Institutional investors like venture capital (VC) firms have been the dominant players on the investment scene for years. While VC firms usually invest in post-revenue startups, angel investors have carved out a niche for themselves by focusing on early-stage startups. Who are these people? What motivates them to put money into risky projects?
Angel investors are people with a high net worth who look to invest in startups and early-stage companies. These people seek deals to secure them a stake in startups that can pan out in the future and generate a payoff much higher than what other investment opportunities can provide. The angel investor-founder relationship is a symbiotic one. While the former looks to make outsized gains on a relatively small investment, the latter gains access to funds that would otherwise not be available to a startup, as banks are unwilling to lend to companies without assets or inventory.
Here are three reasons why angel investors do what they do:
Entrepreneurship is risky business. IT startups face an even higher risk, as documented by Failory: 63 percent of IT startups fail. Therefore, an angel investor putting money into a startup is undertaking quite a risk of losing all that money. That’s why founders willing to attract investors are willing to part with around 20 percent of their equity because that’s what it takes to convince an angel investor to put money into a high-risk business.
Despite this massive risk of failure, angel investors are still lining up to invest in startups at an even higher rate than before. Why? Because of the Power Law. Investors believe that a handful of investments will generate the most returns and more than make up for loss-generating others. These people are looking to score a home run: One investment that will turn into a billion-dollar company and save the whole portfolio. A startup making an exit can create a 10X or 50X return for an investor, which is far more than can be expected from other investment opportunities.
Airbnb, for example, raised a seed round in 2009 at a $2.4 million valuation. At the time of its IPO in 2020, the company was valued at $47 billion, translating into a 20,000X return on investment (ROI). Peter Thiel invested half a million dollars in Facebook and made around $1.1 billion from this investment at a 2,220X return. Such success stories have become part of the Silicon Valley culture, and Power Law has become ingrained in the thought process of tech investors.
Most angel investors are former founders themselves. Having achieved success and earned considerable sums, they see angel investing as a way to remain a part of the startup ecosystem. Some are addicted to the thrill of building a product from scratch and turning it into a competitive product. Becoming an angel investor gives these people a taste of that competitive environment once again, this time without the immense pressure of being a founder.
Talking to founders, learning about bright ideas and the challenges they face, mentoring them, and seeing them succeed can be a source of satisfaction for even millionaires. That’s part of why tech leaders like Sam Altman, Peter Thiel, and Michael Seibel participate in accelerators and angel investment funds.
In addition to the capital they invest, angel investors can make an impact on the prospects of startups through two qualities they bring to the table:
An angel investor with experience in a related industry can be a true asset to a startup. Capital, although crucial for a startup, can be raised from family and friends. Later on, when financials appear, banks can be enlisted for loans. But a mentor who can extend a helping hand during the growing pains of a startup is not easy to find. Someone who has done it before, made mistakes, and learned from them can provide the founders with much-needed guidance.
Founders have so many responsibilities in product development, evangelizing, customer support, hiring, and so forth that they may have trouble putting it all together. Angel investors can help founders with strategic problems like the market analysis. They can also offer guidance in tactical matters regarding execution, helping steer the startup in the right direction at critical times.
Startups rely on their local means and resources in a fight against global competition. What can elevate them and let them tap into resources that otherwise wouldn’t be available to them is a group of well-connected investors. These connections are sure to broaden the horizons of founders and benefit them in multiple ways:
- Founders may leverage the angel investor’s phonebook to talk to top people to sort out technical hurdles.
- Angel investors can boost recruitment efforts, helping founders reach out to talent and pick the best among them.
- Angel investors can lay the foundations for future fundraising efforts. Developing relations with prospective investors and nurturing those relations pay off when the time comes to raise money another time.
Why do people want to write cheques for companies with a small chance of panning out? Michael Seibel thinks of it as a form of “charity.” Charity à la Silicon Valley.
When people finally make it and turn their dreams into hefty deposits in their bank accounts, they want to do good. Some give back to the community they hailed from; others donate to NGOs pursuing certain causes, and some set up funds to ensure that their good deeds will last. These actions are good for your conscience, help your brand, and make sense for your future.
Silicon Valley culture glorifies investing in the startups of nobodies with dreams. Instead of helping people, the tech community prioritizes helping people help themselves. Making a few million dollars in the process doesn’t hurt, either. Giving back to the community and nurturing a new generation of tech celebrities can elevate an angel investor to the level of a thought leader people turn to. This philanthropic act involves regularly investing small sums in a large number of startups and also fits in with the principle of diversifying the portfolio to find a home run.
Angel investors are to the startup ecosystem what bees are to the flora: They promote cross-pollination. By injecting capital where needed and providing wisdom where very little is found, they set startups for success and contribute to upward mobility. What they want to see in founders is another story and deserves a lengthy discussion in another post.