Are you about raising startup funds from angels and want to increase your chances? If YES, here’s exactly how angel investors work and make investment choices.
Table of Content
What is an Angel Investor?
Angel investors are wealthy individuals who scout for viable and potentially profitable business start-ups to invest in in exchange for financial or non-financial rewards.
You can think of an angel investor as an informal lender. Banks and other financial institutions are formal lenders. They lend you money to start and grow your business in exchange for a pre-agreed interest. The most important thing the financial institution is concerned about is whether you can afford to repay the interests and if it turns out that you can’t, the bank will take some legal steps to recover its funds – probably take possession of your collateral security and other legally acceptable measures.
But an angel investor is taking a much bigger risk by investing in your business on a personal level. An angel investor looks for a business that has the potential to do well in the future and provides the funds required to set up or grow the business. The angel investor will expect to own shares in the business or expect to be repaid his capital with some kind of interest in the future.
However, the angel investor does not receive any collateral security from the business and if it turns out that the business fails, the angel investor will have to bear the loss.
Difference Between an Angel Investor and a Venture Capitalist
It is not uncommon for people to confuse being an angel investor with being a venture capitalist because their functions are almost similar- they both provide business funding.
However, an angel investor is different from a venture capitalist in the sense that venture capitalists are group of investors who pool their resources together to invest in businesses. They don’t necessarily provide seed funding; they may invest in any type of business whether existing or startup, as long as they find it potentially profitable.
Venture capitalists also do not invest privately or personally like angel investors do. When venture capitalists come together, they set up a corporation with which they invest in businesses with high potentials. The venture capitalists become limited partners in the business, while the managers of the business who carry out the day to day tasks involved in the business are known as general partners.
Angel investors may also be involved in running the business, or may act as consultants in the businesses that they help fund. Like I mentioned earlier, the angel investor invests on a personal level, and contributes anything else he can contribute apart from cash to ensure that the business succeeds.
What Does It Take to Be an Angel Investor?
Angel investors must meet up with the Securities Exchange Commission (SEC) standards for accredited investors which stipulate that in order to be considered an angel investor, one must have a minimum net worth of $1 million dollars and an annual income of not less than $200,000.
Angel investors use their own money unlike venture capitalists, and if the business should fail in its early stages, the investor will lose his or her money completely.
How Easy Is It to Find an Angel Investor?
However, these angel investors can be difficult to find, and even after finding them, convincing them to invest in a start-up can be quite as tough because of the risk that is inherent in startups.
For instance, new businesses have no sales, the founder of the business may only have a very small knowledge of what management entails, and the business plan may be based on just a mere prototype or concept. Still, even with the tremendous uncertainty, angel investors still go ahead to give a lot of money to new businesses that are neither tested nor trusted with the hope that they will eventually be worthwhile.
Angel investing is usually associated with Silicon Valley but the truth remains that angel investors are active all over the United States. The Halo report gathered that about 20 percent of them were in California. In fact, in the United States alone, angel investors invested a total of $24.1 billion in the year 2015.
About 73,400 businesses were able to benefit from these investments especially those in their early stages. Angel investors are not only limited to the United States. They exist in other countries like Ireland, Colombia, India et al.
How Angel Investors Work
If an angel investor agrees to invest in your business, he is expected to write you a cheque for the amount that you have agreed on with him. Depending on the agreement that you have with your investor, he can provide you with a onetime investment or an ongoing injection of money to support and carry the company through its difficult early stage.
The amount that the angel invests can range between a few thousand dollars to a few million. The money that he invests can come in form of a loan or partial ownership of the business, say 10%. If he owns a share of the business, that means that he will get a cut from future profits.
The investor’s ultimate aim is to sell his share in some years’ time for a sizable profit. In the event of business failure, the entrepreneur will not have to pay back the money that was invested in the business like a normal loan. Due to the fact that angel investors invest majorly in new, unproven companies, business failures are not uncommon resulting in a total loss on the part of the investor. However, when it works out well, the returns can be spectacular.
