How To Become An Angel Investor

Every now and then I get asked about angel investing. Questions such as “What is an angel investor?”, “How do I become an angel investor?” and “What do I need to become an angel investor?” are common and sensible questions.

What Is An Angel Investor?

Let’s start with the most obvious place to start, and easiest question to answer: What is an angel investor? Most simply, an angel investor is a person who invests in companies that are not listed on the stock exchange.

What Is The Difference Between An Angel Investor And A Venture Capitalist?

In a word: size. An angel investor is typically investing 4 to 6 figure sums of money, while a Venture Capitalist (VC) is typically investing 7+ figure sums. Angel investors are typically one person, while VCs are typically a group of people or a company. While angel investors may or may not have things to offer the company above money (mentorship, contacts, etc), VCs typically have more expertise and may even have teams dedicated to assist. Another difference is that an angel investor may not require a position on the board, while a VC almost certainly will want a position. VCs tend to want a larger share of the company and may be more ruthless / pushy to deal with (which can be a good or bad thing).

How Do I Become An Angel Investor?

This is probably the most common question after “What is an angel investor?”. Realistically though, the first question to ask should be “Should I become an angel investor?”.

This is an important question because for most people, angel investing won’t fit in their investing strategy and they won’t have the skills required to be an angel investor.

Angel investing is illiquid, meaning that often it’s extremely difficult to sell your shares. Typically the time-frame for return on your money is very long (5-10 years) and you have little to no control over your investment. For example, if the controlling shareholders decide they will never return money to shareholders because they want to keep growing the company, it’s difficult to do anything about that; hence angel investing doesn’t fit in most people’s investment portfolios. Typically you need a lot more money than you’re investing so that you have the option to partake in future capital raises (so you aren’t unfairly diluted) or sue the directors if things turn bad.

Angel investing also requires a lot of skills, experience and effort beyond other types of investing. Not only do you have to be able to calculate value in a company, understand basic accounting and have an eye for picking companies (researching industries, headwinds, tailwinds, etc.) as with normal investing, you also have to be knowledgeable in legal matters; dealing with people; identifying risks, conflicts and darn right traps; and have business experience way beyond what’s required of a normal investor. Here’s a quick checklist for angel investors that I put together, which might give a clue about some of the requirements to be an angel investor.

If you’re still interested in becoming an angel investor, you might also research the differences between a wholesale investor and a retail investor. It is not the requirements to be a wholesale investor that are of interest, rather the lack of protection and expectation of knowledge that are worth exploring, because this gives a clue about the sort of things one must consider as an angel investor.

If I haven’t scared you off and you’re confident that you have the skills and finances to be an angel investor, and such an endeavor is an appropriate form of investing for your strategy, then I probably don’t need to tell you how to be an angel investor; you probably just need pointed in the right direction to start hunting down investment opportunities. In which case, I refer you to Snowball Effect, which is where I bought my first angel investment. Snowball Effect have a selection of well put together offers for retail and wholesale investors that take out a lot of the effort and (massive amount of ) time in getting the opportunity correctly prepared (business cases, swot analysis, business plans, checking the strategy, use of finances, legals, valuations, etc.), though ultimately it’s important to remember that even if you’re only a retail investor, the responsibility still lies on you, not Snowball Effect. So you have to know what you’re doing.

Business Investing

Why Do Private Companies Sell For Less Than Listed Companies?

As an Angel Investor one of the most common hurdles I see private companies struggling with when trying to raise capital is valuing their business. Specifically, company owners tend to have a disconnect between what they think the company is worth verses what investors are willing to pay.

Too many times I see the valuation set at what the value of the company will be after growth, which leaves no profit in the future for any investor with the risk of losses if the company doesn’t succeed.

I also see valuations being set based on what the owner feels like it’s worth, with no financial justification.

I also see valuations from accountants which are typically based on a DCF methodology. While a DCF is a valid way to calculate a business’s worth, it’s more used to calculate the value in a business rather than the market value, or what somebody would actually pay for a company. This is because it doesn’t leave any room for profit for the investor in the short / medium term, and the discounted rate doesn’t reflect the opportunity cost from an investor’s perspective. An accountant would typically not be in a position to negotiate the level of risk and will typically accept the level of risk given to them by the company owner, giving a more minor discount value.

Finally this brings me to the last type of valuation I see, which is a comparables market valuation. As company owners typically don’t have access to sale data of private companies, they often compare their business to those listed on the stock market. Which brings me to the subject of the article…

Why Do Private Companies Sell For Less Than Publicly Listed Companies?

It seems fair that similar companies should be priced similarly, right? Yet you’ll never get the same price for your company selling it privately than you would selling it publically. The answer to the titular question lies not just in the benefit of liquidity of listing a company, but also in the public nature of listed companies.

When buying a private company, there is a much larger risk premium to overcome due to the fact that there is less data available about the company, that data has not been held to the same public rigor (or sometimes laws) that a public company has. There are also years of documented performance forecasts that can be contrasted against their following year’s results to determine their accuracy, and of course a bunch of laws that must be adhered to in order to fit with the bourse’s requirements, which are perpetually scrutinized by large institutional investors with a copacetic interest to any smaller investor – safeguarding demand. All of which contributes to a lower risk premium for public companies.

There are also aspects of demand that push up the share price of public companies, as not only are such companies easier to buy into, but some institutions may have to buy those stocks to fit allocation requirements.

The benefit of liquidity is also seen in the opportunity for exit. In other words, as public companies are easy to sell, investors don’t need to worry about finding a buyer. This brings supply side pressure on the price of non-listed companies, pushing the share price down.

