Angel Investing 101: What it is and How to Get Started

Photo by Daria Nepriakhina on Unsplash

Angel investing is all about spotting potential in teams and companies.

If you had invested $10,000 in Facebook’s seed round back in 2004, that money would be worth over $250 million today. The same goes for many other companies, where a seed investment would have made a 100x+ return.

You hear all these stories about investors getting in early on startups that blow up, but how does all of this work? In recent years, loosening government regulations and new investing platforms has made angel investing more accessible than ever.

Basics of Startup Investing

Angel investing gives individuals the opportunity to fund very early-stage startups who are not yet ready to raise venture money. Typically, the check sizes for angel investments and seed rounds fall between half a million and two million raised by a couple of people, after which gets into VC territory. You can invest either individually, or join an angel group (the Angel Capital Association has a great list here)

The amount that is invested, however, can be highly variable based on the investors’ and the startup’s needs.

VC Fundraising Journey (University Lab Partners)

In return for the investment, angels are giving equity in the company, which can exponentially grow in valuation in future funding rounds if a company ends up becoming successful.

Traditionally, angel investors needed to be accredited investors (see SEC definition here), meaning that they have over $1,000,000 in investable assets, or have an annual income of over $200,000. However, under Title III of The Jobs Act, even if you don’t meet these requirements, you can now invest through a new breed of crowdfunding platforms.

Making Money through Angel Investing

While your company may grow in value over time, you as an investor can only make money through what is known as a liquidity event that allows investors and founders to cash out some or all of their shares. There are 2 main ways angels can make money:

1. IPO: or an initial public offering, is when a company gets listed on a public exchange
2. Acquisitions: a startup can get acquired by a larger company, resulting in a payout to the startup investors

When making investment decisions, keep these potential exit opportunities in mind.

A Couple Important Investing Terms to Know

• SAFE vs. Convertible Notes — SAFEs, which stand for simple agreement for future equity was coined by Y Combinator, is a warrant to be able to invest in the first round. On the other hand, convertible notes are a form of debt that can convert to equity once a certain funding/valuation milestone has been hit. SAFEs are generally considered to be more founder-friendly than convertible notes
• Priced rounds — startups can also give the investor shares of the company in return for funding. There are usually two stock classes — common and preferred. The common stock usually goes to the founders whereas the preferred shares go to investors and usually come with perks like getting paid back first when there is an exit
• Carry — venture capitalists usually take a percentage of the payout profits as something called carry. For example, VC’s lead the research, due diligence, logistics, and the investment in a startup, and in return are typically compensated 20% of the profits (in addition to management fees). Investments are usually led by experienced investors.

See more VC terms here.

Angel Investing Strategies

In his essays, famous investor Paul Graham advises readers to not get hung up on the nuances of a deal — “When angels make a lot of money from a deal, it’s not because they invested at a valuation of $1.5 million instead of $3 million. It’s because the company was really successful.” Regardless of how much you invested in Snapchat a decade ago, you made incredible returns on your investment.

With that being said, how do you pick a great company?

1. Good market — Marc Andreesen famously said:

When a great team meets a lousy market, market wins.

When a lousy team meets a great market, market wins.

When a great team meets a great market, something special happens.

Essentially, market need is one of the biggest factors in startup success. If there is no widespread need for a product or service, even the best team will not be likely to launch a successful startup. As a result, there are often times where you have seasoned entrepreneurs raising billions in capital on an idea but misjudging the market, causing a painful loss for the investors (remember Quibi from early 2020?)

In fact, lack of product-market fit is the leading cause for all startup failures.

1. Personal fit: Make sure that you invest in technologies that you already understand, or can put time into understanding. With today’s pitch decks, buzz words are thrown around left and right, so having a real understanding of a startup’s core technology is valuable when making a good investment decision. Angel investing also isn’t just about picking the right companies. As an angel investor, you are often able to support these startups beyond just capital. Think about how you can personally bring value to the company.
2. Exit opportunities: This was touched upon above, but think about how you can cash in on your investment — is the startup a clear acquisition target for a larger company? Does the company have the potential to go public?
3. Great team: Finally, the team also plays a crucial role in a startup’s success. As the saying goes, it’s not just the idea that counts, but the execution of the idea. Good things to look for in a team are diverse skillsets, strong technical background in the topic, previous entrepreneurial experience, as well as passion and drive for the company.

Risks

Like we mentioned in our blog on diversification, the majority of startups fail. However, when investing in startups, the magnitude of the outcome is more important than the frequency of your wins (learn more on our previous blog, Investing is Simple, Not Easy).

A general guideline in startup investing is that a small portion of investments will make up the majority of returns, so it is important to look for companies with the potential to become huge.

With early-stage startups, there is also much less information available about their finances and operations, making proper due diligence essential.

Other reasons to angel invest

Besides the possibility of getting in early on the next billion-dollar company, angel investing gives investors the opportunity to work with passionate entrepreneurs solving important issues. Since you get to work with the company so early on, you can play a significant role in mentoring the startup and helping them grow.