Business angel investor funding refers to equity investment from individuals who invest directly in high risk startup businesses with a view to earning higher rates of return than traditional equity investment offers.
What does an Angel Investor Look for?
Business angel investors accept a high risk in order to earn high annual rates of return. It is not unusual for a business angel to require a 20-40% compound annual growth rates on their investment, the higher the risk the higher the required return will be.
Typically, angels are looking for a well thought out business plan showing rapid expansion and an identified exit route, such as a trade sale or IPO, within 3 to 7 years. Normally business angels are not looking for regular dividend payments and would prefer that profits are retained within the business to fund expansion and growth.
Investor Equity Percentage Calculation
It is important when pitching to an angel investor that the business plan and financial projections demonstrate how the investor will get their required return and not concentrate solely on the business and it’s products.
An angel investor will seek to acquire a percentage ownership of the business which will provide them with their required annual rate of return.
Suppose for example, an angel investor is seeking an annual return of 25% on their investment of 150,000 in a business they forecast to be worth 976,500 in 3 years time.
What is the Angel’s Investment Worth After 3 Years?
At the end of 3 years the business angel is hoping that their initial investment of 150,000 has grown at a rate of 25% a year making it worth 292,969, as demonstrated in the table below.
|Year 1||Year 2||Year 3|
|Return @ 25%||37,500||46,875||58,594|
It should be noted that the same answer can be found using the future value formula or the Excel FV function as shown below.
Using the future value formula: FV = PV (1 + i)^n PV = Angel investor funding = 150,000 i = Compound annual growth rate required = 25% n = Term of investment = 3 years FV = Future value of the angel investor funding Future value (FV) = PV (1 + i)^n Future value (FV) = 150,000 (1 + 25%)^3 = 292,969 Using the Excel FV function: Future value = FV(25%,3,,-150000) = 292,969
In order to make a return of 25% the investor hopes that their investment of 150,000 will be worth 292,969 after 3 years.
Calculation of the Angel Investor Equity Percentage
If the investor and the entrepreneur have agreed that based on the financial projections the value of the business at the end of 3 years is expected to be 976,500, we can calculate the percentage equity required by the investor to achieve their annual rate of return as follows.
Angel investor % = Required investment value / Value of business Angel investor % = 292,969 / 976,500 Angel investor % = 30% (rounded)
In summary, the investor will seek 30% of the business for 150,000 in the hope that at the end of three years the business will achieve its valuation of 976,500. At this valuation the investor’s share will be worth 292,969 giving the required 25% annual return.
What is the Value of the Business?
The example above assumes that the angel investor and the entrepreneur have agreed on a fixed valuation of 976,500 on which to base the calculation of the investor’s initial equity percentage.
In reality, for the purposes of this calculation, the investor will try to seek a lower valuation in order to increase the equity percentage, and the entrepreneur will seek a higher valuation to reduce the equity percentage.
If for example, the entrepreneur placed a valuation of 1,953,000 on the business instead of the lower valuation of 976,500 required by the investor, then the equity percentage calculation would show that the investor should receive only 15% of the equity as demonstrated below.
Angel investor % = Required investment value / Value of business Angel investor % = 292,969 / 1,953,000 Angel investor % = 15% (rounded)
Providing the valuation at the end of 3 years is 1,953,000, the investors share will be worth 292,969 and the investor will again achieve their 25% annual return.
In practice the angel investor and the entrepreneur must negotiate a valuation which they are both comfortable with.
Agreeing the Equity Calculation Mechanism
In the above example, the investor sought to value the business at 976,500 giving them 30% of the equity, whereas the entrepreneur wanted a valuation of 1,953,000 giving the investor 15% of the equity.
There are numerous ways in which the investor and entrepreneur can come to an agreement.
For example, the investor and entrepreneur might seek to achieve the following.
- To vary the equity percentage over outcomes between the investor’s valuation of 976,500 and the entrepreneur’s valuation of 1,953,000 in order to provide a constant annual return for the investor of 25%.
- To limit the downside risk of the investor by fixing the equity percentage at 30% for outcomes below the investors valuation of 976,500.
- To keep the entrepreneur motivated by fixing the equity percentage at 15% for outcomes above the entrepreneurs valuation of 1,953,000.
The impact of each of these points on the equity percentage is shown below.
Outcomes Between the Investor’s and the Entrepreneur’s Valuations
For outcomes between the investor’s valuation of 976,500 and entrepreneur’s valuation of 1,953,000, the equity percentage is adjusted to fix the investors annual return at the required 25%.
As we have seen above, to achieve the return of 25% the investor requires the value of their investment to be 292,969 at the end of 3 years. At the lower valuation (976,500) this means the equity percentage needs to be 30%, and at the higher valuation (1,953,000) the equity percentage needs to be 15%.
For valuations in between the equity percentage will lie between these two extremes. For example, if the outcome is 1,465,000, to achieve their required return the investor percentage is calculated as follows.
Angel investor % = Required investment value / Value of business Angel investor % = 292,969 /1,465,000 Angel investor % = 20% (rounded)
Outcome Lower than the Investor’s Valuation
At the investors valuation of 976,500 the required equity percentage was 30%. Under the planned agreement, the investor seeks to limit the chances of making a loss on the investment by retaining the higher equity percentage of 30% for outcomes less that 976,500.
To understand why the higher equity percentage reduces the chance of making a loss lets take a look at an example.
In order not to make a loss, the investor must receive back at least the 150,000 they invested. If the investor holds 30% of the equity the minimum valuation before the investment makes a loss is calculated as follows.
Angel investor share = Equity percentage x Valuation 150,000 = 30% x Valuation Valuation = 150,000 / 30% = 500,000
The valuation would need to fall below 500,000 before the investor makes a loss.
Now consider what happens if the investor equity percentage had been set lower at 15%, in this case the minimum valuation would have been calculated as follows.
Angel investor share = Equity percentage x Valuation 150,000 = 15% x Valuation Valuation = 150,000 / 15% = 1,000,000
At the 15% equity level the investor would start to make a loss if the valuation fell below 1,000,000 instead of the 500,000 calculated at 30%.
Outcome Higher than the Entrepreneur’s Valuation
At the entrepreneur’s valuation of 1,953,000 the required equity percentage was 15%. This time the agreement seeks to motivate the entrepreneur by limiting the investors percentage to 15% allowing the entrepreneur to retain the remaining 85% of the equity for higher outcomes
For example, if the outcome is 3,048,500, the investor’s equity percentage is held at 15% and their return is calculated as follows.
Angel investor share = Equity percentage x Valuation Angel investor share = 15% x 3,048,500 = 457,275 Return = i = (FV / PV)^(1 / n) - 1 PV = Present Value = 150,000 FV = Future Value = 457,275 n = Number of periods = 3 Return = (457,275 / 150,000)^(1 / 3) - 1 = 45% (rounded) Using the Excel RATE function: Return = RATE(3,,-150000,457275) = 45%
It should be noted that although the investor’s equity is limited to 15%, they have still made an annual return of 45%, way above the required return of 25%.