How Does Angel Investing Work? The Ultimate Guide

14 min read

There are many possible sources of funding when running a small business, from crowdfunding to business loans. Once your startup gains enough traction and momentum, you might also receive interest from an angel investor or two.

But what is angel investing, and how does angel investing work? In this article, we’ll explain angel investing from the ground up, from the fundamentals to term sheets, so that you can be fully prepared to seek funding from angel investors.

What is angel investing?

Angel investors are individuals who provide capital for business ventures and startups in need of funding. These are typically wealthy individuals, who are often business founders & CEOs themselves, and exchange their own money for a share of the company they are investing in.

Shows such as “Shark Tank,” in which entrepreneurs pitch their business plan to a panel of potential investors, have helped popularize the concept of angel investing to a wider audience (although the concept has been highly dramatized for TV).

According to the Center for Venture Research, total angel investments in the United States increased by 6% from 2019 to 2020, reaching $25.6 billion. The deal size, the number of deals, and the number of angel investors also increased year-over-year.

What are the benefits of angel investing?

When done right, angel investing has benefits for both the investors and the business owners of angel-funded startups.

By making an initial investment in a business, angel investors are predicting that their stake in the company will eventually be worth more than the funding they provided. Meanwhile, startups that receive angel investing can use this money to hire more employees, expand their operations or products, or launch new marketing campaigns.

Why choose an angel investor?

For startup owners, angel investors have certain advantages over other sources of business funding:

  • Angel investors offer a personal touch to the startup funding process. They often take a proactive, interested role in making your company a success.
  • With the right connections, raising funds from individual angel investors can be easier than getting the attention of large VC firms. If you select the right co-founders, they can help introduce you to angels in the startup community, which is one major difference between founder and co-founder.
  • Angel investments are less risky than business loans. If your startup fails, angel investors won’t expect you to repay the funds they gave you. On the other hand, you’ll still have to pay back the loans you took out, which can be a major financial burden.

What’s the difference between a VC and an angel?

Like angel investors, venture capitalists are a common source of funding for startups and small businesses. The essential difference between VCs and angel investors is:

  • Angel investors are high-net-worth individuals who invest their own money in startups.
  • Venture capitalists are employees of VC firms, who invest the capital of other individuals, corporations, and pension funds.

This difference has multiple repercussions in practice. Angel investors typically invest at earlier stages, and invest smaller amounts of money than venture capitalists.

How much do angel investors typically invest?

According to the U.S. Small Business Administration, the average angel investment is $330,000. (In comparison, the average venture capital investment is $11.7 million.)

However, this figure is likely distorted by larger angel investments, which can go as high as $1 million and typically come from angel investing syndicates. Individual angel investors usually invest more modestly, between $10,000 and $200,000 in funding. A standard angel funding round may thus seek to raise $100,000 to $300,000 from 2 to 10 people.

What is an angel investing syndicate?

An angel investing syndicate is a group of angel investors that join forces to provide funding for startups and small businesses. Syndicates such as AngelList Syndicates make the world of angel investing accessible to a wider pool of individuals.

Syndicates may have anywhere from a few dozen to a few hundred members, and are headed by a syndicate leader tasked with sourcing new investments. In exchange for this work, syndicate members agree to pay a percentage of their profits (known as the “carry”) to the leader.

What stage of companies do angel investors invest in?

Angel investors typically look to invest during a startup’s early stages, before it has received significant funding from other investors. As such, angel investing is inherently a high-risk, high-reward activity: it offers an opportunity for investors to get in on the ground floor and claim a sizable stake before the company strikes it rich.

However, you should be well past the stage where you’re wondering things like “What is a co-founder?” before seeking angel investments. This means having some proof of concept such as a compelling business idea, a minimum viable product, or major customers or partnerships. Angel investors are often the next round of funding after the startup’s founders have raised initial capital (e.g. through crowdfunding or their own savings).

Are angel investors accredited investors?

As defined by the U.S. Securities and Exchange Commission (SEC), an “accredited investor” is a person with at least $1 million in assets or an annual income of at least $200,000. Companies that receive funding from accredited investors are exempt from certain securities filings with the SEC and other regulators.

Angel investors may or may not be accredited investors. Of course, there is some correlation between the two: people with a high net worth have more funds to spend on risky ventures like angel investing. However, there is no legal requirement that angel investors be accredited.

How does the angel investing process work?

During the angel investing process, startup founders and co-founders pitch their business to potential investors, who may choose to provide or decline funding. The steps of this process include:

  • Finding angel investors: Startup founders can find angel investors through their personal network, online platforms, and events in the startup community.
  • Doing your research: Not every angel investor is the right match for every company. Some investors specialize in a particular domain (such as healthcare or software). Angel investors may also differ in the approach they want to take with your company—e.g. serving as a mentor vs. being totally hands-off.
  • Making the pitch: Founders should prepare a pitch deck that gives a brief overview of their company and its major selling points. The pitch may be done in person, or over email to set up an in-person meeting.
  • Negotiating the terms: If angel investors like the pitch, they’ll offer a deal. Like everything else in business, the terms of this deal can be negotiable. Consider discussing factors such as the amount of equity, the company’s exit strategy, and even giving investors a seat on the board.

What questions should entrepreneurs ask angels?

Presenting to angel investors isn’t a one-way street. As much as angels are assessing your business, you also need to evaluate them to make sure that it’s the right fit.

The questions you may want to ask angel investors include:

  • Which other startups or companies have you worked with?
  • What advice do you have for growing this business?
  • What are your biggest concerns about this business or industry?
  • How much do you normally invest in companies?
  • What role would this company play in your portfolio?
  • What role do you want to play in this company after the investment?
  • What happens if this venture fails?

How can international entrepreneurs get funded?

Angel investors and founders often run in the same circles and attend the same events. This means that it’s easier for angel investors in a particular geographical location—say New York or Silicon Valley—to connect with and invest in startups in the same area.

However, international entrepreneurs aren’t entirely out of luck if they want to find U.S.-based angel investors. There are a number of organizations seeking to help international startups break into the U.S. market. For example, UpWest works specifically with Israeli companies, while the Techstars seed accelerator has launched the Global Accelerator Network (GAN) to reach founders around the world.

What is an angel investing term sheet?

In angel investing, the term sheet (also known as the letter of intent) is a document that defines the terms by which angels will make an investment in your business. The term sheet is usually a short document, no more than 10 pages in length. It typically includes details such as:

  • The form of the investment (common shares, convertible preferred shares, or convertible debt)
  • The investor’s voting rights (e.g. a seat on the board of directors)
  • The liquidation preference (i.e. the order in which the company’s owners will be paid if the company is liquidated or sold)
  • Confidentiality agreements and due diligence procedures

Term sheets are typically intended to be non-binding agreements; however, certain portions can be mutually agreed to be binding. Make sure to seek legal consultation before signing any term sheet or other document.

What do angel investors get for their investment?

In exchange for investing a certain amount of funding, angel investors receive a minority ownership stake in the company. This proportion is typically no larger than 20 to 30 percent across all investors, since the founders need to retain majority ownership and also reserve some shares for employee stock options. There are multiple ways for angel investors to take ownership, including equity and convertible debt.

What is equity vs. convertible debt?

Equity is the percentage of shares that an entity owns in a business or other asset. If you own 10% of the shares in a business, for example, then you are said to have 10% equity in the business. If the business is worth $1 million, then your equity stake can be valued at $100,000.

During an angel investment round, investors can purchase equity in the company, giving them a certain percentage of the ownership. This equity stake can then be cashed out at a later date when the company has increased in valuation, earning a profit for the investors.

Startup founders often prefer selling equity because it does not require them to go into debt to the investors. In order to sell equity in your business, however, you’ll need to have some idea of the company’s valuation, which will give you a fair price at which to sell your shares.

Convertible debt, also known as convertible notes, is a type of business loan that the holder can convert into a given number of shares in the company. The holder can also choose to exercise this debt as a traditional loan at a later date, receiving back the principal amount together with the loan’s interest.

Some founders would rather sell convertible debt because it allows them to defer the question of business valuation until later on in the funding process. The value of this convertible debt will be calculated based on the company’s future valuation, instead of its current valuation.

What are SAFE notes?

SAFE (Simple Agreement for Future Equity) notes are equity documents that are intended as an alternative to convertible debt. First created by Y Combinator in 2013, the goal of SAFE notes is to simplify the funding process.

