When a founder needs their first injection of capital for their startup, they typically don’t begin by seeing a venture capitalist. Before the first round of venture financing, startups usually rely on family and friends and angel investors — individuals who give support to businesses at their initial moments in exchange for equity in a company — for funding.
What is an Angel Investor
Angel investors support a startup after family and friends who themselves will usually invest anywhere from $5,000 to $100,000 of their own personal money because they believe in the founder and their ability to execute.
Private investors who invest in an early-stage startup take on an enormous amount of risk. However, they can also be rewarded handsomely. For example, Jeff Bezos’s parents invested $300,000 into their son’s startup in exchange for a 6% equity stake. Today they are billionaires many times over.
After family and friends come the seed investors, who are typically angel investors. An angel investor is usually a high-net-worth individual who invests earlier than venture capital funds. These early investors want to see dedication, talent and resilience on the part of the founders they are investing in, and more importantly, believe in the product or service the startup intends to develop.
Who Can Be an Angel Investor
Angel investors are essential players within Silicon Valley and startup ecosystems across America. Working as an angel funder in startups is not only a lot of fun, startups can also generate superior returns for investors. The early angel investors in Facebook (NASDAQ: FB) and Uber (NASDAQ: UBER) earned billions of dollars. In fact, Garett Camp’s $220,000 angel investment in Uber netted him $3.7 billion at Uber’s IPO!
If you’re interested in becoming an angel investor yourself, the good news is you can get started today. To be an angel investor, you should go through crowdfunding platforms, angel networks or source deals independently.
Thanks to the passage of the JOBs Act, the deals listed on equity crowdfunding sites aren’t only available to accredited investors — having an annual income of at least $200,000 or a net worth of at least $1 million. These sites enable anyone to invest in an opportunity listed on their platforms.
With websites like Wefunder or SeedInvest, users can contribute as little as $500 to startups. Make an account to invest in startups and start your journey as an angel investor.
Angel networks and angel investor groups are another popular way to access deals as an angel investor.
The most well-known angel network is AngelList. On AngelList, angels pool their money with angel investors who get 15% of profits made by investors. AngelList requires a minimum of $50,000 investment in an angel fund.
Other popular Angel networks are those led by Tech Coast Angels, Life Science Angels, and Golden Seeds.
Evaluating Business to Invest In
If you’re in a position to source deals, you may choose to invest independently in a startup company. While there aren’t any hard and fast rules for angel investing, angel investors want to see evidence of dedication, talent and resilience on the part of the founders they’re investing in. More importantly, as an angel investor you need to believe in the product or service the startup is investing in. The most important criteria by which angel investors evaluate startups can be summarized by “the 4 T’s”:
Founders are critical to a startup’s success or failure. Their prior career and industry experience should add up to a set of skills and expertise that helps them execute their idea, build a team and inspire others.
For consumer-focused startups, a passionate and engaged user base is evidence of traction. For enterprise companies, a robust client pipeline and actual revenue is the name of the game. Keep in mind that traction alone doesn’t indicate financial health or wise financial management.
Startups should leverage technology to create valuable and innovative solutions to real-world problems. When you’re convinced of this, you can start evaluating the solution by understanding their strategy to build a solid product. This includes their product roadmap, design and UX. Their product should also have a leg up on the competition.
Central to evaluating investment terms is understanding which instrument you’re using to invest, the company’s valuation and how your investment — or equity ownership — could make you a cash return in the future.
You should beware of startups with poor business ideas, bad financials and stubborn owners. These are red flags that may make a startup not a worthwhile investment. However, by paying close attention to the 4 T’s, you can begin to develop your talents and select worthwhile startup investments.
Early-Stage Investment Instruments
Angel investing isn’t just about selecting a good product and team. You also should be aware of the quality of a given deal. As an angel investor you should know some of the terminology you’ll find on a term sheet when investing early on.
Common stock is the most common and simplest form of ownership of a company. Common shareholders have a right to vote for the company’s board of directors and at shareholders meetings and receive all distributions of profit, but only after bondholders and preferred shareholders have been paid.
These types of shares come with many different rights, such as voting rights and liquidity preferences. Voting rights allow investors to have a say in the company’s business divisions, and liquidity preferences allow investors to receive returns before common stockholders.
Convertible notes are a type of debt instrument that converts into equity. This means that convertible notes accrue interest and have a maturity date. They are typically used in the early-funding stage, before priced or series rounds, but because of their complexities, more and more founders are raising money on SAFES (below), even in the seed stage.
Introduced by Y Combinator, a SAFE stands for simple agreement for future equity. When you invest in an early-stage startup on a SAFE, you aren’t purchasing shares or equity. Instead, you’re purchasing a promise of future equity. It’s similar to the employee options in that SAFEs are contracts that give investors rights to shares in the future. Let’s say an angel investor comes along and purchases $1 million on a SAFE in a seed round. Those shares do not convert to equity until the next fundraising round.
This type of SAFE is an investment contract between investors and companies looking to raise capital. Individuals make investments for the chance to earn a return — in the form of equity in the company or a cash payout — if the company is acquired, goes public or sells all of its assets.
Is Angel Investing Right for Me?
Startup investing requires paying careful attention to a company’s team, traction, tech, and term, and diversifying into startups in different industries.
Although many industries offer significant returns, invest in sectors you’re already familiar with, when possible. Or, choose a new sector to focus on, like the blockchain or artificial intelligence industries. You educate yourself on that industry drawing on your personal network and resources available online and in print. You begin to follow specific trends within that sector and pay close attention to investor updates. Being engaged with your investments helps improve the odds that you pick a winner.
Angel investing has a few benefits for the accredited investors who put up capital. You can receive the Angel Investor Tax credit, which is equal to 25% of an investor’s equity investment.
Before getting started with angel investing, you should be aware of the risks. While some startups become the next unicorn — a privately held startup worth over $1 billion — most startups fail. Ask yourself how much you are willing to lose. Despite the risks, over a long time horizon, angel investing can be an incredibly lucrative endeavor.