Angel investors are individuals who invest in businesses looking for a higher rate of return than they would normally see from more traditional investments. They can be anyone from doctors, lawyers, business associates, or even successful entrepreneurs who want to help others get their business off the ground. Angel investors usually invest anywhere from $150,000 to $1.5 million dollars in a business. Because of this wide range of investment, angel investors typically act as a bridge between a business that is self-funded, and a business that needs the level of funding typically associated with a venture capitalist. In today’s world, angel investors do not just offer their money. They provide their expertise, experience, and contacts in order to help the business succeed. Although there is less information on angel investments than venture capitalism (in part because of the individuality and privacy of the investment), the Small Business Administration (“SBA”) estimates that there are at least 250,000 angel investors that are active within the country. The SBA also estimates that these investors are responsible for funding about 30,000 small companies a year.
This newsletter will focus on how a company can utilize angel investors, the way angel investors are generally compensated in exchange for their investment, and the potential problems that may arise from utilizing angel investors as a mean to obtain business funds.
BRIDGE LOAN WITH WARRANT COVERAGE
A bridge loan is a short-term loan that is used until a person or company is able to secure permanent financing or remove an existing obligation. Bridge loans can be used by both corporations and individuals (especially in the real-estate market), and can be customized for many different situations. Since we are analyzing business financing, let’s use a typical example on when a business may need a bridge loan from an angel investor:
Say that a company is doing a round of equity financing that is expected to close in four months. A bridge loan could be used to secure working capital until the round of funding goes through. The loans are short-term with relatively high interest rates and are usually backed by real estate or inventory.
Obviously, an angel investor will seek compensation for investing or loaning money to a business. As discussed further below, angel investors often require a business to issue Preferred Stock or Common Stock as a form of payment to the angel investor.
COMPENSATING AN ANGEL INVESTOR: PREFERRED STOCK
The primary difference between preferred and common stockholders is the disproportional treatment between the two. Preferred stockholders have a greater claim to a company’s assets and earnings. This is true during the good times when the company has excess cash and decides to distribute money in the form of dividends to its investors. In these instances when distributions are made, preferred stockholders are always paid before common stockholders. However, this claim is most important during times of insolvency when common stockholders are last in line for the company’s assets. If a company must liquidate and pay all creditors and bondholders, common stockholders will not receive any money until after the preferred shareholders get paid. There are five distinct advantages as to why angel investors demand preferred stock as opposed to the latter.
Almost all issuances of preferred stock pay larger dividends than issuances of common stock by any given company. These rates are usually comparable to bond yields.
Dividends paid on preferred stock are guaranteed. Most preferred stock must be paid retroactively if a company skips a dividend payment.
As stated previously, preferred stock dividends must be paid in full before any dividends can be paid on shares of common stock. This includes any accumulated dividends.
Preferred shares are not as sensitive to market fluctuations as common stock. They are less likely to appreciate, but they are also less likely to fall in price.
As stated previously, in the event a company should liquidate, preferred stock shareholders are paid first before any money is paid to holders of common stock.
COMPENSATING AN ANGEL INVESTOR: COMMON STOCK
Owning common stock provides the shareholder with a specified amount of equity ownership in the issuing company. It also gives the shareholder various rights and privileges connected with the operation of the corporation. Common stock is the most widely issued type of public stock, and it is the most common type of security offered in a public initial offering. Although investors and economists usually state that preferred stock is safer and more secure than common stock, there are a couple advantages that common stock has over preferred stock.
Owners of preferred stock do not have voting rights like common stock holders.
Preferred stock does not appreciate like common stock, so the investor does not profit from a rising stock price. Also, preferred stock with a fixed interest rate may decrease in value if the prevailing interest rate climbs. Furthermore, preferred stock is more difficult to sell than bonds.
Angel investors that are seeking riskier investments with a higher level of gain will sometimes turn towards these types of shares. Although they are less secure, affluent individuals that are willing to shell out millions towards new businesses view this as an investment that could pay off in the future.
ANGEL INVESTORS: A RISKY DECISION
There are five distinct disadvantages as to why utilizing an angel investor can be a risky move for a business, especially one that’s a start-up business.
Rarely make follow-up investments
Angel investors usually do not make more than its initial investment because of the risk associated with losing even more money when reinvesting in an unsuccessful company. On the other hand, venture capitalists have a different approach to follow-up investing. Venture capitalists tend to spend about 2/3 of their funds on follow-up investments, taking the opportunity to allow companies to expand while they diversify their current portfolio firms.
Can actually be deceptive
While the majority of angel investors look beyond monetary return, there are a few angel investors who are solely motivated by money rather than in promoting the success of the business. These angel investors tend to be less patient with new entrepreneurs and do not provide any mentoring or guidance during a company’s early stage of development. In order to avoid this situation, it is crucial that an entrepreneur conduct due diligence and obtain complete information about the character and reputation of any potential investors before pursuing and agreeing to any terms.
Can be costly
As discussed before, in exchange for providing the needed capital for a company, many angel investors often require a certain percentage of stake in the company; starting at 10% or more. From the angel investor’s perspective, this is reasonable because he/she is investing in a business that may or may not succeed.
Active company involvement can lead to problems
Each level of company involvement varies from investor to investor; however, it is not uncommon for an angel investor to have a certain amount of control in running a company. The entrepreneur may be forced to give up some amount of control in order to meet their angel investor’s requirements. This can and often leads to resentment on the part of the entrepreneur. Another problem that may arise is the angel investor’s lack of industry experience. Limited knowledge adds very little value to a company’s success. That is why entrepreneurs should only seek angel investors with proven experience in their industry. Make sure to do your research before using an angel investor.
No national recognition
While there are well-documented directories of venture capital firms that are available to the public, there is no national register for angel investors. Because of these differences, angel investors do not have the national recognition as venture capitalists. However, many angel investors choose to remain hidden and mysterious in order to have a degree of separation from entrepreneurs who may pester them with their business plans and telephone calls.
As a small business owner, angel investors can be an effective and convenient way to receive monetary funds (such as bridge loans), and to build up your company. Although there are advantages (such as guidance and mentorship), there are disadvantages as well. The primary disadvantage is the control and power restraints imposed upon you and your company. The amount of stocks you’re allowed to distribute, and the employees you hire for important management positions are sometimes decided by the angel investor(s). Whether you should engage an angel investor or not should be decided on a case by case basis depending on your business needs. In any case, it is a decision that should be made informatively and cautiously.
If you are interested in learning more about angel investors, and how it may affect you, then please contact Larry Horwitz at email@example.com.