Understanding Angel Investing

Understanding Angel Investing

The existence of angel investors and the ability to reach them is critical to entrepreneurs. They are a principal source of seed capital at the start-up stages of companies. At a macro level, entrepreneurs are fundamental to the economy. They fuel, develop and introduce new technologies, products and services leading to the creation of the majority of new jobs. Angel investments have tripled the amount of employment within the European small business sector between 2004 and 2013 (Eban).

Studies regarding the innovation process have established that in no case has the market leader led a radical innovation (Preston, 2001). Small companies are continuously more effective in producing innovations that are able to create new markets, change old ones and create value. Hence, it comes at no surprise that most revolutionary breakthrough have come from companies that have fewer than 500 employees (Baumol, 2004). With innovation becoming a topic at the centre of the 21st century, the need for angel investors has been rising in both recognition and significance.

The study by Roach (2010) of the Kieretsu Forum, the world’s largest angel investor network, illustrates that the availability of angel investments is tightly linked to the success of early-stage businesses and investment capital. Furthermore, the understanding of the dynamics, risks and returns of angel investing will encourage greater participation in the early-stage investing ecosystem.

Roach (2010) notes the angel investing environment is defined by the following theories:

  1. Diversification and portfolio theories. Describe the tradeoffs between risk and return in constructing an investment portfolio, where investors generally dislike risk and favour return. The core of this theory is the notion of “not putting all one’s eggs in a single basket” and spreading out angel investment in multiple companies in order to reduce risk.
  2. Capital asset pricing model (CAPM). Dictates that return from an asset should be proportional to the risk. The basic assumptions of CAPM, do not hold for angel investors. They are not viewed as ‘rational investors’ as they willingly accept specific (non-systematic) risk by betting on the success of the company. This shows that angel investors are investing not only to gain returns, but also for reasons such as the desire to help entrepreneurs and be part of a social community.
  3. Agency theory. Denotes the responsibility of the entrepreneurs and the company to act in the best interests of angel investors. Agency issues occur when there is a discrepancy between the interests of the owners (angel investors) and managers (entrepreneurs). Roach (2010) notes that angels commonly rely on relationships, not legal contracts, to monitor their investments, hence making them exposed to issues such as potential misrepresentation and asymmetries of information. In order to monitor these risks, angel investors should assume active roles and continue to show interest in the start-up company.

As entrepreneurs are oriented as innovative, proactive and willing to accept risk, angel investors need to possess a like-minded outlook - an outlook much unlike traditional banks and venture capitalists. The diverse knowledge, experience and background of angel investors can play a key role in helping entrepreneurs cultivate the seeds of innovation. Equity crowdfunding platforms now bridge the gap between angel investors and entrepreneurs. They facilitate a space that allows to connect the interests of the two, consequently contributing to the growth of business and innovation. The rising importance of angel investors should, hence, continue to not only prompt the need for better understanding, but also the greater recognition of angel investing and equity crowdfunding platforms by entrepreneurs and the government.

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