They may be the answer to your prayers, but care is needed.

Raising money from high net-worth individuals or “angels” can mean the difference between success and failure for an emerging business. Yet before an entrepreneur accepts investment money, he or she should understand the positives, the negatives and the unique dynamics of this new economic partnership.

Where do you find an angel?

Let’s start with the basics. Angel investors are high-net-worth individuals who invest with their hearts and their minds. This generally means that angels invest based on either a warm feeling about the entrepreneur — because of a personal or professional connection — or a good feeling about a market space or industry.

Savvy entrepreneurs probably know potential investors already, including former bosses, mentors or significant customer contacts. Those who are less connected or less experienced can find introductions to local angel groups through their accountant, lawyer or other advisors.

Entrepreneurs also should identify area local angel investor groups, such as Hub Angels and Common Angels. Although these groups often require significantly more “due diligence” and majority approvals, businesses may attract the interest of one or more angel investors, even if the group declines to invest.

How much do they invest?

Although the dollar amount invested varies widely, most angels invest between $50,000 and $250,000 individually and $250,000 to $1 million as a group.

Many angel investors stagger their investments, putting some money in initially with the rest pegged to business or technology development milestones. In addition, many angels anticipate and like to participate in any subsequent venture financing rounds.

What do angels want?

The answer to this question is as wide and varied as the angels themselves, and entrepreneurs should listen before they offer an angel transaction terms.

Most angels will lay out terms in up to three significant areas: control, dilution or current value or return. An angel interested in control is hands-on and often demands a board seat, veto power over certain operational decisions and prompt disclosure of financial information. If dilution is the angel’s hot-button issue, he or she might want straight percentage or full-ratchet protection, understanding that these provisions may fall in a subsequent venture funding — but only after a negotiation with the angel.

Alternatively, if the angel investor prefers convertible debt instead of equity, an option to convert the note at a discount on a subsequent round of financing (e.g. an additional 10 to 25 percent on top of principal and accrued interest) often is added.

Finally, some angels seek current returns — typically in the form of modest but regular cash dividends or percentages of revenues. The key for the entrepreneur is to match the rights and preferences specifically to the angel’s hot button —nothing should be given to an investor without a reason.

Are angels worth the hassle?

Angel investors can and do provide an essential source of funding for emerging businesses, often filling the gap between funds that might be raised from friends and neighbors and venture financing. Despite any necessary negotiations with the angel, the entrepreneur generally will give away less of her company (15 to 25 percent in the typical angel round) and get financing faster than with other alternatives. Challenges arise when the investment terms create hurdles to subsequent financing that will have to be removed later at the request of institutional investors. For example, an angel might insist on an LLC form of entity, which generally would not work for venture investors. The entrepreneur might want to build in an automatic LLC-corporate conversion provision triggered by a significant outside investment.

Angels on the board?

Many angel investors are now requiring board seats, and that can be both positive and negative. Most people become directors for three reasons: to add value by virtue of their experience and contacts; to learn something as the enterprise grows; and to make money.

Here the focus is on the latter. Angel directors add value in the form of business contacts, operational experience or financing strategy. However, given the investment focus, an angel director also can be quite controlling and may have very definite opinions on topics ranging from employee compensation to direct versus indirect selling.

Moreover, many outside directors now are asking for the company to provide D&O (directors and officers) insurance as well as separate contract indemnification for actions by creditors, competitors or disgruntled stockholders, and these protections come with a definite out-of-pocket cost. Special attention also should be given to succession issues —will the angel step down from the board to make way for future venture investors or as the business grows. To this end, some entrepreneurs are building in term limits for angel directors right from the start as a condition of the investment.

Angels can and do fulfill an essential role in funding emerging businesses so long as the entrepreneur has considered both the pros and cons — before accepting a check.

Mass High Tech, 11/15/2004
By Lawrence Gennari

Calling All Angels?