Angel Investing: High Risk, High Reward

Angel investing is a risky business. In 2020, angel investment in the US totalled over $25 billion, with angels being the leading source of seed and start-up capital. However, it is one of the riskiest forms of investment, with a high chance of losing all your money.

Angel investors are wealthy individuals who invest their own money in start-ups in exchange for shares in the company. They tend to be established entrepreneurs themselves, who are comfortable with taking on risk. Angel investors are often interested in supporting businesses in a particular industry or may simply have the desire to be part of something new.

Angel investors usually conduct minimal due diligence on the companies they invest in. They also have little control over the company's outcome, with minimal influence on important decisions. They are minor investors, with a small ownership stake, and no board seat or board observer status.

There are several risk factors that can impact angel investment, including the quality of the company, the entrepreneur's skills and experience, and market conditions at the time of investment. Angel investors can also face adverse selection of deals, lack of market knowledge, poor due diligence, suboptimal deal terms, and maximum risk.

Despite the risks, angel investing can be rewarding, with the potential for high returns. It is important for angel investors to do their homework, diversify their investments, and have an exit strategy.

Angel investing is a risky business

Angel investing is an attractive prospect for many. The idea of getting in on the ground floor of the next big thing is enticing, and the potential for high returns is always appealing. However, it is important to remember that angel investing is a risky business. In fact, it is one of the riskiest forms of investing, comparable only to investing in cryptocurrencies.

The Risk of Loss

The biggest risk in angel investing is the possibility of losing your entire investment. Startups are inherently risky ventures, with a higher chance of failure than established businesses. Most startups fail, and many angel investors lose their entire investment. Even if the startup is successful, there is no guarantee that it will grow as fast as expected or generate the desired return on investment.

Illiquidity

Angel investments are not publicly traded, making it difficult to sell shares if you need to raise cash quickly. Investors may have to wait years for the company to be acquired or go public before they can cash out.

Volatile Equity Value

The value of a startup's equity can be volatile, and investors may see the value of their investment fluctuate greatly. This can be due to the startup's performance, market conditions, or other factors beyond the investor's control.

Lack of Information

Startups often lack the extensive information available for more established companies, making it difficult for investors to make fully informed decisions. This information asymmetry can lead to unexpected risks and losses.

High Expectations

Angel investors usually have high expectations for their investments. As they are typically looking for a significant payoff, the pressure to perform and generate returns can be intense. Startups may struggle to meet these high expectations, especially if they are in a highly competitive market or experience unexpected challenges.

Loss of Control

Angel investors often take an active role in the companies they invest in, which can result in a loss of control for the founders. Even if the investor is hands-off, the founder may still need to explain their decisions and strategies. This dynamic can create tension and affect the company's culture and operations.

Regulatory and Compliance Issues

Regulatory and compliance issues are important considerations for angel investors, especially in industries with strict government oversight, such as healthcare or finance. If the company's business plan is found to be non-compliant or illegal, it could face significant challenges or even be forced to shut down.

Team Risks

The quality of the founding team is crucial to a startup's success. A lack of integrity, insufficient intellectual ability or emotional intelligence, or poor communication skills can all be red flags. Additionally, a startup team that is resistant to advice or mentorship may struggle to adapt and make necessary changes.

Market Risks

Market readiness and adoption are critical factors in a startup's success. Even if a startup has a great product, if the market is not ready or there is strong competition, it may fail to gain traction. Angel investors need to carefully assess the market and determine if there is sufficient demand and a viable go-to-market strategy.

Financial Risks

Startups often have negative cash flow and may burn through cash quickly. If a startup is unable to raise additional funding, investors may lose money. It is important for angel investors to conduct thorough financial due diligence and understand the company's financial health and prospects.

Angel investing is a risky endeavour, but it can also be rewarding. By understanding and carefully managing these risks, angel investors can improve their chances of success and enjoy the potential high returns that come with backing a successful startup.

It's hard to find an angel investor

Angel investors are wealthy individuals who provide financial backing to small businesses and startups, typically in exchange for an ownership stake in the company. While angel investing can be rewarding, it is also a risky endeavour, and there are a number of factors that can make it challenging to secure an angel investor.

Firstly, angel investors tend to have a high tolerance for risk, but this also means they usually have higher expectations for returns on their investments. They often expect a significant payoff, such as a rate of return that equals 10 times their original investment within the first 5 to 7 years. This can put immense pressure on startup founders to perform and expand at a rapid pace. As a result, it may be difficult for some startups to find an angel investor who is aligned with their growth expectations and capable of accepting the level of risk involved.

Additionally, angel investors typically have specific criteria they look for before investing. They assess the team behind the startup, including the founders' skills, experience, integrity, and emotional intelligence. A lack of a capable and well-rounded team with the necessary expertise can be a deal-breaker for angel investors. They also consider market readiness and the size of the potential market, ensuring that there is sufficient demand and opportunity for growth. Startups operating in small or saturated markets may struggle to attract angel investors.

Furthermore, the quality of the company, the entrepreneur's skills and experience, and market conditions at the time of investment all play a role in an angel investor's decision-making process. Angel investors seek out companies with strong growth potential, disruptive ideas, and passionate and experienced entrepreneurs. They may also prefer startups with lower valuations to maximise their upside potential. Startups that fail to meet these criteria may find it challenging to secure angel investment.

Lastly, angel investors are typically busy individuals with limited time and a small number of investments. They are selective and receive numerous investment opportunities, making it difficult to stand out among the competition. Networking and proactive approaches are crucial for startups seeking angel investment.

