The Mechanics of Angel Investing: A Beginner’s Guide
Angel investing is now a critical component of the entrepreneurial finance value chain. It involves high net worth investors seeking much higher returns than can be obtained through the stock market or through debt finance by taking a financial position in a startup. Since 80–90% of startups fail, these investments involve a high degree of risk in exchange for great potential rewards.
As never before, angel investors are playing a catalytic and strategic role in the innovation economy. As such, understanding the mechanics of this asset class is essential.
Who Are Angel Investors?
Angel investing is not unregulated. The accredited investor standard stipulates that an accredited angel investor must have earned income of at least $200,000 for the past two years or $300,000 with a spouse. Another way to achieve accreditation is to have a net worth — alone or with a spouse — -in excess of $1 million in investable assets. Essentially, angel investors must be able to afford to lose money.
Also, aside from wealth, they typically don’t share much in common. Angel investors usually transcend the homogeneity that the venture capital community has become infamous for.
Oftentimes, an angel investor is a successful entrepreneur — not just an MBA but someone who has actually built a business. They’re typically looking to help others do the same.
Angel investors can also be wealthy family and friends; corporate executives; and mainstream professionals including doctors, lawyers and bankers. They may be single individuals or organized as angel syndicates or they can even be from the investing office of a very wealthy family. Increasingly, angel investors are pioneers in using new technologies such as Internet-enabled equity crowdfunding platforms to explore opportunities, conduct due diligence and invest in startups.
Benefits of Angel Investing
There are many reasons, both financial and non-financial, that angel investors become involved with this asset class.
In a rapidly changing technology landscape, the non-financial benefits of angel investing can be quite salient. Even if the venture that the angel investor initially financed fails, the network they develop along the way could provide access to other more lucrative opportunities.
In a very real sense, angel investors are not just paying for equity, they are paying for knowledge and access, which can prove to be immensely valuable over the long run. On top of this, there is satisfaction for angel investors in being able to contribute not just their capital but their experience and the skills obtained through their own previous successes and failures. Angel investors can play myriad roles that can impact the viability of the venture beyond providing capital alone and this mentorship aspect is a great part of the appeal of the asset class.
To founders, the strategic benefits of angel investing are vital to the life of the company. Compared to VCs, angel investors may contribute less money but oftentimes it may be better or more essential money. The reason is that angel investors invest their own money whereas venture capitalists invest other people’s money such as that of institutional actors like pension funds.
Likewise, angel investors do not typically have a great many investments and may devote more time and energy to making sure that their few investments succeed.
Angel investors can be anywhere which means that a startup can raise capital in the most strategically advantageous location. Also, most angel deals are done at the nascent phase of a startup’s development and involve funding rounds ranging from $1 million to $3 million.
80% of individual angel deals are less than $250K and 2/3 of angel groups invest $2.5 million or less. This may seem like a relatively small contribution but this capital is used to develop a prototype, hone the business model, and field test the innovation in a strategically important beachhead market.
These are all elements of a viable and scalable business. So, without the support of angel investors, the enterprise would not be able to get off the ground.
The contrast with venture capitalists is immense. VCs only invest in 1% of startups while angel investors invest in 30% of the opportunities presented to them.
Risks of Angel Investing
The risks of angel investing must not be overlooked. The time horizon for realizing a return on an angel investment can be as long as 7 to 10 years before a liquidity event that will allow investors to take their capital gains.
The illiquidity of these investments relative to the stock market is a major risk factor. Lack of transparency is another risk that angel investors must be aware of and try to mitigate with thorough due diligence.
When dealing with startups, the technology, founders and business model are all unproven which compounds the risks inherent in the illiquidity and deal sourcing challenges. Theranos’ Elizabeth Holmes is a cautionary tale.
The Due Diligence Advantage
Due to the inherent risks of angel investing, an underlying philosophy and strategic focus is essential to success. For example, a major contributing factor to the Theranos debacle is that many of the investors and board members. Most notably, Rupert Murdoch and George Schultz simply did not understand the science and how difficult it would be to engineer a successful blood testing product. In some respects, Theranos is a successful example because top biotech investors did not invest in it.
The values of the founders and their vision are often good indicators of their chances of success since those people interested in more than just money will often fight hardest when the inevitable challenges emerge. GoingVC has developed a useful Screening Scorecard for both angel investing and VC investing.
Models of Angel Investing
There are many different models or forms of angel investing. Individual angel investing is still common, particularly amongst ultra-high network actors who have the funds and acumen to absorb the losses intrinsic to this asset class.
Well-orchestrated organizations of affiliated angel investors are emerging such as the Brown Angel Group, Columbia Angels, Wharton Alumni Angels and MIT Alumni Angels — to name a few. Angel investing is also common amongst the alumni of elite tech companies such as Microsoft and Google.
Microsoft employees founded the Alliance of Angels which is the largest angel group in the Pacific Northwest with 140 active angel investors. It’s led by Microsoft alumnus Yi-Jian Ngy who acts as managing director.
Another example is Alphabet’s Black Angel Group which includes approximately 35 Black executives from across the company as well as Google alumni who are collectively making investments not only to support Black entrepreneurs in the tech sector but also to make ethical seed stage investments.
Given the risks of angel investing, an increasingly popular model of angel investing is the angel syndicate. These are groups of individual angel investors who band together and collectively syndicate investments.
This serves to mitigate risk as it is distributed across the group and each angel investor makes a smaller financial commitment. Just as importantly, knowledge is shared which can increase the quality of the investment while giving each individual angel investor access to the network of their colleague so as to magnify deal flow.
The Angel Capital Association, AngelList, Angel Resource Institute, Gust and FundingPost maintain useful directories of angel groups.
Angel investing is an increasingly dynamic force in the Innovation Economy. They are at the forefront of using the latest technologies to invest in entrepreneurship. Most importantly, they transcend the homogeneity and geographical concentration that is calcifying venture capital and leading to a quest for alternative models of entrepreneurial finance.