Sources of Capital: Individual Investors (Private Placements from Angel Investors)

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al

The base content of this section is adapted from the "Note on Angel Investing," 2003, by Professors Michael Horvath and Fred Wainwright, Tuck School of Business at Dartmouth College. The authors gratefully acknowledge the support of the Tuck Center for Private Equity and Entrepreneurship. Copyright© 2003 Trustees of Dartmouth College. All rights reserved.

Angel investors typically invest in early stage companies in the seed round of financing. However, there are many individuals who make investments in emerging growth and middle-market companies which are outside the realm of angels. Thus the investors we are discussing in this section.

Some companies will choose to raise capital using a direct private placement soliciting individuals to participate based on a predetermined deal structure. These deals range in size from a few hundred thousand dollars to $5 million based on federal and state securities laws; the structure of these offerings varies. The company will establish a minimum investment amount per investor and seek enough to break escrow. Depending on the type of offering, there will probably be a maximum number of investors accepted (typically 35 nonaccredited). For example: A lower middle-market software company generating $8 million in revenue growing at 25 percent per year needs $900,000 to develop and launch a new product line. Let us assume that the company is not a candidate for institutional venture capital and does not want to increase its leverage. If management has an adequate network to access individual investors, then it may choose to undertake a private placement for the $900,000. There tend to be several types of individual investors.

Types of Investors

  • Unsophisticated emotional investors. These are the folks that are known to the entrepreneur, but who really should not invest directly in any private placement and do not have the financial capacity to lose their investment; however, they desire to provide support to their friends, family, and community. We suggest that companies do not accept funds from these individuals. They will usually be high maintenance for management-and besides, in many cases, it is the wrong thing to do.
  • Middle- to upper-income individuals (nonaccredited). There is a segment of the population that does not fit the criteria for being accredited, but has savings and a desire to participate in growth businesses in the community. Be careful with this type of investor, because most of these individuals will be high-maintenance investors for management.
  • Accredited and high net worth individuals. These are folks who meet the legal requirements for investing and may be reasonably sophisticated (but not necessarily so).
  • Professional investors. There are ample sophisticated, experienced, high net worth individuals who routinely invest in growing companies. They will usually have a desired deal structure that has worked for them in the past. Some of these may also be angels.

From a positive perspective, individual investors will be less sensitive to price and valuation relative to institutional investors. They seek opportunities to invest in their local communities and to tangentially participate in the growth of successful teams; they are really investing in the people.

However, raising capital with a private placement from individuals is a long and hard process. Post funding, a significant amount of time is required in communicating with the base of investors-keeping them up to speed and aware of the company's activities. In addition, management and the majority stockholder(s) have a fiduciary duty to protect the interest of the minority investors; therefore, taking corporate action may require extra steps and time.

Angel investors are individuals who use their personal cash to invest in early stage companies. This section describes the fundamentals of angel investing, compares angels with venture capitalists, and offers suggestions for best practices for entrepreneurs.

Angel investors are so named because in the early 1900s wealthy individuals provided capital to help launch new theatrical productions. As patrons of the arts, these investors were considered by theater professionals as "angels." Estimates of the number of active angel investors in the United States vary widely, most being accredited. The SEC Rule 501 states that an "accredited investor" is a person with a net worth of at least $l million or annual income for the most recent two years of at least $200,000 and a reasonable expectation of $200,000 in annual income for the current year.

According to Forrester Research, Inc., the number of households in the United States that fit that profile is approximately 630,000.

Angels fill a critical capital gap between friends and family and the venture capitalist (VC). When a start-up requires more than $25,000 but less than about $1.5 million, angels are a viable source of capital. This level of funding is below the radar screen of most VCs, although some will occasionally fund a seed round of as little as $500,000.

During the past few decades, VCs have raised larger and larger pools of capital, and given that the time and expense of reviewing and funding a company are the same regardless of size, it is far more efficient for VCs to fund larger transactions. Though the demarcation line is blurring, angels and VCs rarely compete for the same deals; you will see in Table 5.2 the major differences in their profiles.

