What Exactly Is An Angel, and Where Do They Invest?

Note: This article is the second in an ongoing series for angels new to investing. To learn more about building an angel portfolio, download this free eBook today - Angel 101: A Primer for Angel Investors or purchase our books at Amazon.com.

Angel investing overviewFor a variety of reasons, the mainstream business press is writing more about angel investing than ever. It seems like more now than ever before, if you tell a distant relative that you are an angel investor, they will say “oh I’ve heard of that” rather than give you a blank stare and assume you are talking about church choir.  

Over the last couple decades, angel investing has become a more serious form of finance. Christopher recently outlined the 7 main reasons for this (professionalization of angels, formation of groups and syndicates, mainstreaming of entrepreneurship, internet and cloud technologies, changes in the exit climate/exit math, and changes in the venture capital business.) But the net result is that people who wouldn’t normally hear about angel investing are reading and seeing more discussion, prompting them to ask what it is all about.

To help address some of that curiosity, I’ve asked Christopher to set the record straight and share his perspective.

Q: Christopher, where did that crazy name “angel” come from?

In Europe, these very early-stage investors are called “business angels” which makes a little bit more sense to me, but in the US they are typically just called angels. Believe it or not, the name is widely believed to have originated in the broadway theatre context in the early 20th century. The person who swooped in with a last minute infusion of capital to save a financially foundering production right before it was slated to open was dramatically referred to as an “angel investor.”  The name stuck, and over time its meaning evolved to refer to any investor putting private capital into a speculative venture at its earliest stages, including the angel investors putting literally billions of dollars into startup companies each year.

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Q: What type of companies do angels invest in?

The short answer is that angels invest in all types of companies, but the nature of some businesses make them a better fit for the classic “risk capital investment” model typically associated with angels and venture capitalists. That risk capital model is premised on the idea of building a portfolio of high risk/high potential investments with the assumption that many will fail but a small number of big hits will generate all the returns for the portfolio.  

The types of companies typically associated with that sort of high potential are usually technology-centric companies. The reason for this is not that tech-centric companies are necessarily better than other kinds of companies, it is that the toughest competition most new products face is the inertia associated with the “this is familiar, it’s good enough, devil-you-know” mindset. New products generally need to be something on the order of 10X “better, faster or cheaper” to overcome this kind of inertia. That kind of leap forward is tough to do with out some kind of technology-driven discontinuity. It is hard to make a restaurant meal that is 10X better, faster or cheaper, but with high tech software or silicon, you can make a 10X improvement in many consumer solutions or business tool and processes.

Note that not all angel deals are done with the “risk capital” mindset. Other deal structures such as revenue based financing can allow angels to work with companies which are likely to grow a little slower. For much more detail on what kinds of businesses angels prefer for their classic risk equity deals see: “Like Moths to Light: Why Angel Investors Seek Certain Types of Companies” and “Oxygen, Aspirin or Jewelry: Which Makes a Better Investment?”  For a detailed discussion of the importance of capital efficiency for angels, see: “Not My Cup of Tea - Some Business Types Are A Better Fit for Angels.”

Q: How do people become angels?

That’s a great question. When you ask most angels, they usually come up with one of three answers. 

The first group say a friend or associate approached them looking for an investment and they helped out. Once you help one entrepreneur, your name tends to be shared and you are approached by other entrepreneurs. So effectively this group started angel investing the “old school” way before they realized that’s what they were doing.

The second group say that they got involved as a by-product of networking groups and activities or in connection with causes. These angels might be impact oriented, for example, looking to support more diverse groups of founders, or to make the investing world more diverse. They might have been solicited to join a fund or group with a social impact element and are motivated as angels in part by the idea of using their investment dollars to have a double bottom line impact.

The third group, which may be the biggest of the three groups, answer that a friend who was an active angel investor told them (perhaps repeatedly) how much they enjoyed it and invited them to get involved as well. In some cases, they join their friend’s angel group or network, and in other cases they might join a fund run by the friend or an associate of the friend.

Of course, there is no need to wait around for someone to invite you. Most decent sized metro areas have a center of entrepreneurial activity or you can check the list of member angel groups kept by the Angel Capital Association to see if there is an organized group near you. As angel investing has grown and professionalized, there has been a growth in the amount of organized coordinated angel activity and training and support for getting new angels up to speed, so I would imagine more angels will be able to get faster starts in the coming decades than ever before.

Q: At what stages do angels invest?

Angels invest at very early stages. They tend to make their initial investments in the “capital gap” between the initial money provided by the founders and their friends and family on the one side and larger institutional VCs on the other. Although the exact numbers change with the times and also vary from region to region, think about it this way: the friends and family round is typically going to be something like the first $50-100K to get the company off the ground. At this stage the company has a couple founders and a reasonably well-thought-out plan, but has not implemented much of the plan and has tested little to none of it.

The early angel round is likely to be in the $250K-$500K range. At this stage the company may well have a rough “minimum viable product” and may have done some early testing with customers (unless it is a life science customer in which case it is just going to have progressed the technology a bit more.) At this early angel stage, it is unusual for a company to have many customers or much revenue - perhaps a paid beta customer or one lighthouse customer who is really interested in the solution and willing to be a very early adopter to test it out.

