Angel investors or angel groups are a popular source of money for startups that need seed capital or early stage funding.
Angel investors are affluent individuals who provide capital to business startups in return for equity shares or for a convertible bond that can be converted into stock. In the United States, angels provide 90% of the outside capital for startup companies. In 2014, the Center for Venture Research reported that there were over 298,000 active angel investors in the United States. Their average investment was $394.000.
In the United States, a person has to qualify as an accredited investor in order to be an Angel investor.
The rule that describes who qualifies as an accredited investor is spelled out in SEC’s Rule 501.
For a person to qualify as an accredited investor, they have to have a net worth, or joint net worth with their spouse, that exceeds $1 million at the time of the purchase. The net worth used to qualify an accredited investor cannot include the equity in their primary residence.
Another way people can qualify as accredited investors is by having an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years. This investor must also have a reasonable expectation of the same income level in the current year.
The value of getting business funding from an angel investor is more than just the money you will receive.
Most angels are successful entrepreneurs that mentor and coach their portfolio companies.
They also provide valuable industry experience, knowledge and business contacts. Having them involved will often give a startup additional credibility. They can also introduce the company to potential customers and investors.
Although receiving angel capital can be a tremendous asset, it comes with strings attached.
- The average amount of equity angels get for their investment is a 23% stake in the company.
- You need to ask yourself if you are willing take the advice from your Angel investors and can accept board of director decisions that you may not always agree with.
- Their exit strategy may require the CEO and other executives to leave the company in three to five years. These requirements are defined in their term sheet.
There are certain criteria that angel investors look for when they evaluate business opportunities in which to invest.
- Angel investors are looking for investment opportunities with high growth potential.
In most circumstances, angels will only invest in companies that have a strong chance of generating a 30:1 return in five years.
- One of the primary motivations for angels getting involved with startups is that they enjoy the entrepreneurial process.
The vast majority of angel investors are previously successful business owners. They see themselves as investors that can add value beyond their capital investment. As a result, most of them will only get involved in deals where they think their knowledge, expertise and business contacts can provide significant leverage to the success of the new business venture.
Angels have the expectation that the management teams running their portfolio companies will gladly accept their mentoring and coaching. They will almost always turn down deals if it appears that the management team will be unwilling to take their advice or accept board of director decisions.
- Most angel investors only invest in companies that are located within one hundred miles of their home.
Most angel investors are retired businesspersons who don’t want to go back to the grind of business travel. As a result, the vast majority of angels are not interested in deals where they will have to travel significant distances to mentor and guide the companies in their investment portfolio. The other reason why so many angels keep their investments local is their desire to invest in their local economy.
- A business opportunity must have sufficient scale and profit potential to qualify for angel investment.
The following data can be used to determine if your business opportunity would interest angel investors.
- Most angels invest $25,000 to $250,000 in a company. In 2014, the average angel investment was $394.000.
- Angel investors usually expect to receive a 10 to 50% equity position for their participation. The average amount of equity given to angels is 23%.
- Angels usually expect a 30:1 return on their investment.
The following is an example of the required scale and growth potential of a startup to get serious consideration for a $394,000 investment by an angel investor.
The capitalization of the company, after the investment was deposited, would have to be around $1,713,043 if the angel received a 23% equity position.
(x)(0.23) = $394,000, where x = capitalization of the company after receiving the $394,000 investment.
$394,000/0.23 = x = $1,713,043
The company would have to have the potential to grow to a value of $51,391,302.00 ($1,713,043 X 30) in five to seven years to get serious consideration.
- A company’s chances of receiving angel capital goes up dramatically if it has team members who have a history of successfully launching startup businesses.
An angel investor is much more inclined to invest in companies that are headed by entrepreneurs with an impressive record of creating hugely successful companies. They also want to see that at least one or two members of the management team have significant knowledge, experience and contacts in the industry that the company is engaged in.
Too often entrepreneurs mistakenly think that angel investors will overlook their lack of experience if they have a product or service that has the potential to be a huge market hit. Unfortunately in these cases, angel investors will usually pass on these deals. Angel investors know from experience how important an experienced management team is to the ultimate success of a new business venture.
- Angel investors will usually avoid investing in a company unless the entrepreneurs involved have made a serious capital investment.
Most angels expect entrepreneurs to invest at least twenty percent of their net worth in their business. They will assume that the entrepreneurs are not serious about their business if they’re unwilling to assume that much risk.
- Angels want to see that a company has sustainable competitive advantage.
Investors will want to see “barriers to entry,” such as patents, trademarks and copyrights, which will prevent competitors from duplicating the company’s product or service.
- Angel investors are looking for a well-defined four to five year exit strategy.
Most angel investors have a 4-5 year investment horizon. As a result, they will usually avoid deals that don’t spell out how they are going to get back their investment and profit within that time frame. The most common exit strategy is the sale or merger of the company to a larger company in the same industry. As a result, companies seeking angel investment should be ready for questions such as:
How am I going to get my investment and profit at the end of four to five years?
