By Akhil Raj Gupta
Edited by Sanchita Malhotra, Associate Editor, The Indian Economist
The science (and art) of angel investing has been creating a lot of hype recently with many individuals, whether accredited or not, who are trying to jump onto the angel bandwagon. An excess of investors eager to fund what they believe could be the next Google, Facebook, Twitter, or LinkedIn, has given a strong impetus to the rise of a ‘startup’ culture around the world. At a time when perhaps the entire paradigm of business might be changing, it becomes crucial to understand the in and outs of angel investing as an ‘alternative asset.’
Giving a brief history of angel investing , the term ‘angel’ quite interestingly originated on Broadway, and was used to describe a financier who would then be given pride of place among the audience and generally be made to feel good about himself or herself. Today angel investors are typically seasoned technocrats with distinguished business careers (although exceptions existing with a few young angels entering the network) and deep pockets. Although definitions vary, most angel investors are required to be accredit investors, thus necessitating an annual income of more than $200K annually or assets worth $1 million. In the financial cycle of an organization, angels often provide for bridge financing i.e. they plug the gap between seed funding (provided by family and friends) and venture capitalism (professionally managed funds that are invested in companies established since a few years and displaying reasonable traction.) Angel investors originated primarily from Silicon Valley and they continue to invest in firms either immersed in technology sector or leveraging a novel technology to create better products. These include health, software, industry/engineering, retail, IT products, and consumer product not limiting to these products only. The average investment size ranges from $25-50,000 and therefore, most companies suitable for angel funding are assumed to have less capital base, and are amenable to some form of mentorship. In light of the above features, it is not difficult to see why Google received its first investment from an angel even before the founders could finish their presentation!
On close examination however, one can notice some features of angel investing that make it truly unique and different (perhaps positively!) from other forms of investment. Angel investors hunt in packs, if one asks any angel in the world, they will almost always confirm that they are part of some group. These so-called angel networks are elitist bodies often consisting of the rockstars of the business world who can mutually benefit from each other’s research, insights, and domain expertise. For example, it is common for a founder of an IT company to reach across to his partner (a CEO of a monolith in the garments industry) for valuable advice on the viability of a textiles startup. This shared risk-reward system differs quite sharply from something like stock investing or currency arbitrage where you can expect the avarice (or fortitude) of George Soros or Warren Buffet to bring an entire market onto its knees. Perhaps it is the uncertain and gambling nature of angel investing that makes these individuals happy to share the losses depending on which way the company goes post-funding.
Angels often provide more than just financial assistance, as Reid Hoffman, the founder of LinkedIn (and also an early investor in Facebook and Flickr) sits on the board of at least half a dozen high profile companies, including Zynga, the founder of the famous online poker game and it is no secret that his advice and networks have played a key role in the success of many startups that made the founders and Hoffman himself very rich. For instance, Hoffman set up the meeting between Mark Zuckerberg and Peter Thiel (co-founder of PayPal) that culminated in Thiel’s investment of $500K in Facebook’s very first financing round. Similarly, many angels around the world actively mentor the startups they invest in as a way of staying up-to-date with business practices and businesses that are going to define the future in reality. Some argue that the desire to mentor young entrepreneurs is often the main driving force behind angel investor decisions but the scope for such strategic intervention in the future remains negligible for most, given that there existed more than 250,000 angels in the U.S. according to last count.
Another feature is that angel investors do not make much money, as given that angel investors are often high net-worth individuals, the angel capital markets remain quite deregulated and distant from public eye, much like the derivatives market at its peak in the early 2000s. Apart from obvious legal constraints against theft, etc. there is nothing that can legally stop an entrepreneur from driving his company (and your money along with it) straight onto the ground. Although formal research is still largely unavailable, one study estimates that only about 2.5% of all companies return 20 times the original investment and that too on carefully selected and professionally managed angel investments. An interesting article on TechCrunch points out how a surplus of angels eager to throw their cash, out in expectation of miracles have buffeted a population of companies with low technical risk but high market risk. The author then argues that prime angel targets should be companies facing the inverse i.e. high technical risk and low market risk, which would also increase the scope and utility of strategic intervention on part of the angel! Off late, the emergence of crowd-funding has allowed anybody with even a five dollar bill to support a startup of his liking. The full impact of websites like Kickstarter on the entrepreneurial system however remains to be seen and I am sure that some intriguing questions related to their regulation are bound to arise.
It is hoped that by end of this piece, you have received a glimpse into a world where intrepid and well- connected investors may often find themselves doing better than others perhaps more technically qualified competitors.
Akhil is currently in his second year at college, pursuing a Bachelor of Arts degree in Economics (Hons) at Sri Ram College of Commerce, University of Delhi. He has been passionate about writing since an early age and is currently involved with the official College magazine and Economics Department magazine at SRCC. His areas of interest include behavioural economics / finance, econometric analysis, macroeconomic policy, and political theory. He spends his free time reading extensively, watching interesting videos on YouTube, and trying to convince everybody around him that he really does know a thing or two about economics in the midst of all the pontification!