The A to Z of Angel Investments

Finance is undoubtedly a critical issue for all businesses but it is most relevant in the case of startups and small-scale businesses. Raising money from angel investors is one way of financing businesses. Angels bring more than just funds to the table. With their tremendous experience and expertise, angels are able to guide and mentor startups as they scale up. Let us dive deeper into what angel investments are all about and how startups can approach angel investors in India.

Although there are multiple definitions of angel investments, simply put, they are typically the earliest investments made in startups. Angel investments are primarily done in three ways:

Equity

Pursuing equity fundraise means that in exchange for the money they invest, investors will receive a shareholding in the invested startup. When you hear an entrepreneur declare that he is raising “INR 1 Crore at 15%”, it means that he is willing to dilute 15% equity in his company in exchange for INR 1 Crore of investment.

Before a fundraiser, the startup determines its valuation – an estimation of what the company is worth at that point. Once an investor funds the startup at a given valuation, he will own a percentage of stock in that company. In case that startup is sold or goes public, the investor receives a proportional compensation, termed as an “exit”. The investor may make a profit or a loss when he/she exits.

Debt Funding/Financing

In case a startup sells debt instruments to investors in order to raise funds, it is termed as debt funding or debt financing. Debt instruments include bonds, bills and notes. It is basically a loan that is given to the startup and the investor is promised repayment of the principal amount along with interest.

Debt financing allows existing shareholders to maintain their percentage of ownership since no new shares are being issued.

Convertible Debt

Convertible debt is essentially a mash-up of debt and equity. An investor lends money to a startup with the understanding that the funds will be treated as a loan and will either be repaid or turned into shareholding in the company at some later point in time, for instance, after an additional round of fundraising or once the business reaches a certain valuation.

Convertible debt is usually pursued by startups who are in their primary stages and wish to delay dilution of stakeholding and valuation discussions with investors.

From the point of view of investors, angel investments provide an opportunity to engage with entrepreneurs and be a part of the exciting journey that a startup undertakes. Apart from the obvious financial benefits (who doesn’t like a big fat exit!), angels enable the next generation of entrepreneurs working on innovative solutions.

Angel investors are typically high net worth individuals (HNIs) who are willing to take the risk of investing in early-stage startups. They back businesses when most other investors are not willing to support them. Angel investors usually have experience of successfully running companies, whether as entrepreneurs themselves or by working at respectable positions in different companies.

Terms such as seed investors and seed funders also refer to angel investors. When different angel investors come together to invest collectively in professionally managed groups, they are termed as angel networks or angel groups.

Angel investors are also quite different from venture capitalists, although they are easily confused as having similar motives. The first point of difference is that angel investors usually invest in their personal capacity from their own finances. Venture capitalists, on the other hand, are usually a part of a group consisting of other investors as well. They have additional sources of capital such as funds from corporations and foundations.

Secondly, angel investors typically invest in early-stage startups while venture capitalists generally prefer backing more established ones. Angels thus invest smaller amounts as compared to venture capitalists. Funding led by angel investors is usually capped at USD 1 Million while venture funds invest well beyond that amount.

It is possible for different angel investors and networks to have their own established way of going about investments. However, here is how the typical investment process looks like:

Screening

The first step is the thorough screening of a startup’s pitch deck. A pitch deck is a brief presentation that helps the investor get an overview of the startup. It includes information such as the business plan, revenue model, market opportunity, competitive landscape and details of the founders.

Basic Due Diligence

Once the primary screening is done and certain interest is generated, further discussion is done over a phone call or meeting. This helps the investors get greater clarity about the startup and also gives them the chance to ask questions directly to the founders.

Pitch

If the basic due diligence goes well, the startup is invited to pitch in front of the investor or a group of investors. The startup is given a limited time (anywhere between 5 to 15 minutes) to present their idea and is generally followed by detailed discussions led by the investor(s).

Signing the Term Sheet

If the startup generates significant interest after its pitch, interested investors sign a term sheet. It is a document that outlines the basic terms and conditions under which the investment will be made. It is non-binding in nature. Among all those interested, the investor with the maximum interest is chosen as the lead investor. He or she plays a key role in determining these terms and conditions. The term sheet also serves as the basis for the final legal document.