Angels Are Varied

Angels can sometimes add significant value to start-up companies. It is important to be aware of the value that is important to your company and its needs as you pursue funding. Keep in mind that angels are subject to their personal idiosyncrasies. One or more of these characterizations may apply to an angel:

Guardian Angel This type of investor has relevant industry expertise and will be actively involved in helping the start-up achieve success. He or she has a strong Rolodex of contacts and has the experience to add substantial value as a board member.

Operational Angel This angel has significant experience as a senior executive in major corporations. For an entrepreneur, this type of investor can add much value because he or she knows what the company needs to do in order to scale up operations. However, be careful because this angel may have no idea of how to operate a small business without the significant management depth found in larger companies. Someone who has been successful in managing by the numbers can be demanding in requests for financial information.

Entrepreneurial Angel An investor that has "been there, done that" may be very valuable to a novice entrepreneur. For example, an entrepreneur can add perspective to the founders on what to expect from investors and how to effectively negotiate financing terms. An entrepreneurial angel with operating experience is ideal!



Hands-off Angel A wealthy doctor, attorney, or similar professional must focus on his or her day-to-day career. This type of investor is willing to invest but usually does not have the time or specific expertise to be of much help to the start-up.

Control Freak Some investors either believe they have all the answers because they have achieved certain wealth or have the personality to convince themselves they know everything. Caveat emptor.

Lemming Some angel investors will not make a decision unless an informal leader in the angel group invests or makes positive comments about a start-up-success breeds success. Even a term sheet from one or two small investors can allow an entrepreneur to access larger investors, who usually become more interested when they find out that fellow investors have committed. Some lemming investors are particularly astute at leveraging the work of other investors, whereas other lemmings simply trust blindly in the due diligence and term sheets of fellow investors. Generally, these investors are not active in the operating decisions of the company.

Angels Band Together

Angel investors increasingly join one or more informal or formal groups. There are various advantages of working in groups:

  • Social bonds and networking.
  • Access to prequalified deal flow.
  • Leveraging intellectual capital and expertise of individual members.
  • Learning from each other regarding deal evaluation skills.
  • More extensive due diligence capability.
  • Alignment of members' interests.

Angel groups can be structured in various ways:

  • Each member owns a portion of the legal entity representing the group.
  • Limited liability entities are formed by individuals to invest in specific deals.
  • The group is a nonprofit entity, and individual angels invest independently.

Typically an entrepreneur must complete a questionnaire and submit an executive summary or a full business plan. A proactive entrepreneur will understand the angel investing process. Some groups require that a member meet with the entrepreneur and determine if the plan is viable before allowing the entrepreneur to present to the group. Other groups allow the administrative staff and managing director to review the plan and invite the entrepreneur to present without a champion. The questionnaire will typically include the following:

  • Name of company.
  • Year founded and legal structure (C corporation, S corporation, limited liability company (LLC), etc.).
  • Who referred you to this angel group?
  • Summary of business (in three sentences or less).
  • What problem is your product or service solving?
  • What is the size of the market, how much has it grown in the past few years, and what is its projected growth?
  • Describe the competition (companies as well as substitute products).
  • What are your company's competitive advantages?
  • Why will your company succeed in the long run?
  • Does the company or its founders have any relevant patents or proprietary technologies (please do not reveal specific proprietary information)?
  • What is the relevant experience of each member of the management team? Please enclose a one-page resume of the CEO.
  • What is the company's sales and marketing strategy?
  • If you have a web site, what is the URL?
  • What are the major short-, medium-, and long-range operational milestones you intend to achieve?
  • Financial information as shown in Table 5.3.
  • Are 50 percent or more of revenues generated from one or two customers?
  • What are the three greatest risks of this venture?


  • What are the liabilities outstanding other than operational payable and accruals-especially off-balance-sheet items?
  • What is your capitalization structure? (How many shares are currently owned by founders and investors? How much capital has been invested so far, and by whom?)
  • How much capital are you seeking, and how will this capital be used?
  • How many rounds of investment and what amounts do you expect to need in total?
  • What is your exit strategy?
  • Please list the names and companies of your professional advisers (attorney, CPA, and/or consultant).
  • Who is the main contact person at the company? Please provide address, telephone, mobile phone, and fax.

