What Is an Angel Investor?
An angel investor provides initial seed money for startup businesses, usually in exchange for ownership equity in the company.
The angel investor may be involved in a series of projects on a purely professional basis or may be found among an entrepreneur's family and friends. The investor's involvement may be a one-time infusion of seed money or an ongoing injection of cash to get a product to market.
Angel investors aren't usually in the loan business. They're putting money into an idea they like, with the expectation of a reward only if and when the business takes off.
Key Takeaways
- Angel investing may be the primary source of funding for an entrepreneur who finds it more appealing than other forms of financing like bank loans.
- This is risky business for the angel investor and usually represents no more than 10% of an angel investor's portfolio.
- An angel investor may be hands-off or get deeply involved in the early stages.
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Understanding Angel Investors
Most angel investors are relatively wealthy individuals who are looking for a higher rate of return than can be found in more traditional investment opportunities. They search for startups with intriguing ideas and invest their own money to help develop them further.
The ventures are by nature extremely risky. A survey by The Angel Capital Association estimated that only 11% of such ventures end with a positive result. Their investments in each venture are relatively modest, averaging about $42,000.
Most angels keep their involvement in startups to no more than 10% of their portfolios.
Why Look for an Angel?
An entrepreneur may seek an angel investor over more conventional financing. The terms tend to be more favorable and, in fact, the angel investor doesn't expect to get the money back unless the idea succeeds. They often seek an equity stake and a seat on the board.
Angel investors focus on helping startups take their first steps rather than getting a favorable return on a loan.
Angel investors have also been called informal investors, angel funders, private investors, seed investors, or business angels. They seek prospects through online crowdfunding platforms or join networks that pool capital for greater impact.
Origins of Angel Investors
The term angel investor originated in the Broadway theatrical world, where plays were often financed by wealthy individuals rather than formal lenders and payments were due only when and if the production was a success.
The term "angel investor" was first used by the University of New Hampshire's William Wetzel, founder of the Center for Venture Research. Wetzel completed a study on how entrepreneurs gathered capital.
These days, Silicon Valley is the center of the angel investor's world, and the ideas being financed are related to the internet, software, or artificial intelligence.
Who Can Be an Angel Investor?
Angel investors have a genuine interest in innovation and a desire to be involved. Many have been entrepreneurs in the past.
Anyone who has the money and the desire to provide funding for startups can be an angel investor. They are welcomed by cash-hungry entrepreneurs who can't get conventional bank loans or don't want the burden of big debt until their ideas take off.
Accreditation of Angel Investors
Angel investors have often obtained accredited investor status, although this isn’t a prerequisite. Accredited investor status is a formal designation, regulated by the Securities and Exchange Commission (SEC), that gives individuals access to the private capital markets based on their assets and financial acumen.
The Securities and Exchange Commission (SEC) defines an accredited investor as an individual who has a net worth of $1 million or more in assets or has earned $200,000 in income for the previous two years, or a couple with a combined income of $300,000. Applicants must also demonstrate an understanding of sophisticated investment proposals.
Sources of Angel Funding
Angel investors usually are using their own money, unlike venture capitalists who pool money from many investors.
Though angel investors are usually individuals, the entity that actually provides the funds may be a limited liability company (LLC), a business, a trust, or an investment fund. These are vehicles that the investor sets up for tax purposes or legal protection.
Investment Profile
Angel investors who seed startups that fail during their early stages lose their entire investments. This is why professional angel investors look for opportunities that have a defined exit strategy, an acquisition opportunity, or participation in an initial public offering (IPO).
The effective internal rate of return for a successful portfolio for angel investors is about 22%, according to one study. This may look good to investors and too expensive to entrepreneurs, but other sources of financing are not usually available for such business ventures. This makes angel investments a good fit for an entrepreneur with a good idea and little or no cash to pursue it.
What Kind of Ideas Get Angel Investor Financing?
It may be most closely associated with the Silicon Valley tech industry but some angels look far afield for good ideas to bankroll.
Ask for Funding, a site for entrepreneurs, lists recent ideas that have gotten backing from their members. They include a plan to build a franchise of archery facilities, a quick-dissolving tablet created by an anaesthesiologist, and a developer of carriers for electronic instruments.
However, many of the pitches were from business owners and would-be business owners seeking to establish or expand a business. A New York marijuana dispensary wants to expand its reach. A UPS worker wants to open a franchise.
What's the Difference Between an Angel Investor and a Venture Capitalist?
Venture capitalists deploy vast sums of cash pooled from many investors. They have big money to spend and they tend to spend it only on existing businesses that they think have an opportunity to turn a substantially bigger profit. For example, they might buy a moribund retail chain with the goal of revitalizing it over the next two years.
Angel investors are a different breed. They are individuals who are looking to put their own money into good ideas at their earliest stages of becoming successful businesses. They are committing their own money in hopes of making a good idea a reality.
What Are the Disadvantages of Angel Investing to an Entrepreneur?
The entrepreneur is giving up a share of the company and its future profits in return for angel investing. Many angel investors want some control over the development of the product as well. They often want a seat on the board or its equivalent.
The Bottom Line
Angel investing has grown over the past few decades into a primary source of funding for many entrepreneurs in the early planning stages of turning their ideas into businesses.
This, in turn, has fostered innovation which translates into economic growth.
For the entrepreneur, an angel investor provides a much-needed lifeline that is not available through more conventional funding sources.
For the angel investor, involvement in early-stage startups has big risks but the potential for big rewards, including personal participation in an innovative project.
