A Basic Primer for First-Time Angel Investors

• By Joe Johnson on February 16, 2017

Joe Johnson, Ph.D.
Entrepreneur. Investor. Start-up Expert.

If you’re considering investing money in a startup, but don’t know where to begin, this article will constitute an excellent basic primer for you. Over the coming months, we’ll be publishing a series of articles that will go into a great deal of detail to help you achieve a more thorough understanding of angel investing and to facilitate your success.

Breaking into angel investing isn’t difficult. In fact, it’s as simple as writing a check. However, becoming a successful angel investor takes time, knowledge, and patience. Before reaching for your checkbook, read this article for a review of these essential questions:

• What does angel investing involve?
• Why does angel investing matter?
• Where to find startups seeking investors?
• Which startups to approach?
• How should startups be vetted?
• How to form a relationship with a startup?
• How to net a profit?

Basic Regulations Applying to Angel Investing

As stated, the idea of angel investing is pretty simple: you invest money in companies in which you believe. Beyond that simple definition, however, is a lot of work and know-how. While it might be simple to invest in a family member’s new business, the same rules don’t apply when investing in a startup.

Historically, startups haven’t marketed their investing opportunities to non-accredited investors due to regulatory hurdles. However, that is currently changing and is a topic for another article. In short, only accredited investors have traditionally been able to avail themselves of opportunities to invest in startups.

In the United States, to be an accredited investor, you must have “a net worth of at least one million U.S. dollars, excluding the value of one’s primary residence, or have income of at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year” (Wikipedia). Accredited investors can invest in all kinds of startups, without regard to how they’re raising money. The fundamental problem with this rule is that startup opportunities have generally only been available to accredited investors and not to the average Joe.

The good news is that this is changing and newly regulated crowdfunding rules permit anyone to invest in companies, without regard to income. The types of companies that may select this type of funding option are limited, however, the popularity of crowdfunding continues to grow, opening up new investment opportunities for many more people.

It ought to go without saying, but the money you invest should always be discretionary cash that will not impact your day-to-day living. Your goal is to enable your money to make money (and you must fully appreciate that any investing activity constitutes gambling), so you should not put your livelihood at risk. This is part of the reason why the SEC believed that these opportunities, at least historically, should be limited solely to accredited investors.

Why Angel Investing is Important

Angel investors provide vital support to business and help to bring new ideas to the fore by encouraging growth and innovation. Their capital facilitates job growth and creation. Those individuals with an interest in supporting a variety of endeavors – and with the necessary cash behind them – can have a huge impact on the success of a business or product.

As previously mentioned, angel investing provides a means for one’s money to make more money. Conversely, absent the contributions of angel investors, some under-financed businesses wouldn’t be able to continue operations. Angel investors supply funding for carefully-selected businesses and receive either equity or convertible debt in return. It offers an opportunity to own part of the business and, eventually, part of any profits earned.

Finding a Startup in Which to Invest

There are numerous means of identifying startups in need of funding and, once you’ve become established as an angel investor, you may find that startups tend to seek you out on their own.

In the beginning, however, it may be useful to investigate an equity crowdfunding platform. Sites such as Angel.co, WeFunder, and FundersClub enable first-time investors to learn more about the process and to bundle their investment with others’. Some sites feature pre-vetted startups, thereby reducing the amount of research you would have to perform on your own. That said, it’s absolutely essential, prior to making any sort of investment, to perform your own due diligence research.

For individuals already involved in startup culture, word-of-mouth alone may provide leads to companies in search of capital. Attendance at local business networking events may also facilitate your contact with potential investment opportunities.

One possible point of entry to the angel investing world is through angel groups. These groups are comprised of like-minded individuals who’ve agreed to share research responsibilities, investment requirements, and, of course, any eventual profits. This niche is growing; the Angel Capital Association reported in 2015 that, since 1999, the number of angel groups in existence had tripled.

Many of us are extremely knowledgeable about a small number of very specific fields. For an angel investor, this is important because the greatest likelihood of success comes when we concentrate on companies in our own areas of expertise. When we know a great deal about a particular industry, we’re much better able to identify innovative ideas and companies. Conversely, attempting to invest in an area where our understanding is lacking can very easily lead to poor results.

