Angel investors are wealthy people who invest in early-stage companies.
They’re often current or former entrepreneurs and executives who, besides wanting to make money, see investing as a way to stay on top of the latest developments in their industry and meet emerging stars. The term “angel investor” came from Broadway, where it was used to describe people who funded the production of shows that otherwise would not have been made.
When to Seek Angel Investment?
Angel investors typically serve as a bridge between two types of investments, the initial “friends and family” round that gets a company off the ground and a company’s first round of venture capital financing. Friends and family can contribute tens or even hundreds of thousands of dollars to a business, but they’re taking a lot of risk and you’re jeopardizing your relationship with them if things go south, as they often do with early stage companies. A venture capital firm, on the other hand, is made up of professional investors investing other people’s money. Because of the size of their funds, it’s generally not worth their time to write checks for less than a million dollars or so.
This leaves a funding gap that angel investors occupy. Although the size of an individual angel’s investment can range anywhere from just $5000 to a million dollars or more, it’s pretty common to see a company in an angel round raise a total of $200,000 to $300,000 from four or five angels.
While the term “angel” might suggest charitable motives on the investor’s part, make no mistake that investors are looking to make a return commensurate with the risk they’re taking. Angels typically want to see a return of 10x or more over five years. This means that certain kinds of businesses are off the table from the outset. If you’re looking to buy an old Victorian house and open a B&B or to start a jewelry boutique, angel investors won’t be interested. They’re looking for businesses that can scale rapidly, like technology platforms. A better option for you would be to try to secure traditional financing (like a bank loan) or bootstrap your business.
The Mechanics of Angel Investment
The key question anytime you’re selling an ownership stake in your company: how much is your company worth? Unfortunately it’s notoriously hard to value an early-stage company. You’re relying on financial projections which, kind of like the Farmer’s Almanac, provide a long-range forecast that’s very often wrong.
Many angel investors prefer the convertible note over straight equity financing because it defers valuation until the company is a bit more mature. Essentially, a convertible note leaves it to the next round of investors to decide what the company is worth, and gives the note-holders a discount on that valuation as a reward for having gotten in early.
Essentially, a convertible note leaves it to the next round of investors to decide what the company is worth, and gives the note-holders a discount on that valuation as a reward for having gotten in early.
Because they are getting in early, angel investors expect their equity to become diluted during subsequent financing rounds. That is, the pie is going to be divided among more investors, so each of the existing investors is left with a smaller slice. That’s ok though, because if the company is growing, it’ll be a smaller slice of a bigger pie, and the angel’s investment will be worth more notwithstanding the dilution.
Often angel investors will request pro-rata rights as part of an equity investment. Pro-rata rights are designed to help protect angel investors whether the company’s value grows or shrinks before the next round of financing. If the value grows, pro-rata rights ensures that the angels will be able to “top up” their investment to maintain their proportional level of ownership and continue their ride on the rocket ship. If the company’s value diminishes, pro rata rights help prevent new investors from diluting old ones while the pie is shrinking.
Beware of Dumb Money
The legal requirements for becoming an angel investor aren’t extensive. You must be an “accredited investor,” which means that you must have earned $200,000 in income for each of the past two years ($300,000 if married) and expect to earn the same amount this year. Or, you must have a net worth of more than $1 million not including the value of your primary home. These are the thresholds that the government has decided make someone sophisticated enough to take on high-risk investments.
Because tech investing seems glamorous and (for some people) has undoubtedly proven very lucrative, there are plenty of accredited investors who are trying to position themselves as angels. But inexperienced investors who don’t understand your business or the world of tech investing in general (“dumb money”) can be a real time suck. They can be high-maintenance relative to the amount of money they’ve put in, and may try to micromanage or otherwise mold the company to their vision instead of yours.
You might not feel like you have the luxury of choosing who to take money from, but if you do, be choosy. The best investors bring a lot more to the table than money. They bring domain expertise, connections, and recruiting prowess for employees and other investors. Before you choose to work with an investor, check and see how much experience they have. How many other early-stage companies have they invested in? Worked in? Are they asking smart, relevant questions? Do you enjoy interacting with them? Talk with other entrepreneurs they’ve worked with and get their impressions.
Resources for Finding Angels
So you’ve decided you’re interested in angel investment — where do you find the angels?
One of the best ways to find them is to talk with other entrepreneurs who have received angel investment. Referrals mean a lot in the angel investment community, and a recommendation from a current portfolio company can go a long way to opening the door with an angel.
Many large cities have angel networks — groups of angels who work together to source deals and pool their money for investments. This can be a good way to get in front of several angels at once. Search the web for angel networks in your area.
AngelList is also an excellent resource. It gives you online access to a variety of angel syndicates and offers background information on investors.
With recent changes in the law, it’s also possible to sell shares in your company through crowdfunding, sort of like Kickstarter but instead of giving away products in exchange for investment, you’re giving away equity. SeedInvest is a great example of a platform for equity crowdfunding.
Angel investment can be an excellent funding option, provided that you’re in the right kind of business and are pairing up with the right investors. Do your homework and remember that you’re selecting the investor at least as much as they’re selecting you.