What is an Angel Investor?
Angel Investor Definition
An angel investor is a high-net-worth individual (HNWI) who offers financial assistance to startup owners or small businesses. Often, angel investors are found in a person’s social network, including family members, friends, or business connections. Depending on the terms set, their investment could be a one-time infusion of capital or a recurring funding arrangement.
Be aware that this is a type of equity financing. In exchange for favorable lending terms, angel investors expect a significant percentage of equity in a person’s business. Nevertheless, this can be great for entrepreneurs interested in receiving the funds needed to get a company off the ground. Most angel investors are successful business professionals themselves. While some prefer a hands-off approach, some might also offer the business acumen needed to make an organization successful. Additionally, this type of funding can jumpstart businesses turned down by banks due to a lack of capital or assets.
Why They’re Called Angel Investors
The first angel investors were wealthy people who funded Broadway productions. They supported shows by lending money and charging interest on it. For this reason, they were called “angels.” Over time, this style of investing broadened to include a wider variety of entrepreneurs in a number of industries. In 1981, William Wetzel coined the term in “Angels and Informal Risk Capital” to describe a similar relationship between entrepreneurs and those providing private capital to fund new business ventures.
Other terms for an angel investor include:
- Business angel
- Seed investor
- Informal investor
- Private investor
- Angel funder
How Angel Investing Works
Typically, a business owner or entrepreneur seeks an angel investor during the beginning stages of launching a startup company. A person can find an investor by marketing their opportunity online, at networking events, or through conversations with family, friends, and other important personal connections.
When someone decides to invest, they can offer assistance privately or by joining a group of investors. For example, they might choose to become a part of a network of investors who combine their resources for large-scale investments.
When it comes to investing amounts exceeding tens or hundreds of thousands of dollars, an investor will likely want to negotiate their conditions. Though this type of funding isn’t designed to prey upon startup owners, a great investment opportunity is never all risk and no reward. For this reason, terms for high returns are a necessity for angel investors. In an article for StartupNation, Bill Payne founder of Vegas Valley Angels says, “During a first round of outside equity financing, entrepreneurs can expect to give up between 20 percent and 40 percent of the stake in their companies . . .” He goes on to explain how the risk adds up: “Forty percent stake may seem like a lot, but if the startup fails—and most do—40 percent of nothing is nothing.”
Other ways startup investors decrease their financial risk is by playing a leading role in the company. The American Angel study found that 60 percent of investors with entrepreneurial experience held an advisory role, 66 percent provided mentorship, 52 percent were a board member, and 22 percent served in management. Additionally, funds distributed might come from a legal business structure that limits personal liability, such as a limited liability corporation (LLC). Another method is to cap the number of startups they fund since, according to the U.S. Bureau of Labor Statistics, nearly half of new companies fail within five years.
Requirements for Being an Angel Investor
Whether you’re looking to become an angel investor or you’re interested in getting one, there are a few things you should know. First, an angel investor should have the funds to invest. A strong indicator of this is whether the person investing fits the Securities Exchange Commission’s (SEC) definition of an accredited investor. In the past, this definition was limited to:
- A person who had made $200,000 per year or had a joint income of $300,000 with their spouse per year for the past two years.
- Someone who held a net worth of $1 million, excluding their primary residence.
In August of 2020, the SEC updated and expanded its definition of an accredited investor in a number of ways. For example, knowledgeable employees of an investment fund, certain types of investment advisors, and entities that own investments of more than $5 million can be considered “accredited investors.” Still, there are many regulations around the modernized definition. Most particularly in reference to a company forming with the specific purpose to invest in an organization. For more information, check out the SEC’s press release on who can be considered an accredited investor.
It is not a requirement for a person to be an accredited investor to be an angel investor. They are not one and the same. Nonetheless, this definition is a good reference point for understanding the financial needs usually necessary for healthy investment conditions.
The Pros and Cons of Angel Funding
Angel investors can be a great option for entrepreneurs seeking capital. Yet, there are a variety of reasons some business owners choose a different path for their startups. So, how do you know if angel investing is right for you? Check out the following list to see if the pros outweigh the cons.
Pros of Angel Investors
- Angel investors offer flexible financing terms that limit personal debt. If the business sinks, the entrepreneur does not have to pay back the money invested in their company.
- Many angel investors are experienced entrepreneurs themselves. They know how to successfully scale a company, and can help others do the same.
- Because of their business experience, they understand they’re playing a long game. They know organizations don’t profit exponentially overnight. For this reason, most are willing to be patient as the company grows.
- Depending on the role they want to play in the business they can fill key positions such as advisor, mentor, or board member.
- Most angel investors genuinely want to help business owners succeed. Unlike a venture capitalist (VC), their personal money is on the line. Investing in someone means they believe in your potential and want to help take you to the next level.
- They’re more inclined to invest in entrepreneurs than VCs. Data from Gust shows angel investors choose to invest in 1 out of every 40 businesses, while VCs select 1 out of every 400.
Cons of Angel Investors
- Angel investing is a form of equity financing, so don’t expect terms that allow you sole control, ownership, and equity in the company. You will have to give an investor a stake in your company.
- Don’t expect overly generous terms—angel investors are aware of the risk they’re taking. “As an angel, you go in believing each of your portfolio companies will be an amazing success, and are truthfully devoted to that goal on a startup-by-startup basis, yet your overall calculus must account for an overall failure rate of over 60%,” angel investor Paul Grossinger writes for Forbes.
- Business owners can expect to hand over anywhere from “25 and 45 percent of the equity,” according to an Entrepreneur article on dividing equity.
- Investors want to cash in on successful ventures and they’ll do what’s necessary to make this happen. Sometimes this conflicts with the founder’s vision, resulting in the entrepreneur feeling a loss of control over their company.
- Angels want the company to succeed. If they believe you’re preventing this from happening as the CEO and they have the decision-making power to nix you, they can.
Appealing to Angel Investors
Does angel funding still sound like a good option after reading through the pros and cons? If so, you’ll want to get started on making your startup stand out in a crowd of entrepreneurs seeking capital.
Here are a few pointers:
- First, make sure you have an outstanding business plan. Be sure to highlight your team’s and your own experience in your industry. Prove your company’s value and potential.
- Next, think about the type of angel that will best suit your company’s needs. Consider a person’s business experience, expertise, and the capacity in which you’ll be working together. Visualize the ideal fit for the startup, and write down exactly who you’re looking to work with.
- Be flexible—understand that your terms and conditions might differ from an investor who is taking a risk on a company that might have little proven success. Think about what you’re willing to offer, and where there is room to negotiate.
- Finally, define an investors’ exit strategy—how and when can they cash out their investment?
Remember, angel investing might not be a great source of funding for all entrepreneurs. This is especially true for a business owner hoping to maintain a high level of control in their company.