Once the presentation is made (usually in 10 to 30 minutes, including a question-and-answer period) the entrepreneur is asked to leave the room. The angels discuss the opportunity, and if one or more angels are interested, then, depending on the group, either the entrepreneur is invited back at a later date for a more thorough review of the plan or an initial term sheet is developed within a week and presented to the entrepreneur. A list of typical terms is provided in Table 5.4.

Sometimes, if an entrepreneur's presentation is weak but the idea has merits, the entrepreneur will be coached on what to do in order to be able to present in a future meeting. Occasionally, the entrepreneur is matched with an angel who is willing to coach the entrepreneur (informally or for a fee) in order to raise the quality of the business to fundable status. Some angels specialize in helping entrepreneurs write business plans and develop their strategies.


Angel groups occasionally band together with other angel groups to share due diligence and invest sufficient capital to complete a round of financing.

Evaluation of Business Plans

Companies do not build themselves. People build companies. Ultimately, an angel investor is selecting a management team. A great team can make even a mediocre company achieve reasonable success, whereas a company with the best technology will not be successful with a mediocre management team.

Some of the key factors of a business plan that improve the success potential of a start-up are shown in Table 5.5. While presented in this section, these success factors also apply to traditional venture capital.

Business plans are inherently subject to change. Projections will change. Teams will change. Competitors will surge or fade. Most successful companies make radical changes to their business plans as managers discover the reality of their situation versus their original expectations. Thus the experience of a management team is critical in order to address sudden changes in strategy. Business plans require updates anytime major changes occur. The right angel investor can play a critical role in mentoring management teams and helping prepare them for venture funding.


Valuation Is Highly Negotiable in Early Stage Investing

Valuation is much more of an art than a science, especially for companies with no revenues or profits. In theory, a company is valued based on its ability to generate cash in the future. These future cash flows can be discounted using basic financial formulas in order to estimate the total present value today of all future cash flows.

For companies without positive cash flow but with revenues or net income, comparisons can be made with publicly traded companies in similar industries. For example, if ABC start-up is in the medical software business,

and publicly traded companies in the same industry trade for approximately two times annual sales, then it is reasonable to estimate the value of ABC as somewhat less than two times its annual sales. Usually a discount of 20 percent to 40 percent is made for private companies due to the fact that their stock is not publicly traded and the likelihood of matching willing sellers and buyers of private stock is fairly low.

Investors refer to the valuation of a company prior to receiving a round of investment as "premoney." Once funding occurs, at that instant, the value of the company rises by the amount of funding and the "postmoney" value is determined. For example, a company valued at $1 million premoney will be worth $1.2 million postmoney after receiving a round of $200,000 in funding. The investor in that round owns one-sixth of the company ($200,000 is one-sixth of $1.2 million).

If a start-up has no revenues, then valuation is subject to much negotiation and relies more on common practices of angel and venture capital investors. A hot company with patents or competitive advantages and potential for hundreds of millions of dollars in sales will certainly command a larger value than one with only tens of millions in potential sales, but hard rules are difficult to establish in the investing industry. Angels commonly value seed stage, concept-type firms with premoney valuation ranges from $500,000 to $1,000,000, while early stage venture capitalists start with premoney valuations in the $2,000,000 to $3,000,000 range.

Latest Developments in Angel Financing

Angel investor groups have had a difficult time since the stock market debacle in early 2000. Many early stage companies ran out of cash as early stage financing dried up. Of those start-ups that survived, many had to reach out to venture capitalists who insisted on significantly reducing the ownership percentage of previous investors, including founders and angels.

During times of major decreases in start-up valuations from one financing round to the next, the VCs' basic message to earlier investors was, "If you can't invest in the company in this new round of financing to keep it alive, then you don't deserve to own much of it." This is similar to a poker game; those players who are unwilling to up the ante lose everything they placed in the pot in previous betting rounds. Tough, but fair. Some of the larger angel groups have either formed their own funds or joint ventured with venture capital funds in order to ensure that young companies have the necessary funding in subsequent rounds to support growth. Thus the angels are better able to monitor their investments as the start-ups achieve greater growth.

