A person gains equity in a company by buying its stock, or builds equity in a house by paying down the mortgage. Equity simply represents an ownership stake, be it in a company, a home, or a startup.
Angel investing is a type of equity financing. Wealthy individuals risk their own capital to back fledgling firms in return for equity—a piece of the business.
If the startup fails, as up to 90% do, the investors lose the money they’ve put in. But if the venture succeeds, the investors receive returns proportionate to their equity stakes. Angel investors in Uber, for instance, invested as little as $5,000 apiece when the ride-hailing startup was little more than a concept. These initial investments delivered multi-million-dollar profits when Uber’s business took off.
So do angel investors get equity? The short answer is yes. But the specifics are, of course, more complex.
How much equity do angel investors usually get?
Angels typically seek stakes of at least 20% in the startups they fund. Some backers ask for as much as 50%, especially in the very early going. Although angel investors are usually individuals, the funds they invest can come from a business entity, a trust, or an investment fund, among other sources.
Most angels are interested in more than equity. Many are corporate leaders, business professionals, or successful entrepreneurs themselves who want to nurture young companies.
Not every would-be angel can participate. The Securities and Exchange Commission allows only accredited investors to take part. They must have net assets of at least $1 million, not including their home, or annual income of more than $200,000 or $300,00 for married couples. Professional knowledge and certifications may also be important. The SEC is considering further revisions to its guidelines.
Determining an angel’s equity
Each angel investment is unique in its terms and structure. But investors can apply some general principles to maximize the equity they receive and improve the chances the business—and thus their investment—will succeed.
Angels usually invest during the pre-seed or seed stages of startup financing. They might invest after the business raises money from family and friends, and before venture capital investors appear with their often-bigger checks.
Angels are typically more interested in companies that show promise in the earliest stages rather than those that are further along. That’s because fledgling companies command lower valuations, meaning angel investors receive a bigger stake for the dollars they put in.
Investment size and company valuation
Individual angels usually invest between $5,000 and $150,000. A round of angel funding relies on more than one person. A typical round can bring in three to five different investors, with the total investment averaging between $100,000 and $250,000. The investors receive equity commensurate with their contributions.
Angels also pool their capital and expertise to make larger investments by joining formal investing groups and syndicates. These groups usually target an industry or geographic region and use local contacts to scout for opportunities. Angel groups often raise $1 million or more for their chosen targets. In April 2022, there were 444 angel networks in the U.S. that connect investors with entrepreneurs.
Angel investors and entrepreneurs can use calculators to determine how much equity their investment dollars will buy—and how much of the company the founders are giving up—based on the company’s valuation. A $50,000 investment in a million-dollar company, for example, yields a 4.76% stake; the same investment in a $5 million company confers just a 0.99% share.
Note that startup valuations are usually subjective and can be based on the venture’s financials, comparable businesses with successful exits, and the makeup of the founders and team.
How angels invest
Angels can gain equity in a startup by providing funds in three ways.
- Direct equity stake. Angels can acquire a direct equity position, such as a 20% to 30% stake in the business. The percentage depends on the startup’s valuation and other metrics. Investors may appoint associates to help manage the business to safeguard their interests.
- Business loan. Angels may offer the startup a loan that can be converted into an equity position once the company takes off. These angels generally require a 20% to 30% equity interest and other benefits, such as a seat on the company’s board.
- Convertible preferred stock. Investors provide funding in exchange for preferred stock that can be converted to equity in the company at an agreed-upon price per share. The shares provide added investor protections such as control rights, prevention of dilution, and preference if the business is liquidated.
Angels and entrepreneurs work out the funding and equity details in a nonbinding agreement that covers basic deal terms and conditions. This term sheet is the foundation for a more extensive, legally binding document should the investment proceed.
Time to returns
Angel investing takes patience and nerve. Very few startups reach a stage where they return any profit to investors—and most collapse and take the angel money with them.
Angel investors can profit if they’re able to sell part or all of their ownership stake in what’s called an exit. The sale can occur during an initial public offering (IPO), acquisition, venture capital buyout, or other approach. The exit lets the investor liquidate their share and make money if the company is successful.
Early investors often expect to get their money back in five to seven years. Successful investments can take 10 years or more to produce a return. Uber, for instance, held its IPO nine years after it received its first round of angel funding.
Angels typically seek to recoup their initial investment—and hopefully more. Studies suggest a portfolio of angel investments can return 27% or greater – with many variations and caveats.
Safeguards for angels
With poor odds for both a startup’s success and an investor’s profits, what can angels do to safeguard their investment dollars?
First, they can insist the terms of their investment deal cover potential stumbling blocks:
- Dilution. Angels want to guard against financial losses if the company they’re backing sells shares to another investor for less money. An anti-dilution clause can specify that the angel investment be recalculated to a lower price if this happens, providing more equity for the original investor.
- Control. Angels want a voice in company governance and actions. Control clauses typically require investors to approve in advance any merger, acquisition, or other event that changes the company’s control or seeks to liquidate the firm.
- Rights. Angels want the option to participate in future financings, especially if the investment is thriving. So-called pro-rata rights let angels invest more. The rights may be open-ended or capped to maintain the investor’s original ownership percentage.
Angels can also work to safeguard their investment by using their talents, experiences, and networks to help a young business succeed. Roles include:
- Advisor. Angels can provide business advice and emotional support.
- Networker. Angels can network to attract customers and provide expertise.
- Recruiter. Angels can advise on interviewing and hiring decisions and refer people they have worked with.
- Marketer. Angels can use contacts and social media to create a buzz for their companies.
- Technical expert. Angels with relevant technical knowledge can test products and apply their skills.
- Board member. Angels may take a board seat to provide higher-level oversight and direction.
The bottom line
Angel investors typically seek an equity stake of 20% or more for putting their own capital into a startup. The ownership stake can pay off for investors willing to wait the five or more years for a successful exit that will deliver returns commensurate with their equity. Angels can safeguard their equity by taking an active role in the business and insisting on terms that give them special rights and protections.