More than ever, angel investing is redefining how cash-strapped startups are able to secure funds to help scale their operations.
But the ins and outs of angel investing aren’t so clear cut.
By comparison, there’s a lot of “common wisdom” being dished out regarding what it takes to succeed in investing.
Most of this “common wisdom”, however, doesn’t apply when it comes to angel investing.
Investing in startups and picking profitable stocks to buy, for example, are two very different ball games.
It’s my hope that by the end of this piece, you’ll be able to understand these four things:
- What to expect when you’re starting out as an investor in startups.
- If you’re really cut out to be an angel investor.
- How profitable angels do it and how you can emulate a proven model that works.
- The not-so-rosy side of being an angel investor.
With that in mind, let’s dive right in.
Who Is an Angel Investor?
Angel investors come from all sides of the economic spectrum.
They can be professionals such as lawyers or engineers and business associates.
Better yet, an angel can be a serial entrepreneur with a keen interest in cultivating the best investing and entrepreneurial culture for the next generation.
Generally, angels are wealthy individuals willing to sink thousands of dollars in a startup in return for a piece of the action (read: equity).
According to the Securities Exchange Commission (SEC), angels are categorized as accredited investors.
An accredited investor is an individual with a net worth of at least $1 million and earns $200,000 annually.
Angel Investors Vs. Venture Capitalists?
A popular public misconception is that angel investors and venture capitalists are one and the same.
Although they share a common goal – providing capital to business ventures for start-up or expansion – they have some important differences to note:
- Angel investors are individuals. Venture Capital usually represents a professionally-managed company or business rather than an individual.
- Venture capital usually comes on board at a later stage after proof of concept. Angel investment comes in during the early stages of a start-up
- Compared to angel investing, the invested amounts are higher in Venture Capital because their business is to pool funds from different investors. Investment amounts are upwards of $1 million. An Angel investment is usually less than $300,000 per deal.
- A seat on the board is required for Venture Capital. On the flip side, angel investors can choose to either be “hands-on” or “hands-off” in the active management of their angel investment.
Will It Thrive or Crash? The Art of Valuing an Early-Stage Startup
Before committing to an investment, any angel who’s worth their salt will always be quick to ask these two questions:
All hype aside, what is the startup really worth?
Will it get to a good exit point and return a profit?
But valuing a company before it has any financial statements to refer to or revenues is pretty difficult.
That’s why establishing the pre-money valuation of a pre-revenue startup is often the first point of deliberation between an angel and the entrepreneur.
Entrepreneurs are always gunning for the highest possible valuation they can get for their companies.
But the lower it is, the better it is for you as an angel investor.
You want the value to be low enough so that the amount you invest translates to a reasonable portion of the company’s equity.
There are many valuation methodologies that can be applied to value pre-revenue startups.
But these three take a holistic approach and offer an excellent starting point for angels and entrepreneurs:
Discounted Cash Flow (DCF). Calculates cash generated by future projects and discounts this capital using the weighted average cost of capital (WACC) to derive a present value.
If the DCF value is higher than the initial investment, this points to a potentially profitable investment that should be considered.
Venture Capital Valuation Method. Valuation is based on expected ROI at the point of exit. It usually applies where investors are looking to exit their angel investment in 3 -7 years.
The Berkus Method. Attributes dollar values to the headway startups have made in their commercialization efforts.
Instead of focusing on a single method, it’s advisable to use a combination of these methods to get an average figure.
This way you’ll be in a better position to identify and negotiate a better deal.
Unfortunately, most early-stage companies have a little-to-no history of past revenue and earnings which can negatively affect the final valuation.
Evaluating Different Business Models
To bridge this gap, angel investing calls for an in-depth evaluation of a start-up’s business model as well.
Instead of focusing on the popular Business Model Canvas to evaluate a start-up’s overall strategy, an economic approach is more sensible owing to the complicated nature of these business models.
When using the economic approach to review a company’s business plan, the first step is to sort out all the information provided into four economic sets:
- Unit economics. The direct selling price and costs associated with a product or service.
- Buyer economics. This is how the company plans to acquire, retain, and support its customer base.
- Market dynamics. What the entrepreneur has to do to actually create a buzz about the product or service.
- Business economics. Any overhead costs, handling of finances, and general running of the company all fall into this category.
These economic sets give you a clear picture of how much money an entrepreneur needs before their company can become self-sustaining.
According to Baumann, the final and most crucial step in valuing an angel investment is analyzing the scalability and break-even-point of the business model.
Scalability and Break Even Point
In business terms, scalability is the relative ease with which a company expands its operations while incurring minimal incremental costs.
This is a key pointer to whether the company you want to invest in will be a winner in the long run.
It’s advisable that when angels meet with entrepreneurs they understand the scalability plans of the company.
Are they planning for 5X, 10X or 200X growth from where they are currently?
Knowing these metrics comes in handy when you’re calculating how much money the start-up needs and how many rounds of funding it will require.
A company with a planned 100X growth, for example, is likely further along in their expansion plans.
Such a company will offer a better exit and return on investment than a company that’s just starting to scale its operations.
In view of this, it’s important to note that some business models are great for scaling while others – companies which require considerable personnel involvement, a lot of customization, and consulting – are not easily scalable.
Key giveaway: Business models that focus on scalability at the expense of customer experience are not sustainable and should be approached with caution.
It’s advisable to pursue a business model which tries to strike a balance.
Ideally, it should be highly scalable and at the same time focusing on addressing consumer pain points.
That’s how big brands are able to stay in business and dominate huge market segments (they identify these pain points and come up with effective solutions).
Mistakes and Pitfalls to Avoid as a First-time Angel Investor
I must admit, it’s tempting to go out guns blazing as a new investor in the current start up scene.
