Angel Investor: Definition and How It Works

What Is an Angel Investor?

An angel investor provides initial seed money for startup businesses, usually in exchange for ownership equity in the company.

Professional angel investors may be involved in multiple start-up projects at once. Other times, entrepreneurs and founders will find angel investors among their family and friends. The investor’s involvement may be a one-time infusion of seed money, or they may provide regular injections of cash designed to bring a product to market.

Angel investors aren’t providing loans. They’re putting money into an idea they like, with the expectation of a reward only if and when the business takes off.

How Angel Investing Works

The term “angel investor” originated in the Broadway theatrical world, where plays were often financed by wealthy individuals rather than formal lenders, and payments were due only when and if the production was a success. It has since come to be used for investors in startup ideas.

Most angel investors are relatively wealthy individuals who are looking for a higher rate of return than can be found in more traditional investment opportunities. They search for startups with intriguing ideas and invest their own money to help develop them further.

These ventures are, by nature, extremely risky because the ideas being invested in are unproven in the market. A survey by the Angel Capital Association estimated that only 11% of such ventures end with a positive result. Their investments in each venture are relatively modest, averaging about $42,000 for investors with more experience and $25,000 for investors with less experience.

Most angels keep their involvement in startups to a small percentage of their portfolios. More experienced investors averaged 15%, while less experienced investors averaged only 7%.

Angel investors connect with startups in need of cash through a variety of paths, including:

• Angel groups or networks
• Friends and associates
• Online or crowdfunding platforms
• Direct contact with entrepreneurs

An entrepreneur may seek an angel investor over more conventional financing such as business loans. The terms tend to be more favorable, especially because the angel investor doesn’t expect to get the money back unless the idea succeeds. Unlike a loan that must be repaid with interest, angel investors focus on helping startups take their first steps. In return, they generally seek an equity stake and a seat on the board.

Angel investors are also called:

• Informal investors
• Angel funders
• Private investors
• Seed investors
• Business angels
  

Becoming an Angel Investor

Anyone who has the money and the desire to provide funding for startups can be an angel investor. They are welcomed by cash-hungry entrepreneurs who can’t get conventional bank loans or don’t want the burden of big debt until their ideas take off.

Angel investors have a genuine interest in innovation and a desire to be involved. Many have been entrepreneurs in the past. They usually are using their own money, unlike venture capitalists, who pool money from many investors.

Though angel investors are usually individuals, the entity that actually provides the funds may be a limited liability company (LLC), a business, a trust, or an investment fund. These are vehicles that the investor sets up for tax purposes or legal protection.

Angel investors who seed startups that fail during their early stages lose their entire investments. This is why professional angel investors look for opportunities that have one of three things:

• A defined exit strategy
• An acquisition opportunity
• Participation in an initial public offering (IPO)

Accreditation of Angel Investors

Angel investors can obtain accredited investor status, although this isn’t a prerequisite. Accredited investor status is a formal designation, regulated by the U.S. Securities and Exchange Commission (SEC), that gives individuals access to the private capital markets based on their assets and financial acumen.

The SEC defines an accredited investor as an individual who has a net worth of $1 million or more in assets or has earned $200,000 in income for the previous two years, or a couple with a combined income of $300,000. Applicants must also demonstrate an understanding of sophisticated investment proposals.

The Bottom Line

Angel investing has grown over the past few decades into a primary source of funding for many entrepreneurs in the early planning stages of turning their ideas into businesses. This, in turn, has fostered innovation that translates into economic growth.

For the entrepreneur, an angel investor provides a much-needed lifeline that is not available through more conventional funding sources. For the angel investor, involvement in early-stage startups has big risks but the potential for big rewards, including personal participation in an innovative project.