What You Need to Know to Become an Angel Investor
Ready to strap on some wings and become an angel investor?
Investing in young companies or startups used to be just for very wealthy individuals with strong networks. But these days, you don’t need to be well connected to participate in deals. Now you only need fairly deep pockets and access to the Internet to get in on the ground floor of what could be the next Google or Facebook. FB +0.15%
Behind the shift is a recent loosening of some government rules. Entrepreneurs can now openly solicit investors for funding—through ways as simple and direct as tweets and status updates—and potential backers can easily find information about cash-hungry startups on the Web.
Investors can also join online syndicates, which usually aren’t as exclusive as real-world angel groups. So, fledgling angels can pool their cash with other investors and make much smaller bets on companies, sometimes as little as $1,000.
Of course, to do any of this, you still need to be an accredited investor—someone with an individual or joint net worth with a spouse that exceeds $1 million (not counting the primary residence). But even that qualification may be loosening. The government is working out rules that would let angels of more modest means buy very small equity stakes of private companies using IndieGoGo-type crowdfundingplatforms.
But while it’s technically easier than ever to dive into early-stage investing, there are many ways newly minted angels can get clipped. Backing startups is very different from the kind of investing that stock-market-savvy people are used to. It takes more hands-on work and a different kind of judgment to assess the potential of young companies without a track record—and you can’t easily spread the risk around the way you would with stocks or mutual funds.
Here are some crucial points to keep in mind.
It’s not like the stock market.
Early-stage investing is an entirely different animal than investing in publicly traded companies. For example, as an angel in most cases you can’t cash out or trade your shares in a private company.
“This is a brutal lesson in illiquidity,” says Rob Wiltbank, vice chairman of research for the Angel Resource Institute. “You don’t get to choose when you sell.”
In general, the only way you can make a profit on an angel investment—or get at least some of your money back—is if the company you’ve funded has an exit event, such as an initial public offering or acquisition. And that can take years to happen, if ever.
For some idea of the time frame involved, consider this: Venture-capital firms, which typically invest in startups several years after angels, wait a median 7.35 years for a startup in their portfolio to achieve liquidity through an IPO, and a median 5.21 years for an acquisition, according to 2012 data from Dow Jones VentureSource.
Another big difference between angel investing and stock investing: You may be expected to get intimately involved in the startups you back, at least in the beginning of their life cycles. “Some entrepreneurs will want an inordinate amount of your time,” says Dave Berkus, an angel investor for more than 20 years in Los Angeles. “I’ve had a meeting and/or a phone call at least once a week.”
Of course, lending a helping hand will be in your best interest, since you want the startups you back to succeed. But this also means that you’ll want to invest mostly in companies related to industries you know well, and ideally ones where you have connections, says Christina Bechhold, co-founder of Empire Angels, an angel-investor group in New York.
And you’ll be accountable for the help you give. “The startup community is small and connected, so your reputation is a critical part of your success or failure,” she says.
The odds are stacked against you.
Roughly three-quarters of venture-backed firms in the U.S. don’t return investors’ capital, according to a study released last year by Shikhar Ghosh, a senior lecturer at Harvard Business School.
What’s more, you can’t minimize your risk by investing in thousands of startups in one shot through a vehicle such as a mutual fund, says Jeff Sohl, director of the Center for Venture Research at the University of New Hampshire. It’s up to you to build a sizable portfolio of your own.
Naturally, the more startups you invest in, the greater your chances of picking a winner. But you can’t just “machine-gun your money out and expect to see results,” says Dr. Wiltbank. “You still have to be caring and try each time to pick genuinely great companies to back.”
At the same time, don’t let yourself fall too in love with any one investment, warns Mr. Ghosh. If a startup you’ve backed is struggling to attract additional investors, resist the urge to sink more of your money into it, since this is a sign that the company is a bad bet. “You’ve got to have the discipline to walk away from investments that have not been able to raise the next round,” he says.
You’re investing in ideas and people.
Since startups are private companies, they aren’t required to report their financials, and because they’re young, they often have little to share anyway. Angels typically need to base their investment decisions on the strength of the idea behind a startup and its people.
