Why Angel Investors Get A Raw Deal

One of the reasons why startups succeed is because they have been backed by angel investors. It’s hard for entrepreneurs to succeed without external funding and the funding for early stage companies is usually provided by angels, because these companies are too small for VCs.

Angels are sometimes made out to be heroes, but a lot of people also think of them as being vultures – fat cats who make a quick buck by exploiting the hard work put in by the founder.

Conversely, a lot of angels stop being angels after a few years, because they have burned their fingers. They that they have been very shortchanged and have got a raw deal.

Angels typically get squeezed and sandwiched at two different levels – when they put in their money; and when they try to take it out.

For example, some founders will take advantage of the fact that angels don’t know much about the company’s product; and they know even less about the founder. Because of this information asymmetry, some founders take angels for a ride. Some will bamboozle them with jargon , and make unrealistic financial projections; others will provide misleading information about their traction; and some will flat out lie. It’s very hard for an angel to be able to track this stuff and get to the truth. Angels typically do not have enough domain expertise to be able to do in-depth due diligence, and most depend on the integrity of the founder. Because angels understand their limitations, they prefer to invest in syndicates, so they can fill in the gaps in their knowledge.

Most angels are bitter about the fact that though they are the ones who take the biggest financial risks, the risk reward ratio is extremely skewed. If the company does badly, the angel loses all his money, and angels are mature enough to understand this. However, the real problem is that even if the company does really well, angels often don’t get to share a proportionate upside. This is because one’s VCs come in to the game, because they are the big boys with the deep pockets, they often bully the angels, who then get so significantly diluted that they don’t make much profit.

Since most startups fail, most angels overall will end up losing money on their angel investment portfolio. Even if they do make money, the reality is that the amount of money which they make over the extended period of time that it takes to make that money means that the internal rate of return ( IRR) on their investment is really not good at all. For one thing these investments are completely illiquid and opaque , and because most of these companies will either fail or will plod along as lifestyle businesses, most angels investors never get a profitable exit.

In spite of this, why do angels like me continue angel investing? Of course we have that fond hope that every once in awhile we will find the next unicorn and become very rich. After all, hope springs eternal in the human breast, and entrepreneurs can be very good at selling themselves when they pitch to investors. However, we know in our heart of hearts that the probability of this happening is very low .

The reason most angels want to help entrepreneurs to make their dreams come true is because we think this is a worthwhile pursuit. Angels may not have halos around them , but we do our best to help founders succeed.

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.