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A Step-by-step Guide to Become an Angel Investor & Evaluate Companies
There are over 472 million entrepreneurs in the world today. And on average 305 million startups come to life every year globally. Over the last decade, we have learned a lot more about the startup ecosystem. Terms like unicorns, stealth mode, raising capital, and exiting, have now become mainstream. Angel investing too has become a lot more common. With so many innovative startups and entrepreneurs, it is an exciting time to become an investor. But what is an angel investor? What sets them apart from other investors? How do they decide which companies to invest in? All this and more, read on to explore.
What is an angel investor?
When the term came into existence, angel investors were high-net-worth individuals who invested in companies at a very early stage. Over the years, these investors are not only high net worth individuals but also those with a good investing mindset having a keenness for the startup world. They may also be referred to as private investors, angel funders, or seed investors. Typically their investment is in exchange for ownership equity in the new company or convertible debt. As this investment amount isn’t typically very large, angel investors could be from the entrepreneur’s personal or professional circles too. In certain cases, angel investors find interesting startups via crowdfunding platforms like Kickstarter. Their contribution mainly helps kickstart companies or pull startups out of difficult situations.
Angel investment is very risky as it is at the initial stage of a company’s conception. It is most often the primary source of funding. Investors believe in the founding team, their idea, and the vision for the future. It is highly recommended that angel investors should keep such investments to less than 10% of their entire portfolio to avoid losses as this is almost always high-risk. Individuals who have a substantial disposable income and wish to invest in avenues that generate better returns than traditional opportunities, choose to become angel investors. Angel investors are very different from venture capitalists, as they are not focusing only on profits. They focus on supporting young companies and entrepreneurs.
How does an angel investor value companies before investing?
Companies that approach angel investors are at a very nascent stage. They do not have existing revenue in most cases. Hence, it is extremely difficult to evaluate if the venture will reap profits. Financial projection and business model analysis is not feasible at this stage. Therefore, angel investors focus more on the founding team and the potential of the idea before investing. However, valuation is vital in order to minimize the risks associated with their investment. There are three methodologies highly recommended and most often used by angel investors during the pre-money valuation of companies:
- Scorecard Valuation Method: Also known as the Billy Payne valuation method, angel investors compare the startup in question with other funded startups. By modifying factors like location, market, stage, and industry, investors evaluate the company better.
- Venture Capital (VC) Method: The post-money valuation is first determined by the angel investors in this method. By using industry metrics, they work their way back to pre-money valuation based on these figures.
- Dave Berkus Method: The founders and the idea are allocated a basic value. Angel investors assign a number to each element that could be a form of risk to the new company. This includes qualitative and quantitative aspects.
Do better valuations lead to better investment outcomes?
The short answer is YES. The ability to value a startup is a true test of an angel investor’s financial acumen. For strategic purposes, valuing a company and making the right investment decisions can go a long way in establishing one’s role as an angel investor. Valuation can occur at different stages, not only during conception:
- Employee stock/ share option planning
- Shareholder disputes
- Leveraged buyouts
In the hopes of getting outsized returns, angel investors make a typical investment of US$25,000 to $100,000 in a company. In many cases, this can go much higher too! Before approaching an angel investor, a company’s founder must be ready with a pitch deck, executive summary, clearly articulated elevator pitch, a prototype or simulation, and in best-case scenarios, customers or early adopters.
What are some frequently asked questions by angel investors before investing in a startup?
Asking the right questions will help both investors and startups. While investors get to make the right investment decisions, startups get ready for the tough world and course-correct before it is too late. We now know what is an angel investor. Let us dive in and check out some questions every angel investor should ask a startup’s founding team before making any kind of investment decision:
- Why have you approached me and not others?
- How much capital do you wish to raise?
- How big is the founding team and what are your qualifications and experience?
- What is/ will be your monthly burn rate?
- Can you show me your detailed projections for the next 24 months?
- If you have based the projections on assumptions, state them all
- How much does it cost to make one unit of your product or service?
- Can you share the unit economics?
- What is your next set of growth indicators?
- Do you have a marketing budget and plan?
Can valuation be learned? Or should it be based on instincts only?
This article has answered the question “What is an angel investor and how to become a successful one?” Valuation of a startup and how to determine it is one of the most important skills a good investor must possess. But, can one learn valuation? Or is it based on one’s instincts?
The good news is that valuation is a skill that can definitely be learned. Instinct plays a huge role in the mix, maybe when it comes to trusting the business idea or team members. Valuation, on the other hand, is a logical, structured, and almost mathematical approach. If you wish to explore finance-related programs, click here.
Also, the Corporate Valuation Program by Columbia Business School Executive Education is a special program that has been designed to help investors make informed investment decisions for maximum profitability. The aim of the program is to help investors of all kinds make accurate valuations and minimize risk. It is a six-week program priced at US$2,600.
Angel investors can choose to invest and only get a stake in the company. In some cases, they might also wish to be a part of the decision-making. To help the company grow, professionals can leverage their experience, knowledge, and interest in the sector. It is advisable to make intentions very clear before investing in order to avoid conflicts in the future. If you wish to know more about the entrepreneurship programs offered by Emeritus, click here.
By Manasa Ramakrishnan
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