editione1.0.1Updated September 19, 2022
You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Angels invest typically in very early-stage companies, providing capital for growth in exchange for equity—partial ownership—in the company. That equity can translate into enormous rewards, or nothing at all—angels tend to have an appetite for risk, and the means to take risks with confidence.
An angel investor might consider herself a patron of experiments, the first outsider tasked with judging a company’s real potential for success.* That outside money can become, for those who choose to let it, a path to the inside, where an angel becomes an advisor and confidante, helping founders make good business decisions and supporting them when things get tough. Other angels will choose a less involved path, staying out of the company’s way after making their initial investment.
Angel investing is different from other types of investing. Like venture capitalists, angels typically invest in companies they hope will grow rapidly and eventually reach a liquidity event. But as the earliest outside investors who do not invest through institutions like VC firms (though individuals may invest as part of an angel group), angels take on more risk. Their investments are also typically smaller than those that VCs make; while VCs can invest tens of millions of dollars (or a lot more), angel investments are typically $25K–$50K and top out at $100K, though they can go higher. To make an investment, an angel must be deemed an accredited investor (which we’ll discuss in detail), meeting income and asset thresholds set by the Securities and Exchange Commission.
Angels usually don’t invest in companies that are expected to stay private and generate an ongoing cash flow for their investors,* the way an LLC might be organized to start or grow a real estate business or chain of grocery stores.
Angel investing is also different from investing in public companies, where you can turn around the day after you invest and sell the securities you purchased to someone else on a public market. In angel investing, once you invest you are generally “stuck” holding your investment for some indefinite period of time, until the company in which you invested is sold or goes public—which could be years away or never happen. In most investment classes an investor can cut their losses when things go badly. Even in less liquid assets like real estate, an investor can sell a piece of property, even one in bad shape or in a bad market, for some residual value; in angel investing, you are generally investing in companies which, if they don’t succeed, have very little in the way of assets to distribute to shareholders.
Angel investing might sound like gambling, but it is not entirely a game of chance. Angels have the chance to spot a company early that’s going to change the world. With robust resources and best practices for conducting thorough due diligence on a company, and making smart decisions around financings and term sheets, you can increase your odds of a great outcome, for both your investment and the company’s trajectory.
While there are many risks to angel investing, the rewards, both financial and personal, are real. If you like spending time with entrepreneurs and learning about new technologies and methods, if you want a ringside seat at the ongoing disruption of industries, if you want to flex your knowledge and experience, or if you want the chance to make an impact, angel investing can be fun, educational, and exciting.
Maybe you bought this book after reading that Peter Thiel made a billion dollars from Facebook out of a $500K investment.* You might even have friends who invested $25K in a business to see it return 18 times that amount. But beware—the majority of angel investments return nothing to investors.
As a benchmark for purely financial return, large portfolios of well-screened angel investments either aggregated by so-called “super angels” or across active angel investing groups can generate internal rates of return of 20% or more.
If you have a large investment portfolio, angel investing can provide diversification, as it represents another asset class. But it is high risk and requires patient capital. Your investment advisor may be able to provide you with suggestions on what proportion of your overall portfolio to allocate to private, early-stage deals.
caution Because angel investments are extremely risky and illiquid, the common wisdom is that you should not invest more than 10% of your assets in angel investments, and you should be able to withstand the loss of all of that money.
Many angel investors are successful entrepreneurs or business people who have benefited from the mentoring of others and now want to give back to the entrepreneur community. You might have knowledge and experience that you want to share with the next generation of doers. That might be general management wisdom, industry specific knowledge (domain expertise), or functional expertise in marketing, business development, or technology. Angel investing frequently involves mentoring or advising founders of companies, so you will have ample opportunity to share your knowledge.
important Entrepreneurs want to change the world; angels can make that possible. Your investment could help bring a new medical device to market, help people stop smoking with a mobile app, increase food safety with organic blockchain barcodes, reduce food waste with AI-driven produce inventory management systems, or make the great American game of football safer with impact-reducing helmets.
Explicitly mission-driven investments aren’t the only path to making a positive impact as an angel. You could help create new social media marketing tools for small businesses, support building a social network for grade school kids, bring an end to the paper business card, make trucking more efficient for truckers, or create augmented reality video game platforms. Whatever the industry, your investment may lead to the development of a company that employs thousands of workers at good wages.
Angel investing is a unique experience, and the field is constantly changing. There are a lot of smart, creative, highly motivated people involved, not just building new technologies and companies, but also building new financial legal innovations (such as SAFEs and revenue loans). There is also increasing activity around combining mission-driven startups with angel investing and mentoring, where as an angel investor you can become a force multiplier for good. Fledge is an example of a conscious company accelerator that mentors both angels and startups focused on social good.
