What Is an Angel Investor?
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What Do Angel Investors Do?
Angel investors typically invest in startup businesses or small ones that need capital to expedite growth. As investing in these new businesses is inherently risky, angel investors offset this risk by taking a sizable equity stake in the company. Accordingly, they expect a higher rate of return compared to other investment options, ranging from 20% to 25%.
Sources of Angel Investment
There is no “limit” to how much angel investors can fund a startup or a small business, although it can vary significantly—from as low as $1,000 to over a million dollars. Most angel investors who diversify their portfolios also keep their angel investments totaling no more than 10%.
Angel investments may come from various sources:
- Family and friends: The most common source of angel investment comes from family members and friends. Since new businesses are highly risky, it is best to be upfront about the risks to avoid severing personal ties.
- Wealthy individuals: These are comprised of investors or people with high net worth and spare cash, including other entrepreneurs.
- Groups: This is a collective of angel investors who pool money for investments, such as a group of a business owner’s friends and family in one unit.
- Syndicates: An angel syndicate is similar to a group, but instead of all members of an angel group having an equal say on the investment, only one member leads the syndicate on investing in a particular business. Unlike groups with no unified strategy, syndicates are composed of experienced investors who know what they want to achieve.
Qualifications of an Angel Investor
The Securities and Exchange Commission (SEC) clarifies that being an accredited investor is not necessary to become an angel investor. The SEC defines accredited investors as any of the following individuals:
- Those with a minimum net worth of $1 million, minus their personal residence.
- Those who have earned at least $200,000 for the last two years (or $300,000 with a spouse).
Still, many startup companies think that accredited investors are more trustworthy and financially knowledgeable, so most angel investors outside of the owner’s immediate personal circle ultimately fall under the SEC’s definition. Being an accredited investor also comes with a few benefits, such as access to investment opportunities otherwise restricted from regular people.
As with any investment, an investor interested in backing a good idea needs to develop a strategy and set expectations. In a sense, an angel investor’s only qualification is that they only know and recognize the risks of funding a startup.
Angel Investors vs. Venture Capitalists
Apart from making a small business loan, a startup owner may also secure funding from third-party investment. They may choose to pitch to angel investors or venture capitalists (VCs), or both. While the investment is the same in principle, they have huge differences, particularly in the investment amount, the investment source, and expectations.
The most apparent difference between angel investors and VCs is the amount of investment they are willing to make. Figures show that VCs invest more considerably than angel investors, with median venture capital amounting to $9 million. Consequently, VCs expect bigger equity in the business and even demand a higher return on investment—an average of 35%, higher than the median ROI expectation of an angel investor.
In addition, while angel investors use their money to finance startups, venture capitalists utilize pooled funds from large corporations, investment companies, and even pension funds to invest in other companies. This is why VCs prefer financing established companies to minimize the risk of losing their entire investment. On the other hand, angel investors are more lenient. They often prefer to inject seed money into startups or serve as additional funding to expand the business.
When it comes to company roles, angel investors often act as mentors. VCs rarely do so, but depending on the size of their investment, they may have a seat on the board or be in a position to make decisions.
Pros and Cons of Angel Investments for Startups
Like any source of investment, utilizing the help of angel investors for a startup has its advantages and disadvantages.
- An angel investor knows the risk they are taking. Angel investing in itself is risky, but most angel investors are experienced in taking calculated risks. Unlike traditional lenders, angel investors do not balk at an opportunity if it comes knocking. Some angel investors are even part of an investor network whose members can pitch in if needed.
- Their help is not a loan. While nothing is completely free (see below), the investor does not necessarily expect the business owner to pay them back. Contrast this with a small business loan, which the lender expects the borrower to repay with interest.
- New business owners can benefit from their experience. Startups and small businesses often benefit from a mentor’s wisdom and experience, a role an angel investor can fill. A study from the Harvard Business School also notes that startups with angel investors in an advisory capacity show more positive returns.
- An angel investor may set higher expectations. The pressure to deliver as a business owner will be more intense, as the angel investor will often expect the business to take off under their investment and advice. Angel investors inject cash into the business to realize a meteoric rate of return, so failure to meet the investor’s expectations may be a problem later on.
- It has strings attached. Though the additional capital from an angel investor does not always need to be repaid, an angel investor would ask for specific concessions. Part of this is equity in the business, which means the investor always earns a percentage of the company’s future profits. As such, it means the owner is not in total control, especially if the angel investor has asked for decision-making capability as well.
Angel investors are individuals with high net worth that provide financial support for startups and small businesses in exchange for equity in the business. Angel investors may come from many backgrounds, but some of the most common include family and friends or wealthy investors who want a large and/or quick (or both) return on investment. The amount of their investment varies, but it is usually smaller than that of a venture capitalist.
Relying on angel investments, however, has its pros and cons. While their financial help is welcome and does not necessarily need to be repaid, they may demand concessions from the business owner, such as a stake in the company and even a decision-making position. However, most studies find that an angel investor in an advisory capacity, whether formal or informal, has a net positive effect on the health of a business.
- Blakely-Gray, R. (2018.) How to Decide Between Pitching to a Venture Capitalist vs. Angel Investor. Patriot Software. Retrieved from https://www.patriotsoftware.com/blog/accounting/venture-capitalist-vs-angel-investor/
- Preuss, M. (n.d.) How to Effectively Find + Secure Angel Investors for Your Startup. Visible Blog. Retrieved from https://visible.vc/blog/how-to-find-angel-investors-for-your-startup/
- Cremades, A. (2018.) How Angel Investors And Angel Groups Work. Forbes. Retrieved from https://www.forbes.com/sites/alejandrocremades/2018/09/25/how-angel-investors-and-angel-groups-work/?sh=5b970c8176dc
- Investor.gov. (2019.) Updated Investor Bulletin: Accredited Investors. Securities and Exchange Commission. Retrieved from https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-3
- The Bonhill Group PLC. (2016.) Business failure: Four in ten small companies don’t make it five years. Retrieved from https://smallbusiness.co.uk/business-failure-four-ten-small-companies-dont-make-five-years-2533988/
- Rudden, J. (2021.) VC global median deal size 2010-2020, by stage. Statista. Retrieved from https://www.statista.com/statistics/828788/venture-capital-median-deal-size-by-stage/
- Harvard Business School. (2017.) New Study Sheds Light on Angel Investors in the US Economy (press release). Retrieved from https://www.hbs.edu/news/releases/Pages/angel-investors-us-economy.aspx