There aren’t too many drawbacks to having a decent amount of disposable income you can call your own. But one question you might ask when you find yourself with money burning a hole in your pocket is - what shall I do with it all? If you are fortunate enough to be in this position, you will never be short of investment options. You could dabble in the stock market, buy property, art, or perhaps even think about starting a business. Or, you could become an angel investor, investing in an existing small business and have the satisfaction of giving it the leg up it needs to grow, hopefully making a tidy return on your initial outlay in the process.
Known as angel investment - because you are, metaphorically speaking, becoming a kind of financial guardian angel to the business you choose to back - this model of private equity funding has become integral to SME financing and therefore to supporting growth in the backbone of the UK economy.
Angel investing has even inspired a TV programme; Dragon’s Den is essentially angel investment turned into a game show.
What do you need to know about angel investing before you get involved? Are you the right kind of person to become a business angel? What are the pros and cons?
A brief overview of angel investment
Start-ups and small businesses often find it difficult to find capital to back their ambitions. Businesses that are still at the ‘ideas stage’, pre-revenue or pre-profit, find it very difficult to attract the attention of venture capital (VC) firms and fund managers. And even if a business is up and running and profitable, the returns might still be too small to turn a fund manager’s head.
That leaves the option of taking out a secured loan to finance start-up costs or growth plans. But the problem then is that the business is saddled with debt, complete with interest repayments, which may apply a brake to profitability for years to come.
Angel investment provides a middle ground. Like VC funding, business angels buy an equity stake in the business in return for their capital input, avoiding the problem of debt. But unlike a VC, angel investments come from private backers using their own disposable wealth.
This means that the typical amounts involved in angel investments - usually between £10,000 and £500,000 - are much lower than those seen in the VC market. It also means that angel investors are agile and able to make quick decisions, meeting the needs of businesses who want the benefits of financial backing without being tied up in red tape.
In other words, angel investors fill a gap in the finance market, providing entrepreneurs with a valuable route to equity funding at levels appropriate to the size of their business and its stage of development. When added together, business angels make a significant contribution.
Given the private nature of the deals, exact figures are hard to come by, and the UK Business Angels Association (UKBAA) estimated that, in 2015 alone, £1.5bn in funding came through angel investments.
Who becomes an angel investor?
It is estimated that there are around 15,000 business angels currently active in the UK, described by Money Week as “typically wealthy individuals and serial entrepreneurs.” According to the UKBAA, there is a concentration of angel investors around London and the south east, with a so-called ‘golden triangle’ between London, Oxford and Cambridge.
However, the only real qualification for becoming an angel investor is that you have the disposable income and capital available, and that you preferably have the experience and acumen in business to back up your cash with wisdom and advice.
Because angel investments result in acquiring an equity stake, angels have a vested interest in actively helping the business they back to fulfil its potential. Indeed, as well as capital, one of the reasons entrepreneurs often turn to angels is that they want to tap into the knowledge of experienced business people to help them achieve their goals.
The pros and cons of becoming an angel investor
One key reason many individuals choose to put their wealth into angel investments is tax efficiency. Under HMRC rules, angel investors may qualify for tax relief under the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS). The UKBAA has again shown that around three quarters of business angels make use of EIS tax breaks.
Beyond tax considerations, angel investors are generally not putting their money into a business purely out of the goodness of their hearts. Indeed, they expect a strong return on their investment. Furthermore, the great thing about being a private investor is that you can follow your instincts and back potential, rather than having to meet the strict due diligence requirements of a fund manager.
When it comes off and the business flourishes, you get great value for your stake, as well as the pride and satisfaction of playing a part in its success.
On the downside, making investments based on instinct and the potential you see in a business plan does involve something of a gamble. If things don’t go well, you might find yourself investing more and more time and energy in trying to kick-start a struggling business just to save your stake.
Before you commit, it is helpful to get clear answers to the following questions, just to have that extra bit of confidence that you are doing the right thing:
- Does the leadership team have the necessary skills, experience and drive? According to the UKBAA, nearly all business angels (93%) believe the competence of the people in the business is crucial to the success of the investment.
- Does the product or service solve a problem? Will it disrupt an existing marketplace or create a new niche?
- Is the product already being sold or has it been through market testing?
- Who is the competition and how does it compare?
- How does the business make money and how good are the margins?
- Is it scalable? Is the potential for growth slow or explosive?
- How big is the potential market?
- Is the deal eligible for tax relief (i.e. under the Enterprise Investment Scheme rules)?
- Is the owner happy to give up shares in return for the investment?
- What sort of exit strategy is on offer?
Angel investing may just be your thing. If so, you may want to allocate your investable wealth into two distinct camps:
Core: this is the money you can’t afford to risk or lose. It’s the same as looking after the farm. The roof over your head is always safe.
Explore: this is the money that you can ‘gamble’ with because if it all goes belly-up, you still have the farm to fall back on.
Angel investing comes into the explore category. Set yourself ground rules. Once it’s gone, it’s gone. No dipping into your farm fund.
If you’d like to find out more about becoming an angel investor or want to discuss other options for managing your wealth, please get in touch with us today.