Angel investors are individuals who invest in businesses looking for a higher return than they would see from more traditional investments. Many are successful entrepreneurs who want to help other entrepreneurs get their business off the ground. Usually they are the bridge from the self-funded stage of the business to the point that the business needs the level of funding that a venture capitalist would offer. Funding estimates vary, but usually range from $150,000 to $1.5 million.

The term angel comes from the practice in the early 1900’s of wealthy businessmen investing in Broadway productions. Today angels typically offer expertise, experience and contacts in addition to money. Less is known about angel investing than venture capital because of the individuality and privacy of the investments, but the Small Business Administration estimates that there are at least 250,000 angels active in the country, funding about 30,000 small companies a year. The total investment from angels has been estimated at anywhere from $20 billion to $50 billion as compared to the $3 to $5 billion per year that the formal venture capital community invests. In fact, the potential pool of angel investors is substantially larger. There are about two million people in the United States with the discretionary net worth to make angel investments.

The Center for Venture Research at the University of New Hampshire which does research on angel investments has developed the following profile of angel investors:

• The average private investor is 47 years old with an annual income of $90,000, a net worth of $750,000, is college educated, has been self employed and invests $37,000 per venture.
• Most angels invest close to home and rarely put in more than a few hundred thousand dollars.
• Informal investment appears to be the largest source of external equity capital for small businesses. Nine out of 10 investments are devoted to small, mostly start-up firms with fewer than 20 employees.
• Nine out of 10 investors provide personal loans or loan guarantees to the firms they invest in. On average, this increase the available capital by 57%.
• Informal investors are older, have higher incomes, and are better educated than the average citizen, yet they are not often millionaires. They are a diverse group, displaying a wide range of personal characteristics and investment behavior.
• Seven out of 10 investments are made within 50 miles of the investor’s home or office.
• Investors expect an average 26% annual return at the time they invest, and they believe that about one-third of their investments are likely to result in a substantial capital loss.
• Investors accept an average of 3 deals for every 10 considered. The most common reasons given for rejecting a deal are insufficient growth potential, overpriced equity, lack of sufficient talent of the management, or lack of information about the entrepreneur or key personnel.
• There appears to be no shortage of informal capital funds. Investors included in the study would have invested almost 35% more than they did if acceptable opportunities had been available.

For the business seeking funding, the right angel investor can be the perfect first step in formal funding. It usually takes less time to meet with an angel and to receive funds, due diligence is less involved and angels usually expect a lower rate of return than a venture capitalist. The downside is finding the right balance of expert help without the angel totally taking charge of the business. Structuring the relationship carefully is an important step in the process.

What Does an Angel Investor Expect?

There are almost as many answers to what angels expect as there are angels. Each has their own criteria and foibles because they are individuals. Almost all want a board position and possibly a consulting role. All want good communication although for some that means quarterly reports, while for others that means weekly updates. Return objectives range from a projected internal rate of return of 30% over five years to sales projections of $20 million in the first five years to the potential return of five times investment in the first five years. Most are looking for anything from a five to 25 percent stake in the business. Some want securities — either common stock or preferred stock with certain rights and liquidation preferences over common stock. Some even ask for convertible debt, or redeemable preferred stock, which provides a clearer exit strategy for the investor, but also places the company at the risk of repaying the investment plus interest. Additionally, the repayment may imperil future financing since those sources will not likely want to use their investment to bail out prior investors.

Some angels ask for the right of first refusal to participate in the next round of financing. While this sounds eminently reasonable, some venture capitalists will want their own players only or certain investment minimums so this strategy may limit who future participants might be.

Future representation of the board of directors also needs to be clarified. When a new round of financing occurs, do they lose their board right? Or should that could be based on a percentage ownership — when their ownership level drops below a certain level, they no longer have board representation.

In order to protect their investment, angels often ask the business to agree to not take certain actions without the angel investors approval. These include selling all or substantially all of the company’s assets, issuing additional stock to existing management, selling stock below prices paid by the investors or creating classes of stock with liquidation preferences or other rights senior to the angel’s class of security. Angels also ask for price protection, that is anti-dilution provisions that will result in their receiving more stock should the business issue stock at a lower price than that paid by the angels.

To prepare to solicit an angel, several critical factors will aid in making the approach successful. First, assemble an advisory board that includes a securities accountant and an attorney. Two important functions of the board are to recommend angels to contact and to work with the management team to develop a business plan to present to the angel. The business plan itself should define the reason for financing, how the capital will be spent and the timetable for going public or seeking venture capital funding. It should include: an executive summary (description of the business, opportunity and strategy, target market, projections and competitive advantages); the industry, the company and its products and services (including entry and growth strategies); market research and analysis (customers, market size and trends, competition, estimated market share and sales); the economics of the business (including gross and operating margins and break-even analysis); marketing plan (overall strategy, pricing, advertising, promotion, and distribution); design and development plans (product/service improvement and new products/services); manufacturing and operations plans (geographic location, facilities and capacity improvements); management team (organization overview, biographies and compensation plans for key employees); financial plan (tax returns, profit and loss forecasts, pro forma cash flow analysis and balance sheets, 5-year projections); and proposed company offering (desired financing, securities offering, capitalization, timetable).

Most of all, take your time in forming a relationship with an angel. You are going to be spending a number of years together at a critical time in your business’ life. Take the time to assure yourself that this is a person who you are comfortable with through both the ups and downs the future will bring.