Pennies from heaven

When Richard Drury and his colleagues started Maelor Pharmaceuticals in 1991 they quickly stumbled on a paradox of business life: that it is easier to raise pounds 1m than it is to raise pounds 250,000.

The owners of the fledgling Wrexham-based producer of sterile products satisfied their initial demand for cash through bank borrowing and "seed capital" from the National Westminster Bank and the Welsh Development Agency. But like many start-up teams, they soon found they needed more - and that was when they encountered the "equity gap". They discovered, as have so many other small firms, that banks and venture capital groups would not lend them what they needed. Either the amount was just not worth the trouble, or the risk seemed too great.

Maelor's solution was to find five private individuals prepared to put up pounds 100,000 in return for a share of the equity. But Mr Drury and his colleagues realised that they also needed expertise. While it was possible to get cash without hands-on involvement, and to buy expertise without obtaining cash, "we wanted a hybrid," he says.

The group of investors signed up and nominated one of their number - a man with a background in finance - to be a non-executive director. He later assumed his present role of chairman and, according to Mr Drury, has played an important role in strategy and investment planning. Without his contribution, it is doubtful Maelor would have reached its present position of comparative stability. "If we had rented that expertise on a consulting basis it would have cost a fortune," Mr Drury says. "This way, it came with the investment."

Maelor's chairman is a "business angel". He is the most interesting variety - someone who brings both cash and expertise to a small company. But the broader definition is anyone who inhabits the world of "informal" venture capital. It is a world that is difficult to measure but is undoubtedly huge: between pounds 2bn and pounds 4bn, compared with pounds 1.5bn in the "formal" venture capital sector. It is also a world that is shy of publicity - Maelor's chairman does not want his name published because he does not want to be bombarded with investment requests.

A new industry has grown up to bring together angels and companies that need their help. So many networks and registers have been set up that there is a danger the concept will be seen as the answer to all small- firm finance problems.

The term business angel is borrowed from the private backers who have traditionally financed theatre productions. According to research carried out for NatWest ahead of its launch earlier this year of a nationwide database of such potential backers, they tend to be about 50 years old and have either run a business in the past or acted as an investment adviser. They invest anything from a few thousand pounds to more than a million, but the average is about pounds 250,000. Though usuallyly associated with start-ups, they will provide funds at all stages, right through to rescue.

Within this overall description there are certain types of angel. First, there are those who are somewhat cruelly described as buying a job. They typically want to use a redundancy payment to get a post that will pay them a modest wage and see them through to retirement; they are often referred to as interim managers. At the other extreme are "patrons", who generally have about pounds 1m to invest but want little involvement. The third group consists of the typical angel - entrepreneurs who have pounds 50,000 to pounds 1m to spend and want to combine their investment with hands-on support.

Though their nickname conjures up ideas of altruism, these people have two main motivations: the desire to make money and the urge to use their experience to help a business improve. For these reasons the concept is never going to be the panacea that some see it as; these are hard-nosed people interested only in financing companies with the potential for high growth.

Lucius Cary, chairman of the business angel "marriage bureau" VCR, says he currently has more than 700 subscribers to his monthly newsletter - more than at any time since the mid-1980s. Last month he had more projects available for funding than ever before. But he is conscious that even a long-established organisation like his is only scratching the surface.

Linc, a not-for-profit organisation sponsored by four banks and the accountants Kingston Smith, works closely with VCR. General manager Susan Krantz is similarly encouraged. She says Linc's 12 agencies made 45 "matches" last year. Though the total funds raised only totalled pounds 2.2m, she believes there is a leverage rate of about 4:1. The businesses probably gained about pounds 9m in funds as banks and venture capitalists came in on the backs of the angels.

Further encouragement has come with government policy. In recent years, initiatives such as the Enterprise Investment Scheme and Venture Capital Trusts have brought tax breaks for angels. They are also able to claim relief from capital gains tax if the proceeds of a sale are invested in another private company.

The problem, it is widely agreed, is that there is too much money chasing too few quality deals. The answer lies in convincing entrepreneurs with good projects that this is a worthwhile funding option, while avoiding a rush of requests from those with less promising ones.

The desire to avoid receiving hundreds of applications for funds is said to be why most investors shun the limelight. Instead of having to wade through all these submissions, they would like to receive a few highly promising projects.

This is what Mark Eardley, director with Leeds-based independent corporate adviser Yorkshire Corporate Finance, says he attempts to do. The difficulty is that such sieving needs to be paid for, and the economics militate against running up too many expenses. Mr Eardley believes angels should band together to form funds that could spread such costs as well as the risks, and become a sort of 3i.

Late last year 50 angels - including David Marsh, who made his money by selling his bus company to Yorkshire Rider - formed the Yorkshire Association of Business Angels. The idea is to vet prospects more effectively so individuals do not have to spend days looking at deals that come to nothing.

Significantly, perhaps, the association found only one deal worth doing in its first six months - and that one was brought to them by Mr Eardley. The angels supplied just over pounds l00,000 to help a management buy-in at a West Midlands upholstery company (now called Jean Chateau) and was also able to come up with a spread of skills. Among the angels involved are Stephen Emmott, a former managing director at furniture group Magnet, and Bob Tilley, a former managing partner with a leading firm of accountants.

The initial plan had been to obtain funding from venture capital, but when no offers came from that direction Mr Eardley decided it would be "better to take funding from a group of individuals who had skills that could support the principal management".

Though Linc, VCR and the NatWest agency have gone some way towards the formalised approach Mr Eardley advocates, some angels have their doubts. Timothy Parker, who operates almost exclusively in the North-west, says he avoids the presentations these and other match-makers organise because the competition to get in on the good deals forces prices too high and threatens the potential returns.

Mr Parker started as an angel in the mid-1980s, after resigning as director of an engineering group that later collapsed. The association with failure meant that "the only jobs I could get were those that nobody in their right mind would take on."

This led him into turnarounds, one of which, Booth Group, proved successful enough to give him the resources to invest in other companies.

In the past decade he has been involved in several companies. Though the sectors vary, he never puts up money without having a finance director or company secretary as a co-investor. He also tends to work with firms of accountants to find appropriate deals. Moreover, confining himself to one part of the country enables him to forge vital personal contacts. "You have to put a lot of energy into a business," he says. "You have to trust them and like them and enjoy what you're doing."

While organisations such as VCR are attempting to bring some order to the business angel market, there are those who believe that its informality is its strength. Personal recommendations are still seen to be the key to success in this twilight world. Hamish Stevenson, who owned a stake in VCR until earlier this year, says only half jokingly that if the government wants to encourage the development of business angels it should forget about tax breaks and build more golf courses.

He has been approached by more than 100 companies since he announced that he was looking to provide hands-on expertise and invest pounds 100,000. But none of them appear capable of meeting his requirement of increasing the value of his capital by 25 times over five years - which he believes is a reasonable demand. "Angels need to blow their own trumpets if they are to attract these star deals and not rely on formal networks which don't necessarily attract the best deals," he says.

The problem with that, of course, is that it increases the already high stakes on both sides - as Mr Drury of Maelor can attest. Back in 1993 he and his colleagues got into talks with a potential angel who strung them along for months before admitting he did not have quite enough cash at the time. Could he work for his equity, he asked? The response was unmistakably blunt. Had there been a formal screening system, Mr Drury says, both sides could have avoided a lot of wasted time.