Those who invest in assets like stocks, crypto, and real estate—know when they’ve made a profit: They sell the investment for more money than they paid for it.
Angel investors, typically wealthy individuals who back early-stage businesses with their own capital, don’t have such easy yardsticks. They put their money into a startup and bet it will succeed based on scant data and their own judgment.
But what do angel investors get in return for their financial support and guidance? This blog post delves deep into the various returns angel investors seek and receive, beyond just financial profits.
How Angel Investing Works
Angels typically consider lots of early-stage startups and whittle down their investment choices to a few. Then, they provide funding to their chosen startups to cover costs until the business starts growing. Angels typically invest $5,000 to $150,000 per startup. In return, they receive an equity stake in the company.
Investors and entrepreneurs may negotiate funding and equity details directly, especially in the earliest ventures. Investors also may use the company’s valuation to determine how much ownership to take.
Who are angel investors?
Angel investors are typically affluent individuals who provide capital for startups, often in exchange for ownership equity or convertible debt. Unlike venture capitalists, angel investors use their personal funds rather than pooled money from other investors. They often invest in the early stages of a startup, when the risk is highest but so is the potential for significant returns.
The role of angel investors
Angel investors not only provide financial backing but also offer invaluable mentorship, industry connections, and business advice. Their involvement can significantly increase a startup’s chances of success by steering it in the right direction, avoiding common pitfalls, and preparing it for future funding rounds.
What Do Angel Investors Get in Return?
Angel investors get their payback through an exit that lets them liquidate their stake and potentially make a profit that’s based on the percentage of the business they own. Generally, investors will pre-plan the details of the exit when negotiating the term sheet before they invest in the startup.
We will classify what the angel investors get in return into:
- Financial returns
- Non-financial returns
1. Financial returns
a. Equity appreciation
The most obvious return for angel investors is the potential for substantial financial gains through equity appreciation. When an angel invests in a startup, they receive a share of the company’s equity. If the startup succeeds and grows, the value of that equity can increase exponentially.
See Also: Who is a Pre-Seed Angel Investor?
For example, if an angel invests $100,000 for a 10% stake in a startup valued at $1 million, and the company later grows to be worth $10 million, the value of the angel’s stake increases to $1 million. This kind of return, though not guaranteed, is what attracts many angels to invest in high-risk, high-reward startups.
b. Dividends
In some cases, startups may reach a stage where they start generating profits and paying dividends to shareholders. While dividends are less common in the high-growth startup environment (where profits are often reinvested into the business), they can provide a steady income stream for investors in more mature companies.
c. Exit strategies
Angel investors typically look for exit opportunities to realize their returns. Common exit strategies include:
- Acquisition: A larger company buys the startup, providing a return on investment through the purchase of equity.
- Initial public offering (IPO): The startup goes public, and the shares held by angel investors can be sold on the open market.
- Secondary sale: Selling shares to other investors or venture capitalists during subsequent funding rounds.
d. Convertible debt
Some angels invest through convertible debt, which is a loan that converts into equity upon a specific event, usually a future funding round. This method offers some protection as it can provide interest payments if the startup does not perform well, while still allowing the possibility of equity appreciation if the company succeeds.
2. Non-financial returns
a. Influence and control
Many angel investors enjoy the influence they can exert over a startup. By holding a significant equity stake and often a board seat, they can help shape the company’s strategy and direction. This influence can be both rewarding and fulfilling, as it allows angels to leverage their experience and knowledge to make a tangible impact on the startup’s success.
b. Personal fulfillment
Investing in startups can be personally fulfilling for many angel investors. It provides an opportunity to support innovative ideas and passionate entrepreneurs. Many angels are former entrepreneurs themselves and find joy in giving back to the community and fostering the next generation of innovators.
c. Networking opportunities
Being an angel investor opens up numerous networking opportunities. Investors often interact with other angels, venture capitalists, entrepreneurs, and industry experts. These connections can be valuable for both personal and professional growth, providing insights, partnerships, and further investment opportunities.
