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What is an Angel Investor?

definition

An angel investor provides financing to a startup, usually at an early stage, in exchange for an ownership stake.

🤔 Understanding angel investors

Angel investors are one way to finance a startup, usually when it’s just getting off the ground. Instead of loaning money, angel investors receive an ownership stake in the company in exchange for the funds they contribute. Angel investors are typically wealthy family members or friends of the business owner who invest their own money. If the business fails, the owner doesn’t have to pay the money back. If the company is successful, the angel investor may sell his or her stake to make a significant profit, but most angel investments don’t end up that way. Due to the risk of investing in a startup, angel investors typically look for high potential returns.

example

Imagine that Laura has a business idea for software that doctors and patients can use to communicate securely. As a new entrepreneur, she finds it difficult to get a loan to launch the company. Laura decides to find an angel investor to fund the business. She approaches Tim, a wealthy friend of the family who likes Laura’s business plan. He invests $50,000 and receives 20% of the company’s stock.

Takeaway

Angel investors are kind of like angels…

They help you out by giving you the money you need to launch your business, even when no one else will. Then they watch over you and the company, sometimes becoming advocates and helping you make business decisions. But angel investors don’t usually do this out of the goodness of their hearts — They believe in your venture and are hoping for a return.

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Tell me more...

What is an angel investor?
How does an angel investor work?
What’s the difference between an angel investor and a venture capitalist?
Who can be an angel investor?
What are the sources and extent of funding?
How do angel investors make money?
Is angel investing profitable?
What percentage do angel investors want?
Do you pay angel investors back?
What are the pros and cons of using angel investors?

What is an angel investor?

Angel investors are wealthy individuals who invest in new businesses with their own money. They provide the capital a startup needs; in exchange, they receive an ownership stake in the business and thus part of the profits.

Angel investors usually know the business owner personally or meet him or her through a mutual friend. However, online platforms that connect angel investors with founders are also becoming popular.

Angel investors are often strong advocates for the company’s success. After their initial investment, they may give additional capital to help the startup get through its difficult early years.

Angel investors hope that the startups they fund will become successful, at which point they can sell their stock when the company goes public or is acquired. If all goes according to plan, the angel investor will reap a large profit.

However, the investment can be very risky, because many startups fail. Since the potential for losses is high, angel investors usually hope for a high rate of return on their investment.

How does an angel investor work?

Angel investors are one way to finance a new business venture. Instead of loaning money to the business owner, an angel investor essentially buys the company’s stock. This means the investor will get part of the profits and have a say in business decisions. However, the owner doesn’t have to pay back the investment.

With a bank loan, on the other hand, the lender doesn’t get an ownership stake in the company, take any profits, or try to influence its decisions. But businesses usually have to repay the debt no matter how the company fares.

Angel investors often plan to finance the company until it’s successful, then sell their stake and make a fortune. However, it’s a risky investment since a lot of startups do poorly.

You might think of the relationship as an “idea and money” duo. The owner has a great business idea but lacks funding. The angel investor has the money, but not a business idea. They combine forces to forge a company they hope will be successful.

What’s the difference between an angel investor and a venture capitalist?

Both angel investors and venture capitalists invest money in small businesses, but there are key differences.

Angel investors are individuals who put up their own money. Venture capitalists typically do not invest their own money. Instead, they pull capital from multiple investors into a fund and manage it strategically. Angel investors usually provide smaller sums than venture capital firms do. They also typically invest at an earlier stage in a company’s life, often when it’s just getting started. Generally speaking, angel investors take on more risk and therefore target higher returns.

Who can be an angel investor?