Being an angel investor is a meaningful way to get involved in your community and to meet other successful business people. Angels love talking about startups and technology and industry trends. As you participate in the angel investing community you will have the opportunity to get to know the local startup incubators, accelerators, and venture capitalists, and to generally participate in your area’s startup ecosystem. If you have time on your hands, helping to grow your local startup ecosystem can be a very rewarding way to spend your time.
As an angel investor, you will hear a lot of company pitches, and review many slide decks. Each company presents a unique learning opportunity, and you will get insight into industries you didn’t even know existed.
If you focus your investing in a specific domain or industry, you can gain insight into the trends and technologies that are going to be impacting that industry. How are new technologies getting applied, how might related industries get disrupted? When you hear how someone is thinking differently about customer acquisition or service levels or product delivery in a related industry, there is often something you can learn that might be applicable to a business you’re involved in.
By talking with entrepreneurs and following startups you will learn about the general processes, tools, and techniques enabling companies to quickly build and test products, inexpensively acquire customers, and the metrics they watch to manage their businesses. If you do not have it already, you will acquire a respect for how difficult it is for someone to build a company from nothing.
Angel investing will test your business acumen, ability to judge character, negotiation skills, research skills, intuition, and discipline. Many of these skills are put to the test in the due diligence phase. If you make some investments, you will have the opportunity to learn from your wins and your losses.
Angel investing is exciting. Have you invested in the next Facebook? Will your friends envy your foresight? Will you kick yourself for passing on a deal that would have made you spectacularly wealthy, or on an idea that could have improved people’s lives?
Part of the fun of angel investing is following the progress of the companies in your portfolio. It is a ticket to the emotional rollercoaster of the entrepreneur—the excitement of the big customer deal, the disappointment of the partnership that got away, the thrill of the payout from an acquisition, or the sting of one of your companies shutting down and winding up.
Angel investing can be challenging for a number of reasons. It can be time consuming and may require you to quickly come up to speed on industries or technologies you know little about. It can involve negotiating investment terms and dealing with unfamiliar legal issues. Additionally, once you invest you may have very little insight into what is happening to your investment and very little (if any) control over what the company does. You will also be impacted by the rights and valuations the company negotiates with any follow-on investors, which can have a dramatic impact on your return. The goal of this book in part is to help you understand the legal issues, deal terms, rights, and limited controls that will have an impact on your outcomes. Ultimately an angel investment is a gamble, and your goal is to try to increase your odds of winning before you place your bet.
Angel investing can be time consuming if you are actively involved in selecting your investments. A typical active angel investor may see 50–100 investment opportunities in a year. They attend angel group meetings, meet with individual entrepreneurs who reach out to them, and see deals from within their network of other angels. They may be interested enough to look into ten of those deals and engage in serious due diligence on a handful or more. On the deals they decide to move forward with, they will spend time negotiating terms and reviewing legal documents. All that work might result in three or four investments in a year.
Your degree of involvement and time commitment is up to you, especially if you are part of an angel group (formal or informal) where members split up a lot of the work. So while it is possible to take a “free rider” approach and jump in on deals someone else recommends and has negotiated, your colleagues may eventually ask you to share some of the workload.
As an angel investor you will get a lot of requests from entrepreneurs who are beginning their fundraising journey. And once you have some investments, you might make time to meet occasionally with the entrepreneurs you’re backing and respond to requests for advice or introductions to potential customers or follow-on investors. If meeting with entrepreneurs (think long hours in coffee shops) and doing due diligence sounds fun and exciting, then you will enjoy the time you commit to angel investing. If you are really committed, you can aspire to be a lead investor, which can be quite time consuming and might enable you to sit on the board of the startup (more time commitment), which has its own set of perils and rewards.
importantEvery angel investor’s situation is different. Some are retired or semi-retired, and angel investing is a great hobby and source of social engagement for them. Other angels are working full-time and have families and other commitments, but can fit in angel group or diligence meetings when they come up. Necessarily, they will be less involved. But the nature of the startup world—where founders are often working days, nights, and weekends on their companies—means you’ll likely be able to fit in founder meetings and other angel investing responsibilities outside of your normal work hours.
cautionIn general, you should think of your angel investments as almost always completely illiquid, meaning you should not expect to be able to sell your convertible note or your restricted shares to get your money out unless there is some sort of liquidity event. Sometimes a secondary market for a company’s stock develops before an IPO, but this is rare. By definition, angel investors are putting in their money very early in a company’s life, and it will typically take five to eight years or more for the company to see a liquidity event;** even then, the company may be acquired by another private company whose shares could also not be sold for cash in a public market. It is possible to have an investment return a profit within a year or two through an acquisition by a public company, but that case is an exception.
