Angel Investing: How To Buy Into The Next Big Thing

10 mins

Angel Investing: How To Buy Into The Next Big Thing

What is angel investing?

Companies – especially small ones – need cash.

Bank loans and the founders’ savings are two of the most common ways of providing this early in a company’s life. But sometimes a business will look to “angel” investors for funds.

What’s an angel investor? They’re individuals who provide cash in return for a share of the company. It’s a bit like the stock market, except you commit to the company directly through a bespoke agreement.

How does an angel make money? Angel investors are always waiting for their “exit” – which can take years to come around. The most sought-after exits are when a company gets acquired by another one or “goes public”.

When a big company like Apple buys a startup, the startup’s investors sell their shares to Apple – usually in return for either cash or Apple stock. Alternatively, when a company gets big enough to float on the stock market, existing investors can sell their shares on the open market during or after the initial public offering (IPO).

When either of these things happen, the returns can be massive: if you invest $10,000 in a company for a 1% slice of the pie (valuing the whole thing at $1 million) and that company is then acquired a few years later for $100 million, you could have a million-dollar payday.

Wow. Are there any other benefits? There are indeed – for both company and investor. The company might choose to partner with an angel experienced in their industry – someone who brings their mentorship and network to the table. And the investor gains some influence over how (and what) work is done at an exciting, fast-growing company.

This sounds like an absolute dream. Why isn’t everyone an angel? Because it’s one of the riskiest things you could ever do with your money! While the potential returns are great, the vast majority of angel investments end in failure. There is a huge likelihood of losing all your money. Investors in a company’s shares (a.k.a equity) are last to get paid if a company fails – those holding debt will be ahead of you in line fighting for scraps of any assets left over. Stockholders generally get nothing. It’s one of the biggest gambles you’ll ever make.

But if that doesn’t put you off, strap in for the rest of this pack, where we’ll guide you as far as angels’ ken!

Risks and rewards

Because angel investments tend to be made in early-stage companies, typically those with an unproven product and business model, they’re much more likely to end in disaster than an established S&P 500 or FTSE 100 company.

On top of this, angel investing is very illiquid: once you’ve invested the money, you’re kind of stuck. It’s not like the stock market, where you can sell shares in a few clicks – there might not be a chance to sell for years. Anything could happen in that time, either to the company or to you, that might make the angel’s risky share no longer quite as palatable.

That doesn’t sound so juicy… It gets worse! Angels are among a company’s first shareholders. But the company will probably raise further rounds of funding later. When new investors come on board, existing shareholders get “diluted”: their percentage holding shrinks. You might initially own 1% of the company, but a few rounds of dilution could shrink that far lower – unless you sink even more money in to maintain your stake.

Though when a startup is growing well and making good use of its money, the absolute value of your reduced percentage should still be climbing. It’s better to own 0.1% of a billion-dollar company than 1% of a million-dollar company.

Why should I bother? Risk and reward go hand in hand. Angel investing is really, really risky, but if you do strike gold the returns can be stratospheric – one or two successful investments can make up for all your losses.

Many countries shower angel investors with tax breaks, too, to support young companies. The UK’s Seed Enterprise Investment Scheme, for example, grants significant income tax relief, lets you offset any losses against tax, and exempts you from capital-gains tax on any profits. Schemes like this make the process less risky and more appealing.

How can I tolerate the risk? Have a broad portfolio! Smaller investments in several different companies help spread the risk. But it can get expensive very quickly: a typical small angel investment would be at least $10,000 and you’d probably aim for more than 10 companies in a fair portfolio – meaning well over $100,000 invested.

If you can stomach the risks without a bilious attack, we’ll show you how to invest like a pro.

What angel investors look for

There are dozens of things angels look at when deciding whether to invest in a company. Here are some of the most common:

Team: They say you invest in a company, but in reality you invest in their people. Smart investors look for those with the experience and skills to succeed. You’ll want a team you can actually get on with – you might be stuck with them for years!

Market: Prudent investors research a company’s target market. Estimate the number of potential customers to figure out the sales potential. Scrutinize the company’s business plan to trust they’ll transform ideas into profit. Remember, most angel investments fail and you need the ones that succeed to succeed big – many investors will only take a punt on companies with huge growth opportunities.

