Choosing the best startup funding for your business

As 2011 winds down, small business owners looking for new financing options would do well to take a slice of the holidays and use it to study the two most common startup funding options — angel investing versus venture capital.

In this two-part series, we’ll do just that. And before the year ends, look for columns on ancillary business funding sources, like crowd sourcing and bootstrapping, that will give you an even clearer picture of the business financing landscape.

First, some background, popular convention has it that venture capital is the most common and popular form of startup funding.

Certainly, VC funding is ample in the U.S. and abroad.

According to recent data from CB Insights, the third quarter of 2011 saw venture capital firms pour $7.9 billion into U.S. businesses.

That’s a solid number, given a soft economy and general reluctance for limited partners to give much cash to venture funding firms. If current trends hold true, CB Insights expects VC funding to reach $30 billion in 2011 — the highest level this decade.

While fresh numbers aren’t yet available for angel investors in the third quarter of 2011, data from the first half of the year — compiled by the Center for Venture Research at the University of New Hampshire — shows “stabilization” in the angel funding ranks.

The CVR reports that the angel market has come a long way since its 30 percent market correction in 2008 and early 2009, with total investments totaling $8.9 billion, an increase of 4.7 percent over the same period in 2010. All told, 26,300 entrepreneurs received some angel funding in the first half of the year — that’s up 4.4 percent from the first half of 2010, UNH researchers say.

“The data indicates that angels remain committed to this investment class and at slightly higher valuations than in 2010,” says Jeffrey Sohl, director of the UNH Center for Venture Research at the Whittemore School of Business and Economics. “While the market exhibited a stabilization from Q1 and Q2 2010, when compared to the market correction that occurred in 2008, these data indicate that the angel market appears to have reached its nadir in 2009 and has since demonstrated a slow recovery.”

But a deeper, longer look inside the numbers reveals that angel funders, over the long haul, are much more likely than venture capital firms to provide seed money to a new business startup. According to Fool’s Gold, a book by Scott Shane, a professor of Entrepreneurial Studies at Case Western Reserve University, VC firms, on average, only fund 400 to 600 early-stage companies in the U.S. each year. Angel investors, on the other hand, fund about 16,000 early-stage (or “seed” companies) annually.

In short, Shane is saying that angel investors are an entrepreneur’s best bet for early-stage funding (at least when compared to venture capital firms) by a 27-to-1 ratio.

In Part II of this series, we’ll examine the pros and cons of working with either venture capital firms or angel investors.

In the meantime, take a good look at these facts on both funding sources, from the business planning and funding firm, Equity.net.

They’ll give you a much better idea of what each investor does, why he or she does it, and what he or she looks for before cutting checks.

Angel Investors

• U.S. angels invest a total of around $20 billion per year in around 60,000 businesses.
• Angels invest in around 1 out of every 10 business investment deals considered, or 10 percent.
• The average angel investor is 47 years old, college educated, and self-employed (or has been self-employed).
• The average angel investor has an annual income of $90,000, a net worth of $750,000, and invests $37,000 per venture. (Angels rarely invest more than a few hundred thousand dollars in a venture.)
• 9 out of 10 angel investments are devoted tostartups with fewer than 20 employees, and 7 out of 10 angelinvestments are made locally (within 50 miles of the angel’s home).
• 9 out of 10angels provide additional support via personal loans or loan guarantees to the firms in which they invest.
• Angels expect a 26 percent average annual return at the time they invest — and expect about one-third of their investments to result in a substantial capital loss.
• Angels spend an average of 3.5 months conducting due diligence on each investment.
• The most common reasons angels reject deals are insufficient growth potential, overpriced equity, insufficient talent of the management, or lack of information about the entrepreneur or key personnel.

Venture Capitalists

• Venture capitalists (VCs) invest a total of around $30 billion per year in around 4,000 businesses.
• VCs invest in only about 1 out of every 100 business investment deals considered, or 1 percent.
• VCs look at substantially more deals than Angel Investors.
• The average VC invests $7.5 million per venture and expects a 25 percent average annual return.
• Although most VC firms have a website and other ways of sending in cold call solicitations, it is best to be referred to a VC bysomeone who is known to the VC.
• VCs conduct significantly more due diligence than angel investors do, spending an average of 5 months on due diligence for each investment.
• Given the high cost of due diligence, one of the main problems of the VC is finding time to allocate to projects that are most promising.
• Every VC firm and every partner has particular reject rules. For example, they may have decided to avoid a particular market or technology area. Or they may be ready to make an investment in an applicant’s competitor. Or they may have decided they are over-weighted in a certain market or technology.
• Overall, VCs have more sector experience, invest in larger firms, and conduct more sector research. They meet an entrepreneur more often before investing, take more independent references on the entrepreneur, and analyze the financials more thoroughly. VCs demand a more comprehensive business plan from the entrepreneur; incur more research costs; document their investment process more; consult more people before investment; and take longer to invest.