The COVID-19 crisis has underscored the challenges of creating and scaling a startup in a rough economic climate. These hardships also emphasize how important it is for startup leaders to solidify a plan to secure stable initial funding that isn’t fickle. For many of them, angel investors may be a great support system, both for financial reasons, as well as the benefits of mentorship.
Angel investors are the financial backers who provide capital to startups or entrepreneurs, often in the early stages of development, when other venture capital investors may not have enough confidence yet to back them.
It’s never too early to start speaking with potential investors. Gary Stewart, the founder of The Nest, an app that addresses the lack of diversity in the tech industry, says that he started talking to investors from the first moments that he started working on the idea.
Of course, it’s important to build relationships with investors at any stage. Angel investors, typically invest purely in a professional capacity while others might do so for other non-financial reasons, such as an interest in the industry or because it is a friend or family member.
Many startups and entrepreneurs seek angel funding as a primary source in their early stages because they often find it more appealing and less predatory than other forms of funding. Knowing what to expect from an angel investor can help you understand the investment process better and lead to superior ourcomes.
How Does Angel Investing Work?
Unlike a typical debt financing scenario, which requires that startups borrow money and then pay it back in the future, angel investors provide funding with no debt or repayment. Instead, angel investors receive equity or shares in the company. Since these types of investments tend to have more risk on them, they normally don’t make up more than 10 percent of an angel investor’s portfolio.
Angel investors can structure their investments in various ways:
Friends and family: A friends and family investment round allows a company’s founders to seek assistance from their immediate family and friends, creating an immediate financing network. In this scenario, angel investors simply have to list that they are an accredited angel investor on the company’s subscription agreement.
Angel groups: Together, a group or organization of angel investors will review and invest in startups. AngelList, for example, is an online network of angel investors startups can use as a resource to find angel investors. An angel group can be created with a like-minded group of friends or even coworkers. If ten people pitch in and fund $5,000 toward a new company, they can already have an investment of $50,000.
Syndication: The syndication process is similar to an angel group, but instead, one angel leads the investment pick. Syndicates are usually very experienced angel investors who have successful deal flows or numerous business deals. This investment structure funds companies at scale and the person who leads the syndication gets a 20% fee, but only upon the business’s success. Many investors like to join in syndication rounds because they are working with leading investors who have years of experience and often fund deals quickly because they have already built relationships with others, making it easier to gain access. Many angel investors can go into an investment alone, but the main reason why they may want to invest with other people is to safeguard their reasons and not invest purely off emotion or excitement for the industry.
The Risks and Rewards
Angel financing is extremely beneficial for startups because it allows them to avoid adding debt to their balance sheets. From an angel investors’ perspective, there are pros and cons to consider.
To succeed as an angel investor, many investors must consider funding companies in industries where they have experience and unique insights into company ideas, which informs better decision-making. Angels who invest in areas they aren’t familiar with are sure to make poor decisions and it’s best to avoid unfamiliar territory when dealing with already high-risk investments.
However, it’s important to diversify in startups since many of them will not be successful. Unlike the stock market, which has years of data backing investment decisions, angel investing more often predicts which companies will generate profit years from now. To optimize for success, you need to be able to make several investments with the goal of one or two being successful outliers. For angels, allocating a budget to invest in at least ten startups over two years is a good start.
While most investments may not normally work out, being right on one of them could pay for all of the money invested in the rest — and with a more diversified portfolio, investors have a better chance of securing a successful outlier.
These investments require patience, since it can take years to find the right opportunity to invest in and wait to see how well a new company can perform and gain profitability.
Taking on this type of investment involves knowing three important factors: knowing the right companies to invest in, the amount to invest and how best to fund those investments.
Considering profit potential and nonliquid returns associated with the business is critical before investing. It may feel important for some angel investors to be engaged in a startup’s growth process as a hands-on approach in earning a minimum rate of return.
Angel investors may also want to look to other experienced investors to learn what companies will likely be profitable, but remember that it’s the people who make an innovative idea work at the end of the day. The capital is a small part of the process.
Finally, it’s critical to calibrate how much of a portfolio should be allocated to angel investments. An allocation between 5% to 10% makes sense for most angel investors. Keeping investments as a small portion of the portfolio can increase returns while lowering volatility due to early-stage, private companies generally holding low correlations with traditional asset classes like stocks and bonds.
In many ways, angel investors are saviors as they help support and guide young startups to gain more independence while they grow in an industry that all parties are passionate about.