In a nutshell, the risk of angel investing is that you could lose your money. But the potential payoff is too good that you’d be silly to pass up the opportunity. Hence, it is best to learn about angel investing risks and rewards.
Already, there are plenty of stories about how some people missed out. One example is Nolan Bushnell, the founder of Atari. Steve Jobs once approached him and offered a third of Apple for $50,000, which he declined.
At $170.33 share price, Apple’s market capitalization would be $2.78 trillion. Bushnell could have owned a third of the company. But he did not invest at that time, citing his lack of interest in home computers.
As it turned out, missing out is one of the investors’ biggest fears. But one who did not miss out is Kavitark Ram Shriram. In 1998, he handed a check for half a million dollars to Larry Page and Sergey Brin to fund their garage startup that became Google. At one point, his stake in the company was worth $1.3 billion.
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What Are the Risks of Angel Investing?
One of the early challenges of startups is creating brand awareness of their products or services. These are, however, activities they can plan for or strategize. A new business can take years before ROI, and that is if the company goes public or gets sold. However, the more pressing concern is the risks of angel investing.
1. 90% of Startups Fail
In 2020, the U.S. Internal Revenue Service (IRS) received more than 4.4 million applications for new businesses. Based on data compiled by the Bureau of Labor Statistics (BLS), about 880,000 (20%) will shut down within their first year. And according to Shikhar Ghosh of Harvard Business School, three-quarters of venture-backed startups will fail.
Success stories are not only fascinating but incredibly inspiring. Yet, not every company can have a fairy tale story. Companies like Google that took the world by storm do not come by often. And for many of the successful startups, it also took them a long time before becoming profitable.
So, considering that 9 out of 10 startup companies will fail, angel investing in these early-stage companies are indeed risky.
2. Regulatory or legal issues
It is not uncommon for businesses that have operated for years to run into regulatory or legal issues. Such is also the case with startups. One may even argue that these issues are more likely to arise in the ranks of inexperienced entrepreneurs.
Here are some of the typical issues entrepreneurs may face:
Safety of employees in the workplace
- Cybersecurity
- Paid leave
- Retirement
- Changes in tax and other regulations
- Healthcare reform
- Pay equity
- Classification of workers
- Privacy of employees
- Use of cannabis in the workplace
One example of regulatory challenges is Uber. In some countries, the company could not operate. If they did, the governing agencies stopped them because of licensing issues. Although Uber spent money on lobbying, they were not always successful. Before issuing operating permits, some countries need government agencies to create a ride-hailing category and regulations.
Uber could be worth $100 billion. But since it began to trade publicly, it has failed to produce a profitable quarter. Nonetheless, their investors are not losing sleep. That is because they invested in various transportation companies, including:
- DiDi Global in China (14% stake)
- Grab in Singapore (16% stake)
- Aurora in the United States (26% stake)
- Yandex Taxi in Russia, Eastern Europe, Africa, and the Middle East (33% stake)
- Zomato in India, Middle East, United Kingdom, and South Africa (8% stake)
- Joby Aviation in the United States (6% stake)
- Lime in the United States (31% stake)
Some businesses, as mentioned earlier, will need to operate for years before turning in a profit. It appears that many of Uber’s investors are still hanging on, waiting for payday.
As one of the many angel investors, a risk you may need to face is regulatory and legal issues. Therefore, it is necessary to consider these matters when reviewing a business model.
3. Timing Risks
Timing is always an issue. One question angel investors should ask is, “why now?”
Common sense dictates that it is difficult for startups to penetrate a market when it has already reached saturation. In this case, you could say that the entrepreneur was too late. But startups can also fail if they are too early.
Before Apple revolutionalized the industry with the introduction of the iPad, there was PalmPilot. It was, at its time, the first and most successful Personal Digital Assistant (PDA) marketed worldwide.
While some millennials may have heard of PalmPilot, not many know about GO Corp.
In 1987, Jerry Kaplan founded GO. Their main product was the EO Personal Communicator. This tablet-shaped pen-based computer with its mobile operating system was, indeed, a remarkable product. However, it came too early that the market was not ready for such a product. As a result, the company failed when the last of its investors, AT&T, pulled the plug in August 1993.
When determining the viability of a value proposition, angel investors must consider product timing. Too early or too late can only mean one thing for you – lose money.
4. Fierce Competition
Competing with well-established brands is more than challenging enough. In some cases, startups will “literally have to battle” the entrenched competitors.
Southwest Airlines is one example. The company started in 1967 as Air Southwest. When they first entered the market, three airlines – Braniff, Trans-Texas Airways, and Continental Airlines – filed an antitrust lawsuit against them. It would take around three years to resolve this legal issue.