Picture this scenario: the entrepreneur is a young, charismatic, and intelligent lad.
The product? Cool and trendy with ground breaking technology behind it to boot.
Investing in such a company might seem like an easy and sure win.
But looking at the bigger picture before making that all-important decision can make the difference between making a profit or suffering an avoidable loss.
You shouldn’t only be evaluating angel opportunities at face value.
Every investment you make as an angel should blend into your overall angel investing strategy and wealth building strategy.
Experienced angel investors like Bill Payne – a long-time angel and a member of the Frontier Angel Fund in Montana – share a lot of good advice for those just starting out.
“Most of us who’ve been doing this for a while encourage new angels to do what we say and not what we did,” offers Payne, who has made over 60 angel investments in a span of three decades.
“Most of us started off by writing checks then later asked – what’s my real strategy? ”
To avoid learning the hard way, it’s critical to understand these 5 factors:
- The risks of being an angel investor.
- Why it’s important to diversify your portfolio.
- Your risk tolerance – are you able to stomach large swings in the value of your assets?
- The total sum to invest as an angel and how much to apportion each deal.
- What you’re passionate about and how it applies to your overall angel strategy.
Angel Investing Key Risks
One thing to always remember is the level of risk associated with investing in early-stage companies in general.
In fact, most of these investments and companies won’t work out.
For example, for every 10 angel investments, investors encounter 5 failures and 3 or 4 investments which will only bring a modest ROI (Return on Investment).
To sum it up, how well your angel investment portfolio performs will be hinged on the success of just one or two companies (out of the 10).
From these few successes, you can expect an ROI of 10-30X.
With these numbers painting such a grim reality, angels have no choice but to diversify their investments.
This helps to minimize risk and optimize the returns they make.
Based on expert opinion and best practices developed by some of the most profitable angels, the guidelines below show you how aspiring angels can leverage risk and diversify their angel investments.
Achieving a Diversified Angel Investing Portfolio
We’ve heard too many disheartening stories about angels who wrote a single big check and lost all their investment cash after the company they’d invested in failed.
Which begs the question: how much of my entire investment portfolio should I allocate to angel deals?
Well, there’s really no right or wrong answer to this – it’s what you feel comfortable with.
Designating 3-10% of your investment portfolio to angel investments is ideal for a start.
Also, to avoid losing a huge sum of money on a single investment, you should initially plan on investing in at least 10 start ups over a pre-defined period.
It makes sense to invest in one or two companies annually and waiting for at least 6 months before making your first investment.
This way you get to learn from more experienced angels as you carry out your own due diligence on the company.
But keep in mind that investing in multiple companies will probably require multiple rounds of funding as well.
Therefore, it’s wise to split up your angel investment pot into equal shares.
Figuring out how much of your investment portfolio you’ll commit to angel deals and the total number of companies you’d like to invest in will guide you on how to size up each investment.
The sweet spot for most angels is allocating $5,000 – $60,000 per round for each investment.
Picking Which Companies to Invest In
Another important piece of the puzzle is knowing beforehand the kind of companies you want to put your money into.
Here you’ll require some level of introspection to determine what matters most to you and the driving force behind it.
Although no two angels are alike when it comes to passion and drive, many choose their investments based on a combination of these factors:
- Past experience or affinity with a specific industry – which has also been linked to greater returns.
- Participation. Angel investors have a higher chance of success when they’re able to interact with the companies in their portfolio a couple of times a month by coaching or mentoring, for example.
- Do you want to support a company that you have a kinship for? An example is a business owner and angel investor who graduated from the same university.
- If you’re a retired investor, you’ll probably prefer an angel investment which gives you the opportunity to practice the business skills you already have.
Taking all this into consideration will open up your eyes to the broader implications of angel investing.
Hunting for Deals: Angel Investing Like a Pro
Some of the most sought after angels like Paige Craig and Chris Sacca have some advantages over most angels just starting out.
They have solid online reputations spanning decades and vibrant networks in their relevant fields.
Every day it’s getting more and more difficult to develop the kind of skills and business networks which can help you gain a competitive edge.
What’s even more discouraging in today’s angel investment scene is how boatloads of money keep chasing the diminishing number of capable entrepreneurs.
Well, there’s a solution to at least some of the above issues if you’re still determined to become a profitable angel.
Enter: AngelList Syndicates
This is one of the safest and most reputable avenues which small-time investors with little to no connections can take to land a profitable angel investment.
Through AngelList syndicates – started by a revolutionary company called AngelList – wealthy individuals can pool their money with an already established angel.
This system gives investors (or Leads) a platform where they can meet other accredited individuals (known as Backers) who want to share in their deals.
Generally, Leads are responsible for sourcing and supporting the angel investment for a share of the proceeds.
AngelList collects 5% of the profits you make from your investment while the angel investor (Lead) gets 15% – the remaining portion goes to you as the backer.
Most renowned angel investors – including Paige and Chris mentioned above – have a syndicate on AngelList.
Other promising syndicates you can consider joining are owned by Tim Ferriss and Jason Calacanis.
Related Read: The Good, Bad, and Ugly of AngelList Syndicates
Conclusion: Angel Investing Generates Wealth, But Also Helps Companies Grow
Granted, angel investing looks quite lucrative on paper, but you’ll still need to put in the work to get the kind of results which make investing in start-ups worthwhile.
If you’re seriously considering angel investment, it’s important to remember that this journey is all about growth and uncertainty.
In my opinion, when you choose to invest in an early-stage venture, helping the company grow should take center stage – not how much you stand to make from the deal.
Eventually, the money will start trickling in when the company is on a more stable trajectory.
I’d like to keep the conversation going – so if you have any questions/thoughts about the tips shared here or more ideas on how to become profitable with angel investing, feel free to leave a message in the comment box below.