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 High-growth startup companies are often looking for non-traditional sources of funding. That's a gap that angel investors are willing to fill. The risk and reward tradeoff holds true for angel investors too. The additional risk they're willing to absorb is balanced with expectations of high returns on investments.
In this publication, 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 an angel investor will have with the 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, often when a product is manufactured profitably, the existing pace of production would limit the company's ability to rapidly 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 of loaning small businesses money. That's why these businesses often borrow money from friends or family members. This 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 a couple of important differences between venture capital and angel investors worth noting.
Angel investors are individual investors. While that individual may elect to structure this business as a limited liability company or trust, the funds are owned by the individual and the investment decision is made by the individual. Since the angel investor would seek to limit their investment 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 capital than the typical angel investor. In fact, most venture capital firms would not invest less than $1 million in a business.
To summarize the above information, small businesses seeking to raise capital via non-traditional lending institutions have three options, and there is an investment hierarchy to those options:
- Friends and Family - can be sufficient when the need for capital funds is less than $100,000.
- Angel Investors - wealthy individuals 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 investor money, usually limited to investment opportunities in excess of $1 million.
As the above information demonstrates, angel investors fill the investment void between friends and family and venture capital firms.
Working with an Angel Investor
Angel investors are looking for exceptional returns on their investment over a relatively short timeframe. When evaluating a small business, angels are going to look for the following characteristics:
- Value Proposition - while many angels will be looking to maximize the return on their investment, there are some angels that are looking for companies that will make the world in which we live a better place. Make sure the angel you're trying to work with is aligned with you 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 angel investors that are willing to loan a small business funds, most angels are looking for an equity position in the company. If you own the business, this means you need to be prepared to share ownership, as well as the decision-making process, with the angel.
- Exit Strategy - the most attractive businesses to an angel investor 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).
Angel Contracts
The terms and conditions of any contract will vary with the business circumstances. Generally, angel 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 to the angel 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 allow the angel to participate in the decision-making process of the business.
Angel Investors
According to the Center for Venture Research, angels invested $17.6 billion via 57,225 entrepreneurial ventures in 2009. That's an average investment of around $307,000 in each venture.
The software industry accounted for the largest share of investments (19%), followed by Healthcare / Medical Equipment (17%), Industrial / Energy (17%), Retail (9%), and Biotechnology (8%).
There were 259,480 individuals acting as angels in 2009. The average annual return for angels involved in exits (via mergers, acquisitions, or IPOs) was between 23% and 38%.
Finding an Angel Investor
When looking for an angel investor, there are a couple of practices that will help you to increase your chances of success. The first is to find an investor that is located close to your business operation. It's much easier to work with someone if they're geographically convenient.
Next, you'll want to follow some of the good business practices described earlier. Preparing a solid business plan will demonstrate to the angel you're serious about your business venture. It's also important to work with an angel that has a genuine interest in your business model. If you're in the software business, then don't try to work with an angel that focuses on medical equipment.
You'll also need to give up some control if you want to work effectively with an angel investor. After all, you're asking them to make a significant investment of their own money into your business. It's only fair that 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 Capital Education Foundation (ACEF) - an organization devoted to the education, information and research about angel investing for investors. Resources include a comprehensive list of regional associations.
- AngelSoft - founded in 2004, AngelSoft 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
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