What is an Angel Investor and What Motivates Angels to Invest?

ROI, Title III and the Benefits of Angel Investing

What is an angel investor? Is it just another name for a venture capitalist? Even though these classes of investors both target startups, an angel investor can really be anyone with the money to fund a young company. Besides this major difference, there are also other motivations and unique benefits of angel investing.

So, What is an Angel Investor Exactly?

An angel investor is an individual who provides capital from his or her own funds to a private business owned and operated by someone who is neither a friend nor a family member.

Angels often provide the first round of “outside” capital—that is, outside of the founder’s family and friends (the three Fs). Angel capital may be in the form of straight debt, convertible debt or equity purchases.

Angels invest in startups for a variety of reasons, one of which is the opportunity to earn a spectacular financial return. Many experienced angels (those who diversify their angel portfolios, negotiate fair deal terms and conduct due diligence) routinely earn respectable returns in the neighborhood of 25% per year, and a few occasionally do earn spectacular returns—along with many losses, duds and liquidations. But return on investment is not the only attraction of angel investing. There are also strategic and social reasons for investing in risky private securities. And with the growth of equity crowdfunding, we expect those social motives to be more prevalent. .

The Difference Between Angels and VCs

Both are a possible source of external capital for startup or early-stage companies (in addition to commercial banks, lenders, trade creditors, etc.), but what is an angel investor in comparison to a venture capitalist?

Angels invest predominantly in companies in the seed, startup and early stages of development, although some do invest in the later (expansion) stages as well. Here is how venture capitalists are different from angel investors: VC firms attract funds from individual and institutional investors, all of whom are accredited investors. The fund manager uses those pooled funds to invest in portfolio companies, usually in the early and growth stages but sometimes dipping into the startup stage as well.

Investors who invest money in a VC fund have no power to select portfolio companies, and they earn a return only after the fund manager takes a percentage of the capital gain (known as carried interest), plus a management fee. Private equity (PE) firms and hedge funds have management and fee structures similar to those of VC funds and are likewise open only to accredited investors, but they have investment portfolio strategies that are different: PE firms focus on acquiring outright (or buying controlling interest in) mature companies, while hedge funds use a broad range of investment strategies that often include both long and short positions.

Angel investors (who may be accredited or non-accredited) make their own selections and invest directly in portfolio companies, focusing mainly on the startup and early stages, and sometimes dipping into the seed stage. Therefore, one of the benefits of angel investing is that angels earn 100% of any income or gains derived from the investment. Angels invest in a much wider range of industries than VCs, who tend to focus more on high-growth sectors of the economy, such as technology and healthcare.

Active Angels

According to various sources, the number of active angel investors (those who made an angel investment during the year being studied) in the United States has risen to more than 300,000 thanks to Rule 506(c), which lifts the ban on general solicitation for some Regulation D offerings. Keep in mind that, according to our definition, these figures do not include family and friends of the founders.

In terms of dollars invested, angels in the aggregate generally invest much more than venture capitalists in the startup and early stages, but much less than VCs in the expansion and later stages.

Before Rule 506(b), more than three-fourths of investors in angel deals were non-accredited, according to Fool’s Gold? The Truth Behind Angel Investing in America. (Under Rule 506(b) of Regulation D, up to 35 investors in each offering can be non-accredited.) That proportion has likely changed as more issuers use the Rule 506(c) exemption, because it allows general solicitation so long as non-accredited investors are excluded.

Financial and Social Motivation

Certainly one of the motives for investing in risky startups and early-stage companies is that investors can potentially earn a greater financial return than they can from investing in public stocks, bonds and mutual funds. But ROI is seldom the only benefit of angel investing.

Some angels value the non-financial benefits of investing in private companies so much that it might be better to view their activity as consumption rather than as investment, much as we look at the purchase of art or expensive homes.

Many angel investors also choose companies based on their social positions. For example, a recent Harvard Business School survey found that female investors—a group slowly on the rise—are twice as likely to invest in businesses with a strong social impact or with female leadership. Furthering a social cause or empowering females in business is a non-financial reward that can be an integral part of the deal evaluation process.

Other non-financial rewards include sharing the excitement of building new, innovative enterprises without having to work long hours.

Strategic investors often buy shares of growing companies, because it allows them to make use of expertise they have developed in a particular industry or technology during their careers. Other motivations include learning about new technology before it reaches the marketplace and gaining an entry into a company where they would like to be employed as an executive. Finally, many locavestors want to support the community in which they live and work, in order to encourage economic development.

