What is an angel investor? Who they are, what they do, and how they help startups grow
- Angel investors are high-net-worth individuals who provide funding to startups, usually in exchange for shares in the company.
- Unlike venture capitalists, angels use their own money; they also invest in much smaller, younger enterprises
- Startup founders benefit from angels' expertise as well as money, but they have to surrender some ownership and management control in return.
New companies need money to get off the ground, of course. But where to find it? Banks tend to shy away from infant enterprises. And despite all the ink spilled about venture capital funding, just .05% of new businesses raise money from VCs, according to Fundable.
That's where angel investors (angels for short) come in. Typically wealthy individuals with cash to burn, an interest in entrepreneurship, and a healthy appetite for risk, these investors fund over 63,000 startups a year, for a total of more than $23 billion, according to the Center for Venture Research at the University of New Hampshire.
In fact, over the years, as investor interest has grown, angels have become a primary source of funding for many early-stage startups.
What is an angel investor?
Angel investors generally are high-net-worth individuals who provide funding to startups in exchange for convertible debt (bonds) or equity (shares) in the company. The term is actually borrowed from show business: Angels originally was an affectionate nickname for backers of Broadway shows, whose money was manna from heaven for struggling artistes.
Angels generally fill the gap between financing from friends and family — usually, the first sources of funds, when a startup is mostly a twinkle in an entrepreneur's eye — and venture capitalists, professionals who enter the scene after a company is up and running.
Typically, angels aren't just wealthy investors, they're also accredited investors. That's defined by the SEC as people with an annual income of over $200,000 ($300,000 for joint income) for the last two years or a net worth exceeding $1 million in investable assets (excluding the primary residence), either on their own or with a spouse. As of August 2020, angels can also include individuals holding professional credentials, like a Series 7, 65, or 82 license.
How angel investors work
Unlike venture capitalists, angels usually aren't in the investment field full-time. Instead, they're usually drawn from the ranks of business owners, well-to-do professionals (doctors, lawyers), and other deep-pocketed individuals who can invest $50,000 or so in a promising startup. Often, they're seasoned entrepreneurs who've built successful companies and want to help the next generation with hands-on advice and the benefits of their experience, while potentially making a good return.
Typically, an angel gets an ownership stake in the company in exchange for their investment, as well as the chance to offer advice and guidance to the founders. Then five to seven years later, if all goes well, they'll expect to make a tidy profit when the startup either goes public or finds a buyer.
But the chances of any one investment reaping super big rewards are slim. So angels also are investors willing to take an educated gamble.
But they don't have to be all that rich these days. That's thanks to the Jumpstart Our Business Startups (JOBS) Act of 2012, which allows more ordinary people to invest in startups via crowdfunding platforms.
The amount investors can invest is limited by their income and net worth. Thus, if investors' annual income or net worth is less than $107,000, they can invest either $2,200 or 5% of the lesser of their income or net worth, per year. Also, companies can raise only around $1 million in a one-year period from a crowdfunding source.
Characteristics of angel investors
Aside from typically being high-net-worth individuals, angel investors also share other key qualities:
- Looking out for the team. Angels tend to veer toward startups that have been recommended to them or are in industries they know well, with the potential to grow rapidly. They also often want to see a working prototype and a clear business plan. But most important to them, is the passion, savvy, and bona fides of the founding team.
- Seeking safety in numbers. Unless you're super angel Ron Conway, developing a healthy pipeline of quality deals isn't easy. That's why they often don't fly solo: Increasingly angels operate in what's known as angel groups, where they can pool their capital along with other accredited investors, raising the total investment level and lowering their personal exposure. In some cases, multiple angel groups join together in syndicates, thereby broadening their reach.
There are now more than 400 angel groups around the country. They're typically organized by geography; some biggies include New York Angels, Houston Angel Network, and Tech Coast Angels. Plus, many angel groups co-invest with other angel groups, individual angels, and even early-stage venture capitalists to make investments of $500,000 to $2 million per round. - Choosing favorites. Generally speaking, angels flock to certain fields and industries. These include software, the internet, and healthcare, along with mobile and telecom, according to the Halo Report. Energy and utilities, electronics, and consumer products and services are also popular.
- Relishing risk. Angels tend to look for returns of about 25% or more over a period of five or so years via an initial public offering or an acquisition. But make no mistake: These are super-risky deals. The best estimate for investor returns, according to the Kauffman Foundation, is 2.5 times their investment, with the odds of a positive return less than 50%. So it might not be surprising to hear that only about 10% of most angels' total portfolios are in these startup investments.
Angel investors vs. venture capitalists
At first glance, angels and venture capitalists seem similar: Both fund young companies in return for ownership. But, in many ways, they're different breeds.
As noted earlier, angels aren't full-time investment pros. Angels usually use their own money, although they typically provide funds through such vehicles as an LLC or a trust, and they tend to focus on fledgling firms — smaller operations than VCs would consider. (In fact, selling their stake to a VC firm is one of the "positive exits" angels hope for).
The average investment made by individual angels for 2019 was $73,700 and the average deal size was $374,225, according to the Center for Venture Research at the University of New Hampshire.
VCs, on the other hand, pool money from outside sources, like pension funds and insurance companies, and then manage it in a fund. They also typically invest the lion's share of their money in companies that are further along in their development.
And their investments are bigger. For example, the median sum for a Series A round — the second stage of startup financing, when venture capital firms tend to get involved — is almost $16 million, according to Fundz.
Plus, VCs charge hefty fees — typically around 2% in management fees and 20% of profits, usually above a certain hurdle.
The upsides of using angel investors
For entrepreneurs, angel funding has several benefits.
- No debt. Since they don't have to take out a loan, entrepreneurs aren't on the hook for paying anything back. That's especially helpful should the company head south.
- Access to expertise. Smart entrepreneurs look for angels with a wealth of business experience they can tap. Particularly useful are investors who have founded successful companies themselves.
- Less paperwork. Companies that raise financing from angel investors are exempt from a variety of filings with SEC and state securities regulators.
- More money down the line. Once angels invest, there's a pretty good chance they'll add another cash infusion later on, in another funding round.
The big downside of angel funding? Loss of control. Recipient firms have to give away anywhere from 10% to 50% of the business to the angel. That also means potentially losing some say over how the company is run, since investors will, by all rights, be entitled to play a role in business decisions.
The financial takeaway
Although VC firms get all the attention, it's angel investors who really form the bedrock of funding for fledgling startups. Angels, in fact, can be a godsend for cash-starved companies that aren't ready —and may never be ready — for venture capital. Plus, they offer invaluable expertise and connections to entrepreneurs who desperately need them.
Ultimately, however, enterprises in the sectors popular with angels raise the most money from these folks. That means companies in less-favored industries need to look elsewhere.
As for angels who want to get a piece of the most promising action, joining an angel group can provide the best access to deal flow. At the same time, while these high-risk investments can sometimes result in hefty profits, angels don't count on that happening. Ultimately, for many angels, it's the thrill of participating in a promising venture's early development that provides the biggest return.