If you are considering seeking angel investment for your business, it is worth weighing up the pros and cons set out below. Although there are numerous benefits of this funding model such as flexibility and access to investor expertise and networks, giving up a stake in your company is a big risk to take.
What is an angel investor?
An angel investor is a person who invests their own money in startup companies in exchange for shares in the company. They are also referred to as business angels or seed investors. Angel investors tend to operate individually but are increasingly investing as part of an ‘angel network’ to create a larger pool of investment cash and spread the financial risk.
The distinctive feature of angel investment is the personal involvement of the investor who, in addition to financial investment, offers expertise, mentoring and networking opportunities to the company and its founders.
The financial risk of investing in a startup business is greater for angel investors but so is the potential for financial return. For this reason, angel investors are picky about their investments and will go through any business plan and projections with a fine-tooth comb (as you may have seen on The Apprentice or Dragons’ Den) to ensure they are comfortable with the risks they are taking.
Angel investors are often interested in supporting businesses in a particular industry or may just have the desire to be part of something new while having the opportunity to convey their experience and knowledge to the next generation of entrepreneurs.
How does the angel investment process work?
Angel investors invest cash into a business operated by a company in return for shares and therefore an ownership stake in that business. This type of investment would not be available to businesses which operate as a sole trader or partnership as the cash is invested into the company rather than the entrepreneur.
If the startup company is a success, the angel investor will realise their investment by way of an exit (sale) of the business with a view to making a profit. If the startup fails, however, the angel investor will have to write off the investment as a loss. This is why an agreed exit strategy is often key for this type of investment. The most common types of exit strategy are via a merger or acquisition where another company will buy the startup either as a distinct business or merge it into its existing business.
What can be put in place to protect your business before investment?
Before going ahead with any investment in exchange for a stake in your company, it is crucial that you have the necessary legal documents in place which set out the terms of the investment itself, manage the risk in relation to the investment, and govern how the company will be run after the investment has been made. Specific terms can be negotiated and agreed in the investment documents to protect your rights and control as a startup founder.
For more detailed information on these provisions, please see the link to our article: What can I do to protect my position as a founder when onboarding an angel investor?
Pros and cons of angel investment
As with any funding model, there are advantages and disadvantages which should be considered carefully before making the decision to go ahead with angel investment. These are set out in summary below.
Pros of angel investment
- Early stage investment: angel investment can be available at the very early ‘seed’ stage in the development of the business which is often when you require the cash the most to get the business off the ground.
- Availability of funding: startup businesses rarely qualify for bank loans as they will have hardly any track record to reassure the bank and few (if any) assets to secure any funding.
- No regular repayments: as you are not taking a loan but exchanging the angel investment for shares, you won’t need to find the cash to make monthly loan repayments, which may be impossible for a startup which is not yet generating income.
- Less personal risk: unlike bank loans, there is no need to secure personal assets (like the family home) with angel investment funding.
- Greater flexibility: angel investors are individuals and invest with their own money which gives them a much greater degree of freedom when it comes to negotiating terms, taking risks and making decisions quickly. The paperwork needed to onboard an angel investor is usually much simpler than that required for bank loans or other more traditional funding options.
- Greater accountability: the involvement of angel investors can help you run the business more efficiently as you will be accountable to other shareholders.
- Experience and resources: most angel investors are successful business people and so can provide expertise, experience and guidance for startups and their founders. They can also open up a network of contacts which can be invaluable for your business both from the funding side and from the development side. There are angel investors all over the world which makes the investment opportunities vast and exciting.
- Rapid growth of your business: angel investors get repaid when they exit the business which incentivises them to help you maximise the growth of the business before the exit.
- Focus on industry: angel investors tend to invest in industries in which they have experience or which are important to them (for example, medical innovation). They tend to be less interested in where the business is based and so you do not have to be located in a big city to secure funding.
- Tax-reliefs: angel investors may be able to reduce some of the risk of investing in startups through two main tax-relief schemes which give potential tax relief on income tax and capital gains tax. These schemes are known as EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Scheme).
Cons of angel investment
- Loss of control and ownership: the most obvious disadvantage of raising financing through angel investment, is the loss of ownership and control of the company as founders may find themselves giving away between 10% and 50% of the shares in their company. This is why it is so important to build into the investment documents certain protections for founders. By giving up too much control to investors, there may be a risk that they decide to replace you and you could find yourself ousted from your own company.
- High risk: making angel investment is very risky as a high proportion of startups fail and the angel investor risks losing all of their capital. Angel investors can also look to manage and reduce their risk by including certain protections in the investment documents, such as requesting warranties (statements of fact) from the founders about the state of the business at the time of investing. If the warranties turn out to be untrue, there may be a claim for breach of warranty against the company and the founder (who will be personally liable for any breach of warranty). The two tax schemes discussed previously (EIS and SEIS) can also go some way to mitigating investment risk.
- Finding an angel: it may take a long time to find an angel investor who not only wants to invest in your business but who you also feel you can trust and is a good fit for the business.
- Lack of formality: with the benefit of greater flexibility comes the disadvantage of a lack of formality and structure. Your legal team will be an essential part of creating this formality and structure by putting in place investment documents which have been reviewed and agreed by all parties and can then be referred to and relied upon going forward.
- Increased pressure: on the flip side of the benefits of greater scrutiny and rapid growth, angel investors may put pressure on you to hit targets and achieve results quickly so they can maximise their return before exit.
- Relationship issues: along with the advantages of a personal relationship with an angel investor, you should also consider what the situation may look like if the relationship turned sour and you no longer wished to work together. Not only would that cause emotional stress but it could also be damaging to the business. Certain provisions can be made in the legal documents to manage such situations.
As mentioned above, angel investment is a personal relationship between the founders and the investors who should both work together in the best interests of the company and the shareholders. Unfortunately, sometimes relationships break down and founders and investors may have different ideas on the direction of the business or even day to day issues. It is vital that the legal documentation you agree at the start of the relationship is comprehensive and covers a wide range of scenarios to protect you and your business as far as possible. Angel investment a risk that can be managed to a certain extent in the structuring of the investment and the provisions of the legal documentation which our experienced corporate team would be happy to advise you on.
For more advice on angel investment, tax-relief schemes and funding options, please get in touch with our corporate team.