Tenex Greenhouse, for example, is an angel group in California that has launched a $20 million (target) venture fund using angel and institutional capital to support successful angel-funded start-ups. Tenex Greenhouse also offers intellectual capital, leveraging its members' functional specialties and industry experience to provide support to funded start-ups.

The well-known Band of Angels, started in 1995 in Silicon Valley, now has a $50 million VC fund with capital from institutional investors. From another perspective, Venture Investment Management Company LLC (VIMAC) is a VC fund in Boston that has a network of more than 200 angels who can co-invest on select deals, especially ones that require more advisory work.

One of the results of cross-fertilization of ideas and organizational structures among angels and VCs has been the emergence of typical financing terms (see Table 5.4). Milestone financing is becoming more common. Investors mitigate their risk by setting operational targets for the start-up that need to be met before another portion of funding is made. The pricing and terms of the milestone funding are preset to avoid excessive subsequent negotiations.

Best Practices for Entrepreneurs

As we have mentioned before in this handbook, only a small percentage (0.2 percent to 0.5 percent) of all business plans presented to either angels or VCs receive funding. Entrepreneurs need to read the necessary books and speak to individuals with financing experience or expertise so when the opportunity arises, they are fully prepared to present their concept to investors. Incomplete business plans are unacceptable in today's competitive environment.

Ideas are a dime a dozen. Fundable businesses are those that can demonstrate that they have the products and the people to enter an identifiable market and take significant market share.

Use informal networks to be referred to individual angels and VCs. It vastly increases the chances that your business plan will be reviewed.

Invest capital in your own start-up. Not doing so is a major red flag for investors. Do not refer to angel investors as "dumb money," regardless of who you are speaking with and especially in a public forum. Believe it or not, this has actually been done. These kind of amateur mistakes will haunt you, because investors and VCs are a close-knit group.

During the initial conversations with an angel group and during the presentation to the angels, it behooves the entrepreneur to find out which of the members are the real decision makers. This is difficult to ascertain but can be very valuable information because angels are human and they feel safety in numbers. The entrepreneur should focus on the more experienced angels and the managing directors of the angel group.

If groups of investors are interested, it is far better for the company to have them to invest as a limited liability company (LLC) than as individuals. VCs are weary of complex capitalization structures, and an entrepreneur risks losing access to larger amounts of capital. In addition, company decision making regarding major events can become unwieldy if large numbers of investor-owners need to be consulted. This process can become like herding cats.

Finding an angel investor is like finding a spouse; personal chemistry is critical because it is a long-term relationship. This chemistry may take time to build, so invest quality time in getting to know the angel. If you are dealing with a group of angels, it is the lead angel who will be on your board or who will manage the investment on behalf of others who should be your focus. It is far better in the long run for an entrepreneur to turn down an angel investment because of lack of chemistry and wait for a better match (though this is rarely done if money is made available).

Keep the investor apprised of the company's progress at least monthly if not weekly. If there are problems, alert the investor early about them. Keep investors informed as to possible solutions. If they have the right skills or contacts, involve them in developing the solution or finding the right people to help. Waiting until the last minute before disclosing major issues risks losing the confidence of the company's investor group.

Practically Speaking

Entrepreneurs owe a tremendous debt of gratitude to angel investors. Angels are the backbone of our capitalist system; they allow ideas to flourish, and allow managers to become heads of companies and jobs to be created. Generally, angels are successful entrepreneurs or investors who want to share in the energy of a new idea and the potential growth of its development. Typically, they require less return for the risk assumed, because generally they are believers, willing to invest at inception. This does not mean they are not savvy. All money is hard to raise. Most of the time angels will be your best investors because they are as committed as the entrepreneur to developing the idea. Institutional interest is in realizing profits and getting there as fast as possible. Angels are more patient, probably because they are in early and are part of developing the idea for commercialization. They are probably more emotionally attached.

The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.