An Introduction to Angel Investing
Startups look for funding not just from institutional players but from angel investors as well. Angel investors are usually accredited investors on the lookout for good business prospects to invest and earn a profit from, even if not immediately. Apart from the financial reward, they seek the opportunity to mentor and help a fledgling business achieve its potential. This means angel investors are bound to face several hits and misses. It is therefore a high-risk investment path.
Who are Angel Investors?
Angel investors like venture capitalists and money managers invest in companies that are starting up and growing at a high rate. The investment usually is an equity investment. In addition to the money they invest, they also help in product development and offer their business expertise. Angel investors are those who bet on an enterprise early on and help the business trajectory move forward more confidently.
Angel investors put down their own money before a company moves to the IPO stage.
Angel investors may choose to take a formal role in the company they are investing in by being part of the Board. Even if they don't, they help monitor the business and mentor the business owners.
Angel investors are accredited investors, which means they make $200,000 per year of income or $300,000 or more with a spouse or have $1 million in liquid assets. In some cases, a trust with an accredited expert at its helm with a pool of $5M is also eligible to make angel investments. This is as per US laws. This will change from country to country.
Angel investors can go solo or become part of a group. Increasingly, angel investors are part of groups in order to hedge their risk and make more informed choices. Angel investors may choose to form a group based on a sector or a geographical area.
The Angel Investing Process
Startups seeking angel investing have to go through several steps before they can get an angel investor on board.
Is your business the right fit?: Companies seeking funds should be clear about communicating their business idea to prospective angel investors. Angel investment is often sought during the seed capital stage before the company is in the market. In this stage, companies do not have revenue flows or profits to show and therefore have to have clarity in terms of what the business will achieve. Some businesses are not suitable for angel investing and shouldn't pursue this route.
Apply: Most angel investors or angel investing groups have an application process. In this, business owners need to simply explain their business and expected revenue streams. If the business falls under technology or medical research, it is important not to confuse investors with jargon. Testimonials from other investors can also be added.
Screening: Prospective investors will review the applications and decide whether they will go ahead with investing or not. If a business proposal is rejected the entrepreneur can request a meeting to understand investor concerns and address them for future presentations.
Presentation: If a business is selected at screening, they are invited to make a presentation or demo of their business. This is usually a short presentation, followed by a Q&A by the investors.
If the investors are keen they will undertake due diligence of the business, else they will reject the proposal and provide feedback.
In-depth meeting: Once the idea is accepted, startups can expect a round or few of in-depth discussions. In this stage, the angel investor understands the amount and type of risk involved in investing. Several queries about all aspects of the business can be expected at this stage.
Due diligence: If the in-depth discussions go favorably, then the angel investor will set the due diligence process rolling. Details about the team, talks with existing investors, suppliers, and customers or target groups, and an assessment of financial projections is done.
If the startup already has a due diligence report in place, they can share it with the angel to reduce decision time.
Deal terms:On completion of due diligence, the angel investor/s will discuss the terms and conditions of the investment deal. A term sheet or the principal terms regarding the potential private placement of equity securities is drawn out. The term sheet usually contains the amount of investment, valuation of the company, type of security, price per share, capitalization of the company, rights, preferences and restrictions of preferred, redemption, board representation, information rights, security rights, sale agreements, transfer of rights, expenses, and confidentiality terms.
Investment: Once the terms are agreed to, the deal can be closed.
Monitoring and exit: Angel investors usually opt to be part of the board and help in steering the business. At an appropriate point in the business, the angel investor will redeem their shares and exit.
Types of Angel Investment Options
Equity: Angel investors get preferred stocks that have higher claims on assets.
Convertible debt: Here angel investors receive a promissory, that can be converted into a certain number of shares or cash of the same value.
Warrants: In this option, angel investors have the option to buy equity in a company at a certain price, before a fixed date.
SAFE and KISSES: SAFE (Simple Agreement for Future Equity) and KISS (Keep It Simple Securities) are both convertible securities that work like promissory notes. Here the investor puts in seed money in return for being able to convert it into equity at a later date.
How do Angel investors earn returns
How do angel investors earn returns on their investments? They earn while on the board through dividends or a salary if they are employed as a consultant.
In startups that do well, angel investors can choose to exit. They earn a payout when they exit. They do so in different ways.
In some instances, the startup will decide to buy back their shares. At this stage angel, investors will sell their shares for a profit.
The entry of larger investors can result in interest in the shares angel investors hold. Angel investors may want to exit and can sell their shares to the larger investor after board approval.
Startups with high potential often get acquired by larger companies. A case in point is Revue by Twitter or Instagram by Facebook. Angel investors get shares in the new parent company or a cash payout. It is possible that angel investors avail both options simultaneously.
The road from founding to an IPO is long, and some angel investors stay till their invested companies reach it. Here the pool of investors they can sell their shares to increases exponentially.
Angel investors expect high returns from startups that do well. Unfortunately, the failure rate of startups is very high. Angel investors can sometimes mitigate their losses by asset-stripping - the sale of assets. Angel investors tend to invest based on potential and may choose to continue holding even when companies do not make profits for a while. The invested companies may have intellectual property that is valued highly since this means they have the potential to do well in the future.
Good angel investors assess their investments carefully and once onboard, they wait patiently. They have a horizon in which they expect the company to start generating revenue and eventually profits. They take a long position on startups and can earn a high ROI when companies go public.
Benefits of Angel Investing
The draw of angel investing is they can use this form of investment to diversify their portfolio, spot and invest in high-profit businesses that choose to stay private, develop a network with other investors, serve on boards, or in a function. Startups can raise funds when they are private, like an internal IPO, and angel investors make good to enormous profits for being stage one investors.
Risks of Angel Investing
Angel investors invest in a business based on future potential and an expected rate of growth. They try to factor in the different variables that can impact the trajectory of the business. Yet, companies can falter to the point of no longer existing. In this case, the investor makes a loss. Sometimes, the company's growth may be very slow and its revenue diminished because of competition. Investor groups state that 90% of startups fail. Some others allow angel investors to break even.
Trends in Angel Investing
Typically, angel investors developed expertise to invest in one sector and built on it. Now, angel investment groups are diversifying into different sectors. There is a slow and steady trend to invest in women-owned or ethnically diverse companies as well. Despite the numbers favoring gender-diverse companies, almost 97% of funds go to companies led by men. The number of angel investors who are women is growing which can lead to a change in angel investing.
The newer areas that angel investing is moving to are climate tech, sustainable replacements for plastic, artificial intelligence, advanced medical devices, and gene delivery to name a few.
Now individual accredited investors can invest in new technologies through online platforms. The pandemic has raised challenges for angel investors that they cannot conduct a face to face due diligence with investors.
Angel investing is a very high-risk form of investing that could almost be called a gamble. There are many factors that make a startup become a formidable player in the market. The ability to spot founders who can take their idea and make it a good company is a skill that is developed over time. The failure rate is high and unless you have the ability to take the hit, angel investment is not a remotely safe bet.
If you are passionate about angel investing it is a better bet to be part of an angel investment network. In this way, you can invest smaller amounts in a larger number of companies and lean on the expertise of other members. The other reason to be an angel investor is that you enjoy helping in the building of a good company. If your objective is to build wealth alone you may find it disappointing.