Investing in early-stage companies with no proven track record can be very risky – statistically, most start-ups fail. At the same time it can be rewarding when an investment pays off.
What is an Angel Investor?
An Angel Investor (an individual who provides development capital in return for equity) will be looking to balance the risk of losing their entire investment (such as if the company fails) versus the potential for a sizable return on investment (ROI) should the company meet its objectives.
Established companies with a demonstrable trading history and ability to generate profits typically offer a “safe” low-risk investment – they may generate modest annual dividends but are unlikely to result in an investor receiving a significant return.
Early-stage companies, however, with no or little trading history present a much higher risk since the product/service offering is unproven and customers are yet to be secured – it is therefore reasonable that an investor backing such a company should receive a greater return when putting their capital at greater risk.
So what are the traits of a company backed by an angel investor?
A credible management team is the most important factor that astute investors take into consideration when appraising an investment opportunity – this is for the reason that it is largely the responsibility of the management team to execute the business plan.
Investors are ideally looking for management who have a record of having built successful companies and generated high returns for the investors. Accordingly, companies seeking investment should be able to provide a list of experienced, qualified individuals who will play key roles in the company’s development.
In order to generate interest amongst investors it is important a company can demonstrate it will target a large, addressable market opportunity.
This is for the reason that in order to generate large returns a company will need to ensure it has the chance of growing sales and scaling. Additionally, the larger the market size the greater the chance of a trade sale to a competitor – this will make an opportunity more attractive to a prospective investor since it provides a potential way to exit an investment (see Exit Strategy below).
Investors will want to invest in market leading products/services offering a competitive advantage. They will be looking for a company offering a solution to a problem requiring fixing or for products/services associated with a more appealing price point, higher quality or better delivery of customer service.
A product/service associated with such characteristic is more likely to generate sales/profits and therefore, a return on investment. Furthermore, if a company can establish itself a positon as a market leader this will create a natural barrier to entry – thus protecting the company from competition and the erosion of market share.
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Most Angel Investors will require a business plan to include a detailed exit strategy – this is the means by which an investor “unlocks” their investment and realises a return. Considering a company’s potential exit strategy should form a key part in determining the risk associated with the investment. An exit strategy should include a timeframe (sometimes referred to as an “exit window”) and detail the means by which exit will be achieved. The typical exit strategies detailed in the business plans of start-ups include:
- Sale to a trade (competitor) buyer
- Partial/full sale to private equity
- IPO (initial public offering) on a quoted exchange such as the London Stock Exchange’s AIM.
Cost of Investment/Pre-money Valuation
The pre-money valuation of a company is simply the value of the company before an equity investment is made – it is vital to the success (or failure) of raising investment.
The pre-money valuation of a company matters because it determines the equity share an investor will receive for their money. For instance, if an investor provides £1m of investment they would receive 16.67% of the equity if the pre-money valuation was set at £5m. Their equity percentage would increase to 20% if the pre-money valuation of the company was set at £4m.
This illustrates that the price an investor pays for equity not only affects their immediate cash outlay but also the amount they would realise on exit (depending on the dilutive effects of subsequent investment rounds and whether the investor participates).
A significant benefit of investing in early-stage companies is that many will be eligible for SEIS (Seed Enterprise Investment Scheme) or EIS (Enterprise Investment Scheme) – both government initiatives aimed at incentivising investment into early–stage companies via attractive tax reliefs.
Under SEIS investors can receive initial tax relief of up to 50% on investments up to £100,000 and if they sell their shares after 3 years, any profit is free from Capital Gains Tax. To qualify the company must have been trading for less than 2 years and be raising less than £150,000. EIS aims to encourage investors to invest in smaller companies by offering up to 30% tax relief.
The scheme also enhances returns by offering a capital gains tax exemption after three years and further tax relief in the event of a loss. Under EIS each individual investor is allowed to invest up to £1million per year
This post was produced by Richard Grimster of the Technology and Tax team. For any further help or advice on Angel Investors feel free to contact Richard using the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.
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