Those who invest in assets that change hands at an agreed-upon price—like stocks, crypto, and real estate—know when they’ve made a profit: They sell the investment for more money than they paid for it.
Angel investors, typically wealthy individuals who back early-stage businesses with their own capital, don’t have such easy yardsticks. They put their money into a startup and bet it will succeed based on scant data and their own judgment. Once they commit, they tie up their funds for an unknown period of time with no quick way to cash in—if they can cash in at all.
Angel investors make money when their stake grows in value, and they’re able to liquidate it in what's known as an exit. But if the startup fails—as most do—the investor gets nothing and loses their initial investment as well.
How angel investing works
Angels typically consider lots of early-stage startups and whittle down their investment choices to a few. Then, they provide funding to their chosen startups to cover costs until the business starts growing. Angels typically invest $5,000 to $150,000 per startup. In return, they receive an equity stake in the company. That averages around 20% but can rise to as much as 50% of a young company.
Investors and entrepreneurs may negotiate funding and equity details directly, especially in the earliest ventures. Investors also may use the company’s valuation to determine how much ownership to take. For example, if an angel invests $500,000 in a startup with a $2 million valuation, the company’s value jumps to $2.5 million and the angel’s equity stake in the company is 20%.
How angel investors make money from investing in a company
Angels get their payback through an exit that lets them liquidate their stake and potentially make a profit that’s based on the percentage of the business they own. Generally, investors will pre-plan the details of the exit when negotiating the term sheet before they invest in the startup.
Angels seek to recoup their initial investment and then some. There many kinds of exit strategies, the most common being:
- Acquisition. Another company buys the startup. This usually generates a return on the angel’s initial investment because the sellers want to make a profit for the work they’ve put into building the company and want—or need—to repay their investors.
- Merger. A company buys the startup and melds it into an existing business.
- Initial public offering (IPO). The startup goes public by offering stock on an exchange. Out of the plethora of startups, relatively few have IPOs. Those that do can have big returns because they’ve made it far enough in establishing a business to generate interest and support from investment banks, and to attract potential stock buyers.
- Venture capital buyout. Venture capitalists may invest in a startup after angel funding and then offer to buy out the angel investor.
- Management buyout. A startup’s executives may combine their resources to buy back an angel’s equity. This occurs less frequently than other exits.
- Retaining equity. An angel investor may also decide to stick with their investment if the company is profitable but isn’t planning a sale or IPO. In this case, an angel may receive a regular dividend for their ownership stake.
Most angel investments fail and the ventures never get off the ground. But sometimes small angel investments can deliver big payoffs. In 2010, Uber received 11 angel investments totaling $510,000. Some angels chipped in just $5,000; only one invested more than $100,000. The relatively small sums yielded huge rewards: When the ride-hailing company went public in 2009, the total angel investments were valued at about $2.5 billion.
How angels choose their investments
Studies suggest a portfolio of angel investments can return 27% or more— with many variations and caveats. Very few early-stage companies turn out to be Ubers. So how do angel investors decide where their money will make the most money? They consider several factors including the startup’s industry, growth potential, and management.
Angels will also consider the likelihood that a startup will grow. That helps them determine the potential return their investment could yield. Sectors with the highest returns on equity in the first quarter of 2022 were:
- Technology: 25.52%
- Consumer non-cyclical: 16.19%
- Capital goods: 15.26%
- Retail: 14.03%
- Basic materials: 13.61%
- Transportation: 11.54%
- Healthcare: 11.13%
- Energy: 11.03%
- Consumer Discretionary: 10.21%
- Services: 7.35%
Angels want to know the startup they’re backing is in the hands of managers with solid skills. They look for:
- Leadership. Are the entrepreneurs and their staff trustworthy, competent, and inspirational?
- Financial acumen. Do managers understand finance and have a solid business plan with financial projections and detailed marketing?
- Experience. Do managers have manufacturing, human resources, accounting, sales, research, or other skills their company relies on? Do managers have a track record of success with other companies?
Once an investor decides to invest, they gauge how much money to contribute and whether more is required. The lead investor teams up with the founder to bring in other investors. Most angels expect a formal shareholder agreement laying out the contingencies of their investment. A term sheet is a document that includes the startup’s valuation, deal flow, and the angel’s own due diligence. Lawyers draft definitive legal documents before any money changes hands. Everyone signs off on the closing package before the deal is final.
Why angel investors would invest in a money-losing startup
Some angel-backed companies have viable businesses but aren’t making a profit. These money-losing startups can still be appealing to angel investors, who invest in them for various reasons:
- The company is growing. Angels may focus on growth potential and market share rather than profits. If a company is quickly winning more market share, that could lift revenue and valuations for future returns.
- The company has intellectual property. A startup may have patents or copyrights that could be valuable to investors.
- The company has valuable assets. Investors may sell off key assets that are more valuable than the whole company. The assets may be undervalued due to poor management or other reasons but may be attractive to outside buyers. When the assets are sold in a process known as asset stripping, investors can be compensated with a special dividend.
- Market valuation. Investors may see the potential in money-losing companies that can achieve high valuations in an IPO. Angels typically invest early, when valuations are low. However, the outcome for investors, especially those in later stages, is not always positive. During the dot-com boom in the mid-1990s, profitless companies went public and their stock prices soared. The tech-heavy Nasdaq composite index peaked in March 2000; by October 2002 it had lost three-quarters of its value.
What angel investors provide startups besides money
Aside from providing capital to a startup, angel investors can help a young company grow by acting as:
- Advisor. Angels can provide business advice and emotional support.
- Networker. Angels can use their networks to attract customers and outside expertise.
- Recruiter. Angels can help with interviewing and hiring employees. They can also refer people they’ve worked with.
- Marketer. Angels can use their contacts and social media to create a buzz for their companies.
- Technical expert. Angels with technical knowledge can apply their skills and test and review products.
- Board member. Angels may take a board seat to dispense higher-level oversight and direction.
The bottom line
Angel investors make money by backing very early-stage startups they find promising, with investments typically ranging from $5,000 to $150,000. In exchange, they receive an ownership stake in the company and expect returns if the company succeeds.
Angel investing is risky, though, with the potential for very big losses or, in a few cases, very big gains. While most angel-backed ventures don’t get off the ground, the few that do can provide outsized returns, turning thousands of investment dollars into fortunes.