Angel investors are typically described as investors willing to provide capital to start-up businesses before the entrepreneurs are able to secure venture capital financing. Many, but not all, angel investors are high net worth individuals with entrepreneurial backgrounds. Individual angels, angel groups, and early-stage venture capital firms may provide seed financing to prove a concept or qualify a start-up for capital. Select individual angels, angel groups and early-stage venture capitalists may thereafter provide start-up capital to complete product development and initial marketing. Thereafter, venture capitalists may provide a first round of financing to initiate full scale manufacturing and sales and later a second or third round of financing for business expansion or to achieve break-even.
“Guardian” angels are active investors who guide and coach the management team to help them grow the company. They usually work with a limited number of start-up companies and invest significant amounts of time in the company. “Professional entrepreneurial” angels usually invest based on the recommendation of other angels they trust and whose expertise they respect. They have entrepreneurial experience, but are often investing outside their area of expertise. “Operational expertise” angels are persons who are, or have been, senior executives in major companies in the start-up’s target industry. “Financial return” angels are usually high net worth individuals who have little relevant entrepreneurial experience and invest in companies in which they have little industry experience. They have often made their money through the stock market, real estate, inheritance, and through professional occupations not relating to starting up companies. These angels are investors looking for high rates of return.
Angel investors find investment opportunities from a wide variety of different sources, e.g., angel groups; attorneys, accountants and consultants; investment bankers; and venture capitalists. However, experienced angels are often less open to taking on deals directly from entrepreneurs unless they have well-defined deal screening processes with established criteria.
Angels will most often invest in start-up companies that have a unique competitive advantage, such as proprietary technology or well-protected intellectual property, to capture a large new primary market; are led by a successful, experienced management team; and where the investment is priced at a reasonable valuation. Angels will usually forego an attractive opportunity if they have a poor assessment of the entrepreneur and the management team. Reasons for a poor assessment can include inexperience in the marketplace or a poor previous track record.
Screening by angels can range anywhere from a “gut feel” to subjecting a potential investment to stringent screening and investment criteria. Typical criteria may include any or all of the following:
- Market and growth potential
- Personal integrity and attributes of the entreprenuer
- Track record of the management team
- Quality of the referral source
- Background of the board of directors
Companies that anticipate pursuing venture capital in later rounds sometimes structure their seed round as convertible debt. The convertible debt securities can be structured to permit the next round of investors (e.g. the venture capitalists) to set the value of the company (e.g., in the Series A round) which is then discounted and used for the conversion price. The convertible debt mechanism eliminates a potential disagreement over price.
Convertible debt, while pragmatic, can be risky since it assumes the next round of funding will happen fairly quickly. Thus, most angel investors seek preferred stock with priority rights over the founders and any other prior investors. Typically, these priority rights relate to liquidation and voting.
Convertibility rights allow preferred stockholders to convert to common stock at some predefined conversion rate typically upon a sale of the company. Participating rights allow angels to be repaid their original purchase price (plus unpaid dividends, if any) and then share in the remaining assets as if they held common stock.
Angel investors are typically low percentage owners, e.g., 5% to 25% of the company. As a consequence, they cannot exert formal control. Therefore, they look for contractual control through board participation, restrictive and affirmative covenants on operational matters such as compensation and capital investments, structural issues such as sales of assets and purchases of other businesses, and on equity matters such as participation in future financing rounds. They will also look to anti-dilution clauses and similar protective provisions.
Putting aside ROI, IPOs are the most glamorous exit strategy, but acquisition transactions are cleaner and provide the investor with easier access to cash. Most angel investors exit when the company is acquired. Generally, they target a 5x to 10x return on their investment over five years. However, as could be expected, a substantial number of angel investments turn into losses.
Angel investors use a variety of methods to improve their chances of realizing their targeted ROI. Before investing, they determine the founder’s need for control and ability to be coached, and the founder’s vision and path to liquidity. In negotiating their investment, they include liquidity and exit clauses in the terms and conditions. After investing, they bring on professional management to lead the company if the entrepreneur does not have the skills to grow the company, and they establish milestones for the exit path. Experienced angels take the opportunity to get out of deals that have lost their upside potential. They get out when losses are small and move on to other deals.