What is an angel investor?
Angel investors are the saving grace of entrepreneurs. Without them, most startups won’t get off the ground- so what is an angel investor? These early investors are aptly called angel investors because they are like real angels for entrepreneurs struggling to start a business.
Angel investors defined
Angel investors are wealthy individuals who use their own funds to finance projects that they believe will result in lucrative returns within five to ten years.
Angel investors are mostly informal investors also referred to as private investors, seed investors, or business angels. These affluent individuals part with their capital in exchange for ownership equity in the startup or convertible debt. These investors typically invest in the early stages of startups.
Angel investors are primarily interested in early- stage startups. Early-stage startups have not yet proven their financial viability, so these investments are risky, and that’s why angel investors allocate only a small portion of their investment portfolio to angel investment.
Some, but not all, angel investors are accredited by the Securities Exchange Commission (SEC). To be accredited with the SEC, an angel investor must have a net worth of at least $1 million or make an income of $200,000 a year (or $300,000 a year jointly with a spouse).
However, angel investors can also be found among an entrepreneur’s family and friends. In addition, entrepreneurs can find angel investors via certain crowdfunding platforms online. Some angel investors work with other investors to pool their capital together.
What are the funds used for?
Most often, the investment is a once-off amount to help the business get off the ground. It can also be an ongoing investment that will support the company in its early days.
Other than looking forward to a return on their investment, angel investors are often motivated to get involved at the early stage of a startup because they are able to offer valuable mentorship to the entrepreneur.
What happens if the startup fails?
For angel investors, it’s essential that the startup has a high potential to succeed. They invest with the intention to earn a high return on their original investment. So, the potential to earn a high return must outweigh the risk of the investment because, if the startup fails, they lose all their money, unless they have convertible debt. In that case, they’ll be repaid when the business is sold or from the proceeds of future funding. At that stage angel investors can choose whether they want cash or equity in the business.
Pros of angel investors
Traditional lenders like banks are not prepared to take the risk of investing in a business that has not proven itself yet. Before you see any money from a bank, the business has to show that it has a recognized business model, is already profitable, and can provide collateral, putting most entrepreneurs out of the running for bank loans. Angel investors don’t have these requirements. Many of them are experienced investors and understand that return on investment takes time.
2. Simplified application process
The application for a bank loan can be tedious and time-consuming, whereas most angel investors are satisfied with a simple agreement. The one most often used is the Simple Agreement for Future Equity, or SAFE, developed by the seed accelerator for startups, Y Combinator.
This is a document that lays out the terms of the agreement in easily understandable terms, saving entrepreneurs and investors the time it takes to negotiate terms, not to speak of saving all the parties legal fees.
3. Investment money is not a loan
If you took out a small business loan, you would be expected to pay back the loan, but angel investment is an investment in the future of your business, not a loan. Your angel investor is not a lender that you have to pay back. Their payment for the funds that you are using, is equity in your business. If it succeeds, they stand to benefit big time. If your business doesn’t make it, you won’t have to pay back your angel investor.
4. Improved chance of success
The presence and guidance of one or two angel investors increases a startup’s chances of success. According to the National Bureau of Economic Research, startups backed by angel investors are more likely to be successful. They are at least 14 percent more likely to survive for 18 months or longer after funding and hire 40 percent more employees than firms that didn’t receive such funding. Angel investors are often serial entrepreneurs experienced in what it takes to be a founder and start an enterprise from scratch, so they have valuable insights that can help new startups. They can provide the mentorship and guidance necessary to facilitate a startup’s growth.
5. Strategic networking opportunities arise
There is nothing like knowing the right people to get a new venture going. Angel investors tend to be well connected and if the startup founder is lucky enough to have an angel investor that is familiar with the industry, it may lead to introductions to influential business people in the field. An angel investor may introduce founders to prominent business people, other potential investors, leads, and even professionals that might become valuable members of the startup team, giving the business a boost.
6. Future funding becomes easier
If a startup has been funded by an angel investor, other investors are more inclined to be interested in investing as well. Most angel investors know other investors and, if they believe in a startup company, they may promote it for investments. Angel investors have a stake in the business, so it’s in their interest to help the startup get ready for the next funding round and to do the necessary introductions to make it happen. This takes a load off the founder, who can then focus on growing the business instead of running around looking for investors.
Cons of angel investors
1. The pressure to succeed mounts
It stands to reason that a person who invests their own money in your business will want to see progress. Angel investors typically demand a return of at least ten times their original investment within five to seven years. That’s a lot of pressure for any new business.
Angel investors have high expectations: they expect to see a return on their investment in a short time. Anyone looking to get money from angel investors, must be sure that the startup has the potential to live up to those kinds of expectations. So, angel investment might not be the right choice for entrepreneurs who are happy to establish a one-man show and are not interested in scaling their business.
2. Angel investors are a scarce commodity
There is a shortage of angel investors worldwide. In addition, there is no obvious way for founders to connect with angel investors and vice versa. It is not easy to get an angel investor. One reason for this is the fact that entrepreneurs are not always aware of the online platforms that put investors and startups in touch with each other. If a founder doesn’t have access to angel investors in their network, it might be difficult to find one. It takes a lot of hard work and marketing to find angel investors and to make them aware of an investment opportunity. On the other hand, investors that an entrepreneur may be aware of, may not be interested in investing.
3. The funding comes at a hefty price
That investor capital may not be a loan you have to pay back, but it does come at a price: you have to sacrifice some of your equity. In other words, a percentage of the ownership of your business goes to the angel investor. That is no small matter. Many founders who have found themselves desperate to obtain funding, make the mistake of giving up too much of their equity in the early stages of their business and regret it later. The percentage of ownership handed over to the angel investor must be carefully weighed so it’s not detrimental to the entrepreneur at a later stage.
4. You lose full control
Of course, if an angel investor has part ownership, he or she also has a say in the business. Depending on how that plays out, it can be very taxing for an entrepreneur who has fixed ideas about the future of the company. Your angel investor might insist on having an active role in making business decisions that you may disagree with. At any rate, even if the angel investor doesn’t take an active part, you’ll be obliged to account for your decisions.
5. Guidance and support are not guaranteed
While the knowledge and experience of an angel investor can be invaluable to a startup, the reality doesn’t always turn out like that. Not all angel investors are interested in or able to help entrepreneurs resolve some of their challenges.
Also, many angel investors are involved with more than one startup and are spread thin, which means they are not as available as the entrepreneur may have expected. Startups that need substantial guidance may have to ensure that the angel investor can provide the support they need before they sign any deals.
The angel investment process is time-consuming, with a lot of paperwork that needs to be prepared like cash flow statements, bank statements, income statements, projections, and more. In addition, it may take months for the actual funds to materialize. While the entrepreneur is busy with these tasks, the business may suffer. In addition, several factors can slow down the process even further, such as the involvement of more than one investor.
Startups with growth potential, have the best chance of receiving funds from angel investors. These individuals play a crucial role in the potential for global financial growth with their early-stage financing of high-growth companies and mentoring of startup founders.