Angel investing | Common Pitfalls | Liquidity event | Plus and Minus

From the investor’s perspective, angel investing — that is, direct investment in a startup or early stage company — is fraught with a variety of risks not associated with an investment in a public company. Even experienced angel investors sometimes find themselves tripped up by pitfalls that only apply to early-stage, private companies.

Angel Investment - Common pitfalls, Liquidity events, Plus and Minus
Angel Investment – Common pitfalls, Liquidity events, Plus and Minus

Common pitfall of angel investing:

The most common pitfall of angel investing is being locked into a company with no attractive way out of the investment. An investment with this characteristic is called a member of the “living dead.” From the investor’s standpoint, this is a form of financial purgatory.

The second most common pitfall of Angel investing is investing in a company whose management proves unable to handle the firm’s growth, requiring the angel to save the company and the investment. This experience is often a painful one and sometimes costly as well.

Liquidity event in Angel Investing

Because of the high risk of being locked into a company, angel investors are interested in creating a liquidity event. A liquidity event is an action that allows investors to recover their investment or in some way make it liquid so they can dispose of it.

The most common liquidity events are selling stock back to the company, a merger or an acquisition by a public company, trading the illiquid stock to another investor for public securities, selling the company to other investors or entrepreneurs, and an initial public offering.

How to increase liquidity event?

To increase the likelihood of a liquidity event, experienced angel investors often insist on special provisions in their stock purchase agreement providing them with a variety of ways to exit the company.

Because of the risk of failure by the company’s management after the angel has invested, angel investors also seek provisions that allow them to change company management or takeover the company.

Plus and Minus of Angel investment

From the company’s standpoint, an angel investment can be a blessing or a curse. From a financial standpoint, an angel’s equity investment has the pluses and minuses of equity generally.

Pluses of Angel Investment

The pluses include the benefit of growth capital without the fixed expense of debt service, the maintenance of financial flexibility to allow borrowing for other opportunities, and access to capital earlier in the company’s life cycle than would be otherwise possible.

Minuses of Angel Investment

The minuses in angel investing include a high cost of capital — the angel provides capital expecting a return greater than 30 percent — and the dilution of existing shareholders.

Blessings and Curses of Angel Investing

There also can be blessings or curses in the non financial, personal relationship between the angel and the company. Much depends on the angel, the angel’s background, and the angel’s motivation. Besides cash, the blessings that an angel investor can bestow on a company include valuable contacts and valuable advice, particularly if the angel investor is an experienced entrepreneur with a background in the company’s industry.

The angel’ s investment can be a curse if the angel’s personality clashes with the company management’s or if there are serious differences over the direction the company should take. This conflict can be particularly difficult if there are differences over such issues as bringing in additional investors or the potential sale of the company.

WATCH THIS: Partner investor angels can be a particular problem. A partner investor who had has a long and successful corporate career often faces a difficult adjustment to the reality of a truly entrepreneurial organization.

In addition, because partner investors typically make only one angel investment, which may be a significant portion of their total net worth, they can be very sensitive to any financial difficulties the company experiences. Partner investors have a very strong tendency to be micro- managers.