There's a lack of formality and structure

Angel investing is a risky business. It is fraught with peril and there is a multitude of factors that can impact the investment, including the quality of the company, the entrepreneur's skills and experience, and market conditions at the time of investment.

One of the key risks is the lack of formality and structure in angel investing. Angel investors are typically wealthy individuals investing their own money, and as such, there is often a lack of formal processes and structures in place. This can lead to a lack of due diligence, suboptimal deal terms, and a higher risk of losing one's entire investment.

Due diligence is crucial in any investment, but individual angels often conduct minimal due diligence on the companies they invest in. This is partly because their investment may only be a small percentage of an early round, and partly because they often lack the bandwidth and expertise to conduct a thorough investigation. As a result, angels may not have a full understanding of the risks and may be making an uninformed investment decision.

Additionally, angel investors usually do not have the same level of influence as venture capitalists in setting the terms of the deal. If the angel is not leading the round or investing a significant amount, they may have little say in valuation, governance, or deal structure. This can result in suboptimal deal terms that may not adequately protect the angel investor's interests.

Furthermore, angel investors often have a higher tolerance for risk, which can lead to higher expectations for returns. Angels typically invest in early-stage companies, and their investments are generally modest in size. This means that the company's future prospects are at their riskiest stage, and the potential for losing the entire investment is high. Angels may expect a rate of return that equals 10 times their original investment within the first 5–7 years, which can put immense pressure on the startup to perform.

To mitigate these risks, angel investors should consider joining an angel network or fund, which can provide greater access to better deals and more influence in setting deal terms. Partnering with other angels can also provide a more comprehensive understanding of the risks and a more robust due diligence process. Diversifying one's portfolio by investing in multiple companies can also help offset the risk of any one company failing.

The pressure is on to succeed

Angel investing is a risky business. While it can be a great way to earn high returns, there are many pitfalls to be aware of. The pressure is on for both the investor and the investee to succeed.

The Risks

Firstly, it is important to understand the risks. Angel investing is often considered the riskiest form of investing, aside from perhaps investing in cryptocurrencies. Startups are high-risk investments; they are unproven and have a higher chance of failure than established businesses. They may be burning through cash quickly and be unable to raise additional funding. The value of a startup's equity can be volatile, and there is often a lack of information about the business, making it difficult for investors to make informed decisions.

The Investor's Perspective

Angel investors are usually wealthy individuals who have accumulated wealth and specialise in investing in early-stage companies. They often have a higher tolerance for risk and, as a result, have higher expectations. They are in the business to make money and will want to see a payoff. It is not unusual for an angel investor to expect a rate of return that equals 10 times their original investment within the first 5-7 years. This puts pressure on the startup to perform and expand at a rapid rate.

The Investee's Perspective

For the startup, the pressure is on to deliver results and meet the investor's expectations. Angel investors will often want to take an active role in decision-making, and the startup may be accountable to the investor for explaining the reasons behind their choices. The startup founders may also need to be prepared to give up a portion of their future net earnings, as the investor will receive an ownership stake in the company in exchange for their capital investment.

Mitigating the Risks

To mitigate the risk of loss, angel investors typically diversify their portfolio by investing in a number of different companies. By investing in multiple companies, an angel investor can offset the risk of any one company failing. Angel investors can also take an active role in the companies they invest in, providing mentorship and guidance to help the company grow and succeed.

The Rewards

Despite the risks, angel investing can be very rewarding. Investors who back successful startups can make extremely high returns, and there is also the opportunity to be involved in a dynamic and growing company. For many angel investors, the most important reward is the satisfaction of knowing they helped a young company succeed.

Relationships can turn sour

Angel investing is a risky business, and one of the risks is that relationships with founders can turn sour.

Angel investors are often established entrepreneurs themselves, and they invest their own money in early-stage startups. They typically receive a minority ownership stake in the company in exchange for their investment. This means that the relationship between the angel investor and the startup's founders is crucial to the success of the investment.

However, there are several ways in which this relationship can turn sour. Firstly, angel investors usually have higher expectations than traditional lenders, such as banks. They are taking on more risk by investing their own money, so they expect a higher return on their investment. This can put pressure on the founders to generate high returns and expand quickly.

Secondly, angel investors often want to take an active role in decision-making and may try to exert influence over how the company is run. This can lead to disagreements between the investor and the founders, especially if the founders are not comfortable with ceding control.

Thirdly, angel investors may have different risk tolerances and investment goals than the founders. While the founders may be passionate about their business and committed to its long-term success, angel investors are primarily focused on financial returns. This can create tension if the company is not performing as expected or if the founders want to take risks that the investor is not comfortable with.

Additionally, angel investors may have concerns about the integrity or capabilities of the founders. If an angel investor feels that a founder is being dishonest or misleading, or if they believe the founder lacks the necessary skills or emotional intelligence to lead the company, they may lose faith in the investment and withdraw their support.

Finally, relationships can sour if the company fails to perform as expected. Angel investors are typically investing in multiple companies, and if one company is not meeting its milestones or financial targets, the investor may choose to cut their losses and focus their time and resources on more promising opportunities.

To mitigate these risks, it is important for angel investors and founders to establish clear expectations, maintain open lines of communication, and work together towards shared goals. Due diligence and a thorough understanding of the risks involved are also crucial to fostering a successful relationship between angel investors and startup founders.

Frequently asked questions