When startups need funding, angel investors can be an attractive alternative to debt financing.

"Angel investing is the act of providing funding to early-stage startups before they're ready to raise venture capital," says Ryan Feit, co-founder and CEO of SeedInvest.

Once the domain of high-net-worth investors, angel financing has become more accessible thanks to the passage of The Jumpstart Our Business Startups Act of 2012, a law enacted to spur small business funding. The act removed some of the regulatory restrictions surrounding financial angels and their investment activity.

You used to have to be an accredited investor or someone with millions of dollars to invest , but now there are more ways for anyone to start angel investing.

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This type of investment can afford new opportunities to diversify beyond traditional stocks and bonds. Before leaping into angel investing, it's important to understand how it works.

What is an angel investor?

Who can be an angel investor?

How does angel investing work?

Angel funding's risks and rewards.

Getting started.

What Is an Angel Investor?

Angel investors are individuals who make investments in startups that have the potential to grow, says Bruce Langer, managing partner at EPIQ Partners in Minneapolis.

In many cases, high-net-worth angel investors who often have a track record of founding successful companies of their own would drive angel investing activity . But there are ample opportunities for individual investors to participate in angel investing today.

Who Can Be an Angel Investor?

Previously, only accredited investors, meaning individuals with more than $200,000 in annual income in the two most recent years, joint income, with a spouse, of more than $300,000 in two most recent years or at least $1 million in investable assets (excluding the primary residence) were eligible to become angel investors. Now, under Title III of the JOBS Act, nonaccredited investors or individuals whose income or assets fall below those limits can participate in angel investing through crowdfunding platforms.

Before you put your money in this high-risk investment, the angel investor needs to opine the business by asking questions to the entrepreneur about their vision of the business to gauge their level of success.

Dan Fleyshman, founder of Elevator Studio in Hollywood, California, has heard many pitches throughout his career and says he looks for answers to the following questions: How much have they studied the market ? What type of competition is out there? How will they make a profit-generating business?

"It's rare that someone will create something new so it's important to have insight into what they are up against," he says.

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How Does Angel Investing Work?

In a typical debt financing scenario, a startup borrows money that has to be repaid at some point in the future. Angel investing follows a different approach.

When an investor provides angel funding, no debt is created and there's no money to be repaid. Instead, the investor receives an equity or ownership share in the company. The amount of equity received is different for every angel investment: The more capital that's provided, the bigger the share may be.

There are various ways angel investors can structure their investments. Fleyshman points out several approaches to how angel investing can work:

Friends and family round: In most startups, you can invest in the company's friends and family rounds where the company's founders tap into their immediate network for financing. Angel investors in this scenario will just have to list that you are not an accredited investor on the company's subscription agreement.

Angel groups: This is a group of angel investors who review and invest in a startup. An example of an online group is AngelList, a network of startups you can invest in with venture investors.

"You can create an angel group with your friends or co-workers; put together 10 people and all pitch in $2,500 each and take that $25,000 toward a startup company," Fleyshman says.

Syndication: This is similar to an angel group but in this case, one angel is leading the investment pick. Syndicates are well-experienced angel investors who have better deal flow or high rates at which they receive business deals. This type of angel investing structure funds companies at scale. The person leading the syndication gets a 20% fee only on the success of the business. People like to invest in syndications because these leading investors have experience and success.

"Syndicates have better deal flow. They're around deals that are funded quickly through relationships so it's easier to gain access," Fleyshman says.

You can go into an angel investment alone but Fleyshman says "the main reason why you want to invest with other people is that you don't want to be investing based off of emotion."

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Angel Funding's Risks and Rewards

Angel financing can be rewarding for startups because it allows them to avoid adding debt to their balance sheet. From an investor perspective, there are both pros and cons to weigh.

For a high probability of success as an angel investor, investing in an area you have experience in will position you well in your decision-making. An angel investor's background can give them an edge in choosing the right investments, says Bryan Rosenblatt, Principal at Craft Ventures in New York City.

"If an investor is a doctor, they may have a unique insight as to whether a startup in the medical space is a compelling idea or not," Rosenblatt says.

On the other hand, investing in an area you know nothing about can lead the investor into insecure decisions, which is not a smart way to deal with high-risk investments .

It's important to be diversified in startups because most of them are not successful investments.

Unlike the stock market where you pick from established companies with years of financial data, in angel investing, "you're more often predicting which companies will ever generate a profit often years down the line," Rosenblatt says. "To learn and optimize for the best chances of success, you need to be in a position to make several investments with the goal of one or two being outlier successes."

He recommends allocating a budget where you can invest in at least 10 startups over the course of one to two years.

"Most investments won't work out but if you pick well, being right on one of them could pay for all of them plus a lot more, but you need to make sure you're investing in a diversified portfolio to have that outlier," he adds.

Making this type of investment work requires patience, since it can take time to find the right opportunity to invest in. Then there's the additional wait to see how well a new company will perform.

Investors should also understand that this is not a liquid investment, Langer says. It can take several years for a startup to become profitable and even longer for a financial angel to realize a tangible return.

There's also the biggest threat of all: The potential to lose all the money that's been invested.

"This is a more high-risk type of investment in general since these companies are just trying to get off the ground and are not guaranteed to be successful," Brooks says. "Depending on your allocation, this can be detrimental to your portfolio."

Getting Started

Taking on this type of investment involves considering three things: knowing which companies to invest in, how much to invest and how to fund those investments.

When choosing startups, it's important to consider both profit potential and any nonfinancial returns associated with the investment. For example, it might be just as important to feel engaged in a startup's growth process in a hands-on way as it is to earn a minimum rate of return.

Langer says it's natural to veer toward angel opportunities associated with companies that investors are already familiar with or have been recommended to them by someone they know. He says it's instrumental to understand what makes a new company tick and who's behind it when deciding which ones to back.

"At the end of the day, it's the people who make an idea or concept work. The capital is only part of the equation," Langer says.

Finally, consider how much of a portfolio should be allocated to angel investments.

Feit says that an allocation between 5% and 10% makes sense for most people, and keeping this part of a portfolio small can increase returns while lowering volatility. The reasoning is that early-stage, private companies generally have a low correlation with traditional asset classes such as stocks and bonds .

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Investors should also keep in mind that it's important to be diversified within that allocation.

"Don't put all your eggs in one basket," Feit says. "If you can't build a portfolio of at least 10 angel investments, you shouldn't do it in the first place."

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