The Role of Angel Investors

In recent years, angel investing has become vital to the startup ecosystem. As an asset class, angel investing is a form of private equity where high-net-worth individuals, seeking greater returns than what is expected through the stock market or private credit, take an ownership stake in early-stage startups.

Who are the Angels?

Aside from having wealth, angels typically don’t have much in common. They often bring more diversity compared to the uniformity that the venture capital world is known for. An angel investor is often a successful entrepreneur - not just an MBA holder but someone who has built a successful business - who helps others do the same. They can be friends, corporate executives, or wealthy lawyers and bankers.

They may also organize as syndicates, where a group of investors uses equity crowdfunding platforms to explore opportunities, perform due diligence, and invest in startups. Equity crowdfunding has become one of the greatest innovations in angel investing, allowing early-stage startups to solicit offerings of up to $5M from either accredited or non-accredited investors. Angel investors are the dominant investing force on these platforms, best suited for startups seeking early capital.

The Roles They Play

In a rapidly changing world, where information and capital flow freely across borders, the dynamics of angel investing have changed dramatically. The role of an angel investor depends on their background and the level of involvement they wish to have in the startup. Financial and hands-off investors provide the necessary capital for growth but may not offer much beyond that. In contrast, mentors, active participants, networkers, and influencers can bring invaluable advice, connections, and credibility to a startup, which significantly impact its growth trajectory and chances of success.

In all honesty, the true value-add of an investor depends on the quality of the founding team. An experienced founder instills confidence in investors, making them more likely to provide funding and strategic advice, but largely letting the team execute on the vision. If the team is less experienced or has gaps in critical areas, an angel investor might need to be more hands-on by providing mentorship, making introductions, or taking on operational roles. This makes ‘fit’ incredibly important, which I’ll discuss later.

Regardless of the role they play, angels don’t just pay for equity - they pay for knowledge and access that is valuable over the long run. Angel investors undoubtedly have greater influence on a startup compared to a Big Tech company. Nearly half of angel deals involve someone assuming a board seat, highlighting the importance of mentorship and knowledge transfer at this stage. But it also has financial implications - according to the Angel Capital Association, deals where an angel investor assumes a board seat have a median size 2.5x larger than those without one.

Fortune Favors the Brave

While many angels wish to help entrepreneurs build lasting businesses that benefit society, they aren't typically altruistic. Stock market returns hover around 8-15% per year, but angel investing has a much greater upside. Consider Mike Markkula, who invested $250k in Apple in 1977. Or Peter Thiel, who put $500k into Facebook for a 10% stake in 2004. When Facebook went public in 2012, Thiel sold most of his shares for over $1B. Similarly, media mogul Jason Calacanis turned a $25k investment in Uber into over $100M.

Granted these are exceptions as opposed to the rule, as most angel investments fail to yield significant returns. But just like stock options or cryptocurrencies in a portfolio, the upside is salivating.

With this upside comes risk, and lots of it. Angel investors typically provide the initial capital required to get a startup off the ground, often referred to as the Seed round. Some invest even earlier during the Pre-Seed stage, helping entrepreneurs develop their initial concept or MVP. Given the early nature of these investments, the timeline for realizing a return can be very long. Anyone can make a quick buck in the stock market, but a startup may take 7 to 10 years for a liquidity event - such as a corporate sale or IPO - to occur, allowing investors to cash out. This illiquidity risk is not found in public equities.

One should also consider the lack of transparency when investing in Seed startups. There is a treasure chest of information available on public companies and the executives that run them, from 10-K filings to equity research reports, making it easier to form educated opinions. Outside of a data room that is prepared for funding, an entrepreneur has much more information on their startup than investors do. They might not share all information, either due to oversight, because they deem it unnecessary, or in the worst case, to intentionally mislead investors.

Startups may also lack established systems for reporting and governance, which lead to situations where investors don’t have a clear understanding of how their money is being used, the progress of the business, or the challenges the company is facing. Many are familiar with the fraud performed by Elizabeth Holmes, the founder of blood testing startup Theranos. Or the lack of oversight at WeWork, the co-working startup founded by Adam Neumann. WeWork’s valuation peaked at $47B in 2019, before plummeting due to its flawed business model and poor corporate leadership. As of this writing, WeWork’s stock price is trading at 17 cents.

These are just some examples, but the risk environment spans far and wide. It’s important to note that certain risks become less relevant for investors as a company matures. For example, a Series C startup typically doesn't focus on product risk, as it has already demonstrated its ability to generate demand and approach profitability. By that point, potential questions surround market risk (is the market large enough to sustain continued growth?) or exit risk (can investors realize a great return upon IPO?).

Intelligent investors ‘de-risk’ these investments by performing due diligence and structuring deals to the downside. Nearly 80% of deals are made in preferred stock or convertible notes, taking priority over a founder’s common equity.

The Founder’s Playbook

So, what should founders look for in their investing partners? Contrary to previous years, angel investors are playing a more strategic role in the innovation economy, so understanding the mechanics of this asset class is essential. As a founder, you want an angel investor who knows their stuff regarding your business: someone who's been around the block with your business model and has connections in the industry in which you’re operating. An investor with a strong network can open doors that were previously unavailable by making introductions to customers, suppliers, and other investors. It is a relationship business after all.

Some people argue that great angel investors should have founder or operator experience in your industry. I disagree with that, for many reasons. Industries evolve quickly, and sometimes people with prior experience can cram the thinking of a founder by sharing outdated advice. The best companies are often built by first time founders in an industry - individuals that avoid traditional biases and challenge legacy systems.

Founders should, however, pursue angels with complementary skills. A technical founder with no sales or finance experience could benefit from angels with strengths in those areas, especially during fundraising. Fundraising with VCs can feel like an intense, high stakes dating game paired with a marathon. An angel who understands financial metrics and how to best position your company can increase your chances of successfully raising a round.

Ultimately, you want a partner who shares your vision for the future and your business. Someone who is aligned with you and won't try to steer the ship in the opposing direction when times get tough (unless asked to help or required to do so). And just like any partnership, chemistry and reputation are important. Avoid angels that ask too many questions outside of the due diligence process or are solely focused on making quick financial returns. Any investor requiring significant management will be a serious opportunity cost on your time and prevent you from entirely focusing on the business.

And remember, not all angels are created equal. Money is a commodity, but a person is always attached to it, which can greatly improve or harm your business. Once they’re invited onto your cap table, it’s very difficult to kick them off.

Cheers for reading.