Angel investors play a crucial role in the startup ecosystem. Angels fill the big gap in the pre-seed and seed funding stages usually referred to as the ‘Valley of Death” due to VCs becoming more risk-averse and shifting to later-stage funding.

Whether you are a professional or a self-made entrepreneur, an angel can open doors, and offer wisdom, and mentorship beyond capital. You can offer “smart capital”, and have the patience to wait for a company to mature successfully.

In this article, I hope to share several steps that you should consider before cutting that first cheque as an angel.

Understand the risks involved in startup investing

Startup investing is inherently risky. The truth is most startups fail to achieve their goals and go kaput. In my work as a startup lawyer, high net-worth people I met no doubt have the risk appetite to stomach the capital loss as an angel, but they underestimated the inherent risk of startup investing.

As an angel, there are common challenges that you need to address:

Failure to understand startup investing as an asset class i.e. liquidity risk
Limited access to quality deal flow thus lacking in diversification
No experience to read on current trends and emerging markets
What to do to invest such as what to look out for in a due diligence
How to negotiate funding terms
Failure to familiarise with the local startup ecosystem and regulations

Be sure to consult your advisers including legal counsel, accountant, and financial planner to assess all these challenges.

Find a company to invest

Finding a great startup to invest in is hard. You may need to compete with other prominent investors to get on the startup’s cap table unless you can show how you can add more value than the rest. VCs even hire scouts (eg, usually seasoned founders that they have venture-backed previously) to help them source for hidden or potential deals ahead of the competitor.

You may want to look into and tap on your own network. The common funding sources of seed funding will be ‘Friends and Family’. You may already be related to a founder through blood or friendship. You should leverage that unique connection.

Also Read: Understanding angel investors with Mysty Rusk

Put up your personal email for companies to send their pitch deck. Have an investor profile on e27.

You will need to screen through the pitch decks. Another great way is to join an angel network in your area and co-invest with other angels like AngelCentral to help you screen the deals.

VCs can also be your friend. If you are already invested in a VC fund, you may check if you can co-invest in deals. At times, VCs may pass on a deal as it does not fulfil their ‘investment thesis’.

Agreeing on the valuation

Dealing with valuation can be stressful. If the company is raising funds for the first time, it may get tricky as there is a chance that you need to decide how much the company is actually worth investing and how much stake you should get in exchange for the capital invested.

There is no hard and fast rule on startup valuation. Generally, a startup may be giving up 10 per cent to 20 per cent of the equity in the company for every round. So a pre-money valuation (i.e. the valuation of the company before the new fundraising) is usually based on how much money the founders think they need.

You will get to hear all sorts of valuation methods and tools. As an angel, you will need to decide if the valuation makes sense. To reduce headaches in dealing with valuation, it may be common for angels to co-invest with a lead investor (usually a VC) that may have done the groundwork in negotiating a price.

Another option is to agree for the round to be an unpriced round. An unpriced round is when investors contribute capital in exchange for a discount on the company’s shares in the succeeding priced round. A priced round is a financing round based on mutually agreed upon company valuation.

Have the correct funding agreements in place

We won’t cover in detail the specifics of the funding documents needed as they will be based on whether you are investing in a priced round or an unpriced round.

Generally, a priced round will include a subscription agreement and a shareholders agreement together with the present shareholders (usually the Co-Founders). An angel usually subscribes to new ordinary shares as opposed to preference shares.

In an unpriced round, you may choose either to use a ‘Simple Agreement for Future Equity’ (SAFE) commonly used by Y Combinator, or a ‘Keep It Simple Security’ (KISS) created by 500 Startups. Like Y Combinator with their SAFE notes, KISS also aims to simplify and standardise seed funding.

Understand the terms “discount rate”, “valuation cap”, “pre-money” or “post-money”, “pro rata rights” and other terminologies and their effect on your investment.

Note that these documents have gone through multiple changes over the years since they were first made available to the public. Be sure to engage a startup lawyer to help you review the funding documents especially if you plan to use a template.

Also Read: Web3 startups: The next big thing investors are flocking to

All founders have signed a shareholders’ agreement

You do not want to inherit a startup’s legal problems and get stuck in a company with a shareholder dispute without any way to exit as a shareholder.

A shareholders agreement (also known as a founders agreement) should contain all the necessary provisions covering topics like shares vesting, assignment of intellectual property ownership, management of the company i.e. board of directors and voting, transfer of shares, non-disclosure clause, and exit and deadlock mechanism provisions.

If a cofounder fails to perform his assigned role, the remaining cofounders can trigger a ‘bad leaver’ scenario. The remaining cofounders will be entitled to re-purchase the shares from the defaulting cofounder (usually at a nominal value). The unvested shares may be offered to a new substitute cofounder in the future or even redistributed among the present shareholders.

Tax incentive

As an angel, you may qualify for tax incentives if you invest in startups depending on where you are domiciled.

To qualify, you usually need to hold your investment for a fixed number of years. Also, not all investee companies may be specified as “qualifying investments” by the tax authority. Consult your tax adviser to check if you can apply for any tax incentive as an angel.

Conclusion

In reality, no one really knows how a startup is going to perform. It is often a mix of luck, preparation, market, and fate. These steps can appear overwhelming if you are planning to go on solo as an angel. I suggest joining an angel network and co-investing with other angels in smaller ticket sizes may best the best way to get started.

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