Detailed Due Diligence

Post signing the term sheet, detailed due diligence is carried out where financial records, operations and other aspects are thoroughly checked. Before investing in any startup, investors need assurance that all required processes are in place and there are no financial irregularities in the startup’s record which may be troublesome in the future.

Shareholders’ Agreement

The last step of this process is the signing of the shareholders’ agreement. This agreement is a legal document that regulates the relationship between different stakeholders, states the division of ownership and influences the working of the management and the way the company as a whole functions. The shareholders’ agreement protects the interests of stakeholders in case of any unforeseen issues or disputes. Again, the lead investor plays a crucial role in the final terms and conditions.

Angel investors consider various aspects of a startup before they invest in them. Here are a few areas that investors most definitely look out for while assessing a startup:

Product or Service and Its Value Proposition

Angel investors firstly look for the product or service that is being presented to them and how they solve the pain points of the consumer. The value proposition explains the ways in which the product or service is unique and how has the ability to outperform any of the other available solutions. The investor must be excited by the solution that is being provided by the startup.

Market Opportunity

Market opportunity refers to the demand trend or industry trend that a startup can capitalise on, especially when it is not adequately done by its competitors. Determining the market’s correct potential is critical since it is easy for entrepreneurs to over-value a market. The market size can be determined through various methods such as the number of potential customers and the historical value of all transactions in the given industry. Entrepreneurs can gather data about TAM, SAM and SOM as well. It is also important to reflect the growth potential of the market.

Traction

Traction is a key element considered by investors. Startups that have conducted pilot projects or are selling their product or service in the market should include metrics related to the same in their pitch decks. This helps the investor understand the momentum gathered by the startup and also how the product has been received by the customers. A decent traction helps a startup stand out from the others.

The USP

Each startup must showcase its USP or Unique Selling Proposition. This is what makes the startup different from all others and is the core of its existence. The USP of a startup is what can truly garner immediate interest from an investor.

Founders and Team

Since startups approach angel investors for funding in their early stages, they do not have strong numbers to back their cause. Thus, angels heavily invest in the ability and skill of the founders and team to take the startup to success. Founders’ credentials, relevant experience, commitment and passion are important for investors. The size of the rest of the team and their skills are also considered.

Relevance for the Investor

Angel investors come from different businesses and thus have expertise in those specific sectors. Investors also differ in the stages at which they fund startups. For example, some may fund very early-stage startups while others may prefer more mature startups. Thus, when a startup is presented to them, all these things are accounted for so that a mutually beneficial partnership can be formed with the founders.

Any angel investor or network receives numerous emails from startups seeking funds. In order to stand out from the rest, you have to make sure that you are quick to grab the attention of the reader. You can use an attractive subject line or a cover letter that quickly explains the most important points of your startup so that an investor is convinced to look into more details.

You should also keep the description as simple as possible without the use of jargon. Contrary to popular belief, investors prefer straightforward explanations. Additionally, do your homework and find out whether you are targetting the right investor. You have a greater chance of getting a reply from an investor who is experienced in your field or has made similar investments in the past.

Angel investments can have numerous advantages for entrepreneurs. Have a look at some of them:

Less Risky Proposition for a Startup

Angel investments, as compared to traditional debt financing, are a safer option for startups. Angel investors are generally aware that startups require time to scale up and reach their full potential and they are willing to guide them through the journey.

Proper Guidance and Mentoring

Another great advantage of having angel investors is that they can provide great advice and help in the decision-making process. Given their vast experience, they are able to foresee problems and can help devise ways to overcome them. Additionally, they can assist in setting short term and long term targets.

Networking Opportunities

Angel investors are generally influential individuals and have built strong networks over the years. When a startup raises money from angels, they might also get access to such contacts that the investor has. This can help them accelerate growth with the right connections as vendors, suppliers, partners etc.

Credibility

When angel investors choose to back a startup, it gives credibility to the startup and opens doors to new avenues. This credibility not only assures acceptance among their prospective business partners & customers but also helps while raising additional investments.

