I was recently asked “What are angel investors looking for?”
My knee jerk response was “a significant return on their investment…”
…and like most knee jerks responses, I was both right and wrong at the same time and (and this is probably where the phrase comes from…) I was a bit of a jerk for not thinking it through better… 
Yes – when an angel invests in a business they are likely looking for a significant return on their investment but that return is isn’t necessarily just measured in dimes, cents, dollars or whichever currency they happen to be dealing in.
So with a good cup of coffee I sat down to think through and home in on what ‘Returns’ an angel investors might be looking for when they make an investment – in other words, ‘What are the key motivations for angel investors?”
Now before I launch in – consider that angels are people and will be motivated by multiple reasons and what motivates them today, may not be what motivates them tomorrow. But I would suggest that there are primary and secondary motivations and by understanding them as an entrepreneur – you are ahead of the game….and by ahead of the game, I mean you are more likely to be able to lock in an angel investor and keep them in your corner if you identify and consider their key motivations. Look for the verbal and body language clues and once you’ve figured them out, keep them in the back of your mind because these are the engines which are potentially driving your angel today and during your ongoing relationship…
This week I thought I would examine what I’m calling ‘the Six Key Motivations of Angel Investors’
The Six Key Motivations of Angel Investors:
Motivation #1: A Financial Return
Angels back entrepreneurs and young businesses – a key motivation for doing so is to see that investment increase in value to the point where, at some stage in the future, they can gain the benefit of that increased value through some form of return.
Angel investors who are driven by the financial return ‘win’ when they invest in a business which goes on to increase in value by a significant multiple and when they can withdraw that financial return through some for of liquidity event – a term meaning some form of occurrence which makes the investment they acquired transferable into cash. These occurrences usually take the form of the company being acquired or being able to offer its shares through a public market of some kind.
Example – you invest in company A and get 1 of 10 shares for $1 (keeping it simple). If that company is then purchased and the company purchasing pays $5 for those shares – that purchase is the ‘liquidity event’ which allows the angel to sell their 1 share and gain the $5 offered for their share.
Some angel investors are focused on making a significant financial return – perhaps they are using these funds as a way of increasing their retirement income – angels who invest early enough can purchase a piece of a company at a reasonable price – but the earlier in the company’s life – the less visible the company’s future and therefore the higher the risk.
If we could all place a bet on a horse just before its about to cross the finishing line then we’d all make money gambling – the challenge is to make a winning bet before the race begins or when its in the first few seconds. The better an angel is at picking those winners early – the more likely they are that they will make mega returns on their investments – we call them investments but really the angel is gambling just like on a race. If you are the entrepreneur, you are the horse and the reason why you get asked some many questions during the due diligence stage is because the angel is checking out your pedigree and looking at your metaphorical teeth. Enjoy!
There are a few important facets to the financial return that investors are looking for – in the above over simplified example an angel buys 1 share and eventually gets to sell it for a multiple of the initial investment because there is an event (in this case a purchase) which allows them to transfer that share of ownership into cash. In many cases companies go through more than one round of fund raising – most go through multiple rounds. A round is just one way of saying ‘times’. So an entrepreneur sells 20% of the stock in their company round 1. During the next round (round 2) they create more shares and sell some more shares – during the second round the first group of investors often get asked if they also want to buy shares in the second round. Why is this important?
Because by selling more shares in the second round, the ownership percentage of the initial investors goes down unless they buy more shares equal to their original percentage in the second round.
Example: angel investors focused on a financial return consider two factors above all else: how much money they’re putting in, and the valuation of the company. The valuation of the company (i.e. how much it is valued to be worth) determines how much stock you give the angel. If an angel puts in $100,000 into a company at a pre-money (i.e. before the money is put in) valuation of $1 million, then the post-money valuation is $1.1 million (i.e. the pre-money valuation + the value of the investment…get it?), and the angel gets .1/1.10, or 9.1% of the company’s stock.
If your company raises a second round, the company will be divided among a larger number of investors which reduces their overall percentage (because you are dividing a slightly bigger cake among more people). If in the next round they sell 10% of the company to a new investor, your 9.1% will be reduced.
So if an angel is motivated by the financial return above all else – this dilution of their ownership stake will be important for them. You may find your initial investors being particularly active during the negotiations of company valuation in subsequent rounds. Interestingly, the motivations of founders are often aligned with the angels – they aren’t took keen on their ownership percentage being diluted either.
So if they are focused on financial return why will they allow their percentage to be reduced?
Because its being diluted by adding more cash to the company – the new shareholders brings in new cash, new contacts, new experience and increase the company’s potential for success. The early angels will often work with the founders to consider the new investors in terms of the whole package – i.e. all they can bring to increase the company’s trajectory and likelihood of success.
When talking with a potential angel consider the questions they are asking you and use that as a guide to what is this angel motivation for investing. If financial return is their key motivation – you’ll know what elements will drive their interaction with you both during the negotiations before they invest and their interactions with you after they invest. Investors who’s key motivation is delivering a significant financial return will emphasis valuation, dilution and achieving milestones towards a defined and reachable liquidity event. Angels are usually motivated by more than one of the key angel investor motivations – but understanding their key driver is critical both before and after they become your angel investor. By understanding this – you can align their interests and yours and negotiate the best deal for you, your business and your investors. Finding an angel predominantly motivated by financial return is neither a positive or a negative – but by identifying that financial return is a key motivator is critical so you know what information to emphasis during and after the negotiation. A good rule of thumb with ALL investors is communicate clearly and honestly about your business (even the problems and challenges – actually especially the problems and the challenges….), now you understand their primary motivation, keep that in mind during all interactions and focus on driving your business forward making sure you achieve the milestones you set and agreed with the angel when you established your relationship.
If you do that then their need for certainty and predictability will be fulfilled and you will be more likely to have happy investors who will back you today and with luck, with all your ventures in the future.
Questions on the first key motivation for Angel Investors? Reach out via the contact page above and join my mailing list by adding your name and email in the box to the right. I’ll also send you some valuable downloads to help…
Andrew
PS: and here’s an interesting video with some good perspectives so you can start getting into the heads of the better angels…
[youtube]http://www.youtube.com/watch?v=M3-ozlr_fYM[/youtube]
