"Angel investors" invest their own money in startups as compared to venture capitalists who invest money raised from third parties.
“Angel investors” invest their own money in startups as compared to venture capitalists who invest money raised from third parties.

This post continues our Financing a Startup Company Series and focuses on angel investors.  The term ‘angel investor’ covers a wide range of wealthy individuals who invest their own money in startup companies.  They usually focus on investing in very early stage companies that have the potential for high growth.  There are angel investors, ‘super angel’ investors who make larger investments, and ‘strategic investors who invest within an industry in which they have prior experience. Increasingly, individual angel investors are forming groups or networks to share costs, diversify risk and allow them to participate in larger deals than they could when operating alone.  Increasingly, VCs are moving into the “seed-stage” space and are launching funds that make ever smaller investments in early stage companies.

What are the advantages of angel investors? Angels often fill the gap between companies that have outgrown bootstrapping, friends and family, and the larger investments that VCs make.  Angels are often a source of funding for early stage companies that need between $100,000 to $5 million.  In addition to their cash, angels can bring contacts and leads from their prior experience working with a specific industry.

What type of investment do angels make?  In exchange for their funds, angels will take either an equity stake in the company or convertible debt. Typically, they are looking for investments that will earn them at least a 10x return within 5 years.  In order to achieve this rate of return, they will take between a ten to over fifty percent stake in the company.

What are the costs and potential disadvantages to accepting angel investments?  Angel investments are usually dilutive, meaning that the angel takes equity in exchange for their investment (either stock or through debt which can convert into equity later).  Any time founders’ give up equity, they reduce their ownership of the company and share of any proceeds upon an exit (such as an IPO or acquisition).  To compensate for the high risk of investing in early stage startups, angels take a relatively large stake (or take convertible debt which can convert into a large stake) in the companies in which they invest.  In addition, Angels will often want board seats and other management control rights that can limit founders’ freedom to operate their companies.  For this reason, it can be a good idea to get to know an angel’s reputation and to find angels that have experience in your specific industry.  An angel that likes to be more hands on isn’t necessarily a bad thing: their experience and business savvy can be a great asset for a startup.

To reduce the cost of the angel investment transaction, standardized seed round documents are available from a number of reputable sources.  Check out the this post on Yokum Taku’s “Startup Company Lawyer” blog for more information on the standardized seed documents.

For more information on Angel Investors, see our prior posts:

Should You Take Money From an Angel, and

Structuring the Angel Investment.