For some more mature investors, the traditional vehicles of stocks, bonds, and mutual funds can be limited and too highly exposed to market-wide fluctuations. Some investors who have substantial cash savings, but do not wish to start their own business, often opt to become “angel investors”, individuals who invest directly in businesses out of their own pocket, seeking higher returns and a more secure degree of control and ownership over a company. They are the opposite of venture capitalists, a group of investors pooling their money together for similar, but more structured investments. The advantages of being an angel are clear – your decisions and profits are yours and yours alone. “Angels” were given their heavenly name in the early 20th century by Broadway producers to the wealthy businessmen who funded their productions. Today, anyone with enough cash and business acumen can be an angel. Let’s take a look at some basic prerequisites that on average, most angels satisfy.
- An annual income of over $90,000
- A net worth of over $750,000
- A comfortable amount of free cash flow
- A thorough understanding of local businesses (usually within a 50-mile radius from your home or office)
- An interest in investing in small companies (90% of angel investors invest in companies with less than 20 employees)
- Previous experience in traditional personal investing or franchising
- Preparation for a 1 in 3 chance that your investment will fail
The Small Business Administration estimates that there are at least 250,000 active angel investors in the country investing in 30,000 small companies yearly. According to net worth, there are 2 million potential angel investors in the United States. Their investments vary widely across the board but nationwide are comparably higher than formal venture capitalist investments, which average $3-$5 billion a year. Angels expect a lower rate of return on their investments than venture capitalists, but the initial informal nature of the relationship needs solid scaffolding before it can proceed. If you are interested in angel investing or seeking out an angel investor, here are some things to consider before building a relationship.
- The target company should have a securities attorney and an advisory board which maintains direct contact with the management to draft a comprehensive business plan for the angel investor prior to consideration.
- On average, angels select 30% of solicited investments. Common reasons for rejections include lack of growth potential, lack of management acumen, lack of key personnel in key positions, and overpriced equity.
- Decide what the required rate of return will be for your invested angel capital – there is no set range, but generally, angels would like to see a conservative rate of return of 26% over five years or an aggressive plan that it return up to 5 times the original investment within the first five years. This must be a realistic goal mutually agreed upon by both the angel and the company.
- Angels usually seek to own 5-25% of a business. This can be in common or preferred stock with liquidation priority over common stock. You must set rules with the company and bar them from share-diluting stock sales at lower prices to raise capital, or issuing additional stock to current management. Should this be a point of contention, the angel investor has the right to ask for price protection, anti-dilution provisions that grant them more shares to balance out diluting shares or gifts.
- It is essential that angel investors seek a board position or consulting role, and maintain a frequent degree of communication with the invested company. Calling for monthly or weekly meetings with you to keep a finger on the pulse of the company. This also helps builds a positive relationship between you and the company.
- As a company shrinks, grows, or rides on market fluctuations, it will inevitably need a second round of financing. When this occurs it must be clarified as an angel investor you retain your seat on the board, or if you retain a percentage ownership regardless of growth?
A solid business plan, which a small business should meticulously prepare, for an angel investing scenario should take into account the following:
- Industry Peers – which competitors it faces in the current market, and their strengths and weaknesses.
- Company Summary – what the business specializes in, its target market, and competitive advantages.
- Market Environment – an analysis of whether or not the market is fertile for the development of the business’s products or services.
- Business Metrics – gross and operating margins, free cash flow.
- Forward Marketing Plan – advertising and PR strategies.
- Design and Development Plan – how to continue expanding the pipeline for new products, the intended direction of the existing product lines.
- Financial Plan – taxes, profit and loss forecasts, cash flow reports, and comprehensive balance sheets with five-year projections.
- Proposed Company Offering – how the company intends to compensate the angel investor, desired financing, timetable, and aforementioned special terms and stipulations.
While this is by no means a comprehensive guide, it will hopefully give you, as either a potential angel investor or small business owner, a better understanding of things to take into consideration before diving into this kind of investment relationship.