Note On Angel Investing
Note On Angel Investing
Note On Angel Investing
Introduction
An angel investor is an individual that uses his or her own cash to invest in early stage
companies. This note describes the fundamentals of angel investing, compares angels
with venture capitalists, and offers suggestions for best practices among entrepreneurs
and angel investors.
Company founders have a plethora of choices when they want to raise capital, including:
• Personal savings
• Credit cards
• Lines of equity
• Second mortgages
• Friends and family
• Government grants
• Asset based loans
• Accounts receivable factoring
• Business loans from banks
• Institutional investors (arranged through investment banks)
• Equipment lease financing
• Corporate strategic investors
• Angel investors
• Venture capitalists
• IPOs
This document was developed by Adjunct Assistant Professor Fred Wainwright and updated by Research Associate Angela
Groeninger as a basis for class discussion rather than to illustrate either effective or ineffective management. The authors thank
Frank Ruderman T’72 for his editorial comments.
Bill Gates, for example, still owns a substantial portion of Microsoft, whereas most
founders see their percentage ownership diluted to less than 5% after numerous rounds of
financing and public stock offerings. Fortunately, if the company has reached an IPO
stage, the small slice of a very big pie allows those founders to achieve a multi-million
dollar net worth.
Angel investors are so named because in the early 1900s wealthy individuals provided
capital to help launch new theatrical productions. As patrons of the arts, these investors
were considered by theater professionals as “angels.” Estimates of the number of active
angel investors in the US vary widely because there are no registration requirements. The
SEC Rule 501 states that an “accredited investor” is a person with a net worth of at least
$1 million or annual income of at least $200,000 in the most recent two years or
combined income with a spouse of $300,000 during those years. According to Forrester
consulting, the number of households in the US that fit that profile is approximately
630,000. The power of angels lies in the sheer number of companies they fund. Some
studies suggest angels invest in 10 to 20 times more companies than VCs.
Angels fill a critical capital gap, between “friends and family” and VCs. When a startup
requires more than $25,000 but less than about $1.5 million, angels are a viable source of
capital. This level of funding is below the radar screen of most venture capitalists,
although some VCs will occasionally fund a seed round of as little as $500,000. Angels
usually invest using preferred stock, which offers the owner more rights than common
stock, and typically acquire 20-30% of a company in the first round of financing. They
like to make a return of 5 to 10 times their initial investment in order to achieve a return
on their own portfolio of between three and five times their investment.
Why don’t angels simply invest in VC funds? According to the European Private Equity
and Venture Capital Association, in the past 10 years European VCs have produced a
14% return to their investors. In the same period, according to the National Venture
Capital Association, VC’s in the US have produced a return of 26%. Angels, though, are
not just driven by returns. They typically fund a venture in its seed or startup stages, and
if the business survives, subsequent rounds are often provided by venture capital firms.
Despite the illiquidity and risk involved in this type of investing, angels believe the
benefits of unlimited upside potential and the experience of building a business far
outweigh the costs. They have a strong emotional stake in investing and enjoy coaching
others and the rush of fast-paced company growth.
During the past few decades, VCs have raised larger and larger pools of capital and since
the time and expense of reviewing and funding a company are the same, regardless of
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size, it is far more efficient for VCs to fund larger transactions. It is important that angels
continue to be actively involved in investing because without seed stage financing, the
country’s entrepreneurial force loses its energy.
Angels VCs
Funding amounts $25,000 to $1.5 million $500,000 and above
Motivation to invest Not just return driven, strong Mostly return-driven with
emotional component (“bragging adjustments for relationships with
rights”, psychological benefits of other VCs and reputation among
coaching, rush from being involved entrepreneurs
in fast paced startups)
Accessibility Prefer anonymity, reachable via Highly visible, usually will only
referrals or through angel groups look at business plans referred by
their network of contacts
(attorneys, etc.)