d. Learning and staying current
Investing in startups keeps angel investors engaged with the latest trends, technologies, and business models. It’s an excellent way to stay current and continuously learn about emerging industries. This continuous learning can be intellectually stimulating and beneficial for making informed investment decisions.
e. Philanthropic satisfaction
For some angel investors, the motivation is partly philanthropic. They invest not just for the potential returns but to support causes they believe in. This could include sustainable technologies, social enterprises, or startups that aim to address significant societal challenges. The satisfaction derived from contributing to a greater good can be a powerful non-financial return.
Risks Involved in Angel Investing
1. High failure rate
Startups are inherently risky, with a high rate of failure. It is estimated that up to 90% of startups fail, which means the likelihood of losing the entire investment is significant. Angel investors must be prepared for this possibility and diversify their investments to mitigate risk.
2. Illiquidity
Angel investments are often illiquid, meaning they cannot be easily sold or converted into cash. Investors might have to wait several years before seeing any return on their investment, if at all. This lack of liquidity can be a significant drawback, particularly for investors who might need quick access to their funds.
3. Valuation challenges
Valuing early-stage startups can be challenging due to the lack of historical financial data and the speculative nature of future projections. Overvaluing a startup can lead to diminished returns if the company does not meet growth expectations. Conversely, undervaluing can result in giving away too much equity for too little capital.
4. Dilution
As startups raise additional rounds of funding, the equity stake of early investors can be diluted. While this is often a sign of the company’s growth, it means that the percentage ownership of initial investors decreases. Investors must understand and accept the implications of dilution.
Mitigating Risks
1. Due diligence
Conducting thorough due diligence before investing is crucial. This includes evaluating the business model, market potential, competition, the founding team’s credentials, and the financial projections. Understanding these aspects can help investors make informed decisions and reduce the risk of failure.
2. Diversification
Diversifying investments across multiple startups and industries can mitigate risk. By spreading their capital, angel investors reduce the impact of any single investment’s failure on their overall portfolio.
3. Syndication
Many angel investors participate in syndicates, where they pool their resources with other angels to invest in startups. This not only allows for larger investments but also spreads the risk among multiple investors. Additionally, syndicates can provide more comprehensive support and mentorship to the startups they invest in.
See Also: 200 Pre-seed Funding Companies That Can Fund Your Startup
4. Active involvement
Staying actively involved in the startups can help angel investors protect their investments. By offering guidance, making strategic connections, and being available for consultation, angels can significantly influence the success of the startup.
Case Studies
1. WhatsApp
One of the most famous angel investment success stories is WhatsApp. Jim Goetz of Sequoia Capital invested $8 million in the messaging app, which later sold to Facebook for $19 billion. This investment resulted in a return of billions of dollars, showcasing the potential for extraordinary returns in the right startup.
2. Uber
Uber’s early investors, such as Chris Sacca and Jason Calacanis, reaped substantial returns when the company went public. Early investments in Uber led to returns that were hundreds of times the original investment, highlighting the high-reward potential of successful startups.
3. Instagram
Kevin Systrom and Mike Krieger received angel investment from Andreessen Horowitz and Baseline Ventures before Instagram was acquired by Facebook for $1 billion. Early investors saw significant returns, demonstrating the value of investing in innovative, high-growth startups.
Conclusion
Angel investors play a vital role in the startup ecosystem, providing the capital, mentorship, and resources necessary for new ventures to thrive. In return, they seek various forms of compensation, both financial and non-financial.
While the potential for substantial financial returns exists, the journey of angel investing is fraught with risks and challenges. So, by understanding these diverse returns and the associated risks, aspiring angel investors can make informed decisions and contribute meaningfully to the world of entrepreneurship.
In the ever-evolving landscape of startups, angel investing remains a dynamic and rewarding endeavor, offering the chance to be at the forefront of innovation while making a lasting impact on the future of business and society.
