Imagine it’s 1995, the dawn of the World Wide Web, and you have a novel idea: a computer program to search and sort through information on the Internet. But how could you get funding to develop it??
Enter a private investor, or angel—with a $100,000 check. This, of course, is the simplified origin story of Google, today’s ubiquitous technology and one of the world’s most valuable brands. This mega-company got its start thanks in part to an angel investor who committed their own cash to back what they viewed as a promising startup.
What is angel investing?
Angel investing is a form of private investing in which a high net-worth individual invests in very early-stage businesses using their own money. Similar to other investors, angel investors typically get an equity or ownership stake in return for their investment, potentially giving them a big payback if the company is sold or goes public.
Angel investors typically step in during a project’s earliest days, when odds of failure are high and traditional venture capitalists or banks aren’t interested in making an initial investment. They are usually wealthy individuals who can afford a lot of investment risk, and may be experienced operators or investors with a honed eye for promising businesses. Angels provide as much as 90% of the early outside equity startups raise (excluding any money contributed by friends and family), according to the Angel Capital Association.
Angel investing history
Wealthy people have always supported entrepreneurs and interesting endeavors—think of patrons of the arts. The term “angel investor” was coined in 1978 in a study on seed funding. An organized, systematic form of angel investing began in the mid-1990s; angel investing groups emerged after 2000. The field has exploded in popularity since, partly due to the growth of the technology industry. Total angel investments in 2020 rose to $25.3 billion, up 6% from 2019.
How does angel investing work?
Angel investing involves the following steps:
- Angel investors identify opportunities. Angel investors research the industries they want to invest in and build their contacts within them.
- Investors screen those opportunities. Investors scout and screen opportunities. One part of screening is determining the amount of return an opportunity might be able to generate. Investors typically seek potential returns of 25% to 60% on their investment, higher than typical returns from traditional investments.
- Entrepreneurs pitch the investors. Candidates pitch their businesses, providing an overview of the business, its financial needs, and ultimate goals. Pitches range from casual meetings to formal presentations.
- Investors review the pitches. Angel investors review the presentation and other pertinent information. They ask follow-up questions, identify roadblocks, and study the business plan. They may prepare a formal due diligence report with items to be addressed.
- Investor and founder negotiate terms. If a deal looks promising, investors and the entrepreneur negotiate terms. They discuss the valuation and structure of the business. They complete a term sheet with details and a diligence report.
- Investors gauge how much funding is needed. Investors gauge how much money to contribute and whether more is needed in a step known as syndication. The entrepreneur and lead investor team up to bring in other investors.
- The deal closes. Lawyers draft definitive documents before any money changes hands. When the investor and entrepreneur sign off on the closing package, angel investors begin making introductions and offering mentorship, advice, and sometimes board service.
What are the most common sources of angel funding?
Investors in early-stage businesses range from wealthy individuals to the entrepreneurs themselves to formal groups of accredited investors. They include:
- The founders. A startup’s founders often spend their own money or credit lines to get their idea up and running. Outside investors like to see the founders’ skin in the game and may be more likely to finance projects that have self-funding.
- Friends and family. Entrepreneurs often get funds from people who know them best. Close relationships can make it easier to agree on terms and get long-term support. Investors must understand the risks, however, including potentially losing their entire investment. Documentation is important and both sides must acknowledge that mixing business with friends and family could have drawbacks.
- Crowdfunding. Founders use this relatively recent tool to gain contributions from personal and professional networks. They use social media and crowdfunding platforms to describe their business, its financial needs, and goals. Crowdfunding can work in several ways.
- Donations. People give money to help a business grow and expect nothing in return.
- Debt. The backer pledges money as a loan that must be repaid with interest by a deadline.
- Rewards. Donors give money and receive a reward in return that can range from a souvenir mug to discounted products or services.
- Equity. Participants may get shares in the business based on the amount they contribute.
- Wealthy individuals. Many angels are corporate leaders, business professionals, or successful entrepreneurs themselves, with money to invest. The Securities and Exchange Commission allows only accredited investors to participate in angel funding. These high-net worth individuals need $1 million of assets (excluding their home) and annual income of more than $200,000, or $300,000 for couples. Professional knowledge and certification can also be factors in accreditation, according to new SEC rules.
- Angel investor groups. Angel investors often form groups that convene regularly to evaluate and invest in startups. They typically focus on a state, metropolitan area, or a specific industry. The groups rely on members’ local knowledge and contacts to find prospects. The members pool their capital to increase their investment dollars and minimize individual risk.
Potential benefits and drawbacks of angel investing
Angel investors may earn higher gains but because they invest in very early stage startups, also take on more risk than they would with other investments.
Potential benefits of angel investing
- Potential returns. Angels can earn higher returns than they may receive with many other types of investments. Studies suggest a portfolio of angel investments can return 27% or more annually, almost triple the stock market average.
- Diversification. Investing in startups diversifies an investor’s typical portfolio of stocks and bonds.
- The ability to drive innovation. Angels can be on the ground floor of breakthrough technologies.
- Putting money into passion projects. Investors can put their money into businesses that are important to them.
- Limited obligation. Investors are not responsible for running the business. Many angel investors, however, do nurture and mentor young companies.
- Learning new skills. Angel investors may learn new skills such as structuring a deal and serving on a board. They can also apply their existing skills to new ventures.
Potential drawbacks of angel investing
- Risk. Investing in early-stage businesses is risky. Research estimates that anywhere from half to 90% of new, small businesses fail.
- Potential losses. Angels can lose all of their money if the company folds.
- A long time before recognizing gains. Businesses may take 10 or more years to go public or be sold.
- A lot may change before the business generates returns. New technologies, economic conditions, and other unforeseen developments can overtake an emerging business before it becomes viable.
- A lack of additional funding the business needs. The venture may not receive the additional funding it needs to grow.
- Tax implications. Investing in a startup has unique tax risks and the rules can be complicated.
Angel investor or venture capitalist?
The terms angel investor and venture capitalist might seem interchangeable, because both describe investors who fund entrepreneurs and nascent businesses. However, there are notable differences.
- Investor. Tend to be wealthy individuals or groups of individuals.
- Funding source. Funds come from investors’ own capital.
- Amount. Smaller investments, generally between $5,000 and $250,000.
- When the investment occurs. Investments occur in the early stages of development.
- The investor’s role. Angels can advise and support a startup but don’t run the company.
- Investor. Investment funds.
- Funding source. Funds come from limited partners and financial institutions.
- Amount. Funding often starts in the millions of dollars.
- When the investment occurs. While some VCs offer seed funding, many will only invest once the enterprise shows some signs of growth.
- The investor’s role. VCs may take a board seat in companies they invest in, but usually have limited involvement in running the company.
The bottom line
Angel investing provides a source of funding for enterprises in their earliest stages. Investors commit their own money; they range from the startup’s founders and their relatives to wealthy individuals and investing groups.
There are success stories, like Google, that have received funds from angel investors. But the risks for investors are high, and the majority of enterprises that angels back do not succeed.