What’s an Angel Investor?
Published on March 30, 2016
By David M. Freedman and Matthew R. Nutting
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 founders’ employees, family, and friends (the three Fs). Angel capital may be in the form of straight debt, convertible debt, or equity.
Angels invest in startups for a variety of reasons, one of which is the opportunity to earn a spectacular financial return. Many experienced angels (who diversify their angel portfolios, negotiate fair deal terms, and conduct due diligence) routinely earn respectable returns in the neighborhood of 25 percent per year, and a few occasionally do earn spectacular returns. 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. (See our article, “Equity Crowdfunding Risks and Returns.”)
In this article we explore how the emergence of Title III equity crowdfunding creates a new class of angel investors, with some of the same financial and strategic motives as traditional angels but some new motives, too: social motives.
Angel Investors Before & After 2016
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.
The Difference between Angels and VCs
Angels represent one of several possible sources of external capital for a startup or early-stage company. The others include the founders’ family and friends, venture capital (VC) firms, banks and other lenders, trade creditors, and credit cards.
Angels invest predominantly in companies in the seed, startup, and early stages of development, although some do invest in the later (expansion) stage 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. So angels earn 100 percent 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.
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 from around 200,000 in 2002 to around 300,000 in 2012, and tens of thousands more in 2015 (thanks to new 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.
More than three-fourths of investors in angel deals are non-accredited. (Under Rule 506(b) of Regulation D, up to 35 investors in each offering can be non-accredited.) That proportion may change if more issuers use the new Rule 506(c) exemption, created by the SEC as a result of the JOBS Act, 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 basis for angels’ investment decisions.
Two-thirds of angel investors report that making money isn’t their primary motivation for investing in private companies. And 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.
Nonfinancial 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 entrée 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, and encourage economic development.
Running the Numbers
Angel investors provided more than $20 billion in financing to more than 60,000 ventures in 2011. “A typical angel round these days might be $150,000 raised from five people,” said Paul Graham, a high-profile Silicon Valley angel investor and founder of the tech accelerator Y Combinator, in 2009. The typical angel round is different when the investors are members of angel groups—the median size in that case was $600,000 in 2013.
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, the average angel investment made by an individual is $37,000. Note that the average is significantly 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 will facilitate much smaller investment amounts from a larger number of investors.
Equity financing accounts for roughly half of the capital raised from angel investors in a typical year. Debt financing accounts for the other half, in terms of dollars. Some deals combine debt and equity, however, and about 30 percent of the deals that involve equity also involve debt.
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 software. But several other sectors received significant angel investment as well. For example:
- According to one study, in the third quarter of 2012, the greatest number of angel investments—in terms of both deals and dollars—were made in Internet-related companies. Those were followed by healthcare companies, mobile/telecom, consumer products and services, and others.
- According to a different study, the top three sectors receiving angel funding in 2012 were software, healthcare, and retail.
- In 2013, the top sectors invested in by members of angel groups (accredited investors only)—in terms of both deals and dollars—were Internet, healthcare, mobile/telecom, industrial ventures, software, computer hardware and services, and energy and utilities.
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 135 members (accredited investors only) are based in Silicon Valley. The Band reported in 2014 that about 4 percent of its investments over 20 years have ended up as Nasdaq IPOs and another 19 percent have resulted in acquisitions. The cumulative internal rate of return for all investments over 20 years (totaling $228 million), including the losses suffered through the dot-com bust, is a positive 54 percent 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 percent is a phenomenal rate of return, Ian Sobieski, founder and managing director of the Band of Angels, provides 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 urge 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, vice chair of the Angel Resource Institute, and partner with Montlake Capital, a late-stage growth capital fund. Wiltbank’s research on angel investors was backed by the Kauffman Foundation’s Angel Returns Study, the NESTA Angel Investing Study, the University of Washington, and Willamette University.
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 than not to lose their money, i.e., to earn less than a 1x return. However, once investors had a portfolio of at least six investments, their median return exceeded 1x.”
- When you aggregate all the data, these angel investors in the United States and the United Kingdom produced a gross multiplier of 2.5x their investment, in a mean time of about four years. In other words, an angel investment of $1,000 today would typically be worth $2,500 in four years, which represents a 26 percent annual return. Keep in mind that Wiltbank surveyed only accredited investors who belong to angel groups (who were willing to discuss their investments), who represent less than 25 percent of all angel investors in the United States. Also, these returns do not account for the time investors spent researching and managing their 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.
- “This is critical,” Wiltbank wrote. “Each investment has to be done as though it’s your only one.” Do not lower your standards at any point just because you are building a diversified portfolio and assuming that diversity in itself will guarantee good returns.
- “Ninety percent of all the cash returns are produced by 10 percent 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 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. 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.
About the authors David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors: A Guide to Risks, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).
Accredited Investor Markets features a section on angel investing, venture capital, and crowdfunding. http://www.AIMkts.com
Angel Capital Association http://www.angelcapitalassociation.org/
Center for Venture Research, University of New Hampshire http://paulcollege.unh.edu/cvr
“Historical Returns in Angel Markets,” Right Side Capital Management, 2010 http://www.growthink.com/HistoricalReturnofAngelInvestingAssetClass.pdf
 Sources: Center for Venture Research, University of New Hampshire; PwC MoneyTree; as reported by the Angel Capital Association, September 2012.
 Scott A. Shane, Fool’s Gold? The Truth behind Angel Investing in America, Oxford University Press, 2009, pp. 11, 36. This estimate is based primarily on the United States Entrepreneurial Assessment, Florida International University, Paul D. Reynolds (producer), 2004, and “survey data conducted on a representative sample of the adult age population conducted by the Global Entrepreneurship Monitor” (Babson College and London Business School), Shane told the authors in 2014.
 Shane, op. cit., p. 23.
 This term was coined by Amy Cortese, author of Locavesting: The Revolution in Local Investing and How to Profit from It, John Wiley & Sons, 2011.
 Paul Graham, “How to Be an Angel Investor,” March 2009, www.paulgraham.com/angelinvesting.html.
 “2013 Halo Report,” released by Angel Resource Institute, Silicon Valley Bank, and CB Insights, March 27, 2014.
 Shane, op. cit., p. 20.
 Ibid., p. 81.
 “Rise of the Angel Investor,” InvestorPitches.com, The Pitch blog, February 26, 2013. Sources included smallbusiness.com, Angel Resources Institute (Kauffman Foundation), and Paul College at University of New Hampshire.
 Sarah E. Needleman, “What You Need to Know to Become an Angel Investor,” Wall Street Journal, December 2, 2013, citing as sources the University of New Hampshire’s Center for Venture Research and Dow Jones VentureSource.
 “2013 Halo Report,” op. cit. When angel groups co-invested with other types of investors, such as VC firms, the median round size reached $1.7 million.
 Internal rate of return (IRR) is a measure of return on investment without adjusting for external variables such as interest or inflation. Technically, the IRR is the discount rate that will bring a series of future cash flows to the net present value of cash invested.
 Ibid., p. 160.
 Robert Wiltbank, PhD, “Angel Investors Do Make Money—Data Shows 2.5x Returns Overall,” TechCrunch, October 2012, http://techcrunch.com/2012/10/13/angel-investors-make-2-5x-returns-overall/.