Business Angel’s – Getting to Know Private Investors
If you have watched the reality television show Shark Tank, you are probably familiar with the concept of business angels (aka private investors). Shark Tank is condensed and simplified for television but the show still provides a sneak peek into the world of angel investors and private investment groups. These so called business angels can make or break a young business just trying to get off the ground.
Today, we’re examining the real world of business angel investors, how they differ from venture capitalists, and what you need to know about this form of investing.
What Is A Business Angel?
An angel investor, also known as a private investor or business angel, is a wealthy individual who supplies startup initiatives with capital in exchange for equity or convertible debt. Business angels operate individually but can also provide funding through angel groups.
Startup companies need capital to continue growing. However, it is not always possible to secure funding as a startup business. Banks are not always willing to lend money to startup companies due to the risks that are associated with startups (90% of all startups fail). Additionally, personal investments from founders or their network can only go so far.
Business angels provide a private solution for startup funding needs and also provide exertise and connections most banks don’t possess.
Business Angels Provide 3 Things:
- Capital: Growing a business requires money
- Expertise: Many business angels have previously founded businesses and can provide helpful advice to a young company
- Connections: Often angel investors are well networked and can help connect founders to potential customers, employees, or other investors
There are also several sub-categories of angel investors to be aware of, as well as different roles a private investor may take within a company.
Types of Business Angels – Affiliated vs. Non-Affiliated
There are two main classifications of business angels. Each category has their own implications for how an angel (or angels) will interact with business owners.
Affiliated business angels are connected to the startup company in some form. Typically, this means the angel is a customer or manufacturing/supplier partner.
Business angels can also be non-affiliated, meaning they have no prior connection to the startup company they have invested in. This form of business angel may function as a serial investor who seeks out new opportunities on their own. Alternatively, non-affiliated private investors are often contacted or pitched by startup owners seeking capital.
Roles of Private Investors
Business angels take on one of two distinct roles within a startup.
Many private investors look to take an active, mentoring position in the companies they back. This relationship makes strong financial sense for several reasons. Business angels often have business experience within the industries they fund, and are able to provide guidance to founders. Similarly, many angels have a diverse personal network that has been cultivated over years of successful practice. This provides additional value to startups and allows founders to network with other potential angels or business owners.
Business angels are also investors at the end of the day. The risky nature of startups means that an investment could become a complete loss if the startup in question becomes insolvent. Therefore, many angels act in their self-interest and guide startups to protect their investment stake.
In contrast, some business angels are hands off and merely provide capital in exchange for equity or convertible debt.
Additional Reading – 7 Proven Ways to Become Rich.
Qualifications For Being An Angel Investor
Strictly speaking, there is no standard requirement to be a business angel.
However, private investors deal with considerable amounts of capital, even exceeding six figures. This means that business angels are high net-worth individuals who are probably accredited investors as well. Accredited investors have an annual income exceeding $200,000 for the previous two years or if they have a net worth exceeding $1 million (either jointly or with a spouse).
How Much Do Business Angels Invest?
According to Forbes, the average angel investment amount ranges from $25,000 to $100,000, but can go even higher. Data from The American Angel shows that the median investment amount across the United States is $25,000. The same study estimates that angels provide approximately $25 billion to 70,000 companies annually.
Startup industry, geographic region, and stage of development influence investment amounts. Additionally, startups may require several rounds of fundraising to achieve their goals. However, it is clear that in terms of averages, business angels do not exceed $100,000 in terms of investment amount.
How Does Business Angel Funding Work?
Unlike Shark Tank would have you believe, the process of securing private investment takes more than a 10 minute pitch to hungry investors.
In reality, most business angels enter during the first or second round of fundraising. This generally occurs after business owners have already invested their own capital or bootstrapped their business as far as possible. The funding process is complex since business angels take on considerable risk and deal with tens of thousands of dollars.
According to the Angel Capital Association, the process of securing private funding involves six steps:
- Application – Involves providing an executive summary for business angels.
- Pre-Screening – Designed to remove incomplete or inadequate applications.
- Screening – 10% to 25% of businesses reach this stage. Screening involves a more thorough look into the finances and state of a business.
- Meeting – The entrepreneur pitches the angel investors.
- Due Diligence – 25% to 50% of companies that reach this stage are funded. This process takes several months and involves validating the business plan and overall investment opportunity.
- Terms – Involves agreeing upon funding terms and finalizing the agreement.
Small business owners must be prepared to make several presentations to prospective investors. Due diligence is a lengthy but important practice for both parties. Ultimately, the goal of due diligence is to ensure a suitable match is made between investors and founders.
Business Angels Vs. Venture Capitalists
The main difference between business angels and venture capitalists, or VC firms, is the amount of money that is involved.
Angel investors make investments under $100,000. In contrast, VC firms desire larger ventures. According to the National Venture Capital Association, 2018 was a record year in the world of venture capital. Almost 8,500 venture-backed companies raised more than $130 billion in funding, with 864 VC-backed exits bringing in more than $122 billion as well.
Compared to the estimated $25 billion that is contributed by angel investors on an annual basis, it is clear that venture capital is a much larger game.
This difference in monetary power also means that venture capital firms are constructed differently. Many angel investors operate independently. In contrast, VC firms raise money from multiple sources in order to invest such large sums into startup initiatives. Examples of VC funding sources include high net-worth individuals and institutional investors (such as banks, pension funds, or endowment funds).
Return On Investment Goals – Business Angels Vs. VC Firms
Startup investing is risky. Regardless of the amount of money involved, investors are at risk of losing their entire investment if a startup fails. However, since private investors and venture capital firms operate on completely different levels of scale, the desired return on investment (ROI) for each group is different.
