Not Rich Yet | Managing higher incomes

May/10

19

How to be an Angel Investor – Pt I

Today I am kicking-off a multi-post series on Angel Investing. This is an interesting avenue for high income individuals with tolerance for risk.

The topics I intend to cover in this series are:

  • What is angel investing?
  • How angel investing works
  • What the requirements for angel investing are
  • What to look out for as an angel investor
  • How to become an angel investor

Angel investing – what is it?

In 1998, Andy Bechtolsheim, a successful entrepreneur and co-founder of Sun Microsystems, was approached by the founders of Google. Larry Page and Serge Brin pitched their idea to Andy, and he consequently wrote them a $100,000 check as a seed investment for their brand new idea. Fast forward a decade, and Andy’s investment in Google is worth more than $1.5B.

Angel investing is a high-stakes, high-risk form of investing by one or a few investors into promising ventures. Typically these investors are expected to contribute more than just money, but also facilitate contacts, provide expert knowledge and generally be helpful. In return, they are allowed to invest at “basement” level, and can achieve amazing returns – if unlikely as spectacular as those of Andy Bechtlolsheim – if the venture does well.

Typically, such investments are equity purchases (stock or stock options) or convertible debt (loans that convert to stocks). Pure debt deals are rare as they don’t allow the investor to profit greatly if the company does well.

Typical investments

Most importantly, angel investors typically invest in companies that will have some sort of “exit” or liquidity event. Internet start-ups or biotech companies will typically have an IPO or be acquired by another company if they succeed. Such an event allows the investor to convert his or her initial stake into cash or tradeable shares. Before the event, the investors shares were illiquid since the company was not publicly listed and tradeable.  An angel investment in a company that never intends to have a liquidity event is a moot point – why sink money in a deal that you can never sell?

Companies most attractive to investors since they will likely follow the route above typically follow the profile

  • Technology or biotech focus
  • Own strong intellectual property such as patents that will afford them a defensible advantage
  • Are not “life-style” businesses but instead highly scaleable businesses that can drive tremendous revenue and profit with a small base of employees
  • Organized as C-Corp or more rarely as LLC
  • Are for-profit

What this means is that businesses that do not meet the criteria above are unlikely to be attractive to angel investors. Restaurants, bars, ice cream shops, consulting companies, advertising agencies and other businesses that rely on people instead intellectual property are unlikely to attract angel investors.

The risk

Angel investing is risky. One angel investor I know mentioned that only a handful of the over 50 investments he made were doing well. In fact the risk is at multiple levels

  • First, the company has to do well overall and turn an idea into a roaring business
  • Next, most companies need to change their business model a couple of times in their life. During such changes, esp. if they involve near-death experiences for the company, new investors may force unfavorable terms onto the company, often “cramming down” older investors. What this means as an angel investor is that while the company may be doing well overall, your personal investment could be doing horribly
  • Finally, you need to have a liquidity event that is successful. Many a dot-com start-up was bought up in the hey day giving their angel investors huge returns on paper – e.g. through stock swaps – only to find after the 12 month waiting period that the buyer negotiated that the stock market tanked and their shares are worthless

For this reason, the US government actually requires angel investors to meet certain requirements. The government wants to avoid that innocent and inexperienced investors get suckered into such deals, so they require investors to have a minimum networth or income (to be discussed in detail later).

Given the risk discussed above, most investors I know only invest a small percentage of their portfolio in angel deals, often 5% or less.

My experience

As a disclaimer, I am not an active angel investor myself but have received angel investments from others as an entrepreneur. I have negotiated over 15 such investments and have assisted investors in their due diligence in other transactions.

Next

In my next post in this series I will explain how the nuts and bolts of angel investing work.

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