Geographical focus Regional, within 4 hours drive time Regional, national or international,
depending on the firm
Key reasons to invest Personal chemistry with Nearly developed product,
entrepreneur, detailed market operating history, strong and
analysis, sustainable competitive experienced team, sustainable
advantages competitive advantages
Number of investments Less than VC firms because have the More than angels because need to
luxury of being selective make a minimum number of
investments in a given year
Term sheet issuance Relatively fast (one day to three Can be fast, but usually is at a
weeks), terms are somewhat moderate pace (several weeks),
negotiable (more than with VCs) terms are fairly standard and not
very negotiable
Investment vehicle Common or preferred stock, Preferred stock (convertible to
occasionally convertible debt (debt common)
convertible to equity shares)
Equity percentage 10% - 30% 20% or more
Typical post-money $250,000 to $10 million $5 million and above
valuation of startups*
Due diligence Relatively fast and light Relatively slow and methodical
Funding process Lump sum or milestone Lump sum or milestone
Long term value added Operational experience, common Experience in managing growth,
sense advice, specific industry deep pockets, networks of
expertise additional sources of capital,
rolodex, experience in managing
IPOs and sale exits
Reaction to bad news Roll up the sleeves and help solve the Intense communication and
problem, open up rolodex coaching; open up rolodex; help
structure joint ventures, new
financing rounds or mergers; fire
management
Target exit time 5 to 7 years 3 to 5 years
Target IRR returns 15% to 25% 20% to 40%
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* For a description of basic valuation concepts, see the valuation section below.
Angels can add tremendous value to startups. On the other hand, angels are humans and
are subject to their personal idiosyncrasies. One or more of these characterizations may
apply to an angel:
Guardian angel
This type of investor has relevant industry expertise and will be actively involved in
helping the startup achieve success. He or she has a strong rolodex of contacts and has
the experience to add substantial value as a board member.
Operational angel
This angel has significant experience as a senior executive in major corporations. For an
entrepreneur, this type of investor can add much value because he or she knows what the
company needs to do in order to scale up operations.
Entrepreneur angel
An investor that has “been there, done that” is very valuable to a novice entrepreneur. For
example, an entrepreneur can add perspective to the founders on what to expect from
investors and how to effectively negotiate financing terms.
Hands-off angel
A wealthy doctor, attorney or similar professional must focus on his or her day-to-day
career. This type of investor is willing to invest but usually does not have the time or
specific expertise to be of much help to the startup.
Control freak
Some investors either believe they have all the answers because they have achieved
certain wealth or they have the personality to convince themselves they know
“everything.” Caveat emptor.
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Lemming
Some angel investors will not make a decision unless an informal leader in the angel
group invests or makes positive comments about a startup. Success breeds success - even
a term sheet from one or two small investors can allow an entrepreneur to access larger
investors, who usually become more interested when they find out that fellow investors
have committed. Some lemming investors are particularly astute at leveraging the work
of other investors whereas other lemmings simply trust blindly in the due diligence and
term sheets of fellow investors.
Angel investors increasingly join one or more informal or formal groups. There are
various advantages of working in groups:
• Social bonds and networking
• Access to pre-qualified deal flow
• Leverage intellectual capital and expertise of individual members
• Learn from each other regarding deal evaluation skills
• More extensive due diligence capability
• Alignment of members’ interests
Names and contact information, if available, of angel groups in the West Coast and
northern New England are shown in Appendix 1.
Annual fees in angel groups are usually in the range of $100 to $2000 per member. These
fees cover meals, conference rooms and administrative staff.
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Sometimes, if an entrepreneur presentation is weak but the idea has merits, the
entrepreneur will be coached on what to do in order to be able to present in a future
meeting. Occasionally, the entrepreneur is matched with an angel that is willing to coach
the entrepreneur (informally or for a fee) in order to raise the quality of the business to
fundable status. Some angels specialize in helping entrepreneurs write business plans and
develop their strategy.
