The goal for angel investors is to provide capital seed funding for early stage companies with the promise of receiving high net worth in the end. There are many misconceptions about the length of time that an angel investor should invest in a company. Some entrepreneurs believe that once the angel investors give them the money, these angels will simply wait around for years until their funds are returned with interest. Angel investors can be very patient and willing to make long-term investments; however, they need to envision a clear picture of the company’s overall rate of return on their investment.
According to Dr. Jeff Cornwall, the Director of Belmont University’s Center for Entrepreneurship, an angel investor should not be tied to any financial commitment with a company for more than three to seven years. Some contracts between entrepreneurs and angel investors may have a longer term commitment, but angels should never approach any financial agreement with that length of time in mind.
Both entrepreneurs and their investors must have the same ambitions for company growth and exit. This is why most angel investors request a time-frame set or viable exit strategy as part of their financial negotiations. Once entrepreneurs become successful at growing their business, angels make the returns on their investments and exit it through a sale or merger. It is crucial for the angel investor to meticulously study the industry to make sure that their exit plans are agreeable and realistic. The relationship and responsibilities of both the entrepreneur and angel investor can be complicated. That is why it is imperative to plan an early exit strategy and for all parties to mutually agree to all the terms.
In a recent study that analyzed 86 U.S. angel groups and 539 individual investors, it was discovered that an angel’s overall investment return was an impressive 2.6 times in 3.5 years. However, angels who invested in startups and provided more follow-up funding ended up losing more money on their investments 70% of the time. When angel investors are forced to reinvest in a company, many times, they have hope that the business will generate more revenue the second time around. What happens is they end up losing even more money, generate significantly lower returns, and the company eventually goes out of business. This is a common occurrence, since angel investors reinvest in 1/3 of all their deals. This is exactly why follow-on investments are risky.
This study also analyzed three important components that contribute to an angel investor’s success:
Due diligence– This term refers to the investigation and analysis that angel investors perform in order to determine if the investment opportunity meets their criteria for funding. When investors exercised more comprehensive due diligence, they experienced better returns.
Industry expertise– Angels who have experience in a specific industry nearly doubled their investments when they invested in businesses that were in their related field of expertise.
Participation– Angels received more returns when they actively participated in a company’s financial venture, including mentoring, coaching, and financial monitoring.
*Angel investors who made follow-on investments generated significantly lower returns.*
The Exit Strategy: Every investor needs to know when and how they will leave their partnership and how they will make a return on their investment. In addition, business management teams need to carefully weigh the pros and cons of different exit strategies and be flexible regarding their specific needs.
There are a few basic exit strategies that investors usually encounter:
1. Buyout by a competitor. A practical known exit strategy is when larger competitors buyout their smaller counterparts. This is a common example of how large companies can grow even larger through acquisitions. An entrepreneur should reflect this in their detailed plans.
2. Going Public. Offering shares of your company to the public markets can be viewed by some as an appropriate exit strategy. If your management team agrees on going public, an entrepreneur must make certain that someone on the management team has some knowledge and experience of running a public company.
3. Investor Buyout. This occurs when a larger venture capital firm buys out angel investors or a smaller venture capital investor.