The good news is that much of what seasoned angels look for to make such an assessment is online free. New online platforms like AngelList (angel.co),FundersClub.com and CircleUp.com feature profiles of startups seeking funding with valuable information such as their top competitors, founder and team bios, customer testimonials, product demos and industry statistics. If you like what you see, you can even invest in many of the companies through the platforms themselves, though some take a cut of any earnings. For example, investors who back startups through AngelList pay 10% of the profit per fund.
You may be able to learn more about a startup by reading what’s being said about it on social-media sites like Twitter, LinkedIn and Facebook, not to mention in the press.
But you can’t find everything online. Once you’ve homed in on a startup you like, be sure to spend some time with its founders and staff before you invest so you can see how they’re building the company firsthand, advises Brian Cohen, chairman of New York Angels, an angel-investor group.
You also can learn a lot about the team’s work ethic, how everyone gets along and more. For example, a dirty or disorganized office with employees frequently bickering or playing games might indicate a lack of seriousness on the company’s part—and a bad bet for you. “Angel investing is a contact sport,” he says, adding that a phone conversation or video chat isn’t a substitute for face-to-face interaction.
Grant Allen, an angel investor in Washington, D.C., recently decided against backing a mobile-technology startup after meeting its two founders for coffee. He was introduced to the duo by a former business-school classmate and was intrigued by their pitch. He also liked what he read about them on LinkedIn and other websites. “They looked great on paper,” he says.
But his impression soured when he sat down with the founders separately. “It became clear that there was a fair amount of bad blood and discord between them,” he says, adding that the company has since folded. “At the end of the day, a business is about people.”
Get a pro to help with the paperwork.
Buying shares in a private company is a legal transaction, so if you’re serious about making an angel investment, you’ll need to sign various legal documents committing to a deal. An unsophisticated investor might not know what to look for, or what’s missing, warns Mr. Berkus. So, guidance from a seasoned investor or legal adviser can be a big help.
For example, veteran angels will commonly seek a provision that prevents a startup’s founders from selling their shares in the company. A startup’s success is tied to its founders, who may become less motivated or inclined to leave once they no longer have much skin in the game.
“You’re investing in the jockey more than the horse,” says Mr. Berkus. “Sometimes the founder’s share is diluted, and he or she doesn’t care as much about the company anymore.”
Sophisticated investors also will ask founders to put their shares in escrow for two to four years to ensure their continued participation, he adds.
Another tricky area is negotiating valuation—the amount of money a startup is worth, which affects the ownership stake that investors get in return for their money. New investors often accept too high a valuation, which can make it difficult for the entrepreneur to raise a later round of funding, says Marianne Hudson, executive director of the Angel Capital Association in Overland Park, Kan. Or, if a valuation eventually needs to be corrected and made lower, or “crammed down,” it can dilute investors’ stakes in the business, she adds.
You don’t have to do it alone.
Many angels form groups and invest in deals together. Usually, one member takes the lead and divvies up the due-diligence work. If you join a group, more seasoned members may be willing to teach you the ropes. You also may get a chance to participate in the best deals available, since seasoned investors tend to be the first to learn about these due to their deep networks.
Traditional angel groups usually meet regularly in person and tend to be exclusive: They often require an invitation from an existing member to join and charge membership fees. By contrast, online angel “syndicates” usually aren’t as strict. These groups have been forming recently on sites like AngelList, in some instances to go in together on just one deal.
New members typically don’t need an invitation, and some groups will let you invest as little as $1,000 per deal—although you may not get to meet with more seasoned members face-to-face for networking and counseling. You may also need to share in the profits. Backers on AngelList pay up to 15% of the profit per deal to the syndicate lead and 5% of the profit to AngelList.
No matter which kind of angel group you join, it’s wise to conduct your own due diligence, even if the lead investor on a group deal has an impressive track record. Marco Giberti of Miami came to this conclusion after making one of his first investments—$50,000 in a technology startup—through an angel group in mid-2011. He says prior to investing, he did minimal research into the company, trusting the lead investor to do the heavy lifting. Six months later, it became clear that the company didn’t have a sound strategy for executing its business plan.
“There were no controls, and 35% of [the money] we put in was burned on previous debts,” says Mr. Giberti, an entrepreneur who has built and sold three companies. “It was a completely different allocation than what I expected.”
Mr. Giberti now puts the same amount of research into every potential investment he makes, even if he’s teaming up with more experienced investors on the opportunity. “Everyone’s due diligence is different,” he says. “I will never co-invest again without doing a serious analysis on my own.”