Relative to a small business loan
, the direct, upfront cost of money from angel investors is low. However, there are a host of other, indirect costs associated with angel investors you should be aware of.
Before we dive into the pros and cons of this type of financing, though, let’s quickly review the definition of an angel investor.
What is An Angel Investor?
Angel investors are typically wealthy individuals that trade capital for equity in small businesses. Angels provide the capital and the business owner gives up a percentage of the company in the form of stock or convertible debt. Convertible debt is a loan that can be converted to equity at a specified date.
If you’ve ever seen the show Shark Tank, you’ve seen a heavily dramatized version of angel investors. Of course, in reality, these investors don’t generally invest in companies based on a two-minute pitch. They’re also usually much less antagonistic in real life. After all, these investors make money when their companies do well, so the relationship should be collaborative.
Angels are similar to venture capitalists
in that they invest in and provide support to early-stage companies. However, unlike a venture capital firm, angel investors fund their investments with their own capital.
Angel Investor Pros and Cons
The Pros of Angel Investors
1. A viable alternative to traditional sources of funding
Unlike banks and credit unions, angel investors aren’t beholden to credit scores and income statements. Typically, angel investors can and will invest in potential, even if the numbers aren’t there yet. So if you can present a compelling case
for your company, you could secure angel investment.
2. Strategic support
Angel investors tend to invest in companies within industries they’re familiar with. So usually they have expertise and connections in your industry. Because these investors have a vested interest in your success, you’ll gain access to their valuable expertise and connections. For a start-up or early-stage company, expertise and connections can be as valuable as capital.
As individuals, angel investors don’t have inflexible corporate policies. As a result, there’s more bandwidth for them to creatively structure investment deals. For startups with few financial resources, this expands their range of investment opportunities.
The Cons of Angel Investors
1. The average deal size is relatively low
As you might expect, individual investors tend to invest less money than a group of investors. In 2020, the average angel deal size was $392,025
, which is far lower than 2020’s median early-stage VC deal size of $4.5 million.
2. Owners may lose control
By definition, angel investors gain some control over the business ventures they invest in. In some cases, angels gain so much control that owners can’t run the business how they want to.
Before finding an angel investor, you should thoroughly review your business plan and consider your future goals. If maintaining primary control of your business is a priority, you may want to consider other funding options.
3. Potential for misunderstanding
One of the best parts of angel investors is their relative informality. However, that also means it’s easy for angels to be vague or ambiguous in the terms of the deal.
Until you work with an angel investor, it’s hard to know how much they’ll support you and to what extent they’ll be involved in your business.
How Do Angel Investors Operate?
Creating a successful relationship with an angel investor starts with negotiation
. As with any negotiation, understanding what your counterpart’s incentives are is critical.
Angel investors are accredited investors
, a designation created by the Securities and Exchange Commission (SEC). They typically have a net worth well over one million dollars and for regulatory purposes, their household income has to be at least $200,000. Compared to retail investors, angels have very high-risk tolerances and return expectations.
Angel investors expect their investments to double at least a few times over. A typical angel investment would be $200,000 for 20 percent of a company’s equity. If that company’s valuation rises from $1,000,000 to $5,000,000, the angel earns a 5X return on their investment.
The Verdict on Angel Investors for Small Businesses
Like any other form of financing, whether angel investors make sense for your business depends on your situation. Your industry, business model, and personal preferences determine whether this type of funding will benefit you.
Generally speaking, startups and early-stage companies with an opportunity to grow rapidly are most attractive to angels. So those types of companies will win the most favorable deal terms. Yet even with favorable terms, angel investment only works if you’re willing to give up some control over your business.
A final thing to consider when deciding on an angel is the expertise they may or may not bring. An angel investor who’s engaged and experienced can help fuel your growth as effectively as any angel capital they provide.