In his book Originals, popular Wharton professor and author Adam Grant shares the Segway story. Dean Kamen, whose primary expertise was in the medical technology field, based the Segway’s underlying technology on his previous invention (the iBot, a stair-climbing wheelchair) and convinced himself that a market existed for the Segway and that it would revolutionize transportation. He began discussing the Segway with individuals whom he thought might be interested in investing. His excitement was contagious and many investors – including those with little-to-no knowledge of transportation – jumped on board, including Steve Jobs and John Doerr.

Despite early predictions that Segway would be the quickest company in history to reach $1B in sales, early optimism was derailed both by market apathy (not helped by high unit price and regulatory roadblocks) and a massive safety-related product recall. After absorbing over $100M of development money, Segway has yet to achieve profitability. Investors have not recouped their money, let alone made any profits.

Although it’s easy to chuckle now about the Segway, it’s important to understand the story’s lesson for investors. If you aren’t highly conversant (at least) with a particular industry, chances are excellent that you won’t be able to spot a good idea – or a bad one. To have the most assurance of success, it’s critical to stick to what you know. That said, it’s never too soon to begin learning about other industries in order to widen your investing horizons.

Additionally, you may want to determine whether a given company or product happens to reflect your own moral code. The best investments, after all, are the ones in which you personally believe.

How to Vet a Startup

The importance of thoroughly vetting a startup cannot be overstated. Similar to the pre-purchase research you perform prior to buying a car or a home, making an investment in a company requires an even-greater degree of due diligence. The more startup-specific experience and knowledge you have, the better.

Over time, you’ll increasingly be able to craft your own filters to help determine whether a particular company is likely to represent a good investment. For now, you should concentrate on the most important points to learn and on which questions to ask. You want to ensure that everything lines up, from the basic business model to the management team.

The determination of whether a startup is likely to represent a good investment can be distilled to these four factors:

The Proposition

Every business is predicated on a particular proposition that they are attempting to prove by their very existence. Fundamentally, this proposition posits that people are willing to pay money for a given product or service because it will add value to their lives. Often, this proposition is highlighted in a company’s mission statement. Prior to investing in a company, you should agree that their essential proposition is both true and achievable.

Consider:

• What essential proposition is the startup trying to prove? Are they selling smart thermostats tuned to the Internet of Things? Redeveloping an old warehouse into modern apartments for Millennials? Disrupting the tech scene with something truly new?
• Do you have personal knowledge about this particular innovation? Are you familiar with the industry and its various related verticals?
• Does the company produce a product or service with which you personally agree? Do the company’s goals align with your morals?

The Players

The individuals running a business can either help propel it toward success or can drain it of vital resources. Familiarity with the person at the helm is critical. You need to check (at a minimum) the résumé and business history of all involved parties.

Consider:

• Who is the founder? What are his prior accomplishments? What’s his track record of success and failure? What relevant experience does he have, especially in this field?
• Are all of the executive team members both qualified and energetic?
• Does the team give the impression of being ready to fight for their dream? Are they excited about their company and product?
• Is the company culture one of positivity and optimism?

The Plan

If you’re not a fan of business plans, it’s time to make your peace with them. Understanding a company’s business plan or model is absolutely necessary for the performance of a thorough vetting process. The plan will provide insight into the company’s framework, what its founders expect to achieve, and the timeline by which they expect to achieve it. Even if a founder shows you an amazing presentation, be sure to obtain a copy of his business plan and prospectus to review more closely on your own time. Also be sure to investigate the company’s structure and to review any relevant legal documents. If these documents are difficult to obtain, it may be an indication that the startup is attempting to hide something.

Consider:

• Is the business plan sustainable and realistic?
• Does it clearly show how the company intends to make money?
• Do you believe in the plan’s viability and is it grounded in sound assumptions?
• Is there an exit strategy?
• Does the prospectus paint a good financial picture?