The nature of sale of private companies also comes with problems, in that any buyer is likely to buy the company in its entirety. This changes the calculation on how much a company is worth, because it’s no longer a silent investment that pays you regular dividends, it’s a job for someone to get their money from the company. Consequently, an investor of a public company might be happy with a 5% dividend because it’s better than the return from the bank, but an owner operator doesn’t want to buy a business, then work all day for the same amount of money they would get from putting their money in the bank.

Finally, there are additional risks and costs related to investing in private companies. For example, one might spend anything from 2 to 30 days researching the company and going through legal processes, incurring costs of thousands of dollars just to make the purchase of the shares.

All of the above make angel investing and owner-operator company purchases less attractive, which makes private companies sell for less than publicly listed companies.


Legal Matters: Should I Become A Company Director?

As an Angel Investor, there are always opportunities to become a director, and this is a very attractive proposition. You get to have influence over your investment, which is both fun and protects your investment to some degree because you can influence the thinking at the board meeting.

There are however, downsides to becoming a director, especially in early stage companies. Directors are personally financially and legally responsible for the actions of the company. This means that if the company becomes insolvent and the company owes money, the directors will be chased by the debt collectors. This is a particular problem if you are an angel investor in the company, for two reasons:

  • You probably won’t have enough of an investment to control the decisions of the board
  • As an investor, you’ll probably have more equity than the other board members (otherwise why else would they have sought equity at the cost of losing some of their business?)

This means that if the company becomes insolvent, debt collectors will probably come after you first, as they always chase the director who is most likely able to pay. This will be particularly frustrating because the board can make decisions that are against your will because you do not represent the voting majority of the board.

Secondly, directors are responsible legally. This means that even if the board acts against your advice as a director, you are still legally responsible for the company’s actions.

Finally, did you know that you can be a director without being a director? For example, if there is a sufficient paper trail to prove that you’ve been acting as a company Director without being on the board or registered as a director in the Companies Office, you can be held responsible as a director if things go South.

Before taking the position as a director, I recommend looking at the company’s financials to make sure there are no liabilities of concern and things are tracking in the right direction. I also recommend considering the risks of existing contracts that might factor in. You might do some Google searches and check the DRO and insolvency registers on the other directors, large shareholders and any shareholders that may be related to any of the directors. You might also take a look at Prover/Premise to take a punt a what level of equity other directors have, in case of the event of company insolvency. You might also want to look at directors insurance and consider getting a list of warrants from the company for more certainty around things, such as if any PAYE is owed or other undisclosed liabilities. I’ll start to build a list of warrants at the end of this article.

I hope that helps someone decide whether they want to accept an offer to become a director. Obviously their a positive points that I’ve not listed, but these are the catches that I think might be useful.


A Checklist For Angel Investors

This article provides a checklist for Angel Investors prior to investing in a company. It’s a list of documents you’ll need and things you’ll need to check before buying shares in a private company.

  • Business Plan – This should include a SWOT analysis, Risk Analysis with mitigation if possible, forecast (with solid justification for the numbers), information about any planned future capital raises, and a plan for how they’re going to spend the money. There are some good Business Plan templates on the internet for this.
  • Exit plan – which should be a conversation about each directors intentions.
  • Evidence of the things in the Information Memorandum (IM) or business plan, such as a copy of contracts to prove ongoing sales.
  • Financials for the past few years (which you’ll need for the valuation).
  • Financial Models – I like to see that a company has done some financial modelling to show that they’ve can justify their decision to seek funding from an investor. They should have modelled the projection of the business without investment, with other types of investment, etc. It should be obvious to you why they’re willing to give up part of their precious business rather than just take a bank loan.
  • A Company Constitution – You’ll want to have a commercial lawyer check this after you’ve checked it. Getting a good lawyer is very important. All lawyers say that they do commercial law, but the fact is most are only good at family law. It’s very important that you get a lawyer that specializes in commercial law – which usually means hiring a big law firm.
  • A Shareholders Agreement – Again, you’ll want to have a commercial lawyer check this after you’ve checked it.
  • Valuation – The company will likely have their own idea of the value of the company. You’ll need to do your own valuation to ensure that you can see value (and the right ROI) of your investment in the company. You’ll need to be able to justify this to the entrepreneur if you want to negotiate on the price.
  • Check the Companies Register for existing ownership structure, company history, and search each director and shareholder to ensure that they don’t have a conflict of interest.
  • Check the Insolvency and DRO Register to see if any of the directors have a history there. You may wish to give the director a change to talk about the reason they are listed on the register before walking away from the investment.
  • Check the LINZ database to ensure that the addresses of the directors matches that of the NZ companies database and also get clues about their financial position from dates of mortgages registered against the property title. I recommend using Prover for this, as property data in NZ is complicated, and I believe that this company does the best job of assembling this data into a useful tool.
  • Check the ID (Drivers License / Passport) of the person that you are dealing with to ensure that they are who they say they are, and are listed on the Companies Register as a director.
  • View the Directors Resolution.
  • Search for the directors, shareholders and company on Google and social media websites and read up as much as you can.
  • Ensure that the Shareholders Agreement or other legal document ensures that IP is owned by the company, and new IP that is relevant to the business, which is created by the directors of the company is owned by the company. This stuff should all be in the Shareholders Agreement.
  • Get a list of assets owned by the company.

Get the following Warrants from the company, if they are relevant:

  • There is no outstanding debt, shareholder loans, GST & PAYE is all paid.
  • There are no undeclared convertible notes or other unlisted shareholdings, etc.
  • There is no contractual restraint of trade to another company (such as a former employer) and have no such arrangement pending would also be good (they might be selling a large business that has a restraint of trade term which makes them unable to work in the business in which you are buying shares).

Your lawyer can help with a list here, as they are likely to have a boiler plate template with a list of warranties – though it’s your responsibility to check these off before the contract stage.