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Angel Investing: A High-Risk Ground Floor Opportunity

Angel Investing: A High-Risk Ground Floor Opportunity

May 06, 2024

Most people are fine with investing in public companies. But what if they want to get in on the ground floor of the Next Big Thing? Maybe they know about an early-stage startup whose founders are incubating a game-changing technology or medical treatment. All they need is some working capital to keep the company afloat while they bring their idea to life.

That’s where angel investors come in. They’re wealthy individuals who are willing to take on the significant risks of funding an unproven enterprise, fully understanding that they may be locking up their money for years. And there’s a good chance that they’ll lose it all.

Financial advisors can’t generally help them find or evaluate opportunities, since startups are privately held and not subject to SEC regulatory scrutiny.

Planting the seeds

Angel investors provide seed capital to fund primarily early-stage private companies in exchange for equity in the company.

Often the only employees in these startups are their founders, whose main assets are a groundbreaking idea for a new product or service and the knowledge and expertise to make it a reality.

It doesn’t matter that they don’t have an office, customers or even a solid business plan. Angel investors make long-term bets on a dream they believe may someday come true—and reward them handsomely for their faith and patience. 

Not just for entrepreneurs

Contrary to what you might think, not all angel investors are entrepreneurs, self-made millionaires, or retired CEOs.

Some simply have a strong professional understanding of certain industries they’d like to invest in. Others want to help underrepresented entrepreneurs, such as women or minorities.

But what they all have in common is wealth.

Entry requirements

Investing in startups is like investing in most hedge funds or private equity funds. These private companies aren’t regulated by the SEC. They’re not legally required to post quarterly results or financial statements. Shares aren’t sold on stock exchanges. Invested capital may be locked up for years.

Because of this higher level of risk, people who want to invest in startups must generally be accredited investors. This means they must either earn annual income of at least $200,000 per year (or $300,000 as a married couple) or have at least $1 million in investable assets (not including their primary home).

Initial investments

Very early-stage companies might accept as little as $5,000 in seed capital from “friends and family,” while others may require investments of at least $50,000 or more. The larger the investment, the higher the ownership stake in the company investors receive.

Measuring progress

Angel investing is a long haul. It may take years for the company to get to a point where it’s generating enough revenue that it doesn’t require further infusions of capital from investors.

Generally, the founders will work with angel investors to establish certain milestones. For example, the first milestone might be the development of a beta version of its application. The next might be the landing of a first revenue-generating customer.

What angel investors count on are increasing valuations. As the startup begins to bring its product or service to market and starts generating revenue, the value of each investor’s stake rises as additional investors (including in some cases, venture capital funds) decide to buy in.

A key diagnostic concept in angel investing is “runway.” This refers to how long the company’s capital reserves are expected to last. Well-funded startups that are earning revenue or managing costs wisely should have lengthening runways.

Shortening runways often mean that a company is spending too much money and may not be able to achieve a particular milestone before cash runs out. In this case, investors may have to choose between providing more capital or letting the company sink or swim on its own.

The end game

It’s estimated that between 75% to 90% of all startups fail.* And even among those who survive, very few make it to an initial public offering (IPO) stage.

Most angel investors realize this. They’re not expecting the startups they invest in to “go public.” But they do hope that those that survive will eventually be acquired by another company. One that will pay a premium to buy their stake.

Finding opportunities

Unless angel investors have connections with founders at promising startups, finding opportunities on their own can be challenging.

That’s why many join an angel investing group. These are communities of angel investors who evaluate and invest in startups together. Members can often rely on their collective expertise to recommend promising opportunities and conduct the level of due diligence needed to assess a startup candidate’s strengths and flaws.

Some of these groups focus on specific regions or industries. Others focus on funding companies started or led by minorities or women. 

Before jumping on the bandwagon

Would-be angel investors need to have a full understanding of the risks involved. While a successful exit could earn them a very attractive return on investment (and a possible jackpot if the company goes public), it’s far more likely that they’ll lose their money.

That’s why those considering angel investing might want to discuss the idea with a financial advisor. They won’t be able to find, recommend, or provide any sort of opinion on specific opportunities. But they may be able to help figure out where such investments might fit within their client’s overall asset allocation strategy and the maximum amount of money they may be able to afford to invest without putting the rest of their net worth at risk. 

 

 

 

Please note that Canby Financial Advisors may not provide a recommendation, opinion, call to action, or otherwise guide an investor to a decision on whether to buy, sell, or hold any security not offered through Commonwealth. Additionally, Canby Financial Advisors may not provide a recommendation or opinion on specific angel investor groups.

Angel investing and other private equity investment strategies are speculative and not appropriate for all investors. Investors could lose all or a substantial amount of their investments. Investments in private companies are usually often illiquid and there may be restrictions on redeeming private shares. Investors must meet specific suitability standards before investing. There is no assurance that the investment objective of any investment will be attained. This material has been provided for general informational purposes only and does not constitute investment advice.

This article was authored by Dan Flanagan and Jeffrey Briskin. Dan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or dflanagan@canbyfinancial.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.

 *Sources: https://corpgov.law.harvard.edu/2023/09/29/startup-failure/,  https://www.forbes.com/sites/neilpatel/2015/01/16/90-of-startups-will-fail-heres-what-you-need-to-know-about-the-10 

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