What it means
A new company with an idea, a prototype and no revenue cannot borrow, because it has no cash flow to repay a loan and nothing to secure it on, and it is too small for most venture capital funds, which need to deploy millions per deal. Angels fill that gap.
They are usually successful entrepreneurs, executives or professionals investing a portion of their wealth in businesses they understand, accepting that most will fail in the hope that one or two will return many times the money. The investment is structured either as ordinary or preferred shares at an agreed valuation, or as a convertible note or simple agreement for future equity (SAFE) that converts into shares at the next priced funding round, usually at a discount or with a valuation cap to reward the angel for early risk.
Convertible instruments avoid the difficulty of valuing a company that has no revenue. Angels rarely take control, but they often negotiate information rights, a board seat or observer role, pre-emption rights on future rounds and protections against dilution.
For the founder, angel money is expensive in equity terms: a $200,000 investment at a $2 million valuation gives away 10% of the company, which could be worth far more later. It is also patient in a way bank debt is not: there are no repayments, and the angel is paid only if the company succeeds.
The best angels add more than money. An angel who has built and sold a company in the same industry can open doors to customers, hires and later investors, and can spot mistakes early.
Founders are advised to choose angels for what they bring beyond the cheque and to check what past founders say about them. Angel investing is high risk.
Studies of angel portfolios consistently show that more than half of investments lose money and a small minority produce most of the returns, which is why angels diversify across many companies and why many governments offer tax relief to encourage it.
In practice
Real-world examples.
Example
A retired software executive invests $50,000 in each of twelve start-ups over five years; eight fail, two are sold for modest sums, one returns three times her money and one returns forty times, making the portfolio profitable overall.
Example
A group of twenty angels in a regional syndicate pool $30,000 each to make a $600,000 investment in a medical device company, with one member taking a board seat on behalf of the group.
Example
A founder chooses an angel who offers $150,000 at a lower valuation over one offering $200,000 at a higher one, because the first has built two companies in the same market and the second has never invested before.
Think of it
“An angel investor is a wealthy individual who bets on startups with their own money-the first believers.
Formula
Calculation
Ownership Acquired = Investment / Post-Money Valuation
Post-Money Valuation = Pre-Money Valuation + Investment
Return Multiple = Exit Proceeds to Investor / Investment
Worked example 1, a priced round. A start-up agrees a pre-money valuation of $2,000,000 with a group of three angels who invest $500,000 between them.
- Post-money valuation = $2,000,000 + $500,000 = $2,500,000
- Angels' ownership = $500,000 / $2,500,000 = 20%
- Founders' ownership falls from 100% to 80%
Five years later the company is sold for $30,000,000. After two further funding rounds the angels have been diluted to 12%.
- Angels' proceeds = 12% x $30,000,000 = $3,600,000
- Return multiple = $3,600,000 / $500,000 = 7.2 times
- IRR over five years = (7.2 to the power 0.2) minus 1 = 48% a year
Worked example 2, a convertible note. An angel lends $100,000 on a convertible note with a 20% discount and a $4,000,000 valuation cap. A year later a venture fund prices a round at a $6,000,000 pre-money valuation.
- Conversion at the discount: $6,000,000 x 80% = $4,800,000
- Conversion at the cap: $4,000,000
- The angel converts at the lower of the two, $4,000,000, receiving shares worth $100,000 / $4,000,000 x (the company's share count), an effective ownership of about 2.5% before the new money, compared with 1.67% had the note converted at the round price. The cap has rewarded the early risk.Case study
Seen in the real world.
A two-founder food technology start-up raised $350,000 from five angels at a $2.8 million pre-money valuation. One angel, a former supermarket buyer, negotiated a board seat. Within six months she had introduced the founders to the category managers of two national chains and rewritten their pitch from a product story into a margin-per-shelf-metre story that buyers understood.
The company won a trial listing that its founders later said they would not have obtained for two years on their own. Eighteen months after the angel round the company raised $4 million from a venture fund at a $16 million valuation; the angels' stake, diluted to 8.5%, was worth $1.7 million on paper against $350,000 invested. The founders' reflection was that four of the five angels had been passive and valuable only for their money, and that the one active angel had been worth more than the rest of the round combined.
Watch out
Common mistakes.
- Raising angel money at too high a valuation. It flatters the founders now and makes the next round harder if the company has not grown into the price.
- Taking money from too many small angels without a lead, which leaves the founder managing twenty investors and no one able to make decisions for the group.
- Choosing angels for the size of the cheque alone. Relevant experience and a good reputation with previous founders matter more.
Questions
People also ask.
How is an angel investor different from a venture capitalist?
An angel invests personal money, usually smaller amounts, at an earlier stage. A venture capitalist invests a fund's money, in larger amounts, usually once a company has revenue or clear traction.
How much equity do angels usually take?
Typically 10% to 25% of the company in a first round, depending on the amount raised and the valuation agreed.
What is a SAFE?
A simple agreement for future equity: the investor pays now and receives shares at the next priced round, usually with a discount or valuation cap. It defers the valuation question and keeps legal costs low.
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