With already established companies, determining whether to or not invest in them can be quite straightforward. Established companies produce sales, make profit and also cash flow can be used to infer how valuable the enterprise is.
However, these indices are not available for startups and new businesses and as such, angel investors have to put in a lot more effort to determine if an investment is worth their time. Their aim is to make enough gain from successful enterprises that will cancel out the loss from the less successful or unsuccessful ones.
Here are some key considerations that an angel investor can make use of when trying to invest in a new business.
How Angel Investors Make Investment Choices
- A game changing technology or service
This could be a product or service that brings something fresh, new and innovative to the table. Most angel investors are not just looking for a marginal design change but are out for something that is much smarter and cheaper. Angel investors are known to look for competitive advantages in the market. They want their investments to be able to generate sales and profits before competitors can enter into the market with something similar.
2. Management team
This is one of the most important parameters that inform an investor’s choice to either invest on a business or pass on it. The team are the people who will make the idea see the light of day. The people behind a product or service are just as or even more important than the product itself in terms of achieving success.
An incompetent team can end up ruining the best of products and an excellent team can make a mediocre product successful. Investors look out for a team that has skills such as strong background for the task at hand, are enthusiastic, energetic, willing to listen and learn, among others.
3. A large market
No investor wants to invest in a product that will appeal to a very small demographic, most look to conquer the country or even the world with their investment. A business that shows the ability to target a large market is very vital for grabbing the attention of angel investors. In other to get large returns from investments, angel investors usually want to make sure that the businesses they invest in have a chance of growing sales worth millions of dollars.
Angel investors expect that business plans should include a concrete market size analysis. This analysis should be gathered through careful research and not just hearsay and conjectures.
4. Strong scalability: this means that the company can grow quickly in revenue while still managing to keep expenses at the barest minimum thus resulting in a healthy profit margin. Some businesses are easily scalable while some are not.
Consider a startup that intends to go into the manufacture of ball point pens. The pens can be produced at a low cost and as such, is a scalable business when compared to a company that requires a lot of customization or expert time in installation or consultation.
5. Exit and valuation: every potential exit comes with a return that will be based on a combination of some factors such as how much you invested, the pre-money valuation, how much of the stocks the investor owns and the acquisition purchase price. In this vein an angel investor should have an idea of how much the company might be sold for and if additional investment rounds will dilute your ownership percentage.
6. Assessment and risk: no matter how you look at it, startups and businesses are bedeviled with a lot of risks and uncertainties. When angel investors meet and interact with the owners of the business, or read their business plan, they will like to know in details what the business has been able to accomplish so far and what still needs to be accomplished with additional funds. They need to provide answers to certain questions like;
- Could regulatory or legal issues arise later on?
- Is this product ripe enough for the market now or will it be best to be implemented in the future?
- Is there an eventual exit from the investment and a chance to see a return?
The methodology that is used by various angel investors to measure the risk that is inherent in a business and thus make an investment choice, vary from person to person. Some individuals are able to tolerate a higher risk venture if a lot of profit is involved, whereas some other people want something that is more secure. In the end however, angel investors try to reduce risks while ensuring that the investment they go for yields the maximum amount of returns.
How Angel Investors Make Money
Angel investors scout for businesses with potential to perform well within a preferred time frame. They make their money in diverse ways such as:
- Sell the Startup: Angel investors may invest in a startup and then when the business begins to thrive and make profit, they may sell the business to other investors and then receive cash, stocks or a combination of both in exchange. Each angel investor (if there is more than one) will receive money or shares according to what they have invested in the business.
- Sell off Shares: An angel investor may also choose to cash out by selling his own shares in the business to another investor in exchange for cash. Such private shares can be sold through a private broker or via online platforms like SecondMarket, Sharespost and Equityzen.
- Go Public: The investors may also decide to take the business public and sell off some of the shares of the business on the stock exchange market such as the New York Stock Exchange (NYSE) , NASDAQ and other global stock markets.
- Receive Dividends: An angel investor may decide that he wants to remain a part of the business for a very long time, and then opt for receiving dividends from the profits of the business.