Over the years, Southwest Airlines became a successful company with a history of introducing innovative measures to capture market shares. For the investors who held on, their patience resulted in positive ROIs.
While Southwest Airlines is one positive example, countless others failed. Hence, assessing the competition should also be one of the primary concerns when you think of angel investing in startups.
5. Founder Risks
Are the founders and their entire team competent enough to deliver their value proposition to consumers and capture value?
A startup founder may be a recognizable person with a successful track record in some cases. For instance, angel investors can have high confidence in Daniel Ek. And why not? He was the founder of:
- Tradera (subsequently bought by eBay)
- Advertigo (subsequently bought by TradeDoubler)
- Served as the CEO of μTorrent (which was bought by BitTorrent)
So, when Ek founded Spotify, investors were more than ready to write a check. But the vast majority of them are unknown names. As difficult as it is, angel investors need to find as much information about the founders. Their focus would be on trustworthiness, leadership ability, and business acumen, among others.
Due diligence in checking the background of founders is necessary. Otherwise, you may lose money by trusting the wrong person.
What Are the Rewards of Angel Investing?
In their 2020 annual report, the Center for Venture Research estimated that the total angel investment reached $25.3 billion. Furthermore, the number of active investors increased by 3.5% to 334,680. Considering that most startups eventually fail, there must be compelling reasons why angel investing is thriving.
Here are the usual reasons why individuals decide to become angel investors:
1. Extremely High Returns
There is no such thing as too good to be true for angels. Most of them are continually looking for the next unicorn – a startup valued at $1 billion. But rather than investing haphazardously, they take the time to review business models and make an educated assumption.
Yes, the chances are high that they will not recover their money. But one way they look at these risks is that out of ten companies, nine would fail. The one that does not can earn them more money than the combined losses in others.
Google is an example. In 1999, they raised $25 million in angel investments. By the time they launched its IPO, that investment was worth $500 million. Granted that the angels have had setbacks with other companies, the money they made from the IPO was worth so much more.
And so, before investing, you have to weigh the potential returns versus the risks.
2. Support What Is Important for Them
It is a misperception that people venture into angel investing to make money. While most do, there are individuals whose motivation is not only wealth. Some of them, for example, may choose to put money into businesses that are important to them.
If supporting something important is your motivation, then angel investing can be rewarding. Perhaps the founder is an entrepreneur close to you. Or it could be a particular demographic, such as women or minority entrepreneurs. You might also come across startups that you believe can make a difference in a community or society.
3. Getting Involved and Learning New Skills
Being an angel investor does not mean that you cannot have an active role in the startup. But that depends on the circumstances. Suppose the investor is an experienced entrepreneur. In this case, the investor can offer mentorship and provide investment advice. It is also not uncommon for some investors to be a part of the management.
Another scenario in which an investor could take an active role is when the motivation is to learn something new. For some angel investors, picking up a new skill interests them greatly.
4. Meeting New People
Some people’s primary motivating factor is meeting new people. Hence, angel investors can use this opportunity to expand their network. Not only do they get to know the team, but they may also meet other entrepreneurs. They can share ideas and perhaps even embark on projects in the future.
5. Diversifying Portfolio
One of the smartest moves any person can make is diversifying their portfolio. Instead of putting all their finances in one basket, it is better to allocate only portions to different income streams. In this manner, they can insulate themselves from fluctuations in stocks and bonds.
What Do You Need to Consider Before Making an Investment?
You should consider these three essential things when angel investing:
- Have a complete grasp of the risks and rewards of angel investing. Upon investing in an early-stage startup, you should realize that the odds are against you. It is, however, possible to get a 10x return from 1 or 2 out of 10 investments.
- Develop a strategy for angel investing. Having a portfolio early on is a way of protecting yourself. You can do this by deciding on the number of companies you will fund and the total investment amount. You could then calculate how much you can invest in each startup. Be sure to choose businesses that you are familiar with and understand.
- Know where to find the best startups. There are plenty of ways to find companies that might interest you. Already, there are several online portals you could try. And you can take advantage of advanced technology in this regard, too. For example, you can join a startup investment platform that uses AI to match you with startups that suit your preferences.
Angel Investing Is Risky But Can Be Highly Rewarding
High risk, high reward – that is what angel investing is all about. But as to the kind of reward you could get, that depends on what makes you tick. For angel investors, financial gain is the primary goal. But not everyone is the same.
Angel investing can also provide you with these other benefits:
- High returns
- Support what is important to you
- Learning new skills
- Meeting new people and networking
- Diversify your portfolio
Regardless of your reasons for investing, the one thing you should ensure is understanding the risks involved. You could also seek help in determining the viability of a startup. By choosing investment opportunities carefully, you will not eliminate the risks. Instead, you are increasing the likelihood of investing in the right company.