Angel Investors: Financing for Startup Businesses

Is your early-stage startup in need of some capital? One potential source of funds is angel investors: private, wealthy investors who will finance your business in exchange for an ownership stake.

Here’s an overview of angel investors, some of the pros and cons of this kind of financing, how to determine whether it’s right for your startup and how to bring potential investors on board.

Angel investors are entrepreneurs and accredited investors (those with either a minimum net worth of $1 million or at least $200,000 in annual income) who provide financing for small startups or early-stage businesses. Investment amounts can range anywhere from $5,000 to $1 million or higher, depending on the size of the startup and the percent of ownership sold. Angel investors may also form an “angel group,” in which they evaluate businesses and invest together, pooling resources to make larger investments.

Each year, angel investors invest more than $20 billion in U.S. startups, according to Inc. Magazine, and roughly 225,000 people have made an angel investment in the past two years, according to the Angel Capital Association.

Angel investors also may invest when a business can’t get financing from a bank or a financial institution, says Craig Smalley, an accountant and financial advisor for small businesses in Orlando, Florida. “Usually the type of business is something that a bank won’t invest in — it’s usually businesses that banks don’t understand very well,” he says.

Generally speaking, angel investors are interested in high-growth, high-potential startups that can earn them several times their original investment. In other words, the potential rewards need to be substantial enough to outweigh the numerous risks of investing in a startup. After all, about half of all new businesses don’t survive their first five years, according to the U.S. Small Business Administration.

Although angel investors may invest in any industry type, technology tends to be the most popular sector for angel investments, says Kevin Strophel, a financial advisor with Kumquat Wealth in Chattanooga, Tennessee.

“Technology is one of the industries that appeals to angels because the product can be immensely scalable, with an often limited requirement for additional resources,” Strophel says. “This drives profitability, which drives valuation and return on investment.”

Typically, the capital provided by angel investors is exchanged for equity ownership (stock in the company) or convertible debt, which refers to a loan that can be converted to equity at a later date.

With equity, the investor would provide upfront capital for an ownership stake in the company. For example, a company that is valued at $1 million might sell 20% of its equity worth $200,000 to an angel investor or an angel group.

It’s important to know the value of your company, as angel investors are looking for an investment based on its valuation, Smalley says.

“For instance, if you want somebody to give you $100,000, and you’re willing to give them 25% of the business, your business better be worth $400,000,” Smalley says. “A lot of angel investors will tear apart a bad valuation.”

It’s also important to believe in yourself and what you’re doing. “There’s nothing worse than a business owner that doesn’t believe in what they’re selling,” Smalley says.

• Angel investors are often experts in the industry in which your business operates. It’s also possible they are entrepreneurs themselves and started their own business in your field. If this is the case, they should be able to provide firsthand business advice and high-quality coaching to help your business succeed.

• Angel investors tend to have a lot of industry connections, so they may be able to introduce you to potential new customers, additional financing sources, business partnerships and other relevant contacts.

• Angel investors only make money if your business is successful. This should motivate them to help add as much value as possible to your business.

• If your small business is in need of financing in the future, follow-up investments from angel investors are possible.

• The financing is not that easy to obtain. Even if you think your company offers outstanding growth potential or a game-changing type of product, angel investors still might reject your pitch. After all, investing in a startup is risky.

• Some angel investors might demand a larger ownership position because of the risk involved; you may give away a larger equity position in your company than you had planned.

• Not all angel investors are helpful. For this reason, it’s important to do the proper due diligence on the angel investor to ensure their interests are aligned with yours. Ask for references and, if possible, talk with other investors who have also raised money from this investor. You want to make sure the angel investor will be a good business partner, help your company grow and contribute to its success, instead of just looking for a return on their investment.

• You’ll likely need to prepare a lot of paperwork, such as income statements and projections, balance sheets, cash flow statements and bank statements, so be ready for a potentially lengthy, time-consuming process.

Only startups and early-stage businesses that can be scaled for growth are suitable for angel investments. This means your business should be able to increase its sales very fast over the next few years without a huge increase in fixed costs and expenses, because this is what appeals the most to angel investors.

If you’re willing to give up equity ownership and potentially majority control of your company, and you think you’d benefit from bringing an experienced investor on board, then angel investors could be a smart move. That investor can provide the upfront capital and guidance your startup needs. It’s vital the investor you bring on board is credible, has proven experience in your industry and can help add value to your company.

Angel investors can be friends, family or inner networks, individual angel investors, or a team of investors, also known as an angel group. Angel investors congregate at both regional and national events that are focused on sourcing new investment ideas and screening companies, Stophel says.

You can find potential investors at either the Angel Capital Association, which is the official industry alliance of over 100 of the largest angel investor groups in the United States, or the Angel Resource Institute, a nonprofit that provides education and information on the best practices in the field of angel investing. FundingPost is one resource that brings entrepreneurs together with angel investors through its roundtable events.