An angel investor is a person who invests in a new or small business venture, providing capital for start-up or expansion. Angel investors are typically individuals who have spare cash available and are looking for a higher rate of return than would be given by more traditional investments. An angel investor typically looks for a return of around 25 to 60 percent.
Angel investment is a form of equity financing–the investor supplies funding in exchange for taking an equity position in the company. Equity financing is normally used by non-established businesses that do not have sufficient cash flow or collateral with which to secure business loans from financial institutions.
Angel investors fill in the gap between the small-scale financing provided by family and friends and venture capitalists. Attracting Angel Investors is not always easy, but there are things you can do. First, consider whether angel investing is truly right for you and your business.
Advantages and Disadvantages of Angel Investors for Business Owners
The big advantage is that financing from angel investments is much less risky than debt financing. Unlike a loan, invested capital does not have to be paid back in the event of business failure. And, most angel investors understand business and take a long-term view. Also, an angel investor is often looking for a personal opportunity as well as an investment.
The primary disadvantage of using angel investors is the loss of complete control as a part-owner. Your angel investor will have a say in how the business is run and will also receive a portion of the profits when the business is sold. With debt financing, the lending institution has no control over the operations of your company and takes no share of the profits.
Typical Sources of Angel Investors
Angel investor is a somewhat general term. And you can actually find these types of investors in a few different forms. Angel investments normally come from:
Family and friends: This is by far the most common source of funding for business. Startups that are interested in finding business start-up money and is the only option for many. Given the high rate of failure with new businesses, it is also risky. In terms of the possible impact on relationships if the business is not successful. It is important to be upfront about the risk of failure.
Wealthy individuals: Another good source is successful business people, doctors, lawyers, and others. That have a high net worth and are willing to invest up to (typically). $500,000 in return for equity. Often this is done by word of mouth through business associates or associations such as the local Chamber of Commerce.
Groups: Angels are increasingly operating as part of an angel syndicate. (a group of angel investors), which raises their potential investment level accordingly. Investors contribute funds to the syndicate and a professional syndicate management team chooses the investments.
Crowdfunding: A form of an online investing group, crowdfunding involves raising. Funding by having large groups of individuals invest amounts as small as $100.
Communicate Before Deciding
It’s important for any business person thinking about accepting an angel investment to be very clear about. What the investor is bringing to the deal besides money, such as expertise in business. Operations or access to good suppliers, for example. You would also want to develop an understanding of what the angel investor would be. Like to work with since this person could have their own conflicting ideas for how your business should be operated.
It’s also important to have a comprehensive business plan in place. As a small business, you’ll need it in order to secure financing from lenders or investors.
Now coming to the point why Angel Investors do not invest or refrain from investing. So, if you are thinking of becoming an angel investor read the next section carefully.
The premier venture firms succeed because they have proprietary knowledge of the characteristics of winning companies. Over the years, the knowledge of what it takes to succeed is passed down from partner to partner and becomes part of the firms’ institutional memory. In a professional setting, it’s not the failures that teach people the most, but the successes. Failures teach us a lot personally, but that’s a different story.
The premier venture capital firms know the best investments have high technical risk and low market risk. Market risk causes companies to fail. In other words, you want companies that are highly likely to succeed if they can really deliver what they say they will. Unfortunately, consumer Internet companies don’t follow that pattern. They usually have low technical risk and high market risk. There is very little chance they can’t deliver their product. The big issue is whether the startup’s product is of value to a large enough audience.
Most people see angels as taking market share from venture capitalists’. This is the wrong perspective: The premier venture capital firms have consciously outsourced consumer Internet companies’ bad market risk onto the angels, maintaining their returns as a result.
How low are returns for angels? As explained in the research, the overall return for the venture capital industry has been quite poor (the average VC fund barely returned investor capital after fees). According to an annual seed financing survey only 45 percent of companies that received seed financing in 2010 went on to raise venture financing in the next 18 months. Twelve percent were acquired, but likely in talent acquisitions that lost money for the angels.
If the average VC fund barely makes money, and seed investments represent even less compelling opportunities than the ones pursued by venture capital firms, then the typical return for angels must be atrocious. Even Ron Conway’s second angel fund, which had the good fortune to invest in Google (a 400x cost winner), only broke even (that means close to a 0 percent IRR)!
Some of you are thinking you’ll be the exception to the rule. Maybe, but if so, it won’t be because you’ve been a great executive at a startup. Running a company has not improved investing skills, which are completely unrelated to being a good leader and strategist. Unfortunately, many entrepreneurs do not understand that being a good executive has nothing to do with being able to pick companies likely to succeed on the large scale needed to generate a good investment return.
The conclusion is that unless you are a legendary founder and can have the pick of the best technical founders in the Valley, or you are a member of a prestigious institution, you should not be an angel investor. A few elites have a chance of making money. The rest of you are in for pretty dismal results.
If you do, and decide to make angel investments, here are a few tips:
Assume you are going to lose all your money. Treat success as a complete surprise. Successful venture capital firms generate approximately 80 percent of their returns from less than 20 percent of their investments. The chances are high your angel investments will be losing bets.
Don’t do it unless you are worth at least $1 million or earn at least $200,000 per year. The SEC requires these minimums for angel investors because it is the minimum regulators believe is necessary for an individual to withstand the loss of the investment.
Take a portfolio approach. Whenever you invest in a risky asset class like startups, movies or new artists, you need to have a portfolio, because the law of small numbers will likely lead to a complete loss on your investments. Remember talent acquisitions, which represent the vast majority of successful angel investments, usually result in a loss for the investors. Try to build a portfolio of at least 15 companies.
Limit the size of your angel portfolio to 10 percent of your investible assets. Even sophisticated institutions that have the financial wherewithal to take significant risk and have access to the premier venture funds tend to allocate no more than 5 percent to 10 percent of their portfolios to venture capital. You don’t have the staying power or the financial expertise of these endowments, so try to limit the size of your overall bet.
Perhaps the best angel investment you could make is choosing the right company to work for. The value of the options associated with a successful company will swamp the return on any angel investment you’re likely to make, even if you do happen to have a success. True fishermen cast their lines not because they want the fish, but because they like fishing. It’s fine to be an angel investor – just don’t do it for the money
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