In Terms of Dollars

In 2019, an estimated $15.7 billion was invested in angel and seed-stage deals, though the most active, early-stage investors have come from accelerator Y-Combinator. The typical, or median, investment in a single deal by an angel investor before 2009 was $10,000, according to research by Scott A. Shane, PhD. According to more recent data, a typical angel investment may be $25,000 to $50,000 per individual. Note that the average may be higher than the median because of a small number of very large investments (outliers, in the lingo of statistics). Remember that Title III equity crowdfunding facilitates much smaller investment amounts from a larger number of investors.

Equity financing accounts for a portion of the capital raised from angel investors in a typical year. Debt financing accounts for another portion, in terms of dollars. Some deals combine debt and equity, however.

The highest-profile angel investments have always been in technology startups, and the superstar angels tend to be located in high-tech communities. Indeed, based on many recent studies of angel investment, the sectors with the most angel investment were Internet and healthcare. Where’s the ROI?

Return on investment is not the only motive for investing in private securities, but it is one we can try to measure. The problem is: ROI is an elusive statistic in the angel capital markets because issuers and investors are not required to report such data. Statistics coming from academic studies are sometimes taken out of context and distorted by the media, and survey results coming from professional associations are sometimes biased because, after all, they are promoting their members’ interests.

The Band of Angels, founded in 1994, is one of the most successful angel groups in the United States. Most of its 165+ members (accredited investors only) are based in Silicon Valley. The Band reports 62 profitable M&A exits and 13 NASDAQ IPOs. The cumulative internal rate of return for all Band of Angel investments over 20 years (from 1994-2014, totaling $228 million), including the losses suffered through the dot-com bust, is a positive 54% per year. (That means if you invest $1,000 today, it will be worth $1,540 in one year, $2,372 in two years, $3,652 in three years, etc.).

While 54% is a phenomenal rate of return, Ian Sobieski, founder and managing director of the Band of Angels, provided this caveat: “We’ve had more than 200 investments [actually 270]. If you take the top nine performing deals out of the basket, the IRR drops to zero. So only one in 20 really moves the needle. Since the average investor invests in only 10-or-so deals, the odds of any one angel being in a winner are only 50 percent.”

In most surveys of angel investors and their returns before equity crowdfunding became legal, the estimated returns on investment tend to be overstated, because they fail to consider the cost of investors’ time. Investors might spend considerable time sourcing deals, conducting due diligence, and negotiating deal terms before the transaction, and advising or helping the founders after the transaction. “Angel investing is not passive, like putting money into a mutual fund, a venture capital limited partnership, or a hedge fund,” writes Shane.” Some investments require more active involvement from angels than do others, but these are rarely passive investments. Equity crowdfunding is a whole new reality, however. It is quite unlikely that equity crowdfunding investors will be obligated, or even invited, to participate in the operation or governance of the company, as we will explain further.

We want to be careful not to create unrealistic expectations, so we invite you to read Chapter 6 of our book, Equity Crowdfunding for Investors (Wiley & Sons, 2015), which presents detailed statistics from a number of studies about returns from angel investing. In this article we will cite just one of those studies.

Robert Wiltbank writes that “the best estimate of overall angel investor returns . . . is 2.5 times their investment . . . in [an average] time of about four years,” which yields a very respectable 26 percent annual return.

Robert Wiltbank, PhD, is associate professor of strategic management at Willamette University, Angel Resource Institute (ARI) Fellow and former partner with Montlake Capital, a late-stage growth capital fund. In 2012, Wiltbank described the results of his survey of individual angel investors—all of whom are accredited and members of angel groups—in which he asked them to disclose the financial results of their angel investments over a 15-year period We must take into consideration that the respondents were self-selecting; in other words, we might hypothesize that investors who had lousy returns were less likely to respond to the survey.

