tl;dr – Angel investors are generally high net worth individuals who provide capital to early-stage businesses (I.e. start-ups). Angel investing is a great way to provide a high-growth startup with its initial outside capital while investors build a portfolio. Understanding who can become an angel investor, how to start investing and get access to deal flow, and understanding key terms in the investment documents are paramount.
Accredited v Unaccredited Investors
Angel investors are usually individuals with accredited investor status. The SEC definition of an accredit investor is someone who has had income over $200K for the previous two years (or a combined $300K for married couples filing jointly) or a net worth of at least $1M, not including their home. In 2020 the SEC updated its rules to also give certain knowledgeable individuals accredited investor status. The SEC rule 506 allows an unlimited number of accredited investors and up to 35 other purchasers of securities. It is the job of the issuer of the security (I.e. the start-up raising money) to verify accredited investors.
While being an accredited investor is not mandatory to be an angel investor, it is the easiest and most common approach. Oftentimes start-ups only want accredited investors on their cap table due to strenuous reporting requirements for unaccredited investors. Reg CF allows for crowdfunding with less stringent reporting requires but more seasoned investors are inclined to pass on such raises. The reason being that the fees paid to the platforms are high and the perception that the start-up quality may be low as other investors could have passed on the investment.
How to Invest in a Business as an Angel
Deal sourcing is key. Angel investors typically have a network of founders in their area of expertise. For example, a software engineer is likely to know other engineers and be able to invest in their businesses. If this type of network doesn’t apply to you, you can always participate in investments as a group. For example, AngelList is an online community to help get started and now implements an SPV system to allow smaller checks to get in on deals that are still private.
A great way to start off angel investing is in a syndicate. You can adjust your level of involvement in the dealmaking and running of the company. Ask yourself, “do I want to be on the board or just provide capital?” Often in a syndicate deal a lead investor does the brunt of the negotiating. If you are negotiating the deal on your own, seek out a lawyer that frequently works with venture capital, startups, or securities.
Startups receive a formal valuation once they take outside capital. The founder will want the business to be valued at what he or she thinks it will become, while the angel will want a more current price and adjust for the risk of failure at the start-ups current stage. The risk premium is higher the earlier the start-up is in its lifecycle. VCs may use a Discounted Cash Flow (DCF) analysis to determine the present value of the future income rights of the business for later stage start-ups but are more likely to look at comparable companies to determine valuation. T There are numerous other ways to value startup investments. It is important for both investors and the entrepreneurs to get a reasonable price and you certainly should understand the dangers of selling equity to family and friends for early stage startups.
For a pre-seed raise the start-up generally sets the terms after it receives feedback from advisors and potential investors. Angels generally invest in convertible instruments (e.g. SAFEs, Notes) at this stage. The start-up may share a term sheet or simply send over the definitive documents for review. The documents will state whether there is a valuation cap, discounts, conversion triggering events, liquidation preference and other terms that are applicable to that security. From an investor’s perspective we generally recommend that counsel from at least one investor in the round review the documents. While I represent start-ups I believe all sides of a deal should have adequate representation.
The real requirement to becoming an angel is having the capital to afford making the investments. You should plan on writing many checks, including follow-ons, if you wish to succeed at investing at this stage. Picking the right start-up is hard. If you make 10 investments you should expect no return on 5, some of the capital back on 3, maybe 2-3x on 1, and hopefully a 20x return on one.
Good luck and go out there and support the start-up ecosystem!