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For startups and new entrepreneurs, securing funding is one of the most important and challenging processes. An angel investor is an important term in the startup ecosystem as they help early-stage startups by providing them funding when they have no other source of money.
But why do angel investors take huge risks, how do they work, and how do they make money?
Angel investors or private funders are high net worth individuals who provide capital to early-stage startups in exchange for equity in the company.
Angel investors could include:
Founder’s family or friends
Professional investors and angels
Domain experts
Entrepreneurs
Angel syndicates
Crowdfunders
An angel investor differs from other investors because they invest early in the startup. Sometimes, this means that there is just an idea that hasn’t been developed entirely or that the startup has minimal to no traction. Since it is such an early stage in the startup, getting any funding from VCs or even the government is difficult. That is why angel investors are called ‘angels’ because they help startups when no one else is ready.
Furthermore, angel investors not only provide funding to startups and companies but sometimes they also provide consultation, networking opportunities, connections, publicity, etc.
For example, Marc Andreessen is one of the famous angel investors and has invested in many successful companies like Facebook, Github, Pinterest and LinkedIn. Another example is David Sacks, who has invested in Uber, Lyft and Scottylabs.
Since it is very risky to invest in companies at such an early stage, angels usually invest less than venture capitalists or investors who provide funding at a later stage. Their main goal is to provide enough funding to cover startup costs until it can receive further funding and gain some traction or revenue.
The amount to be invested is decided based on initial traction, the industry, growth potential, the idea, team qualification and startup stage. Generally, the investment amount is between $5,000 to $150,000, but it may vary based on different industries and different startups.
What Is The Angel Investing Process?
A general investing process includes the following steps:
Deal flow and screening: angel investors start by researching available investment opportunities and then screening them to suit their needs and investment capacity. Usually, they start with a large number of startups and eventually boil down to a few suitable ones considering the idea, potential market and startup stage. Then, they go through pitch decks, set up meetings with founders, and develop a final list. However, even after meeting and pitch deck, there is a long process where investors conduct their due diligence before deciding to invest in any startup.
Term sheet agreement: once the investor decides which companies they want to invest in, they prepare a term sheet and clarify all the aspects of the investment. The term sheet includes clauses like deal structure, valuation, equity economics, investor rights and protection, the scope of management and control in the company and exit strategies.
Investing the money: The investor decides to raise the money at this stage. This stage is the beginning of the investment process, and it is often known as deal syndication.
Finalising the legal agreement: finally, a legal contract is documented and signed by both parties. After that, the deal is closed, and funds are finally released.
Does An Angel Investor Only Provide Funds?
No, generally, an angel investor provides more than just funds to a startup. This is because the investor will get a more significant return as the company succeeds. So they usually try and help the startups grow and provide consultation on how to move ahead. Furthermore, they provide connections, networking opportunities, recruiting services, technical advice or assurance and many other things. So the scope of services provided by angels is very large. However, all these terms and conditions regarding the time and the services provided by an angel investor are agreed upon by the two parties at the beginning of the contract.
How Do Angel Investors Make Money?
Since it is very risky for angel investors to invest in early-stage startups, they demand a percentage of equity in these companies in return for their investment. However, it needs to be kept in mind that angels do not take significant control of the startups. Instead, they look for enough equity so that they can plan an exit and get a return on their investment once the startup succeeds. Generally, investors seek 20-25% equity in the startup.
What Is An Exit?
An exit is the most common way an angel investor makes money. An exit is when the investor decides to end their involvement with a startup. It simply means that the investor decides to sell his share of equity in the startup to some other entity. It can be another investor, common public or a private company. The exit allows the angel investor to liquidate their share and even profit if the company is successful. Investors generally pre-plan their exits and even include them in the term sheet clauses.
How Do Angel Investors Get An Exit?
There are usually two common ways using which the angel can get a return on their investment, including:
Buyback: Stock buyback is when a company repurchases its shares from the shareholders at the market value. There can be many reasons for a buyback, including company consolidation, reducing the number of shareholders in the company, increasing equity value or reverting stock undervaluation.
Larger investors: As the startup succeeds and raises funds in various rounds, the small investors, including angels, stand a chance of an exit. Generally, investors make money based on the percentage of equity they own. For example, a larger investor may buy shares from an angel if they want to buy more stock in the startup than the startup wants to sell. However, this deal only happens after the company board approves it.
Acquisitions: Another very common exit is when the startups in which angels have invested get acquired by a larger company. Acquisitions are relatively common in the startup ecosystems as companies are always looking for inorganic growth by acquiring smaller startups, be it for their resources, employees(acquihires), or surpassing the competition. In such a situation, the angel investors either get equity in the new organisation, cash or a combination of the two.
