logical and obvious a need for decision makers to overlook. By adopting the right course of action, the climate for angel investing should only brighten.
Joanna Rzesiewska is a senior consultant in Myall Consulting's SME Financing Division.
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