The terms of the follow-on rounds of investment have a big impact on your investment outcome and can determine to a large extent whether you make a lot of money or none on your angel investment. We will cover the deal terms that you can use to influence how follow-on rounds may affect your investment.
The SEC rules exist to protect consumers by trying to ensure that the investor is financially savvy enough to broadly understand the implications of investing in private equity, and that they can afford to lose the investment.
important To the latter point, you must be able to afford to lose your entire investment! To be a successful angel investor, you should build a portfolio of investments over time and be able to afford to see those investments fail—hoping that the success of one or more investments outweighs the losses on the rest. Ideally, you are placing multiple educated bets and hoping you hit the jackpot.
danger Angel investing can be a great portfolio diversification strategy (in addition to more liquid assets like public stocks and bonds and real estate), but it should not be your retirement strategy.
This book is designed to make sure you deeply understand the terms and implications of your investment in addition to helping you be selective about those investments. But people without a high appetite for risk will find that angel investing isn’t for them. The thrill of the risk should be a draw to you.
There are a number of reasons it is beneficial to join an angel investing group.
An angel investing group (or angel group) is a syndicate of angel investors that collaborate on deals. These groups can be large and formal (like Seattle’s Alliance of Angels, which has over 140 members as of this writing), or small and informal (especially when not based in a major metropolitan area). They can help green investors learn the ropes of angel investing, improve access to deals, and share the work and potential costs of due diligence and negotiations.
There are over 400 angel groups spread across the U.S. and Canada according to the Angel Capital Association, which maintains a directory on its website. You might also be interested in the Angel Capital Association’s FAQs About Angel Groups.
important If you want to educate yourself before joining a group, or if you can’t find a group that aligns with your interests or investing goals, then this book will go a long way towards getting you up to speed on the process, terms, and other topics that will give you the confidence to move forward with your angel investing!
You may also decide to invest as part of an AngelList syndicate. Make sure to do your due diligence on the syndicators.
It is easy for entrepreneurs to discover the local angel groups, so being part of one means you will likely get exposure to a regular flow of deals. Angel groups tend to be known in their community and entrepreneurs will seek them out because it is an efficient way to get in front of a large number of angels. As a member, it will be easier to see a lot of deals if you attend the angel group’s regular meetings where some number of entrepreneurs will pitch their companies to the assembled group of angels. Additionally, most groups have a screening process, so the main membership group will only invest time in looking at deals that have passed the initial filtering process. If you’re not a member of an angel group, there are still lots of ways to see deals, which we cover in Finding Opportunities.
20–40 hours of due diligence per company is recommended;* it’s nice to be able to share that workload among a group of interested angels. Within a larger angel group there is almost always someone who is expert in the specific field that a startup is engaged in, whether that is a medical device or a social media marketing tool. Having that domain expertise in the diligence team brings insight about customer pain points and behaviors, competition and the ecosystem generally, distribution and pricing, and a host of other topics that would otherwise take significant effort to understand.
There will almost always be experienced angel investors in a group, and you can benefit from their knowledge and wisdom if you let them lead the terms negotiation for your first investment or two. They will have a sense of what is customary in the terms and which terms are worth fighting for. Those angels can act as mentors when you are ready to lead a deal and negotiate terms yourself. This book will bring you up to speed on the deal terms for the most common types of investments, but it is still useful to have guidance on the ground when going through the process.
An angel group is a great opportunity to network with other successful business people who have a passion for angel investing, and you can learn from their experience. You will see a lot of deals, which will provide a valuable perspective on the range of investment opportunities. You will begin to learn what a great opportunity looks like versus a more risky one, what a complete team should look like, how much traction is an indication of product/market fit, and so on. You can participate in due diligence to learn that process even if you do not plan to invest in the company. Some groups check in on the companies that pitched a year or two ago and present updates to the group. This provides great insight as to why some companies fail to reach their goals and the types of pivots that may happen. This learning enables you to ask the right questions the next time you are doing due diligence on a similar company.
Startup CEOs spend a surprising amount of time trying to raise money. Over the course of five to ten years they will likely raise many rounds of financing from many different sources, including angel investors. Each round of financing impacts the value and rights associated with the previous rounds of investors, and as we will discuss later on, many of the terms negotiated in an angel round will deal with the impacts and opportunities regarding these future rounds of financing. A company may not go through all of the stages laid out below, and it is also possible that they will do multiple rounds of investment in any one stage. Your goal as an angel investor is to get to an exit—a liquidity event—in order to realize a return on your investment.