Product: You want to be sure that whatever the company’s trying to sell is actually worth something. That means knowing what competitors are doing, figuring out if this product is better, and using your best judgement to guess if it will actually sell. That’s where your industry expertise comes in particularly handy – it’ll give you a good idea of what will and won’t in a given market.

Unfair advantage: Business is ultra-competitive, and one of the easiest ways to succeed is to have an advantage that no-one else does. A patented invention, an amazing contact network, or an all-star team of geniuses: anything that would stop someone else from doing the same thing. This magic ingredient is worth a ton to investors.

Valuation: If you’re ponying up cash, you need to know what you’re getting in return. Typically, a company will set a valuation (e.g. $1 million) and then you invest accordingly (so $10,000 would get you a 1% share). As an investor, you should figure out if that valuation makes sense (maybe by looking at the valuation of similar companies), and if it’ll give you the returns you need. There’s often room for negotiation, too.

Trust: The price has to be right. But offering you a greater percentage of the company for your cash can only go so far. You shouldn’t have confidence in a company where the founders and employees keep too small a stake in the game to incentivize themselves (and paying them greater salaries to make up for it would bleed your cash away). You’re trusting this team to work hard and to make your share worth something more one day.

Now that you know what to look for, it’s time to think about if this is right for you…

Is angel investing right for you?

As you may be gathering, serious angel investing requires a hefty wallet. You’ll need a broad portfolio – and that quickly adds up to a small fortune. This cash also needs to be completely disposable: with angel investing, the rule is to assume that you will never see your money again. If you’re lucky enough to have all that at your disposal, you’re in a good position to get involved with angel investing.

What else should I worry about? You’ll want to consider your experience with investing in general – angel investing is typically only recommended to “sophisticated investors”. Know a decent amount about the startup world: that’ll involve lots of reading, paying attention to news and trends, and getting to grips with more technical concepts (like market sizing and financial modeling).

What’s market sizing? Professional investors in early-stage companies are betting that these startups will grow to the moon. So they’ll closely examine metrics such as Total Addressable Market, a theoretical measure of how much a company might stand to get in revenue if it eventually expanded to control an entire industry.

This is why many angels focus on just one or two sectors that they know deeply. As your insights and connections in that sector grow, you’ll also become a more appealing investor to startups. And hence you’ll probably get a better deal.

Where do I even find companies to invest in? It’s all about networking. As the startup world grows ever bigger, more and more people want to get involved in angel investing: so much so that startups sometimes get to pick and choose their investors. This means that a lot of the really good deals might never come your way, because they’ll be snapped up by investors with more experience and better contacts than you. Consider whether you actually have good opportunities in front of you – and if you don’t, then do something about fixing that “deal flow”.

Finally, we’ll look in detail at how to sniff out these angelic opportunities.

How to source deals

Angel investing is all about who you know. And who you’re willing to trust (and at what price). Remember, it’s a speculative enterprise.

The best way to find great opportunities is your personal network: ideally a group of entrepreneurs and fellow investors who’ll call you up when something interesting comes along. Go to networking events, get in touch with startups you find interesting, talk to friends and friends of friends – you have to actively seek people out. Opportunities will hopefully follow.

So I have to invest with other people? A single angel rarely has enough dough to fully finance a startup’s fundraising round. But you’ll want to know who else you’re getting into bed with. Angels can club together by forming a “syndicate”: an experienced investor will collect deals for you and you invest alongside them. You can tap into others’ expertise and capital, but the syndicate leader will charge a fee for the privilege – you’ve placed your wealth under management. There’ll likely be local angel investing syndicates in your city to check out.

Should nothing come up organically, there’s always the internet: sites like Angel Investment Network (UK) or AngelList (worldwide) collate opportunities and are worth checking out.

Isn’t this all a bit risky? Yes. It cannot be stressed enough just how risky angel investing is. It’s very much for those who are already very wealthy and have a great understanding of the investment world. In fact, many platforms require you to be an “accredited investor” with plenty of assets (excluding your house – you don’t want to be left homeless).

Are there ways I can get involved without so much commitment? If you want to invest in startups without the potential of bankrupting yourself, there are alternatives! Check out our pack on Equity Crowdfunding for a look at ways to invest in startups without putting so much money on the table.

And if you do decide to get involved in angel investing… good luck!

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG