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Angel investing can feel like a closed club of exclusive, high net worth individuals slapping each other on the back and doing whatever they can to ensure their investment pays off.

But thanks to new tools and networking groups that have emerged over the past decade or so, angel investing isn’t quite the private members club it used to be.

In this alternative asset guide I’ll look at what angel investing is and how to get started.

Topics covered

• What is an “angel investor”?
• Different types of investors compared
• An end to end example
• How can you get started in angel investing?
• Key terminology

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Firstly, what is an “angel investor”?

The term angel investor is synonymous with tech investors and while anyone can be an angel investor in any type of business, it is the tech industry which tends to make the most noise about the concept of angel investments.

An angel investor is simply an individual or group of individuals who want to put their own personal cash into a startup at the very early stages of its development in return for a substantial chunk of equity.

When an angel investment goes well, the payback can be huge (we’re talking hundreds of millions of dollars in some cases), but when compared to investing in, say, the standard stock market, the risks of angel investing are huge. Needless to say, angel investing is really not for the faint hearted!

Chris Sacca and Jason Calacanis were early angel investors in Uber which led to multi-million dollar payouts, Ashton Kutcher has invested in companies like Airbnb and Spotify, Gary Vaynerchuk has invested in companies including Twitter, Facebook, and Shopify and there are countless other examples of celebrities and high profile names who have chosen angel investment as an alternative asset.

But to truly understand the world of angel investment, we need to get to grips with how the tech startup funding system works and the core differences between investing in private and public companies.

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Different types of investments compared

For this alternative asset guide to keep things simple, we’ll focus on angel investing in the context of a tech company.

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Tech companies are typically funded in one of 4 ways - or a blend of some of these. These include:

Bootstrapped - this is where a company and its founders put their own personal capital or money from friends and family directly into the business.

VC funding - once a startup begins to show traction (of if the founder has a solid record), they can call upon venture capitalist funds to invest in their startup. Depending on the size of the firm, top VC firms can have funds that comprise tens of millions, hundreds of millions or billions of dollars. Sequoia Capital has over $50 billion in assets under management, for example.

IPO / public listing - this is when a company decides to go public and raise money from the public markets.

Angel investing - and finally, the funding option we’re interested in - angel investing. This is where an individual or a group of individuals decide to invest in a startup - typically in the early stages of the business, in exchange for a chunk of equity in the business. This chunk varies wildly from startup to startup and could range from 1% to 25%.

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How angels invest

Angels can gain equity in a startup by providing funds in three ways.

Direct equity stake

This is the most common way angels invest. Angels can acquire a direct equity position, such as a 20% to 30% stake in the business. The percentage depends on the startup’s valuation and other metrics. Investors may appoint associates to help manage the business to safeguard their interests.

Business loan

Angels may offer the startup a loan that can be converted into equity once the company takes off. These angels generally require a 20% to 30% equity interest and other benefits, such as a seat on the company’s board.

Convertible preferred stock

Investors provide funding in exchange for preferred stock that can be converted to equity in the company at an agreed-upon price per share. The shares provide added investor protections such as control rights, prevention of dilution, and preference if the business is liquidated.

Angels and entrepreneurs work out the funding and equity details in a nonbinding agreement that covers basic deal terms and conditions. This term sheet is the foundation for a more extensive, legally binding document should the investment proceed.

Angel syndicates

Angel investors often join syndicates, where multiple investors pool their resources to invest as a single entity. This allows them to share risks and responsibilities, and it provides startups with a single point of contact. Syndicates can also offer a broader range of expertise and connections to the startups they invest in. We’ll look at some tools which you can use to get started with this later.

An end-to-end example

Let’s imagine we decide to invest $25,000 in an early stage startup for a 2% stake in the early stages of the company.

After deciding to invest, you negotiate the terms of the investment. You agree to invest $25,000 for a 2% equity stake, valuing the company at $1 million. This involves drafting a term sheet outlining the investment terms, including valuation, equity percentage, and any investor rights.

As an angel investor, you may provide mentorship, strategic advice, and networking opportunities to help the startup grow. Your involvement can vary from being hands-on to taking a more passive role

Exit strategy

With the company's growth, you explore exit strategies to realize your investment returns. Common exit options include:

• Acquisition: A larger company acquires the startup, allowing you to sell your shares for a significant profit.
• Initial Public Offering (IPO): The company goes public, enabling you to sell your shares on the stock market.
• Secondary Sale: You sell your shares to another investor or venture capital firm. This is something many new investors don’t factor into their investments since they assume that the only way stocks will ever be worth anything is by waiting until the company either IPOs or gets acquired. Secondary sales allow early investors to sell their shares at a set price even if a merger or acquisition doesn’t happen.

Assuming an exit occurs at a $1 billion valuation, your 2% stake would be worth $20 million. This represents a substantial return on your initial $25,000 investment.

This example illustrates the potential for significant financial returns through angel investing, although it also highlights the risks and time commitment involved in supporting a startup from inception to exit. Angel investors need a lot of patience since it can take years (even decades) to liquidate assets.

How can you get started in angel investing?

While you don't necessarily need to be an accredited investor to make angel investments, many startups prefer working with accredited investors.

To qualify as an accredited investor, you must have a net worth of at least $1 million (excluding your primary residence) or an annual income of $200,000 ($300,000 for married couples) in the last two years. For more info on how to become an accredited investor, check out this handy guide.

1. AngelList: One of the most popular platforms for angel investors, AngelList connects startups with investors and allows you to filter opportunities by location, industry, and more. It also provides resources for finding employees and networking within the startup community.
2. SeedInvest: This platform offers opportunities for both accredited and non-accredited investors to invest in startups. It provides a competitive due diligence process and has a lower minimum investment requirement compared to traditional startups.
3. Republic: Known for its low entry requirements, Republic offers a wide range of investment opportunities, including equity and cryptocurrency-focused ventures. It is accessible to both accredited and unaccredited investors.
4. Gust: Gust provides tools for managing investments and accessing a large network of angel investors and startups. It also offers resources like CRM systems, investor communications, and legal documents.

Key terminology relating to angel investments

One of the most common barriers to becoming an angel investor is the terminology that’s used that can often be a bit off-putting to outsiders. Here’s a selection of some of the most useful terms worth knowing when you’re

Term Sheet: A non-binding document outlining the terms and conditions of an investment. It serves as a foundation for negotiation before the formal investment agreement.

Convertible Note: A form of short-term debt that converts into equity at a later stage, usually during the next funding round. This allows investors to defer determining the company's valuation.

Dilution: The reduction in ownership percentage of existing shareholders due to the issuance of new shares. This is a common concern for investors as it affects their control and returns.

Cap Table (Capitalization Table): A document that outlines the ownership structure of a company, detailing the percentages of ownership and types of securities held by each investor.

Preferred Stock: A class of stock that gives investors certain privileges, such as receiving dividends before common stockholders and having a higher claim on assets in the event of liquidation.

Vesting: The process by which employees or founders earn their stock over time, incentivizing them to stay with the company. A typical vesting period might be 3-4 years.

Further reading

The definitive modern guide to angel investing is probably Angel by Jason Calacanis. Jason has invested in 150 early-stage startups including 4 that have achieved billion-dollar valuations (so far) with his most successful being a $25k investment in Uber when it was valued at just $5 million. Now, Uber is valued at over $120 billion - so that’s quite a return on that investment!

Some of Jason’s key takeaways and advice from the book include:

• Angels need to look at 5,000 startups over 5 years to try and find a hit
• Being located in Silicon Valley is an advantage (although this may have changed since the book was originally published in 2017)
• Jason only invests is around 1% of the companies he looks at
• Selling 25% of a stake before an IPO is wise to avoid the risk of losing everything if an IPO fails

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Hope this guide was useful!

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Jason

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DISCLAIMER: None of this is financial advice. Finbrain is strictly for educational purposes.