Most successful startups are powered by angel investors. This is true for firms across many sectors, from information technology to finance to healthcare. As the companies scale, the angel investors behind them stand to make substantial returns, making it one of the most lucrative investment strategies. If you’ve ever been curious about it, here’s everything to know about becoming an angel investor.
When most people think of investments, they think of stocks, bonds, real estate, or traditional avenues. Angel investing was considered to be the domain of high-net-worth individuals or institutions. But things have changed over the last few decades.
Anyone can become an angel investor provided they have the required funds and are willing to do due diligence about the sectors and firms they would be investing in. Of course, if you want to be an angel investor, you should also be willing to take substantial risks because you’ll be funding companies with no proven track records.
What is an angel investor
An angel investor, also referred to as a seed investor, invests in startups at an early stage. In return for their investment, angel investors get an ownership stake or convertible debt in the company. Since the company would be in its early stages, it wouldn’t need large investments from an angel investor.
When a startup is formed, a part of the investment would come from the founders and their families and friends. According to the Angel Capital Association, 90 percent of the rest of the investments come from angel investors.
The size of the investment would depend on the operational costs, the funds it would take to bring the product or service to the market, and other early-stage costs of the startup. It would also depend on the sector that the startup operates in. It’s been found that the typical investment of an angel investor would be between $5,000 and $100,000.
Why do startups need angel investors
- Easier access: Startups find it difficult to secure funding from traditional financial institutions because of the high risk involved. Even when a bank or another institution agrees to fund, the process can be long and tedious. With an angel investor, funding gets fast-tracked once they buy into the product or service.
- Funds for development: Other than the risk associated with funding any new venture, traditional financial institutions are wary of financing startups because most of them may not have developed their product or service at that stage. An angel investor’s funding, on the other hand, is to help them develop it.
- Guidance: Angel investors are usually current or former entrepreneurs or those with close ties to the startup world. They can bring much-needed guidance to founders and inform them of the best practices and cost-effective methods to run their operations.
- Objectivity: A seasoned angel investor would objectively analyze the idea behind a product or service and offer constructive suggestions before it gets made. This will save considerable expenses and time for the founders. It will also help fine-tune the product for a better market fit.
- Networking: Entrepreneurship, especially in the initial days, can be a lonely affair. Angel investors don’t just infuse funds but open up a world of other founders, investors, and experts in the domain. Startup teams can immensely benefit from this networking and find best practices to optimize their operations.
How does angel investing work
When a company is being formed, the founders get in touch with prospective angel investors to help get their business off the ground. In return, they’re offered convertible debt or more commonly, equity in the company.
Since it would be an early-stage company, there may not be a product or service. The founders may have a great idea and a business plan and would be seeking funding to develop a minimum viable product or service. In other words, it’s a business with no product or service in the market or revenue at this stage. This means the angel investor is taking on substantial risk.
Venture capitalists would enter the picture once the business finds customers and begins to grow with increased production, operation, and marketing. They would be funding the next round for the startup. Angel investors can continue to invest in the firm or sell their ownership back to the company or other investors.
How to become an angel investor
The world of angel investing was once reserved for high-net-worth individuals. But now, anyone with access to funds can become an angel investor following these steps:
Understand the responsibilities
Once you’ve learned the basics of the process, you should know your responsibilities as an angel investor. The first task is to identify the startup you want to fund. You should analyze the idea, sector, market potential, and the founders before you make a decision.
Secondly, your role would also involve guiding and mentoring the founders and their teams. This means you should regularly measure their performance and learn how you can add value to the process.
Evaluate the risks
Angel investing can pay rich dividends when things go well. But it also comes with huge risks. As an angel investor, especially if it’s your first investment, you should carefully analyze the risks against the potential payoffs. Due diligence isn’t complicated once you learn the basics.
This calls for detailed research of the company, idea, competitors, realistically attainable market share, profitability, and rate of growth. It’s also a good idea to talk to other investors to objectively analyze the company’s potential.
Learn the regulations
Angel investing is regulated by agencies at the federal and state levels in the United States. If you don’t have a personal relationship with the startup you’re investing in, you would be classified as an accredited investor.
To be an accredited investor, you should have a net worth of more than $1 million and an income of $200,000 or more over the previous two years. You also have to be an executive, director, or partner at the startup. SEC programs do permit investors who aren’t accredited to invest through crowdfunding.
Evaluate investment opportunities
Before choosing the company, you should select the sector you want to invest in. Some industries are highly scalable while others are not. Carefully study how different companies have grown in those sectors, their scalability, and revenue.
These are some of the industries that have been getting high interest from angel investors over the last few years because of their market potential and shifting consumer behaviors:
- Healthcare
- Electronic vehicles
- Alternative energy
- Artificial intelligence
- Internet
- Mobile communications
- Fintech
- Internet of Things (IoT)
- Consumer products and services
Join a platform
If you’re entering the world of angel investing, it can be challenging to do it alone. One of the smartest moves would be to join a group of angel investors in your city or your chosen domain. This will introduce you to fellow investors and help you learn from their experiences.
Almost all credible investing groups have digital networks and offline meets for members to learn the best practices from each other and to find new opportunities. An excellent benefit of joining a platform is that not only would you regularly discover investment opportunities but may also find partners to join you in angel investing.
Identify a strategy
Not all angel investors are alike. Your reasons for becoming an angel investor could be different from someone else’s, even when you both operate in the same category. Your investment strategy should be based on the following parameters:
- The total amount you’re willing to invest
- Your angel investment in proportion to your overall investments
- The number of investments you want to make over a period
- The industries you’re interested in
- The return you want from your investment
- The timeframe for selling your ownership/equity
Select a valuation method
Angel investors use either the Benchmark Method or the Berkus Method to compute a company’s valuation. The Benchmark Method analyzes the performance of similar companies’ performance in the same area or industry. Angel investors figure out a benchmark by analyzing the average pre-revenue values of these businesses.
The method also considers the uniqueness of the product, the strength of the competition, the quality of the team, and the amount of funding needed. By learning the average performance of similar companies, investors can arrive at a valuation.
While the Benchmark Method looks at the industry benchmarks, the Berkus Method relies on selected value drivers to arrive at a valuation. These value drivers include the robustness of the business idea, quality of the prototype, profitability, and quality of market relationships.
Once you choose a valuation method, analyze it with your investment strategy, and you will know whether the investment amount and equity are worth the risk.
In short
The world of angel investing isn’t an exclusive club anymore. With adequate preparation, due diligence, and constant outreach to other investors, anyone can become an angel investor.