A later more mainstream angel round is likely to be $500K to as much as $2.5M, and these typically occur at the point where the company is starting to show a little bit of early traction. They may not have a repeatable sales model yet, but they have a few customers and are beginning to suspect they know how to sell it. This financing round is typically focused on funding a ramp up of sales and marketing investment, in addition to a bit of team build out and maybe some key additional functionality to the product.

While there might be one or even two additional angel rounds to help extend the runway and allow the company to achieve “Series A” VC metrics, generally speaking from conclusion of one or two mainstream angel rounds, larger institutional venture capital firms will likely lead the charge for companies which are going to go on and need significant additional capital.  

Many angels will continue to co-invest in those later rounds. In fact, a majority of experienced angels believe such “follow-on” investing is critical to their returns. They make smaller initial bets on a number of companies to see which ones start to break out and then they put larger amounts of “smart” money into the winners as they begin to gain traction. But at some point most angels peel off.  Unless an angel has an ultra-ultra-high net worth, they cannot afford to put endless cash into high valuation later stage rounds and still achieve an adequately diversified portfolio. In addition, angels tend to enjoy and be more interested in the companies at the earlier stage. The teams are more accessible, there are more ways to get involved, help and advise, and things happen more quickly and with more excitement than at the later stages when a company is just trying to grind it out for more growth.

Q: So you didn’t say anything about “seed stage.” I hear about seed stage and early stage and angel stage.  What is the difference between seed stage, early stage and angel stage?

It is true that the terminology does get confusing. Part of the confusion stems from the fact that in regular usage the definitions are sufficiently imprecise that the meanings can actually overlap quite a bit.  

  • Early stage is the broadest term and is really a superset which can be used to describe all of the various stages of young startup finance.  

  • Seed stage has typically been used to describe the absolute earliest rounds - friends and family and early angel rounds.  

  • Angel stage has been used to describe companies which are a bit more organized and have accomplished a bit more of their plan than at the seed stage.

I would argue, however, that people make too much of this angel/seed distinction. Many angels and sometimes even VCs will invest at the seed stage. To my way of thinking it is more of difference in mindset than a difference in stage.  I would argue that seed stage investors are just regular angels or VCs who like to go in very early. I would further observe that what generally seems to be the case when these investors go in early is that they have some kind of special affinity to the company. They might have an affinity to the founding team because they have worked with them before or invested in them before. Or, they might have an affinity to the technology or solution because that is their area of special expertise, or, they might go in early because they have an affinity for the market - perhaps it is the market space that they have spent their entire career working in. So in my view, a seed investor is a regular investor who happens to have an affinity in that particular case.

Q: So what is the difference between angels and venture capitalists?

At the 100,000 foot level they are the same. They make early investments in high potential companies hoping that a small number of the companies in their portfolio will provide a big win. But there is one very key distinction between them, and that distinction drives a lot of differences in the way they think and act. The key difference is that angels are investing their own money and VCs are investing other people’s money.  

Angels tend to be individuals with an interest in business or technology who are investing a portion of their after-tax investable net wealth in working with start-ups. VCs tend to be professional money managers who are investing money from a structured fund they raised from limited partners. This distinction drives quite a few differences.

The biggest difference has to do with perspective about capital intensity. A group of angels tends to have a relative scarcity of financial capital (they are using their own money), but a relative surplus of human capital (there are lots of them and they are volunteering their time to help out). A venture capital fund is the opposite. It has a billion dollars it is trying to put to work but only a small number of partners who can help all the companies they put money into.  As a result, VCs and angels tend to to be solving slightly different problems. The angel is thinking to herself “how far can we get this company on $1M?” And the VC is thinking (and I am paraphrasing for the sake of humor) “what the heck am I going to do with all of this money, and how much can I stuff into this company?”

Because they have a massive fund to generate a return on, VCs tend to prefer massive scale opportunities which have the potential to drive a billion dollar return. They are not scared off by capital intensity in a business plan because they have the capital to keep investing up through the massive later rounds. Angels tend to be more attracted to capital efficient businesses because they cannot fund heavy capital needs and unfunded capital needs represent extra risk. They might not get funded and the company will die, or they might get funded by VCs who have a very different view of the exit and the plan. The angels will be heavily diluted and sidelined to mere passengers along for the ride.

There are quite a few other more subtle differences. One example is “patience” - VCs are typically working on a time clock driven by the fixed length of their 10-13 year fund, whereas angels can afford to be a bit more forgiving and patient if they need to. But this over-simplification of the key differences will suffice for the purposes of this discussion.

So that is a whistle stop tour of what angels are, where the name came from, what they invest in and why, what stages they prefer, and how they differ from their VC colleagues.  As I said at the beginning, from a distance they are remarkably similar in what they do, but when you get close up and begin to observe the details a lot of subtle and not-so-subtle differences begin to emerge.

Want to learn more about building an angel portfolio and developing the key skills needed to make great investments? Download these free eBooks Angel 101: A Primer for Angel Investors and Angel 201: The 4 Critical Skills Every Angel Should Master, or purchase our books at Amazon.com.