What companies do you think would be interested in buying your company now or in the future?
Are the CEO and other officers of your company willing to step aside in the case of a merger or acquisition?
Most angels view an initial public offering (IPO) as an unrealistic exit strategy for their investment. The reason for this is because of the huge costs and regulatory hurtles of an IPO.
It is important to be well-prepared before you approach an angel investor for business funding.
After determining that you want to obtain business financing from an angel investor, it is important to get all your ducks in a row before approaching any potential investors. Remember that you are only going to get one chance. As a result, make sure your product or service is developed or at least is very close to completion. It is also important to have a concise and well-written business plan that describes how everyone is going to make a great deal of money.
It is important to realize that most angels and angel groups will not sign non-disclosure agreements during the initial stages of the evaluation process.
The reason why angel investors are unwilling to sign nondisclosure documents is that they see just way too many deals that are often very similar to yours. As a result, it would be prudent to at least apply for a provisional patent in order to get a patent pending for your technology. Keep in mind that the stronger your market protection is from potential competitors, the more attractive your opportunity will be.
Angel groups are usually the best funding sources in cases where funding needs range from between $100,000 and two to five million dollars.
In the United States, approximately 10,000 to 15,000 angel investors are organized into 300 angel groups. The average angel group has 42 members and invests in about seven deals per year.
In 2014, the Angel Research Institute reported that the median angel group investment in a new company was $2 million.
Obtaining angel funding from an individual investor will be a more informal process. With an angel group, however, the process is more formalized.
The following are the steps a company must go through when applying for investment capital from an angel group.
Angel groups require companies to initially submit an application. The following are links to several established angel groups.
- Band of Angles (Menlo Park, Calif.)
- Pasadena Angels
- Investors’ Circle (San Francisco)
- Tech Coast Angels (Los Angeles)
- New York Angels
- Alliance of Angels (Seattle)
- Golden Seeds (New York)
- Hyde Park Angels (Chicago)
- Ohio Tech Angels (Columbus, Ohio)
Most groups have a website that describes what documents need to be submitted. Many of them will request an executive summary of your business plan. Other groups have a specific application form.
Please be aware that 38% of angel groups charge entrepreneurs application and presentation fees. The average application fee was $151. The average presentation fee was $338. The Angel Capital Association recommends that the fees should not be more than a few hundred dollars for application and no more than $500 for presentations.
Step 2: Pre-screening
After the angel group receives a completed application, hired staff or a committee of members will review it to determine if the business meets the group’s general requirements and investing preferences. In general, about 10 to 25 percent of all entrepreneurs who apply go on to the next stage of screening. Pre-screening usually takes between one to two weeks.
Step 3: Screening
At this stage, a group of angels further review the business deal. Oftentimes, they will request a full business plan at this stage of review. The group may also select a “champion” or “deal lead” that will be responsible for steering the application through the screening process. In some cases, a due diligence committee will be organized within the group. Some groups will have face-to-face meetings with the entrepreneurs during this phase. Screening is usually completed within one to three weeks.
Step 4: Presentation
The entrepreneur is asked to make about a twenty minute pitch of their business opportunity at an investment meeting of all members of the angel organization. The following is a link to more information on how to create an effective pitch to an angel group.
Angel investment meetings are usually held every month or two. A question-and-answer session follows the presentation. After the entrepreneur leaves the meeting, members discuss the opportunity and decide if there is any initial interest in making individual or group investments in the business venture.
Step 5: Due Diligence
A team of members interested in investing in a particular business opportunity and experts with inside knowledge of the industry will conduct a thorough check of the management team and the business plan.
One of the objectives of due diligence is to validate that the business correctly values the business opportunity. What they are looking for is a proven concept with high gross margins, a large niche market, and a major competitive advantage. They also want to verify that the business can credibly generate a 30:1 return on investment within a three-to-five year time frame. Another critical element that the angel group will be looking for is a well-defined exit strategy within 3-5 years.
Another goal of due diligence is to verify that the management team is capable of accomplishing their intended business goals. They also want to know if company executives are willing to accept their coaching and advice.
Preliminary negotiations regarding a term sheet are often discussed at this stage. Be aware that angel investors will get very concerned when entrepreneurs say they want to retain 51% of their company.
Between 25-to-50 percent of the companies that reach the due diligence stage are actually funded. This step can take anywhere from two weeks to several months to complete.
Step 6: Negotiate the Terms of the Term Sheet
If an angel group chooses to invest in a company, they will begin negotiating terms for obtaining capital. This is presented in a document called a term sheet. Some of the items that angel investors will often include in the term sheet are preferred stock, a board position, information rights, anti-dilution clauses and liquidation preference.
Be aware that the average equity stake for angel investors is 23 percent. The equity they request can range from as little as 10 percent to as much as over 50 percent share of ownership in the businesses that they finance. In most cases, the share of equity an angel investor takes is directly related to both a business’s monetary value and the amount of funding it needs in financing.