In general, anyone can become an angel investor if he or she has enough money and is willing to invest in startups. Most companies look for angel investors that meet the Securities Exchange Commission’s definition of an “accredited investor,” since that exempts them from various regulatory filings. You can become an accredited investor by meeting one of two qualifications:

  • Have a net worth of $1M or more, not including your primary residence (this can be combined net worth with your spouse)
  • Have earned $200,000 annually for the past two years (or $300,000 in combined income with your spouse) and expect to make the same this year

On Oct. 30, 2015, the SEC adopted rules to allow non-accredited investors to invest money in startups through online crowdfunding. In these cases, several individuals invest smaller amounts into a single business through a website. However, there are strict limits on this practice. Investors with an annual income or net worth of less than $107,000 can only invest up to $2,200 or 5% of their income or net worth (whichever is lower) in one year. Someone with an annual income and net worth of at least $107,000 can invest up to 10% of either figure (whichever is less) in a year.

What are the sources and extent of funding?

Angel investors provide their own money, but they may use a limited liability company or another vehicle to finance a startup.

Angel investors can choose to invest a wide range of sums. According to the Angel Capital Association, investors with an entrepreneurial background put in an average of $39,000, while others contribute an average of $28,000. The specific amount depends on the investor and business in question.

Usually, a business faces its greatest challenges during its first years. Angel investors are aware of this fact and may give additional capital to help carry the company through its early years. It’s common for angel investors to initially invest in a startup knowing they will likely have to provide more cash in the following years.

Collectively, angel investors provide up to $24B in funding to more than 64,000 startups each year.

How do angel investors make money?

Angel investors have an ownership stake in the company, usually in the form of preferred stock (a type of stock that gives investors a higher claim to dividends). That means they’re entitled to a portion of the profits. However, they typically make most of their money when they sell their stock, either when the company goes public or when another business acquires the company.

Like any investment strategy, angel investors try to buy low and sell high. They can buy low if they invest in the company when it’s just starting out and has a low valuation. They may be able to sell high if the company takes off.

Angel investors usually exit (sell their stake in the business) in one of two ways:

  • Another firm acquires the company, paying the angel investor a sum of money
  • The company offers stock to the public through an initial public offering, and the angel investor sells his or her stock

Not all exits are profitable. According to one industry survey, angel investors report that, on average, 11% of the companies they fund produce a positive exit.

Is angel investing profitable?

Angel investing can be profitable, but it’s very risky.

Some angel investors report returns higher than 10 times their initial investment after selling their stake in a company. However, most angel investments do not result in exits, let alone profitable ones. Most studies suggest that only 5-10% of angel investments make a profit. Among successful exits, the results still tend to vary significantly.

If you plan to be an angel investor, you may want to carefully research the company and industry you’re investing in and understand the risks. An angel investor should be comfortable with the strong possibility of losing the entire investment.

What percentage do angel investors want?

In return for financing a startup, angel investors usually get a chunk of the company’s stock. For an initial investment, angel investors typically ask for a 10% to 20% ownership share. However, the amount varies depending on:

  • How much the angel investor is putting in
  • How much control the owner is willing to forfeit
  • How promising the startup’s future is

The owner and angel investor should discuss these details at length before agreeing to the investment.

Do you pay angel investors back?

A business owner does not pay back an angel investor even if the company fails. That doesn’t mean angel investors are giving away free money. They own part of the business, so they get part of the profits. It also means they will receive proceeds if another company acquires the business or if it goes public.

What are the pros and cons of using angel investors?

Turning to angel investors has both benefits and drawbacks compared to other sources of funding:

Pros:

  • Low-risk financing. Business owners are off the hook for paying back the angel investor, even if the company fails.
  • Long-term outlook. Angel investors usually understand the struggles companies face in the early stages and take a long-term view. This means they’re likely to stick it out even when things look bad.
  • Source of expertise. Angel investors are often professionals, such as business owners or lawyers. They can offer professional advice and guidance when the startup is navigating difficult challenges.

Cons:

  • Expensive financing. Angel investing is risky, so investors usually ask for a large stake in the company. This can cut into profits and reduce how much the owner makes in a sale or public offering.
  • Loss of control. Angel investors have a say in how to run the business since they partly own the company. For a business owner, that means giving up some influence.
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