Investing money in a business startup in exchange for equity has obvious risks, but it offers a potential return of 10 to 20 times the original investment in a three- to seven-year period
Investment industry insiders mention “friends, family, and fools” when talking about the inherent perils of “angel investing.”
“Usually four out of five deals don’t come to fruition,” says Palm Desert investment banker Haddon Libby, who has raised millions in angel capital. “You must have real confidence in the people you are investing in at those early stages.”
The University of New Hampshire’s Center for Venture Research at the Whittemore School of Business and Economics reports that 51,000 U.S. companies received funding from 234,000 angel investors in 2006. On average, each company raised about $500,000. Healthcare services, medical devices, and equipment accounted for the largest share of angel investments.
To endow a startup business, you must be an accredited investor under Securities and Exchange Commission Regulation D, Rule 501. This rule requires a net worth in excess of $1 million, either alone or in combination with a spouse, or an annual income in the past two years of more than $200,000, or more than $300,000 when combined with a spouse’s income.
“Angel networks provide you access to other professionals in your group who are knowledgeable and have expertise in specific areas. That way, you work together to see if an investment makes sense; yet each individual makes their own investment decision,” says Steve Weiss, founder and CEO of the Coachella Valley Angel Network, one of 250 such groups in the United States (a number that has grown from 10 in 1996). “We are a nonprofit organization that facilitates introductions between qualified entrepreneurs and qualified investors. Each party must do their own due diligence.”
Angel network members often have backgrounds in law, medicine, or finance or are entrepreneurs who’ve started and sold companies multiple times. “It’s a chance for someone who is semi-retired to roll up their sleeves and get involved — beyond just investing — as a coach and mentor, because that’s what these companies need,” says Michael Napoli, CVAN’s vice chairman.
For well-balanced portfolio, angels should diversify by investing in a variety of startups. “Out of 10, you hope that maybe two or three will make it big,” Napoli says.
It’s also important to plan an exit strategy. “You need accurate disclosure at the beginning of how you will get out, whether it’s a buyout or stock registered in an IPO,” says Ron Rossi, a corporate and securities attorney with Greenburg Traurig LLP.
Tom O’Malia, director of the Lloyd Greif Center for Entrepreneurial Studies at USC’s Marshall School of Business, offers this final thought: “Smart money does not invest in a startup. It invests in a company that has proof of concept and a clear model where money will enable specific actions. The time for generality is the domain of family, friend, and fools. Angels beware!”