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Pursuing Angel Investors: What You Need to Know
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For most people, the term, “angel investor,” probably conjures images of a kind-hearted individual who can help get your dream business off the ground or provide much-needed cash infusions.
But what is an angel investor? There are basically two types. The first consists of people you know, like friends and family. The second are investors seeking a higher Return on Investment (ROI) than from traditional investments like equities. To achieve higher ROI, both kinds of angels provide capital to new and existing companies.
There are at least 250,000 active angel investors in the U.S., according to the University of New Hampshire’s Center for Venture Research. That number was as high as 629,000 in 2003, according to the U.S. Small Business Administration’s Office of Advocacy. The SBA estimates that angels were responsible for $228 million in investments in 2006. They also invest in a variety of business types that are continuously in flux. For instance, the Center for Venture Research notes that retail businesses accounted for only 6% of investments in 2007. While in 2003, the SBA determined that retail businesses accounted for 25% of all angel investments.
Depending on your business, this may sound like a no-brainer, but is angel financing really right for you? Here is some information to consider when pursuing angel investors:
Friends and Family
Despite sometimes being called, “friends, family, and fools,” there can be benefits and disadvantages to asking people you know to invest in your business. Here are a few:
Benefits:
• You trust them because you know them well
• They understand the blood, sweat, and tears you’ve put into your dream business
• They are probably geographically close to you and your business
• They can serve as mentors
• Disadvantages:
• They may not truly understand your business model
• They could meddle in your day-to-day operations
• They could try to change the repayment terms if they’re unhappy with the progression of your business
Going this route?
Approaching a friend or family member for investment can be a nerve-wracking experience. If you choose to pursue the friends and family route, setting the meeting over dinner at a restaurant can be a common approach. Bring your prepared proposal. Your preparation as well as the formality implied by the setting will help set the right tone for your pitch. Your family member or friend will be impressed by your thoughtfulness and, at the very least, consider your proposal.
Angel Groups
If you would rather not involve people that you know in your business, a formal angel investor can be an attractive option. Pursuing organized angel groups can also be accompanied by benefits and disadvantages, including:
Benefits:
• They are likely to be knowledgeable business professionals that can easily understand your business model
• They likely have a history of investment experience
• They can serve as mentors
• Disadvantages:
• They could have an interest in exit strategies that do not meet your goals
• They may want generous repayment terms
• They may demand an active role in your company’s operations. However, there is one caveat. While this may seem like a headache, depending upon your needs, negotiation or mediation skills, their applied expertise could help your business.
Going this route?
There are several ways to approach angel investors. One of the most effective ways is through referral. Engage the services of a lawyer, accountant or other specialized professional that has experience in local angel investor networks and ask him or her for an introduction. Another way is to perform online research for local angel investor groups and inquire about opportunities for an introduction. A SCORE workshop, Chamber of Commerce event, a local University-based entrepreneurship center may be good places to identify investors or ask about angel investor networks in your area.
Making a Fair Exchange: Understanding an Investor’s Rights
Angel investors provide funds in exchange for certain rights, including common stock and preferred stock. In some cases , they may make a short-term loan called a bridge loan. These terms are explained below:
Common stock confers minimum rights for an investor which includes voting rights and membership on the company’s board of directors. However, if a company is liquidated or sold, common stock holders receive payments last, after preferred stock holders and other debtors.
Preferred stock provides more security for angel investors at the expense of voting rights. For example, holders of preferred stock are paid dividends before common stock holders both during the normal course of business and in the event of a sale or liquidation.
A bridge loan is short-term financing that is often used for businesses that are securing second- or third-round financing (such as venture capital) and can be used as working capital in the meantime. Bridge loans often carry high interest rates and need to be secured by your company’s assets for collateral.
These are fairly complicated financial concepts, so consider these options carefully. Consult with an accountant or an attorney that specializes in finance to discuss each financial instrument to determine which best meets your business goals and needs.
Making an Exit
Angel investors often expect to see a return on their investments through exit strategies like mergers and acquisitions (M&A), Initial Public Offerings (IPO), a business sale, and liquidation. According to the Center for Venture Research, M&A activity accounted for 65% of the exit strategies in 2007 (IPOs accounted for only 4% that year). This can be very good news if your start-up or existing business operates in a market with plenty of “big fish.” However, exit strategies change all the time. IPOs may rise again, while M&A activity may fall.
Selling your business is another exit strategy. A business sale is different from an M&A scenario because it often involves selling your business to someone that you know. It is a sensible option if you achieve a sales or profit benchmark, and you and the prospective buyer can agree on the value of your business. This scenario will allow your investor to recoup his or her investment while you move onto the next milestone in your life. Finally, liquidation is another way to exit. Though, few business owners would choose this as an exit strategy. A business can voluntarily choose to be liquidated. However, there are other cases where investors and other creditors can force liquidation on a business.
As you consider the exit strategies available to you, consider what works best for your business model. Prior to meeting with an angel investor, research their previous deals, if possible, to determine the exit strategies that they have historically chosen. If they align with your business goals, discuss their repayment terms and preferred exit strategies during an interview. This will help ensure that you and your investor are on the same page. Then mull it over both alone and with the help and advice of a professional that has familiarity with the angel investing field.
Contracts and Schedules
Whether you choose family, friends or professional investors, always create a contract. With the help of an attorney who specializes in finance so that your business is protected. The contract can specify the preferred exit strategy, the value proposition (the benefits, costs, and value that your business delivers to its customers), the expected Return on Investment, rights and responsibilities of each party and any methods for recourse.
A development schedule can also be helpful for both you and your investor(s). This schedule can list the use of the investor’s funds and let the angel know when certain financial benchmarks are reached.
Seeking angel investment can be a difficult and time-consuming process. It is not an investment choice that benefits all businesses. However, if you find an investor who trusts you, shares your vision and goals, and understands your business model, then partnering with an angel investor can be a match made in financial heaven.
What you should do before you pursue:
• Take the time to determine company’s value proposition and the expected ROI and create a contract that incorporates these items
• Determine your comfort level with each of the equity options discussed above. Identify the type you are willing to offer to investors and let each potential investor know which type they can expect
• Prepare a schedule that outlines the stages of development and/or use of funds for the investor
• Consult an attorney to help you clearly define an exit strategy that can satisfy both you and your investors
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