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.
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.
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:
As the above information demonstrates, angel investors fill the void between friends and family and venture capital firms.
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:
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:
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%.
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:
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