Angel groups occasionally band together with other angel groups to share due diligence
and invest sufficient capital to complete a round of financing.
Too many entrepreneurs limit their opportunities by writing weak business plans. Great
ideas are common; much rarer are businesses with the people and products to enter a
market and take share or dominate. Only 1 % to 2% of all business plans presented to
angels or VCs receive funding.
Some of the key factors of a business plan that improve the success potential of a startup
are shown below.
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Table 2 – Success Factors
Factor Description
Management • Years of operational experience in a similar industry
• Startup experience with a similar business model that led to a
successful exit
• Willing to be coached
Market • Addressable market that is fragmented and growing
• Customers already lined up
Technology • Patent protected
• Creates strategically defensible position
Competition • Shows that company has some competition, regardless of
product or service
• Clearly summarizes competitors and key threats
Business model • Similar to one or more used by successful companies
• Demonstrates that customers have real pain that product or
service solves (“must have” vs. “nice to have”)
Exit strategy • Identifies target acquirers
• Shows deal history of acquisitions and IPOs with key financial
multiples and ratios
Risks • Objectively assesses risks and describes actions to reduce,
mitigate or eliminate them
Financial projections • Shows conservative, expected and targeted figures with
assumptions for each
• Focuses on cash flow and profitability
Capital structure • Detailed
• Preferrably shows ownership by founders and only small
numbers of unprofessional or inexperienced investors
Investment desired • Places an offer on the table - indicates valuation
• Shows uses of funds in detail
• Details expected future rounds and uses of funds from each
round
One thing is certain about any business plan: it will be wrong. Projections will change.
Teams will change. Competitors will surge or fade. Most successful companies make
radical changes to their business plans as managers discover the reality of their situation
versus their original expectations. Thus the experience of a management team is critical
in order to handle sudden changes in strategy. Angel investors play a critical role in
helping management teams make adjustments and prepare for venture funding.
Valuation is much more of an art than a science, especially for companies with no
revenues or profits. In theory, a company is valued based on its ability to generate cash in
the future. These future cash flows can be discounted using basic financial formulas in
order to estimate the sum total of value today of all future cash flows.
For companies without positive cash flow but with revenues or net income, comparisons
can be made with publicly traded companies in similar industries. For example, if ABC
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startup is in the medical software business, and publicly traded companies in the same
industry trade for approximately 2 times annual sales, then it is reasonable to estimate the
value of ABC as somewhat less than 2 times its annual sales. Usually a discount of 10%
to 40% is made for private companies due to the fact that their stock is not publicly
traded and the likelihood of matching willing sellers and buyers of private stock is fairly
low.
If a startup has no revenues, then valuation is subject to much negotiation and relies more
on common practices of angel and venture capital investors. A “hot” company with
patents or competitive advantages and potential for hundreds of millions of dollars in
sales will certainly command a larger value than one with tens of millions in potential
sales, but hard rules are difficult to establish in the investing industry. Angels commonly
value seed-stage, concept-type firms at around $4 million while venture capitalists prefer
to invest in early stage companies that they value at $10 million and higher. The
following table lists some common valuation methods that angels might use when
investing in a company.
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Table 3 – Examples of Valuation Methods
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Exits
Angels need to exhibit a level of patience with their investments and understand that they
will not likely recognize a return for a number of years. Angel investments are usually
illiquid until some form of an exit strategy is employed. The founders should include
their exit strategy in the company’s business plan, and it should be agreed upon between
the entrepreneurs and the investors. Although market conditions may cause the exit
strategy to change, investors want to know the plan as well as the time frame for
harvesting their investment. The following list details some of the most common
harvesting methods:
During the “boom”, the large number of angel investors can be attributed to the fact that
while some of them had both wealth and experience, many lacked the industry expertise
characteristic of this type of investing. Less due diligence, a shorter period to exit, and
less value-added contributions became common during this period.1 After the stock
market debacle in early 2000, angel investor groups had a difficult time. Many early stage
companies lost customers or ran out of cash. Of those startups that survived, many had to
reach out to venture capitalists who insisted on significantly reducing the ownership
percentage of previous investors, including founders and angels.
