The term “angel investor” has grown in popularity in recent years, even to the point of becoming trendy. But what does it mean to be an angel investor and is that what you really want to do?
Definition of an Angel Investor
An angel investor invests his or her own money in a business, usually in exchange for an ownership percentage (i.e., equity) of the company. Contrast this with venture capitalists who invest other people’s money. Interestingly enough, the term comes from the world of Broadway theater when an “angel” would donate money to specific productions. The term we use today was coined by William Wetzel, founder of the Center for Ventrue Research at the University of New Hampshire.
In recent years a combination of factors has to lead to a rise in the number of angel investors. First, many individuals are looking for alternative and more lucrative avenues for investment than the traditional stock market. Second, as banks continue to be tight on giving bad credit loans and even general business loans, the need has increased for alternative business funding. Third, technology gives individuals the opportunity to connect across distances on a level that has never been seen before. Fourth, equity investment and angel groups allow people with smaller amounts of funds to invest to be a part of funding companies.
Do I have to be a Billionaire to be an Angel Investor?
It is a common misconception that you need to be a millionaire or billionaire to invest. If you are a family member or friend and you invest $60,000, for example, in a start-up, you are an angel investor. Typically, an angel investor is someone who has “extra” cash they can invest that if lost, it would not affect their day to day standard of life.
In attempts to protect investors from being taken advantage of, the U.S. Securities and Exchange Commission (SEC) has set up certain restrictions for non-accredited investors and requirements to become an accredited investor. The following are the two most generally used SEC standards of an accredited investor:
- Outside of your primary residence, you must have a net worth more than $1 million, either alone or together with a spouse; or
- You must have an annual income that is more than $200,000 or $300,000 if filing jointly with your spouse. You must be able to show that you have maintained the annual income for two years and that there is a reasonable expectation that you will make that money in the current year.
What are the Risks of Being an Angel Investor?
As with any investment, there are risks involved. If the company you invest in does not make it and must close its doors, you will probably lose the money you invested. This is the case for anyone anytime they invest funds. Therefore, it is wise to not invest if you can’t afford to lose 100% of that investment.
Another potential risk has to do with what happens to your shares after you purchase them. If you do not secure preemptive rights (also known as anti-dilution provisions, or subscription rights), the initial buy-in can get diluted so much that your investment may lose its value. When a company needs to do their next level of fundraising, they will generally “dilute” the shares by selling more. This common and completely legal practice means everyone has a smaller slice of the pie and the shares they do own are worth less than they originally were. For example, let’s say you invested in a company and received 1 of the 100 shares. Dilution would happen if the company sold another 100 shares of the company, now your share is worth 0.5%. If you have preemptive rights, before the 100 shares go up for public sale, you have to option to buy enough to maintain your 10% ownership. You are not obligated to buy them, but you do have the option.
While being an angel investor comes with risks, you have more options available to you than ever before. It is easier to connect with entrepreneurs or products you are interested in. Additionally, equity investing groups or angel investment groups make it easier to connect and spread some of the risks.