Angel investing or venture capital: which of these sources of funding is right for your small business? Both of these options have similar functions. They typically provide funding to startups in the early stages, trading money for equity in the company. However, there is a key difference between angel funders and venture capitalists.
Angel investors are usually high-net-worth private investors who spend their own money. Conversely, a venture capital (VC) firm is an investment fund that uses capital from its investors to fund companies in the startup phase.
The distinctions between angel investing and venture capital during the startup investing process are important. They have implications for how founders go about fundraising. They can also impact a startup founder’s exit strategy, including the decision to go with acquisition or initial public offering (IPO).
With that said, why should founders prefer angel investors during their search for early-stage investing funds? In this article, we’ll discuss everything your startup needs to know about angel investing, from what is an angel investor to how does angel investing work.
How does an angel investor get paid?
Early-stage startups have attracted major investor attention in recent years, and angel investors are no exception. According to the Center for Venture Research, the total amount of U.S. angel funding in 2020 reached $25.3 billion, increasing by 6 percent since 2019. The report also found that high-tech industries like healthcare (30 percent) and software (23 percent) attracted the most funds from angel investors, which is not surprising, given the context of the COVID-19 pandemic.
Like any smart investor, angel investors are looking to make a healthy return on the funds they provide to their portfolio companies. So how does an angel investor make money, exactly?
The most common way for angel investors to make money is by “exiting” the company, i.e. by selling their equity share to another individual or company. This may happen in several ways:
- Initial public offering: In an IPO, the startup allows members of the general public to purchase shares of the business. This is perhaps the easiest way for angel investors to sell their own equity stake, as long as there is sufficient interest from the public.
- Mergers and acquisitions: In an M&A deal, the startup is acquired by a larger company. Depending on the terms of the deal, angel investors may receive a cash buyout for their shares, or their equity may be transferred to the new company.
- Buyouts: As the startup grows and gains momentum, other investors such as VC firms may be interested in increasing their equity. Angel investors can sell their shares to other parties for a tidy profit.
- Buybacks: In some cases, startups will buy back a portion of their equity from angel investors and VC firms. The reasons for this move are usually strategic, such as consolidating the company or increasing the founders’ equity share.
How much money do you need for angel investing?
Startups typically receive investments through a series of fundraising rounds. They include Series A, B, C, and more. Series A funding is usually for early-stage startups with some kind of track record (e.g. a consistent level of revenue or a stable user base). Series C funding is typically for highly successful startups looking to expand into new products or markets, or acquire a new company.
Before the Series A funding round, however, many startups will have an initial round known as “seed funding.” This is often the point at which angel investors become involved with the business.
This means that there’s no lower limit to how much money a startup needs to have raised before approaching angel investors. Indeed, angel investors are often the first source of funding for early-stage startups (after “pre-seed” funding such as family, friends, and crowdfunding campaigns).
Wondering about how to start angel investing for yourself? What about another question: how much money do you need to have to be called an “angel investor”?
Some define angel investors as “accredited investors,” who have either $1 million in assets or $200,000 in annual income. However, “angel investor” isn’t an official title, so there is no defined limit for how much funding you need to provide.
Another definition includes anyone who invests enough money to receive a significant amount of equity in a business. Your investment could be anywhere from thousands to millions of dollars, and the equity stake you receive is typically in the range of 10 to 40 percent.
Is angel investing a good idea?
Of course, angel investing is a “good idea” in the sense that it is a vital source of funding for early-stage startups. However, it’s not necessarily the case that angel investing is a better idea than venture capital or other sources of startup funding, such as debt instruments. No two startups are quite the same. What works for one company could be a disaster for the next.
Still, there are a variety of situations in which angel investing is preferable. Below are five reasons why startup founders and small business owners might prefer angel investors to venture capitalists.
1. Greater risk tolerance
Angel investors typically provide funding at an earlier stage than other investors, such as VC firms. This means that angel investors typically have a greater appetite for risk. Many are willing to take a big gamble on startups, even if it ultimately doesn’t pan out.
However, angel investors accept this risk in exchange for a potentially higher reward with startups that make it big. If you believe you have a great idea for your startup, but are worried about your ability to attract funding, then angel investors will likely be more open to hear your case.
2. Fundraising “practice”
Fundraising is one of the most valuable skills that any startup founder should know. Being able to effectively and efficiently make your case about the value of your company will serve you well not only with investors, but also when speaking at conferences and in news appearances.
If you’re a first-time startup founder, then you’ll need all the practice you can get with refining your startup pitch. Presenting to VCs can be intimidating, and you don’t want to squander the chance when you find an investor that seems like the perfect fit.
Getting more practice by speaking with angel investors can help you hone and optimize your pitch. Many angel investors are themselves founders and CEOs, and can offer invaluable advice about the startup community.
Because angel investors are individuals rather than corporations, they are often willing to take a more hands-on role in the business. Many angel investors are willing to take on a fundraising mentorship position—after all, they want to give their investment the greatest chance for success.
The right angel investors can offer support and guidance throughout the lifespan of your startup. They often have experience building their own companies in your industry and can help with everything from sales and marketing to product development.
In particular, angel investors are often well-connected in the startup community. This makes getting to know angel investors a very wise decision for startup founders. They can provide invaluable connections, greasing the wheel for you to acquire other sources of funding, potential new hires, or business partners.
Founders should look for angel investors who are willing to provide mentorship and networking services as part of long-term strategic engagement with the business. According to a study by the University of Washington and Willamette University, angel investors who met with the company twice a month saw returns of 3.7 times their initial capital—versus returns of just 1.3 times capital for investors who met twice a year.
5. More control
Although angel investors are just as devoted to the success of your startup as you are, many of them are happy to take a passive, advisory role in your company. This is less likely to be true for investors at later funding stages, such as venture capital firms.
Because VC firms usually cut larger checks than angel investors, they often want to have more input on your company’s marketing, operations, and product development. If you want to retain greater control over your startup—at least for the time being—pitching to angel investors is likely the better choice.
To learn more about startup investing and funding, see if you qualify for membership to join Founders Network.