The Profitability

A business that cannot make money is not, in the end, a good investment. While this concept would appear to be self-evident, there have been cases where investors flocked to companies that didn’t have a clear monetization strategy (Twitter and Pinterest, to name two recent examples). For a first-time investor, this is generally a very poor strategy to employ. While it may work out in the case of an extremely rare ‘unicorn’ valuation, it is absolutely the exception to the rule.

To intelligently mitigate risk, it’s necessary to understand both how a company proposes to make money and how much it expects to make over a specified period of time.

Consider:

• Is it possible for the business be profitable as-is?
• If the business plan is executed perfectly, can the business make enough revenue?
• Do the financial forecasts make sense?
• What is the projected growth?
• How much growth is necessary to justify investment?
• How long will it take for the business to attain profitability?

Knowing When to Invest in a Company

The companies you encounter in the process of seeking investment opportunities will all be in different stages. There are benefits to getting in on the ground floor with your capital, as well as to investing in a company that has already received outside funding.

As an initial investor, you run a bigger risk of failure, but enjoy a correspondingly greater opportunity to achieve a higher return. Additionally, initial investors can have a significant role in shaping a company and helping to launch a great idea.

Investing in an already-funded company may constitute a safer bet as it can better demonstrate a successful track record. The return-on-investment is likely to be smaller, though investing once a company’s lock-up period is over can aid in making a determination of anticipated long-term viability. That is, an assessment of how many initial investors have maintained their stock holdings.

The right time to invest will vary from startup to startup, but the goal never changes: determine a company’s likely potential and invest in time to facilitate its growth and maximize your profit.

Forming a Relationship

With your vetting process complete, you’re still not ready to make an investment. An appropriate valuation must be agreed upon and the terms of your relationship negotiated. Having professional advisors with plenty of startup and angel investing experience is critical at this stage. Anything agreed between the parties at this point is generally codified in legal documents.

If you’re the sort of investor who prefers to be involved in decisions and have a seat at the table, the companies you approach should know that upfront. If, however, you’d prefer to simply write a check and allow the startup team to do what they do, they should know that, too. Openness, honesty, and communication at the beginning of the relationship are important and can help to ensure a good and lasting fit. When it’s time to draw up contracts, ensure that all parties’ expectations are addressed.

Netting a Profit as an Angel Investor

Make no mistake about it: angel investors are choosing to participate in a high-risk game. Most startups fail. Properly vetting a prospective investment opportunity can help to limit the possibility of investing in a startup bound for failure. Likewise, diversifying your investments and spreading your capital between a number of startups can help to increase the likelihood that one of ‘your’ startups will succeed.

We’ve all heard that one shouldn’t “…put all of one’s eggs in a single basket.” You’ve also probably encountered the same wise advice being applied to stock portfolios. A diverse portfolio helps to mitigate your risk by hedging your bets. The same applies for angel investing. While you might occasionally get the urge to go all-in on a particular startup, it’s important to remain grounded and rationally assess the investment’s potential outcomes. Always remember that the ‘unicorn’ opportunities that net millions of dollars for early investors are the rare exceptions despite the volume with which those results are trumpeted in the business press and popular news.

When investing in a startup, especially a small one, be prepared to wait for a return on your investment – possibly even years. It takes time to build a viable business. Shut out the noise from the rare companies that shoot to profitability like bottle rockets (and sometimes fizzle just as quickly) and allow your investment to mature at the optimal rate for the company and industry involved. Patience is an essential trait for an investor.

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On the surface, angel investing might appear to be simple. However, to effectively support viable businesses and generate a profit in the process, a great deal of thoughtful, diligent research must be accomplished. When combined with a diversified investment strategy, angel investing can be a profitable, exciting way to support innovation and business.

Despite this post’s “Primer” title, I urge you to learn as much as possible prior to making any investments. In fact, you should be prepared to lose all of your money, at least in your first few investments. Being a successful angel investor requires a substantial time commitment and years of experience. It is not for everyone, but for those who are willing to go through the process of learning, getting the right experience, and making the investment commitments, it can have huge payoffs.

About the Author

Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).

Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.

Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.