During times of major decreases in startup valuations from one financing round to the
next, the VCs’ basic message to earlier investors was “if you can’t invest in the company
in this new round of financing to keep it alive, then you don’t deserve to own much of it.”
This is similar to a poker game; those players who are unwilling to up the ante lose
everything they placed in the pot in previous betting rounds. Tough, but fair.
Some of the larger angel groups have either formed their own funds or joint ventured
with venture capital funds in order to ensure that young companies have the necessary
funding in subsequent rounds to grow rapidly. Thus the angels are better able to monitor
their investments as the startups achieve greater growth.
1
Cutting Edge Practices in American Angel Investors, John May and Elizabeth F. O’Halloran, The
Darden Batten Institute,
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Tenex Greenhouse, for example, is an angel group in California that launched a $20
million venture fund using angel and institutional capital to support successful angel-
funded startups. Tenex Greenhouse also offers intellectual capital, leveraging its
members’ functional specialties and industry experience to provide support to funded
startups.
The well known Band of Angels, started in 1995 in Silicon Valley, now has a $50 million
VC fund with capital from institutional investors. From another perspective, VIMAC is a
VC fund in Boston that has a network of over 200 angels who can co-invest on selected
deals, especially ones that require more advisory work.
Milestone financing is becoming more common. Investors mitigate their risk by setting
operational targets for the startup that need to be met before another portion of funding is
made. The pricing and terms of the milestone funding is pre-set to avoid excessive legal
costs.
More recently, angel investing has returned to a more sustainable condition. Individual
net worth has declined, but so have deal values. Therefore, while angels are investing
about half of the average deal price compared to 2000, their equity received per deal
remains relatively unchanged, in the +20% range. Angels have returned to their normal
practices of conducting stricter due diligence reviews and exhibiting patience when it
comes to exit strategies.2
Always be on the lookout for opportunities to help the startup. An angel often has
industry networks that can be great sources of valuable information. Entrepreneurs can
become so focused that they do not realize major trends are shifting or simply do not
have time to network appropriately if they are deeply involved in product development,
for example. Angels can be the eyes and ears of startups, and angels can help find good
potential employees through social networks. Angels can also find other angels and
venture capitalists for further rounds.
Diversify your risks by investing smaller amounts in more startups. Angel investments
should be less than 10% of your portfolio, due to the risks of potential losses. The
portfolio approach is key: estimates suggest that angel investors lose their investment in
one-third or more of the companies they fund. Set aside at least the same amount you
invest in a startup so you can make follow up investments in future rounds. This will
allow you to retain your percentage ownership or at least mitigate its dilution.
2
Ibid.
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Fund deals that you’ve shown to venture capitalists who have indicated they will fund
future rounds if certain operational goals are met.
Know the ramifications of term sheet clauses in both upmarkets and downmarkets.
Appendix 4 describes details of term sheets.
Angels who lead the due diligence process and sit on a board on behalf of other angels
should be compensated with a small percentage of equity. The best board members are
angels with relevant operating experience, not those with the deepest pockets.
Do not overcontrol the entrepreneur. There is a reason why the entrepreneur has started
his or her own company: he or she prefers to run the show. Even though an angel has
provided capital that does not give the angel the right to wrest control from the founder,
except of course if the business is not meeting its operational goals.
Only 1% to 2% of all business plans presented to either angels or VCs receive funding.
Entrepreneurs need to read the necessary books and speak to individuals with financing
experience or expertise so when the opportunity arises, they are fully prepared to present
their concept to investors. Incomplete business plans are unacceptable in today’s
competitive environment.
Ideas are a dime a dozen. Fundable businesses are those that can demonstrate that they
have the products and people to enter a market and either take significant market share or
dominate.
Entrepreneurs should use informal networks to be referred to individual angels and VCs.