According to Venture Giants, a U.K. based angel investor group, angels seek 31% to 40% return on their investment. Anything lower is not worth the risk, and higher amounts often sound too good to be true.
This range is simply a ballpark, however. As One Thousand Angels, another angel network, state on their investor FAQ section, “the “target” return for a well-balanced portfolio of high quality startup investments is typically an IRR (internal rate of return) of 25%. This represents a cash on cash return of approximately 3x over five years and 9x over ten years.”
In contrast, venture capital firms make money in several ways and have different investment goals.
How Venture Capital Differs
VC firms make money in two main ways:
- Management Fees
- Carried Interest
Management fees are simply a percentage of capital under management (around 2%).
Carried interest is a share of fund profits that act as an additional way to compensate fund managers/firms for their risk. In order to benefit from carried interest, VC firms basically require a company in their portfolio to exit through acquisition or an IPO, allowing investors to sell their position. Carried interest generally ranges from 20% to 25% depending on the firm.
Ultimately, this means that VC firms seek around 10x return on their investments (this is largely to offset other losses in a fund as well). VC firms are quite aggressive in terms of buying equity in their investment.
Companies Suitable For Business Angel Investing
As outlined by the Angel Capital Association once again, there are several characteristics for a business to be suitable for an angel investment.
Business owners should:
- Be willing to give up some ownership and control of their business.
- Outline how their company will reach significant revenue (at least $10 million) within the next three to seven years.
- Articulate how their company will generate a meaningful return for investors.
- Outline an exit plan.
Additionally, business angels invest in management teams and people, not just business ideas. An ideal candidate for private investment has a proven business track record, a strong management team, personal involvement with their company, and a meticulous business plan.
As mentioned, most companies don’t make it past the screening phase of angel investing. Angels are looking to increase their wealth by finding the next Starbucks or Amazon, and these opportunities don’t grow on trees.
How To Find Angel Investors
Business owners that require angel investing must obviously understand their plans for managing an influx of capital. Similarly, business owners should familiarize themselves with what business angels are looking for in terms of investment opportunity and the entrepreneurs they back before approaching.
Once ready, there are two main ways to find angel investors.
Angel Investment Groups
Individual angels invest approximately $25,000 on average. Angel groups provide larger funding support for startups. Plus, there are angel investment groups across the world, including:
- The Angel Capital Association – Comprised of 14,000+ angels and 250+ angel groups. This is a directory, not a funding source.
- Angel Forum – One of the largest angel networks in Canada.
- FundingPost – A comprehensive angel group directory.
- SyndicateRoom – A U.K. based directory for business angels.
Many major cities also have their own local private investment groups. Tech-hub cities like Seattle or San Francisco are especially competitive when it comes to both VC and angel funding as well.
Business Angel Networking
Business owners who need smaller amounts of capital don’t have to turn to a private investment group. Rather, these business owners may find a suitable business angel by turning to their own network.
Since many angels are involved in the businesses they back, searching locally makes sense. The typical angel is again, a high net-worth individual with experience in the industry they invest in.
Networking with professionals in your own industry is a natural place to start your search. Attend conferences or trade shows to get started. Speaking at local networking events is another option to meet high net-worth individuals in your industry. Alternatively, local angel groups can still take on smaller capital needs.
AngelList – Invest in or work for angel backed businesses
AngelList is an excellent platform to check out if you are seeking angel funding, if you want to invest like an angel, or if you want to work in the startup world.
The platform has three main areas that will appeal to anyone interested in the angel ecosystem:
- AngelList Talent: Apply to tech and startup jobs
- AngelList Venture: Invest like an angel in private investment opportunities or post your company in hopes to receiving angel investment
- Product Hunt: Discover the next big thing in the tech industry
Business Angel Success Stories
Angel investing is risky. Most startups fail, and private investors need to back winning companies to see a meaningful return.
However, there are plenty of business angel success stories. In fact, some incredibly wealthy businesses and current Fortune 500 companies got their lucky break from angels.
Notable business angel related wins include:
- Facebook – Angel investor Peter Thiel of Clarium Capital made a $500,000 investment on Facebook back in 2004.
- Starbucks – Twenty five angel investors contributed $1.6 million to help fund Schultz’s coffee ambitions.
- Amazon – Jeff Bezos states that 20 initial investors each contributed $50,000 each back in 1994. Each of these angel investor’s gained roughly 1% stake in Amazon. This would have been a return of 70,000x if the investors had held onto shares and shares were never diluted through additional funding.
Pros & Cons Of Seeking Angel Investment
Deciding to give up equity or control is not easy. However, outside capital helps to sustain business growth, and this is why business angels exist.
The main benefits of seeking out private investment include:
- Loan-Free – Unlike bank loans, angel investors aren’t expecting interest payments or your house should your business fail. Selling equity and potential reduces taking on debt for the entrepreneur.
- Business Experience – Business angels that take a mentorship or advisory role provide a wealth of knowledge and experience.
- Access to Additional Funding – Angels know other angels. If your business needs additional funding, your initial business angel may have the right contacts.
To mitigate their risk, angel investors set the bar high, and this has some drawbacks for founders:
- Loss of Control – Giving up equity and advisory seats reduces overall control of the business owner.
- High Expectations – Angels invest to make a return. Decision making is swayed by a combination of what is best for the business and what is best for their investment. This can lead to disagreements regarding exit strategy, timing, or other aspects of business development.
Business Angels – Final Thoughts
There isn’t a cookie-cutter solution for startup funding. However, business angels and private investment groups ultimately provide additional flexibility for startup companies looking to grow. Additionally, these investors help fill the void between securing a bank loan and turning to larger venture capital firms. Startups are risky business, and business angels don’t always win. But, with the right backing, perhaps the next Amazon is around the corner!