In order to understand SAFE notes, equity, and convertible debt, you should be familiar with a few crucial concepts:

  • Discount: With SAFE notes, early angel investors may receive a discount on the purchase price compared with later (e.g. Series A) investors.
  • Valuation caps: SAFE notes can set a maximum cap on the company’s valuation, limiting the amount that investors will pay when buying shares at a future date.
  • Early exit payback: If a company is acquired or changes hands before SAFE notes can be converted, investors can have the value of these notes paid back to them.
  • Company type: Using SAFE notes usually requires the company to be listed as a C-Corp rather than an LLC. This is because SAFE instruments assume and specify that the company is a corporation, not an LLC.
  • Conversion: Unlike convertible debt, which requires a specific amount of funding to be raised, SAFE notes can be converted into equity in a future round regardless of the funding amount.
  • Term (maturity date): SAFE notes are not debt, which means that there is no required maturity or expiration date.
  • Interest rate: Also unlike convertible debt, SAFE notes do not have an interest rate.

SAFE notes can take four different forms:

  • Discount and valuation cap
  • Discount, but no valuation cap
  • No discount, but valuation cap
  • No discount and no valuation cap

What are the benefits and drawbacks of SAFE notes?

There are various pros and cons of SAFE notes over alternatives such as convertible debt. By far the greatest benefit of SAFE notes is their simplicity. SAFE notes are generally easier to work with: the document itself is only a few pages long, making negotiations shorter. Using SAFE notes also enables startups to defer the question of business valuation until later on in the process.

SAFE notes are generally more advantageous for startup founders than for their investors. This is because they lack a maturity date or interest rate, making them more flexible for startups with an uncertain growth timeline. On the other hand, because SAFE notes are not debt, investors must accept the risk that they won’t receive payment in the form of equity if the startup goes under.

In terms of disadvantages, startup founders need to consider the risk of equity dilution caused by using SAFE notes. Investors purchasing large quantities of SAFE notes can help lift the business off the ground. When these SAFE notes are converted to shares later on, however, it can seriously dilute a founder’s stake in the company, giving them less control and making it harder to attract Series A investors with the remaining shares available.

What is the average return for an angel investor?

According to a 2007 study by Robert Wiltbank and Warren Boeker, the average return on angel investments was 2.6 times the initial investment after a period of 3.5 years. This comes out to an internal rate of return (IRR) of 27%.

A meta-analysis of angel investment returns supports this estimate. Of the studies examined in this report, the average IRR of angel investors ranged from 18% on the low end to 37% on the high end.

What is the success rate of angel investing?

Although angel investing does generate positive returns on the whole, the success rate of individual ventures is mixed. The same 2007 study found that 52% of startup exits did not generate enough capital to pay for the initial angel investment—which would make for a 48% success rate.

The success of an investment isn’t determined solely by breaking even, however. Just 7% of angel investments generated returns of more than 10 times the initial investment. However, this small percentage accounted for 75% of all the returns from angel investing.

Is angel investing lucrative?

Angel investors get into the field for many reasons. Some are fascinated by the intellectual challenge of finding profitable new startups, while others are simply looking for a higher rate of return than traditional investments.

The good news is that angel investing can be a very lucrative endeavor—but like many other investments, what you get out of it is proportional to the time and effort you put in.

The 2007 study by Wiltbank and Boeker found that the profitability of angel investment depended on three factors: investors’ due diligence, their industry expertise, and their involvement with the business.

  • Due diligence: Investors that performed less than 20 hours of due diligence on a company had an average return of 1.1 times their capital. Spending over 40 hours of due diligence correlated with an average return of 7.1 times their capital.
  • Industry expertise: Investors with over 14 years of experience in a given industry had double the returns of investors with less experience.
  • Business involvement: Investors who met with the company twice a month had average returns of 3.7 times their capital. Meeting twice a year saw average returns of only 1.3 times capital.

What does an angel investor do in their startup company?

After investing in a startup, what role does the angel investor play? Every investor will have a different answer here—from serving in an advisory role on the board of directors, to adopting a totally hands-off approach.

Of course, it’s in both parties’ best interest that the startup succeeds, so most angel investors do actively assist with the venture. If investors do choose to involve themselves in the startup, there are a number of parts they can play, including:

  • Providing business advice from an external point of view
  • Drawing on network connections to source new customers
  • Helping recruit and hire new employees
  • Offering fundraising mentorship for additional funding rounds
  • Generating marketing buzz for new products

How can you end an angel investment?

Angel investments typically end in one of two ways: either the startup successfully exits and generates return for the investor, or the startup closes its doors and the investor writes it off as a loss.

Rarely, you may be able to buy back the angel investor’s equity if both sides agree to end the deal. However, if your startup has grown since the investment, be prepared to spend significantly more money than the investor originally paid for the shares.

In the best case, an angel investor’s initial investment is the start of a long-term partnership. If investors are happy with the outcome, they may choose to work with entrepreneurs again during their subsequent ventures.