It vastly increases the chances that a business plan will be reviewed. Also, entrepreneurs
should target investors that have a history of interest in a sector or the stage of a business.
An entrepreneur should invest capital in his/her own startup. Not doing so is a major red
flag for investors.
During the initial conversations with an angel group and during the presentation to the
angels, it behooves the entrepreneur to find out which of the members are the real
decision makers. This is difficult to ascertain but can be very valuable information
because angels are human and they feel safety in numbers. The entrepreneur should focus
on the more experienced angels and the managing directors of the angel group.
If groups of investors are interested, it is far better for them to invest as an LLC (limited
liability company) than as individuals. VCs are weary of complex capitalization
structures and an entrepreneur risks losing access to larger amounts of capital. In
addition, major company decision making can become unwieldy if large numbers of
investor/owners need to be consulting. This process can become like herding cats.
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Finding an angel investor is like finding a spouse. Personal chemistry is critical because it
is a long term relationship. This chemistry may take time to build so invest quality time
in getting to know the angel. If you are dealing with a group of angels, it is the lead angel
that will be on your board or that will manage the investment on behalf of others that
should be your focus. It is far better in the long run for an entrepreneur to turn down an
angel investment because of lack of chemistry and wait for a better match.
Investors need to be kept appraised of the company’s progress at least quarterly if not
monthly. If there are problems, investors should know early about them. Involving them
in developing possible solutions or finding the right people to help is a wise course of
action. Waiting until the last minute before disclosing major issues entails the risk of
lawsuits from an investor for fraud or misrepresentation.
Conclusion
Entrepreneurs are responsible for knowing basic financing concepts, preparing well for
investor presentations and choosing their financing partners carefully. A company can
sometimes survive operational mistakes, but running out of cash means the company
ceases to exist. By having a good understanding the financing process as well as the pros
and cons of financing methods, entrepreneurs will increase the likelihood of their
company’s survival and long term success.
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Appendices:
1. Angel groups in the West Coast and northern New England
2. Reading list
3. Typical angel questionnaire
4. Typical financing term sheet concepts
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Appendix 2 - Reading List
The Angel Investor’s Handbook: How To Profit From Early Stage Investing, Gerald
Benjamin and Joel Margulis, Bloomberg Press, 2001
Winning Angels: The 7 Fundamentals of Early Stage Investing, David Amis and Howard
Stevenson, Prentice Hall, 2001
Angel Investing: A Guide For Entrepreneurs, Robert Robinson and Mark Van
Osnabrugge, Jossey-Bass Publishing, 2000
Every Business Needs An Angel, John May and Cal Simmons, Crown Publishing, 2001
Business Angel Investing Groups Growing in North America, Marianne Hudson, Susan
Preston, Mike Franks, James Geshwiler, John May, Robyn Davis, and Mary McNamara,
Ewing Marion Kauffman Foundation, 2002
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Appendix 3 - Typical Preliminary Questionnaire From Angel Groups To
Entrepreneurs
• Name of company:
• Year founded and legal structure (“C” Corp, “S” Corp, LLC, etc.):
• What is the size of the market, how much has it grown in the past few years, and what
is its projected growth?
• Does the company or its founders have any relevant patents or proprietary
technologies? (please do not reveal specific proprietary information)
• What is the relevant experience of each member of the management team? Please
enclose a one page resume of the CEO.
• What are the major short, medium and long range operational milestones you intend
to achieve?
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• Please complete the table below:
• What is your capitalization structure? (How many shares are currently owned by
founders and investors? How much capital has been invested so far, and by whom?)
• How much capital are you seeking, and how will this capital be used?
• How many rounds of investment and what amounts do you expect to need in total?
• Please list the name and company of your professional advisors (attorney, CPA,
and/or consultant):
• Who is the main contact person at the company? Please provide address, telephone,
mobile phone, and fax:
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Appendix 4 – Typical Term Sheet Clauses
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