What It Takes to Be an Angel Investor: Requirements, Risks and How to Mitigate Them

Angel investing has emerged as an exciting opportunity for individuals eager to invest in promising startups. As an angel investor, you provide early-stage capital to help these startups grow in exchange for equity or convertible debt. You are not only contributing money, but often offering advice, mentorship, and valuable industry connections to the founders. However, angel investing is not without risks, and there are specific regulatory hurdles and tax implications to consider before diving into this world.

This article will cover what it takes to become an angel investor, the risks involved, the regulatory requirements, and some smart strategies for mitigating those risks.

 

What is Angel Investing?

Angel investors are typically individuals who invest their personal money in early-stage companies or startups. These businesses often don’t have access to bank loans or venture capital funding because they are still proving their business models. By providing funding, angel investors help fuel innovation and have the potential to reap large rewards if the startup succeeds. However, for every success story like Uber or Airbnb, many more startups fail, meaning the risks are high.

 

What Does It Take to Be an Angel Investor?

1.      Financial Stability

Angel investing requires a certain level of financial security. In the U.S., to be an angel investor, you usually need to be an accredited investor. The U.S. Securities and Exchange Commission (SEC) defines accredited investors as individuals with an annual income of more than $200,000 (or $300,000 with a spouse) for the last two years, or a net worth of over $1 million (excluding the value of your primary residence).

While not legally required in all countries, being an accredited investor in the U.S. is typically necessary to participate in certain types of private investment opportunities like startups. This requirement ensures that the investors have enough financial resources to withstand the risks associated with early-stage investing.

2.      A High-Risk Tolerance

Investing in startups is risky because most early-stage companies fail. Therefore, you must be comfortable with the idea that many of your investments won’t succeed. However, by investing in several startups (diversifying your portfolio), you increase your chances that one or two will pay off handsomely.

3.      Patience

Angel investing is not a quick way to make money. You may have to wait several years before seeing any return on your investment—if you see one at all. It can take time for a startup to develop its products or services, gain traction, and generate returns.

4.      A Willingness to Help

Beyond capital, many angel investors also offer mentorship and expertise to startups. If you’re knowledgeable in a specific field, that advice can be invaluable to a young business and increase its chances of success. Often, angel investors take a hands-on approach to guide startups through the various challenges they might face.

 

Regulatory Hurdles and Requirements

Angel investing comes with regulatory requirements that you need to be aware of, especially in the U.S.

1.      Accredited Investor Requirements ¹

As mentioned earlier, in the U.S., angel investors generally need to qualify as accredited investors. This requirement was put in place by the SEC to ensure that individuals engaging in high-risk investment activities are financially capable of handling the potential losses. The SEC recently expanded the definition of accredited investors to include individuals who hold certain professional certifications, designations, or credentials, even if they don’t meet the income or net worth thresholds.

2.      SEC Regulations

In the U.S., angel investors must comply with specific SEC regulations. When you invest in a startup, you’re participating in the sale of securities, so both you and the startup must follow the applicable securities laws. Startups often raise money under certain exemptions that allow them to avoid registering the securities with the SEC, but as an investor, you need to make sure you understand these regulations and whether the investment complies with them.

3.      Due Diligence

It’s essential to perform thorough due diligence before investing in a startup. Due diligence means researching the company’s management team, business plan, financial statements, legal standing, and market potential. The SEC expects investors to take reasonable steps to verify whether the company they are investing in is operating within the law.

4.      Blue Sky Laws

Each state has its own securities laws, known as "blue sky laws," that regulate the sale of securities. You may need to register your investment with the state securities regulator.

5.      Foreign Investment Restrictions

If you're investing in a foreign company, you may need to comply with foreign investment laws and regulations.

6.      Disclosure Requirements

You may need to provide certain disclosures to the startup you're investing in, such as your investment amount and any material conflicts of interest.

Tax Implications of Angel Investing

Angel investing comes with significant tax implications. In the U.S., the gains from your investment (if the startup succeeds) may be subject to capital gains tax. If you hold the investment for more than a year, it is typically taxed as long-term capital gains, which have lower tax rates than ordinary income.

However, some U.S. angel investors may benefit from Section 1202 of the Internal Revenue Code, which offers tax exclusions on qualified small business stock (QSBS) ^{2, 3}. If your investment meets certain criteria, you may be eligible to exclude up to 100% of your capital gains from taxation.

On the downside, if your startup fails, you may be able to claim a capital loss on your taxes, which could offset some of your other investment gains.

It’s essential to work with a tax advisor to understand the specific tax implications of your angel investments.

 

Risks of Angel Investing

As exciting as angel investing may sound, it’s essential to acknowledge the risks involved:

1.      High Failure Rate: Studies suggest that up to 75% of startups fail. As an angel investor, you should be prepared to lose money on many of your investments. That’s why it's crucial to invest in multiple startups to spread your risk.

2.      Illiquidity: Angel investments are often illiquid, meaning you can’t quickly sell or cash out your investment. Unlike publicly traded stocks, there’s no secondary market for startup equity, so you may have to wait years to see any return on your investment.

3.      Dilution: As startups grow and raise more capital, your ownership stake might get diluted. While this isn’t always a negative outcome (if the company grows exponentially), it means your slice of the pie will shrink over time unless you participate in future funding rounds.

4.      Lack of Control: As an angel investor, you typically won’t have control over the startup’s operations. The management team makes key decisions, and you’ll have to trust them to run the company effectively.

 

How to Mitigate Angel Investment Risks

1.      Diversify Your Portfolio: Instead of putting all your money into one startup, invest in several startups across different industries. This way, if one company fails, you still have other investments that may succeed.

2.      Join Angel Networks: Angel networks are groups of investors who pool their resources to invest in startups. These networks can help reduce your risk by providing access to better deal flow, expert opinions, and shared due diligence processes.⁴

3.      Conduct Thorough Due Diligence: Before investing, take time to analyze the startup’s business model, financials, market opportunity, and management team. By doing your homework upfront, you can identify potential red flags and avoid risky investments.

4.      Work with Advisors: Consider working with experienced financial and legal advisors to help you navigate the complexities of angel investing. Advisors can assist with structuring deals, tax planning, and understanding the legal risks involved.

5.      Stay Informed: The startup world is dynamic and ever-changing. Stay informed about industry trends, regulations, and new investment opportunities to make smarter decisions.

 

Final Thoughts

Investing in alternative investments like angel investing offers a unique chance to back innovative startups and potentially earn significant returns, but it’s not without challenges. If you're considering becoming an angel investor, make sure you meet the financial qualifications, understand the regulatory requirements, and are prepared for the risks involved. With the right approach—diversification, due diligence, and perhaps joining an angel network—you can mitigate some of the risks and increase your chances of success.

References:

¹ U.S. Securities and Exchange Commission (SEC): Accredited Investors

² Bloomberg Tax - IRS Section 1202: Qualified Small Business Stock Exclusion

³ U.S. Small Business Administration (SBA): Qualified Small Business Stock: What Is It and How to Use It

⁴ Angel Capital Association: How Angel Investing Works

U.S. Small Business Administration (SBA): Small Business Investment Company (SBIC) Exemption