Angle Investing and Venture Capital
 

So you’ve decided to enter the world of angel investing. Perhaps you find the startup ecosystem fascinating and have accumulated some capital to invest in this growing asset class. Whether you’re just beginning your journey as an angel investor or you’re a seasoned startup investor, be sure to thoroughly read through this guide or bookmark it for future reference.


Angel Investing & Venture Capital

Angel Investing is the act of making investments in the venture asset class. Companies that issue securities within the venture asset class are typically early-stage startup companies with the potential to experience, or are currently experiencing rapid growth. Angel investments are inherently illiquid, long-term investments. Because of the high risks associated with angel investing in the illiquid securities issued by a fledgling company, investors demand a much higher return on an angel investment than they would on investments in publicly traded companies.

Venture Capital (VC) is an asset class comprised of financial securities issued by early-stage companies prior to an initial public offering (IPO). VC financing is a commonly used fundraising medium for companies experiencing, or having the potential to experience rapid impending revenue and/or employee growth. In the United States, individual investors have become fast-growing consumers of the VC asset class since the passage of Title III (Regulation CF) and Title IV (Regulation A+) of the Jump Start our Business Startups (JOBS) Act clearing the path for equity crowdfunding.

Legal Qualifications to Engage in Angel Investing

Access to angel investing opportunities have historically been exclusive to accredited investors and investment companies, but that is no longer the case. Title III and Title IV of the JOBS Act has provided similar access to investors under Regulation A+ and Regulation CF+. Would-be investors who do not meet the elite financial standards of accredited investor status can now invest in many companies under A+ and CF. In light of these changes, angel investing and VC in general has taken on new form and definition in capital markets.

There are some angel investments that are still exclusive to accredited investors though, like private placements under Regulation D. Ordinarily, companies that sell securities to the public must register their offering with the SEC. There are some exemptions for companies that are selling their securities only to accredited investors. These exemptions are the legal basis for most startup investments. The rules define an “Accredited Investor” as anyone who earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

Understanding How Angels Fit Into the Funding Landscape

Angel investors and venture capitalists both play an important yet distinct role in the financial life-cycle of a startup company. Venture capitalists typically invest in startup companies at a later stage than angel investors. VCs make an investment after a startup has been validated in some form (metrics, customers, revenue, etc.) in order to provide capital to help grow the company and acquire market share. An angel investor will usually invest after a company raises money from friends and family (the first money a startup raises from outside investors) during a company’s Seed or Series A round (or an intermediate round known as a “Bridge” round). Rather than investing in companies with long proven track records, angels typically fund companies that have developed a Minimum Viable Product (MVP) or prototype, or have achieved some substantial technical development and early market entry.

The nature of the money invested by angel investors and venture capitalists differs as well. Venture capitalists tend to make larger investments in startups, pooling the investments of multiple individuals and entities. Angel investors make smaller investments as individuals with their own money. The timing and nature of angel investments grant the potential for a large payoff but at the cost of increased risk.

Understanding the Angel-Entrepreneur Relationship

The nature of an angel investor’s relationship with an early stage company makes angels particularly attractive to entrepreneurs. Angel investors don’t typically ask for board seats or additional rights, technically making them “passive investors.” This doesn’t mean that angels are not actively involved in helping the startups in their portfolio. As an angel, you can contribute significant value beyond your monetary investment. Angel investors can leverage their personal and professional networks to introduce entrepreneurs to potential customers, suppliers, distributors and new hires. Angels can lend their expertise to help startups grow, bringing a fresh perspective to a startup’s challenges. Angels with commensurate enthusiasm and experience can be tremendously beneficial, becoming brand evangelists for a startup.

However, it’s worth noting since the passage of Title III of the JOBS Act the average angel investment amount has decreased. The voice of an angel investor risking $1,000 into a deal versus another angel investing $25K+ into the same deal will likely have different levels of influence, especially when the pre-money valuation of the respective company is very low — less than $1 Million – $3 Million. Nonetheless, Angel investing provides a unique opportunity for individuals to engage in impact investing and add value to early-stage companies by providing startups with much needed capital, strategic connections and valuable advice.


Angel Investing – Types of Securities

Common Stock

Common shares are ordinary company shares most commonly held by founders and employees, although there are plenty of exceptions where early investors have also invested into the common shares. Common stock is the simplest form of equity. Common shareholders are generally granted voting rights, but can be limited and often have lesser rights than those granted to preferred shareholders. Most significantly, common shareholders can only claim their share of a company’s assets after the claims of debt holders and preferred equity holders (in that order) have been met.

Preferred Equity

Preferred equity is usually issued to outside investors and carries rights and conditions that are different from that of common stock. For example, preferred equity may include rights that prevent or minimize the effects of dilution or grants special privileges in situations when the company is sold.

Convertible Note

A convertible note is a unique form of debt that converts into equity, usually in conjunction with a future financing round. The investor effectively loans money to a startup with the expectation they will receive equity in the company in the future at a discounted price per share to future investors. You can learn more about convertible notes here.


What is Carried Interest?