In October 2012, based on his survey data, Wiltbank looked at more than 1,200 angel investments in the United States and the United Kingdom that resulted in what we call a termination event, where investors sold, redeemed or forfeited their shares and realized a gain or loss. These events ranged from the company going out of business (possibly a total loss for investors) to an acquisition (possibly a loss but more likely a gain) to an IPO (probably a big gain). Based on what those investors told him, Wiltbank reported the following:

• In any single investment, an angel investor was more likely to lose their money, though their returns were positive once their portfolio consisted of at least six investments.
• Angel investors in the United States and the United Kingdom produced a gross multiplier of 2.5x their investment, in an average of about four years (an annual return of 26%). Keep in mind that Wiltbank’s survey only included accredited investors who belong to angel groups and did not account for time invested in researching and managing investments..
• As a rule of thumb, “angel investors probably should look to make at least a dozen investments” to diversify their portfolios in terms of one or more of the following: industry or sector, geography, vintage, and/or stage of development.90% of all the cash returns are produced by 10% of the exits. This proportion applies to venture capital as well as angel capital. In fact, this proportion is essentially constant everywhere, not just in the high-tech centers of Silicon Valley or Boston, and across all industries.

Keep in mind that those survey results tend to represent investments by wealthy investors who target fast-growth and high-potential companies, rather than companies that strive for steady long-term growth, dependable (rather than volatile) profitability and longer time before an exit for investors. The latter are probably underrepresented in Wiltbank’s data, as they are more likely to be rejected by angel groups (because of their longer exit horizon), so they are consequently more likely to filter down to equity crowdfunding as a path to financing. Rejection by angel groups does not necessarily make them bad investment opportunities. In fact, some of them may be less risky than the fast-growth startups that accredited investors chase. Although their returns may be less spectacular, they can yield income (from profits) over a longer term, as well as respectable capital gain.

Angel Investors in the Era of Equity Crowdfunding

For two primary reasons, the emergence of Title III equity crowdfunding creates a new class of angel investors. The first reason is that before the launch of equity crowdfunding, individual angel investors typically had to commit large sums of money to participate in an angel deal, amounting to tens and sometimes hundreds of thousands of dollars, in return for straight equity or convertible debt (debt securities that could be, under specific conditions, converted to equity securities). By contrast, through most Title III crowdfunding portals and broker-dealer platforms, investors can buy in for much smaller amounts—as little $1,000 or $500, or even much less.

The second reason this new class of crowd-angels is different is based on access. Before equity crowdfunding, the average investor did not have easy access to private securities offerings. Angel deals were offered mainly to: (1) angel groups, the members of which were accredited investors only; (2) professional angel investors who were well known for writing checks to entrepreneurs; and (3) strategic investors who worked in the same industry as the issuer and therefore were colleagues of or had affiliations with the issuer or its broker-dealer. Now, thanks to equity crowdfunding, many angel deals are aggregated on website portals and platforms for everyone to see, no matter who you know or don’t know.

Angel Groups and Angel Crowds

Considering the evidence, you would logically conclude that angel investors who belong to angel groups have an advantage over those who don’t. And since non-accredited investors are excluded from those groups, non-accredited angel investors are at a disadvantage.

But equity crowdfunding creates a new kind of angel group—the crowd—to which all investors can belong and reap the benefits of angel investing. The SEC declared in October 2013, when it released its proposed rules for Title III (on page 376): “A premise of crowdfunding is that investors would rely, at least in part, on the collective wisdom of the crowd to make better informed investment decisions,” which is why “we propose to require intermediaries to provide communication channels for issuers and investors to exchange information about the issuer and its offering.”

When you sign up for and become a member of an equity crowdfunding portal (or equity crowdfunding platform operated by a broker-dealer), you have the ability to collaborate with other members through three methods:

• In Q&A forums you can ask questions of issuers. Your questions and their responses are posted for all members to see, or at least the members who have indicated an interest in that issuer’s offering.
• Portals also enable crowd members to engage in discussions among themselves, share research, and invite their professional advisers to join the discussions.
• Crowd members can and often do contact each other off-platform to engage in private discussions. Almost certainly, equity crowdfunding investor meet-up groups will form in major cities across the country, just as angel groups have.

Institutional investors (such as pension funds, university endowments, and banks) will seek to diversify, perhaps in an exploratory sense, by buying shares in early-stage companies, especially in the technology, consumer products and real estate sectors. They have prodigious resources for conducting due diligence. If you are aware that an institutional investor is participating in a Q&A forum or discussion on a crowdfunding portal, pay close attention to their questions and comments.

As equity crowdfunding continues to develop and more non accredited investors enter the market, the answer to what is an angel investor will continue to develop as well.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds and Due Diligence Before Investing. This is an updated version of an article originally published on March 28, 2016.]

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