- Last Updated: Monday, 26 October 2020
High-growth startup companies often look for non-traditional sources of funding. That’s a gap that angel investors are eager to fill. The additional risk they’re willing to absorb is balanced with expectations of high returns on investments.
In this article, we’re going to be covering the topic of angel investors. As part of that discussion, we’ll first talk about how their approach to investments can provide small and growing businesses with much needed capital. Next, we’ll talk about the typical arrangements these investors will have with a startup business. Then we’ll finish this topic by talking about how to become an angel investor, and where to find one.
Capital Investments and Angel Investors
It’s not easy for a small business to grow, even if they can make a highly-profitable product or provide an in-demand niche service. For example, when a product is manufactured profitably and demand rapidly increases, the existing production equipment oftentimes limits the company’s ability to expand. An immediate infusion of capital dollars is needed to increase manufacturing output to meet market demand.
Traditional financial institutions often shy away from the risk associated with loaning small businesses money. That’s why these entrepreneurs often borrow from friends or family members, which is sufficient to fill a need if less than $100,000 is required.
Venture Capital versus Angel Investors
If a friends and family approach is insufficient to meet the capital investment requirements of a business, then funding can be sought from non-traditional lenders such as venture capital firms or angel investors. In fact, there are several important differences between these two investor-agencies worth noting.
Angels are individual investors. While that individual may elect to structure a business as a limited liability company or trust, the funds are owned by an individual and the investment decision is made by an individual. Since this investor would seek to limit their risk through diversification, the amount of capital raised via angel investors is usually limited to less than $1 million.
Venture capital firms involve a large number of investors. Money is pooled together, and the investment targets are selected based on the expertise of professional money managers. Because money is pooled together, venture capital firms can provide more money to a business than the typical angel investor. In fact, most venture capital firms would not invest less than $1 million in a business.
This means small businesses seeking to raise capital through non-traditional lending institutions have three options, and there is an investment hierarchy within those options:
- Friends and Family: can be sufficient when the need for capital funds is less than $100,000.
- Angel Investors: wealthy individuals that may be willing to invest as much as $1 million of their own money in a startup or growing business.
- Venture Capital: a pool of investors’ money, usually limited to opportunities in excess of $1 million.
As the above information demonstrates, angel investors fill the void between friends and family and venture capital firms.
Working with an Investor
Angel investors look for exceptional returns on their investment over a relatively short timeframe. When evaluating a small business, they’re going to seek out opportunities with the following characteristics:
- Value Proposition: while many individuals will be looking to maximize the return on their investment, some will be looking for companies that will make the world a better place. Investors need to be aligned with the company’s value proposition.
- Efficient Operations: the business must be well-run. This is both in terms of the management team as well as planning activities. The company should have a documented business plan that includes a vision statement, objectives, strategic initiatives, forecasts, and competitive intelligence.
- Business Structure: while it’s possible to find investors that are willing to loan a small business funds, most will be looking for an equity position in the company. Business owners need to be prepared to share the decision-making process with an investor-partner.
- Exit Strategy: the most attractive businesses to investors are ones that allow them to share ownership in the short-term, and then easily move to their next opportunity over the longer-term. Exits include mergers, acquisitions, or Initial Public Offerings (IPOs).
The terms and conditions of any contract will vary with the business circumstances. Generally, contracts fall into three categories, depending on the proposed funding arrangement:
- Notes Payable: also known as a promissory note, with this type of contract the issuer makes a promise to repay a specific sum of money under pre-agreed to terms.
- Convertible Preferred Stock: a hybrid between debt and common stock, the angel can exchange this preferred stock for common stock under pre-agreed to terms.
- Common Stock: a form of corporate ownership, stock with voting rights allows participation in the decision-making process of the business.
According to the Center for Venture Research, angels invested $23.9 billion via 63,730 entrepreneurial ventures in 2019. That’s an average investment of around $375,000 in each venture. The Healthcare and Software industries accounted for the largest share of investments (31%), Finance (7%), Retail (6%), Energy (5%) and Biotech (4%). There were 323,000 individuals acting as angels in 2019. The average annual return for angels involved in exits (via mergers, acquisitions, or IPOs) was 30.7%.
Finding an Angel Investor
When looking for an angel investor, there are practices that will increase the likelihood of success. The first is to find an investor that is located close to the business operation. It’s much easier to work with someone if they’re geographically convenient.
Next, it’s important to follow the good business practices described earlier. Preparing a solid business plan will demonstrate the business is a serious venture. It’s also important to work with an investor that has a genuine interest in the business model. If the business produces software, then don’t work with an angel that focuses on medical equipment.
Giving up some control is critical to working effectively with an angel investor. After all, they’re being asked to make a significant investment of their own money into a business. It’s only fair they have a say in setting the overall direction of the company.
Angel investors are typically organized around local associations. These associations can be at the state or regional level. Two noteworthy service providers that help connect angel investors and small businesses include:
- Angel Resource Institute (ARI): an organization devoted to the education, information and research about angel investing. Resources include a comprehensive list of regional associations.
- AngelSoft (Now Gust): founded in 2004, Gust provides tools that bring together professionals in the early-state investment industry. Includes new funding applications as well as the ability to reach nearly 500 angels and venture groups.
About the Author – Angel Investors