IPO or an initial public offering: Itis the stage when the startup goes public and offers its shares or stocks for the common public to buy. The journey to an IPO is very long, and very few startups have reached this milestone. However, once achieved, an IPO gives tremendous returns to investors. This is because the angel investor can now easily sell their equity share to the public or an investor.
Other Income Sources
An angel investor doesn’t always need to plan an exit to make money. Some other ways through which they can get a return on their investment include:
Regular dividends: although it is pretty rare, there may come a stage when the startup becomes profitable or does not need any further funding or investment. In such situations, the company board may decide to pay regular dividends to the investors. These dividends are usually determined beforehand by the investor and company and are included in the term sheet clauses.
Employee compensation: sometimes, the company provides employment (as a CEO, CFO, etc.) to an angel investor if it values its services. In such a situation, the investor receives a salary as any other company employee.
How Much Return Do Angel Investors Expect In Return For Their Investment?
Angel investing is seen as a high-risk feat because it is too early to evaluate the risks and merits of investing in a startup. But, according to various studies, angels can expect a combined annual return of around 27%. However, returns are never guaranteed. It depends on the type, and the number of companies an angel investor invests in. that is why they diligently evaluate startups with a fine-tooth comb before investing in one.
Angels usually follow a portfolio approach where they analyse and evaluate their options. Studies have shown startup failure rates to be approximately 60%. So, if the investor funds ten startups, at least 5 or 6 of them have a high chance of not giving any returns. Thus, the investor will have to make up enough profit from the remaining one to cover their losses as well as make up some profit on the whole deal.
How Do Angel Investors Make Money From Loss-Making Startups?
Although some startups may look like loss-making companies, they attract many investors who see enough growth potential in them. For example, even though Flipkart is a loss-making company as of December 2021, and it is predicted to remain that for the future, many investors are interested in investing there.
Growth potential: investors are more focused on a company’s growth potential and market share than its profits. Therefore, angels usually invest in such startups to help them capture a larger market share. These companies can gradually increase their revenue and market valuations over the years, and the investors can get good returns.
Intellectual property rights: certain loss-making companies have patents or copyrights with high valuations. This reduces the risks of investing in such a company as even though it is making losses right now, it definitely has the potential to provide considerable returns to investors.
Asset stripping: sometimes, investors fund a loss-making startup only to sell off its assets and generate dividends or profit for the company’s shareholders. This is generally done when the individual assets of the startup are more valuable than the entity itself. Asset stripping often results in dividends for investors, which is why such companies are attractive for angels.
Potential market valuation: when Lyft announced its IPO, the company was valued at $24.3 billion. The company saw this success after looking at huge losses for a long time. Lyft is an excellent example of how even a loss-making company can provide considerable returns to investors. Furthermore, as angel investors as usually the first ones to invest in a startup, they can get incredible returns if they look beyond losses and recognise the potential of a startup.
Advantages Of Being An Angel Investor
There is a high probability that a majority of the startups an angel investor invests in fail and provide essentially no returns. However, angels are still interested in funding startups because the ones that succeed provide huge returns. Furthermore, there are several other advantages of becoming an angel, including:
Asset diversification: investing allows angels to diversify their assets into high-risk and high-reward asset classes.
Networking opportunities and Entrepreneurial community: investing allows angels to build a network within the entrepreneurial community. This will enable them to learn new skills, meet new people and entrepreneurs and support their interests.
Monetising expertise: Another advantage of being a part of the community is that they can monetise their expertise, whether it’s consultation, marketing or human resources.
Risks And Challenges Faced By Angel Investors
Investing in startups is a tricky and risky feat in itself. But investing in startups that aren’t fully developed and don’t have any valuation or traction is highly challenging. Some of the risks and challenges faced by angel investors include:
Asset risks: this is one of the most significant risks investors face. This is because the investors could lose the entire amount if the company shuts down or goes bankrupt, which is very often the case with startups. Furthermore, even if the company doesn’t shut down, there could be a delay in returns because it may take long for the investor to exit. So, there are limited options to liquidate and the more the investor waits, and the more diluted funds get in subsequent funding rounds.
Competition risks: in every industry, there are certain competitors of startups, which means that to sustain growth, a company will have to create certain entry barriers or some USP for its product or service. However, competitors can cause significant problems for startups, such as price wars that dilute margins and make it difficult to attract more investors.
Growth risks: one of the preferable outcomes for an investor is the startup’s growth. However, as a startup grows or expands, there are new challenges and hurdles, which may put pressure on the company. To succeed, a startup requires constant funds and new strategies to sustain itself. That is why investors are sceptical while investing in early-stage startups.
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