It is not only entrepreneurs who benefit from angel investing but also angel investors themselves. Here are a few advantages in store for them:

Be a Part of Unique Businesses

Angel investors can put their money in businesses that they find unique and interesting without having to bear the burden of overlooking their day-to-day functioning. If investors can foresee great potential in the startup, they give themselves a chance to earn healthy returns on their investment as well.

Chance to Back Skilled Entrepreneurs and Diverse Ideas

Angel investments can provide HNIs with the opportunity to back entrepreneurs who they deem are passionate and skilled and have the ability to lead the startup to success. It is an exciting chance to be a part of the startup’s journey from the very beginning and help it expand its business. Additionally, since angels have more knowledge and skills related to the industry they are in, angel investment gives them an opportunity to back ideas that they don’t have the time or skills to carry out themselves.

Opportunity to Share Knowledge and Learn

Investors being so experienced in their fields have the opportunity to provide valuable advice to budding entrepreneurs. Since they have seen both the good and the bad, they can guide entrepreneurs in times of adversity. Additionally, angel investments also provide an opportunity for investors to learn. With markets that are extremely dynamic, angels can gather knowledge about upcoming fields and advancements. Based on the success rate of their investments, they can take better calls in the future.

The Case of Uber and Airbnb

Back in 2008, no one would have thought that there could be a market for a company that lets its customers commute in some stranger’s car by using a mobile application. Rob Hayes was one of the early-stage investors who could envision the potential of Uber and invested in it. Today, Uber has a market cap of roughly USD 50 Billion.

Airbnb also had a similar story. The thought of going to a new place and living in a stranger’s home or letting a stranger enter your private property was not considered earlier. Airbnb capitalised on this very market and became a unicorn. The ability of the entrepreneur and investor to understand the potential of an early-stage firm is imperative in determining its long-term success

Google

Another interesting example is of that Andy Bechtolsheim. He invested USD 100,000 into Google way before the company had any revenues, in fact, before the company was even officially founded. His current net worth of USD 6.5 Billion stems from this investment of his.

Although an angel investor wishes to help the startup wherever required, he or she also has the long term vision of a healthy return on investment. The return on investment comes when the investor seeks an exit. In simple words, an exit is when an investor forgoes his or her stake in the company. Depending on the state and performance of the startup, an investor may make a profit or loss on his or her investment. There are various possibilities of an exit, some of which are:

Mergers and Acquisitions

A merger takes place when two companies are combined together as one while an acquisition occurs when one company buys the other, taking control of its stake and assets. In both of these cases, angel investors can sell their stake in the portfolio company for acceptable compensation, usually cash.

Initial Public Offering (IPO)

An IPO is when a private corporation sells some parts of its business to the public in the form of shares. The company is listed on a stock exchange in order to follow through with the process of selling its shares. When a startup is prepared to do an IPO, it can reimburse its present investors and allow them to secure a healthy exit.

Venture Capital

Startups can look to raise subsequent bigger rounds of funding such as Series A, B, C and so on. This is when venture capitalists come into the picture since they are willing to invest a larger sum of money into the startup. If a strong Venture Capital firm is willing to back the startup, it not only helps in its growth but also allows its current investors to get good exits.

Angel investments, no doubt attractive, are a risky proposition. Here is what one should keep in mind before making an angel investment:

No Overnight Success/Guaranteed Returns

In any angel investment, the average time for any substantial return is 5 to 10 years. This is because any startup needs adequate time to stand on its feet and scale its business effectively.

All Investments Will Not Bring Returns

The odds of getting returns on your investments will generally be against you. your principal investment. It is said that about 30% of investments done by an angel will bring 1x return, i.e, the principal amount. This stems from the fact that more than 90% of startups fail due to multiple reasons. Chances of high-value exits, where returns are more than 3x, are only 1 in 10.

Diversity is the Key

The best way to mitigate risk is by investing in diverse startups. An investor should not only look to put money in a greater number of startups but also look to back startups from different sectors. This ensures that even if a couple of startups are unable to perform as expected, the remaining investments may still cover up for them.

Keep the Right Expectations

There is no doubt that an angel investment can be your jackpot. However, the challenge is that there is no pattern that can tell you when you are going to hit it. A decent amount of time and capital is consumed during this journey. Patience is extremely important for any angel investor.