The simplest way to think about carried interest is as a performance fee. Carried interest is also called carry, promote or performance fee. In the world of venture capital and private equity, it is a share of the investor’s profit that is paid to the manager of a fund.

Carried interest in and of itself is not a bad thing – it creates an incentive for fund managers to put investors’ money to productive use and make sound investment decisions on their behalf (because if the fund doesn’t perform well, the manager doesn’t receive any carry). However, in the world of equity crowdfunding, carried interest can be a significant cost to the investor and one that misaligns platforms and investors.

See examples of carried interest on portfolio carry and per-investment carry.


Risks of Angel Investing

Angel investments are going to be among the riskiest you have in your portfolio, even if they are at a later stage. There is a very small chance that any individual investment you make will ever see a liquidation event, so when that coveted liquidation event does occur, it should have a chance of being big enough to offset a significant amount of losses in other investment you’ve made in the venture asset class.

Fully understanding all of the risks is of crucial importance when evaluating any investment opportunity. A detailed explanation of startup investment risks, security risks, and business risks can be found in our Startup Investing Risks guide.


Evaluating an Angel Investment Opportunity

Term Sheets & Pitch Decks

Term Sheets: A term sheet is a non-binding agreement between a company and investor (or investors) that outlines the proposed terms under which a potential investment will be made. However, the term sheet is not a legal contract in and of itself. It provides a foundation for negotiations between the issuer and investor.

Pitch Decks: Different investors have different priorities when assessing a potential startup investment. In an investor presentation or pitch deck the entrepreneur will summarize the key points about the business that they think are relevant to investors. The pitch deck provides a useful starting point for evaluating a company, but investors should also take the time to review the other materials provided in the data room.

This is a very brief overview of the full scope of term sheets and pitch decks. If you’ve never seen one before, or just want to learn more on this topic, you can check out our post on How to Assess a Startup Investment in the SeedInvest Academy.


Digging Deeper into Evaluating an Angel Investment

Seedinvest tries to do its best to help screen out the noise, but your angel investing journey may take you beyond the scope of what is offered on SeedInvest. Here are some tips in evaluating a potential investment:

  • In earlier stage investments, you’re investing in people – not a company.Look for a strong management team. The lowest risk teams are those with several members who have experience bringing companies from inception, through the fundraising process, and onto an exit of some kind at a lofty valuation. Management teams with these a-list type leaders will generally demand a premium on their valuation in this scenario, but an argument for that premium based on strength of team may be justified. Higher risk teams are made up of first-time entrepreneurs, c-level team lacking skill-sets in core team members in order to execute the next step of the corporate vision, and generally speaking less experienced people at the helm.
  • Look for companies and people whose values are aligned with yours.Try to invest in companies that are doing things you truly believe in or are passionate about. This is especially important when considering early and seed stage investments. Liquidation events typically won’t occur for at least 4 – 7 years, that’s a long time to have your money tied up. If you’re following the progress of a company that is doing something you believe in, then you will likely feel more comfortable with this fact and investing in future rounds.
  • Stay on planet Earth.Look for a clear path to profitability. In most situations, you won’t need to be a financial expert to see if a company has a road to profitability. Many companies out there are looking for funding. Don’t choose one that isn’t telling you how you will make your money back in a clear and concise manner.
  • Understand the scope of the problem being solved by the company.Understand the size of the opportunity. Coming back to the second bullet in this list, most entrepreneurs will be pitching a vision of grandeur. It’s up to you, the prudent investor, to determine the true size of the market opportunity. Determining the amount of the market competition has already snagged up is as important as evaluating the total size of the market.

Additional questions and information regarding the investing process as a whole, due diligence, escrow, legal documents, and the importance of diversification can be found in our guide titled: How to Invest in Startups.


Angel Investing Tips from VC Investors

Bradley-C.-Harrison_Managing-Partner

Brad Harrison on Team:

“I think the best indicator of a successful startup really comes down to the team—how long they’ve worked together, how much experience they’ve had with prior startups. Spend a lot of time getting to know your founders. Before you make an investment it makes sense spending a lot of time getting to know the team—see the team dynamic, how they interact with one another, and how they overcome some obstacles. Spend a lot of time with your investment and make yourself available to answer questions and provide experience to help young entrepreneurs be more successful.”

 
Erica-Minnihan1

Erica Minnihan on Target Startups:

“You really need to dig into: What are the dynamics of the market? What’s the competitive landscape? What’s their market strategy? Let me look at the financial model and let me do some sensitivity analysis. Let me do some background checking on these guys and see what they have been able to produce in the past and what’s the history of their work ethic.

The people that make the most successful companies aren’t necessarily the people that come to you with the best idea in the beginning, but they’re the people who can pivot and who can adapt and change and aren’t so focused on their product or their technology being a reflection of their own egos. They’re able to transform what they’re bringing into the market into something that the market wants, and that’s really valuable.”

 
markpeterdavis

Mark Peter Davis on Patience:

“One of the biggest mistakes I made early on was rushing. When you see things that seem like they’re going to be interesting and you, and you haven’t seen enough companies to realize there’s 5,000 more behind it, it’s easy to get too excited and want to make a bet.

