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Explaining Informal Investors

If you're an entrepreneur, at one time or another you have probably sought to answer the question: "Where can I get the capital I need?" For most people, the answer is from their own savings or the existing cash flow of their businesses. But for some, it means seeking money from others.

The many sources of external capital for entrepreneurs range from banks to trade creditors to credit cards to venture capitalists. Getting a loan from an outsider is more common than getting an equity investment. And some sources, such as credit-card companies, provide small amounts of money to lots of people while others, such as venture capitalists, provide larger amounts to a handful of businesses. But one source frequently mentioned in books and articles is "informal investors," a term that lumps together friends, family, and business angels.

How Many Informal Investors Are There?

If you're going to look for debt or equity capital from a particular source, it's probably a good idea to know how much money that source tends to provide. So how prevalent is informal investing?

A couple of data sources recently put a number on this activity. The Federal Reserve Survey of Consumer Finances (SCF), a representative survey of U.S. households, provides an estimate of the share of households that own a private business that no one in the household has an active role in managing. In 2007, the latest year for which the survey was conducted, approximately 1.6% of U.S. households were passive owners of a private business. This rate of passive business ownership was unchanged from 2004 but was up from 1.2% in 2001.

The 2009 Global Entrepreneurship Monitor (GEM), a representative survey of the adult age population, shows that slightly less than 4% of U.S. residents ages 18 to 64 had made an informal investment in someone else's business in the past three years.

Moreover, those who make these investments don't make a large number of them. Analysis of data contained in Entrepreneurship in the United States Assessment, another representative survey of the adult age population, this one conducted in 2004, reveals that between 2001 and 2003, the average informal investor made just under two investments.

(The GEM's informal investment numbers are higher than the SCF numbers because the GEM measures the investment flow over the past three years, while the SCF measures the stock at one point in time. In addition, the SCF measures households, while the GEM measures individuals who might make investments together as part of a single household. Perhaps most importantly, the GEM appears to pick up "investment" that takes the form of loans, while the SCF focuses on equity. But even the higher GEM number still indicates that informal investing is something done by a small share of the population.)

Informal Investors Are Different

Two factors differentiate the small share of people who make informal investments from those who don't. The first is wealth. The odds of being an informal investor go up with a person's income and net worth.

But keep in mind, this doesn't mean that a lot of wealthy people make informal investments—just that they are more likely to do so than people with less money. According to analysis by Paul Reynolds in his book, New Firm Creation in the U.S.: A PSED I Overview, only 10.5% of accredited investors surveyed in 2004 had made an informal investment during the previous three years.

The second is being an entrepreneur. Both the GEM and SCF data reveal that informal investors are more likely than non-investors to be entrepreneurs themselves. The 2004 GEM Financing Report explains that "entrepreneurs are four times as likely as non-entrepreneurs to be informal investors." The 2007 SCF shows that business-owning households account for a third of the informal investing households, even though they make up only 12% of the total number of households.

What Do Informal Investments Look Like?

Most informal investments are made by friends and family, not business angels. According to an analysis of the Entrepreneurship in the United States Assessment data, 92% of informal investment is provided by friends, family, neighbors, and co-workers.

The dollar amounts of informal investment are quite small. The 2009 GEM numbers show that on a per-small-business-in-the-economy basis, approximately $7,200 is invested annually. Even the businesses receiving informal investments tend not to get huge amounts. The 2004 GEM Financing Report explains that informal investments average around $24,000.

Much of the money that informal investors provide takes the form of loans. Analysis of the Entrepreneurship in the United States data indicates that debt accounts for more than half (56%) of all informal investment.

Financial considerations don't seem to dominate informal investors' decision making. According to the 2004 GEM Financing Report, "Fifty-one percent of informal investors expect a negative or zero return, and only 22% expect an annual return of 100% or more."

In short, entrepreneurs seeking informal capital should recognize that:

• Only a small fraction of the population provides it;

• Wealthy business owners are the most likely people to provide it;

• The average informal investment is small;

• Much of the informal capital is provided in the form of loans;

• Most is given by friends and family members rather than by business angels;

• Most informal investors don't expect to make money from their investments.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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