An angel investor is an individual who invests in a business or startup in return for a stake of equity. Various instruments can be used to conclude a deal (to be discussed in a follow up blog) some of which can be equity linked. Angel investing is different from other forms of investing in two ways in the main: firstly, investments are riskier and secondly the investor becomes a partner in the business and has a fair degree of control as a result.
In his book, Angel: How to Invest in Technology startups, Jason Calacanis describes angel investing as the act of investing into a startup in the earliest round of investment, with the objective of gaining massive returns. These startups are usually less than 3 years old and still trying to find their product-market fit. Product-market fit simply means that the product or service that the business offers has found a market, customers are buying what the company is offering. The term “Angel” is appropriate because angels come to the rescue of startups in their hour of need, by believing and investing in an entrepreneur when the startup is not yet established.
What does Angel Investing involve?
Angels invest in companies with a high but commensurate risk-return profile, the journey and the lure of substantial returns is what attracts them. This journey involves becoming a partner in the business. An angel derisks his or her investment by getting in the trenches alongside the entrepreneur, guiding through mentorship and opening doors when required. In this sense, angels can be seen as brave, daring and at times even crazy!
Amongst other things, angel investing involves sourcing, screening, performing due diligence, negotiating, structuring the legal contracts and syndicating where necessary. Post investment management involves another set of engagements which we will cover in a follow up blog. Some or all of these tasks are often performed by investment networks like Jozi Angels.
What are the risks of Angel Investing?
The risk is high, roughly 95% of startups fail. When done properly the return profile of these startups can be equally as high. Traditional asset classes such as bonds, mutual funds, listed equities and real estate carry a low risk-return profile.
Calacanis states that he only invests in 1 out of every 100 companies he looks at or assesses. Most of your angel investments will fail, although it just takes one successful investment to rope in great financial returns of 10x or even 20x your original investment. In fact, one good investment can make up for all your other failed investments.
“You only have to be right once”- Mark Cuban.
Risks associated with angel investing include:
Technology risk - technology factors may affect the industry as well as the startup;
Product-market fit risk - customers may not want to buy the product being offered;
People or team risk - the entrepreneurs may not be able to execute on the plan;
Valuation risk - the entrepreneur and investor may have challenges in valuing the startup which could have an effect on future fund raising rounds;
Liquidity risk - a startup investment is for the long haul, 5 to 7 years if it goes well. There are however potential liquidity events at each investment round; and
Minority investor risk - the angel is likely to have limited voting rights due to his or her minority shareholding.
In addition to this, angel investors assume risks associated with traditional asset classes such as changing market conditions, tax risk and liquidity risk. Its therefore hugely important that an investor diversifies their portfolio.
Should I consider Angel Investing?
Angel investing is not for everyone. In his book, Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups, David Rose identifies several characteristics that make a good angel investor. These include having:
A long term view;
A strong economic base and ability to tolerate losses;
A high tolerance for failure;
An even temperament and self discipline;
Strong people skills to deal with entrepreneurs;
A willingness to learn; and
General love and respect for entrepreneurship.
If this is you then the answer is YES, you should consider angel investing. Remember that major companies such as Apple and Microsoft were at one stage also small, private companies who needed the right people to believe and invest in them. People such as Mike Markkula who invested in Apple and Andy Bechtolsheim who invested in Google.
It is worth reiterating, if you cannot tolerate the risks then you should not consider angel investing. Having said this, even in losing money there are positives that can be taken from the journey, including the experience and the networks you’ll build.