When you’ve seen the show enough times, you know that there’s always another one. So if something is close, but not enough to get you really excited, the right move is to pass. When you’ve got this mandate in your head that you’re going to start writing checks, there’s a predisposition to confirmation bias. Wait for the one where you can’t believe you’re getting in on the deal, and that’s when you should invest.”


Managing a Portfolio of Angel Investments

Most investors are aware of the benefit of diversification. Investing in the venture asset class is no exception, and perhaps is most beneficial due to the amount of risk that can be diversified away. Therein leads to the importance of understanding best practices for managing a portfolio of startup investments.

Important Considerations for Managing a Portfolio

    • Return on Investment (ROI) — understanding the typical timing of return and potential outcomes
    • Dilution — the potential for future dilution, anti-dilution protections, and net-positive dilution
    • Follow-on Rounds — multiple follow-on rounds and follow-on investment strategy
    • Monitoring
    • Losses — loss of capital and taxation
    • Exits — liquidity events as a whole, acquisitions, IPOs, secondary sales, and recapitalization

Detailed information on all of the above bullets can be found in our guide titled: Managing A Portfolio of Startup Investments.


The Evolution of Angel Investing

Traditionally, the angel investor community has been comprised of a small set of well-connected individuals located in a few hub cities across the country. With the advent of online equity crowdfunding, this limited group is expanding and a new type of angel is emerging.

5 Ways that Equity Crowdfunding has Changed Angel Investing

  1. Increased Access to Deal Flow

    Prior to the rise of online funding portals, there were several hurdles limiting an investor’s deal flow. For one, an investor needed to be close to one of the country’s few innovation hubs (e.g. San Francisco, New York City, Boston, etc.) to reach entrepreneurs coming out of those regions. Unless they had strong personal or professional ties to established startup communities, investors outside these regions lacked direction when looking for startup investment opportunities. In addition, under the old rules of private placements (Rule 506(b) of Regulation D), companies were prohibited from advertising their raise, requiring that they rely on their existing networks and warm introductions, further containing investment opportunities within the existing startup community. Under Title II of the JOBS Act (Rule 506(c) of Regulation D), companies can now engage in “general solicitation” allowing them to advertise their raise and theoretically reach any accredited investor, regardless of location. This change in policy has allowed equity crowdfunding platforms to consolidate deal flow from around the country onto an easily accessible online platform, democratizing access across geographic and social lines.

  2. Fresh Perspectives

    Historically, investors have only diversified within the traditional asset classes (stocks, bonds, commodities, and currencies). Those who invested in private deals typically restricted investments to local real estate and small businesses. Startup investing was limited to investors with a pre-existing network and a history of activity in the startup space, often as both an entrepreneur and an angel investor. Equity crowdfunding is opening early-stage investing to individuals who haven’t spent as much time in the tech ecosystem. These angels can provide entrepreneurs with fresh eyes to judge their efforts and give feedback entrepreneurs may not have received from the traditional startup community. Furthermore, many of these new angel are successful professionals from various backgrounds who are able to use their career experiences to be true value-add investors, providing insightful advice, making strategic introductions, and leveraging their networks for the startups in which they invest.

  3. Easier Evaluation

    Even if investors had a strong network and access to entrepreneurs, they had to evaluate deals through the time-consuming process of meeting individual companies one-on-one. In addition, there has been no easy way to access the key documents and financials of a potential investment. Online equity crowdfunding platforms have streamlined this laborious process, allowing angels to engage with entrepreneurs online and consolidating a company’s business plan, legal documents, and financial information in one place. As a result, angels can now quickly conduct due diligence on multiple investment opportunities. Because angel investors review multiple startups across a variety of sectors, a new investor can now quickly gain an understanding of the startup investment landscape and feel more confident in evaluating potential investments.

  4. Easier Diversification

    Traditionally, angel investors placed relatively large bets on a small group of startups. This trend was driven by inadequate access to startups across verticals, limited exposure to high-quality deal flow, and the need for startups to achieve their fundraising goals from the small number of active angels in their community. Today, via equity crowdfunding platforms, angel investors can access multiple startup investment opportunities in a variety of industries. Also, because entrepreneurs fundraising through equity crowdfunding platforms have access to a larger group of potential investors, they can potentially achieve their fundraising goals with lower investment minimums and a larger number of investors. Angel investors can therefore diversify their startup investment portfolio by making smaller investments in a larger number of companies in various industries.

  5. More Transparency

    Dialogue between angel investors was historically limited. Geographic barriers and insular communities prevented communication between different angel groups. As a result, angel investors were limited to the viewpoints present in their immediate networks and were seldom exposed to outside ideas. Equity crowdfunding platforms break down these communication barriers and create online communities of investors. These serve as forums for investors from different backgrounds to discuss potential investments. Investors can share investment insights and learn from each other’s varied perspectives and experiences.

As newcomers to the field, today’s angels are bringing fresh perspectives to startup investing and contributing valuable knowledge, networks and capital to entrepreneurs. As their sophistication and experience grows, startup companies only stand to benefit from this new face of angel investing.

This post was written by Scott Fruchter on October 27, 2016

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