What should you consider before becoming an angel investor?
Angel investors (“angels”) take up a critical position in the start-up ecosystem. Venture capitalists (“VC”) have become more risk-averse leaving a void where smart capital and mentorship is needed to grow a business successfully.
The only true sources of smart finance are angel investors. They contribute their own know-how, provide mentorship and share their connections with the businesses they invest in. They are thus the main drivers of innovation and the natural leaders of the world’s early-stage investment markets.
In this article I want to give a bit of background & introduction on angel investing in general and what you should consider if you are thinking about diving in to this (very exciting & rewarding!) field.
How do startups get funded?
Friends & Family
‘Friends & Family’ provide the first USD$50.000 (on average) often referred to as ‘pre-seed money’. Enough for an entrepreneur to get started but not enough to generate sufficient revenues to scale the business.
To grow rapidly, entrepreneurs may need an injection of capital, but banks have little appetite to lend to high-risk businesses with insufficient cash flows. VCs and PE firms usually do not invest less than $1 million: too much for a seed stage startup. Individual angels or angel groups typically provide anywhere between USD$100.000–USD$500.000 during the seed stage.
This void in funding between what friends and family can provide and what VCs and PE firms are willing to invest is referred to as the “Valley of Death,” and it can be nearly impossible to traverse without the help of angels.
In countries that lack VCs and PE firms, angels & angel groups fill the void by supplying additional rounds of funding to growing companies. So when investing as an angel investor it is very important to look at the possibilities for this so-called ‘follow-on funding’ so a company will not run out of money when the angels do.
VC / PE / banks / corporate institutions
> $1 million and beyond. Often referred to as a the ‘Series A or the venture capital stage’.
VC have become more risk-averse?
While historically VC used to take up the role that angels are currently fulfilling (ie. drive innovation and provide smart funding), they have now shifted to later stage funding. There’s generally speaking several reasons for this that I have discussed here. The three most important reasons are:
- They focus on building large funds (due to their business model) which requires them to make larger investments as it’s easier to manage a few large investments than it is to manage a large portfolio of smaller investments.
- They are organised as money managers and lack the knowledge to be really hands-on and help the company during the pre-seed and seed stages.
- VC invest other people’s money and hence are restrained by the ‘investment thesis’, which prevents them from investing beyond certain pre-defined stages, geographies & industries.
We do expect VC to shift back to earlier stages in the next couple of years and change how they operate. And next to that we see a larger role for the so called “micro-VC” & “venture builders”, but that’s food for another article.
There remains a large void (opportunity!) as mentioned earlier that needs to be filled by angels to continue and drive innovation.
Who are angel investors?
Angel investors are typically experienced professionals or successful entrepreneurs who can offer wisdom, network and mentorship (beyond capital) to the entrepreneur and have the patience to wait for normal company maturation.
Earlier I wrote about how companies like Intel & Atari became successful due to the introductions made by their early-stage investors.
What do returns look like for angel investors?
The reason that angel investing is so risky is that most start-ups do not achieve their founders’ goals and are closed.
For this reason, angels should invest in portfolios of companies. Among the successful companies, 9 percent provide investors with returns of 10 times their investments, which compensates for failed investments. Most exits in the developed world are in the form of strategic trade sales, with overall returns of 2.6 times the original investment in the U.S., and 2.2 times the original investment in the UK, with profitable exits taking around 6 to 8 years to achieve.
Data on returns in the developing world are more limited. However, according the Kauffman Foundation’s research on angel investors in Asia, between 75 to 79 percent reported returns meeting or exceeding initial expectations.
What are common problems facing angel investors?
- Limited access to quality deal flow in order to establish diversification
- Missing out on opportunities (as mentioned earlier, being part of the ‘winners’ is critical to compensate for the ‘failures’ in order to get good returns)
- Missing a trusted network to reflect & brainstorm
- Limited time to source new deals perform due diligence & negotiate terms
- Not familiar with the local startup ecosystem & regulations
I will dedicate several article to these problems in the future as part of a more detailed series about angel investing. For now I want to briefly focus on ‘angel groups’ as a potential solution for certain challenges faced by angels.
What are the advantages of joining an angel network?
While we need individual angels, there is only so much one investor can do alone.
An angel network, which pool the resources and knowledge of their members, can overcome many limitations associated with solo investing and investing in risky environments, such as emerging markets.
What should you look at while evaluating the potential membership of a network?
- Does the network have a strong lead (with track record) that manages the group?
I think a network can only provide value if it is managed by a strong lead (ie. experienced investor such as an angel or former fund manager). As most of the members have limited time the network won’t be properly managed without a lead driving the progress.
- Is there a foundation of sufficient experienced members with a background across different industries?
Being part of a knowledgeable network is critical every step of the way. Make sure there’s sufficient members that you think can help you during your investment journey.
- Does the network have a mission & cultural statement and do you agree with it?
It is important that the values and goals of the network are in line with your expectations. You ultimately want to make sure you can invest in companies that you like. One way of researching this is to look at the current investment portfolio of the network lead and try to imagine having some of his companies in your personal portfolio.
- Is the network (or lead) able to generate sufficient quality deal flow?
Sufficient deal flow is critical. It is not uncommon that a lead has to evaluate 100 companies before finding a few ‘potentials’ that he can present to the members of the network. Building a diversified portfolio is critical and hence the network should be able to help you get there.
- Does the lead have strong connections with the local ecosystem?
Again, to source quality deals a lead should be well connected. But beyond sourcing it is important that there’s connections with follow-on funding options and even service providers such as lawyers and accountants.
The above is a brief introduction on angel investing and some of the potential pitfalls that you want to avoid.
This article is part of a series on angel investing
We discussed earlier:
- What does the portfolio of a successful angel investor look like?
- Why Southeast Asia is great for your angel investments
- What can we learn from successful venture capitalists?
- Why founders & venture capitalists in the Asia Pacific and Europe should start thinking globally
- How angels evaluate their opportunities
- How do angel investors source opportunities?