How to de-risk your investments as an angel investor

Angel investors play a pivotal role in the startup ecosystem. They provide an essential factor of production—capital—to early-stage startups.

However, angel investments are not charity donations.

“By backing bold ideas and promising startups, angels...create opportunities for prosperity,” says Umulinga Karangwa, founder of Africa Nziza Investment Advisory.

Startup investments are an asset class; angels can get wealthy from investing in startups early on. In the first quarter of 2016, Kendall Ananyi invested in Paystack. At the time, the startup was less than a year old. By 2020, Mr. Ananyi's investment earned him a 20x return (🤯) after Stripe acquired Paystack. Early-stage institutional investors—like YC—who invested more money in the startup earned returns north of 100x.  

You can become an angel investor with $1,000 and above.  

However, it's not all gloom in startup land. Several other angels have lost their money from investing in startups.

“Startup investment is extremely risky. Only invest amounts you are willing to lose,” Osita James, Partner at BlackcrestLP, tells Bendada.com. For a return as high as the one Kendall experienced, the risk of losing your money is equally high. It's an investment principle called the Risk-Return Tradeoff.

“Huge risks usually follow huge returns, so ensure you are willing to accept the risk before you invest so that you can manage your expectations,” adds Mr. James.

“You can’t truly secure an angel investment but you can de-risk it with due diligence and proper governance, " according to Oo Nwoye, who facilitated a round of Angel investment into Paystack in 2016.

So, what now? What do you do if you are interested in Angel investing but do not want to lose money? Well, you can mitigate your risk and better de-risk your investments.

This article will provide ways to de-risk your investments as an angel investor.

Due diligence is the foundation

Angel investors understand that meticulous due diligence is the bedrock of de-risking their investments. The process involves investigating the startup's viability, market potential, and founding team.

“Angel investing diligence is much less structured than VC diligence, which takes months,” says Zachariah George, co-founder of Startupbootcamp.

There isn't so much to look at but you have to be diligent about a few things.

The first question to ask and the answer is, who are the founders? what's the founding team's experience, skills, and track record? You should ascertain whether the team possesses the necessary expertise to execute the idea effectively.

According to Osita James, an Angel investor should carry out a CV review, and team LinkedIn profile review; confirm the team's expertise, and assess team dynamics; proof of working together as a team in a previous project or business

A cohesive and capable team is often indicative of a startup's potential for success. There's a startup adage, “Invest in people, not just ideas”, which holds profound truth in the context of angel investing. The founding team's expertise, experience, and cohesion are critical factors that significantly influence a startup's journey.

A visionary idea can only manifest its potential if it's executed by a team capable of turning dreams into reality.

A hallmark of a great angel is his ability to recognise a great team, back them, and get good returns. A case in point is Stripe’s acquisition of Paystack, Jason Njoku, a Nigerian business leader said: “Angels who invested in the seed round of Paystack back in 2016 made ~1,440% ROI. That's x14.4 of their money in only 5 years. Paystack raised at various SAFE valuations between $5m and $10m.”

“Most of the people in my network invested at a $7m valuation cap (which we all agree at the time seemed a bit rich), but Oo was convincing and Shola seemed like he knew what he was doing,” according to Njoku.

It is important to also critically assess a startup's business model to understand how it generates revenue and achieves scalability.  The core blueprint of a startup, the business model, defines how the venture creates, delivers, and captures value. As an Angel investor, one must dissect this model meticulously, evaluating revenue streams, customer acquisition strategies, and scalability potential.

A robust and sustainable business model is a cornerstone of long-term success. To take it further, one has to carry out a market fit analysis to examine whether the product or service aligns with current market needs and demonstrates a clear competitive advantage. Startup concepts abound, but true validation is grounded in evidence of market demand. Seek startups that have undergone rigorous testing, showcasing a substantial market appetite through pilot programs, prototypes, or early customer commitments. Tangible market validation enhances the likelihood of a startup's success.

Intellectual property (IP) is a crucial asset for startups, especially in the case of hardware solutions. Investors should verify that the startup has appropriately protected its IP through patents, trademarks, copyrights, or trade secrets. Additionally, assessing any potential legal disputes related to IP is essential.

Osita James advised that Angels should further pay attention to things like CAC filings, to ensure the startup’s CAC filing is up to date. Pending Litigation is another important thing to ask about, you want to also make sure that the startup has no pending litigation in court.

"Ask for and review their Founder's agreement, ensure the startup founders have a binding founders agreement." He advised, "Ensure the startup has records of all the SAFE notes executed by other investors."

Structuring Contracts

Contracts are the legal backbone of an angel investor's engagement with startups. These agreements define the terms and conditions of the investment, outline investor rights, and establish mechanisms to mitigate risks.

A well-crafted term sheet is a foundation upon which the entire investment rests. This preliminary agreement delineates investment terms, equity stakes, valuation, and investor rights. Its clarity is paramount in preventing misunderstandings and disputes during subsequent stages.

Clear investment terms are vital. One should outline the amount of investment, the equity stake or convertible note terms, and any specific conditions tied to the investment. This information ensures alignment between investor expectations and startup goals.

Convertible notes offer a balanced approach to investment. These instruments convert into equity during a future funding round, often at a predetermined discount rate. This mechanism guards against the uncertainties of valuation shifts while positioning investors to benefit from subsequent growth.

The contract must delineate the angel's rights and responsibilities. This encompasses voting rights, participation in decision-making processes, and the level of involvement in the startup's operations. Clear communication of roles minimises potential conflicts down the road.

Equity agreements further outline the intricate web of ownership among founders and investors. These agreements establish clear guidelines on equity allocation, voting rights, and the mechanisms for dealing with potential disputes. Clarity here is essential to avert future conflicts.

Mentorship, reporting, and exits

Effective angel investors contribute more than just capital; they offer mentorship and guidance. Regular interactions with founders provide opportunities to share insights, connections, and strategic advice that can reshape the trajectory of the startup.

It is important to maintain an active role in monitoring the startup's performance. Regular updates, meetings, and financial reviews help investors track progress, identify potential hurdles, and proactively address challenges.

A critical aspect of angel investing is the exit strategy. Investors should contemplate avenues for realizing their investment, whether through participation in subsequent funding rounds, acquisition opportunities, or public listings. A well-defined exit strategy aligns investor and startup goals and must be captured in the contract.

There must be plans for how they can exit their investment, whether through acquisition, initial public offering (IPO), or secondary markets. Liquidation preferences will detail how proceeds will be distributed in case of a company's liquidation or acquisition.

Anti-dilution clauses protect investors from substantial equity dilution in subsequent funding rounds. These provisions adjust the investor's equity stake if the startup issues new shares at a lower valuation than the investor's initial investment.

“Never invest all your money in one startup at any given time. Diversify your risk by investing across verticals in different startups that meet your criteria,” Osita advised in his final statements during the conversation with Bendada. To reduce risk, he also advised investing with other angels: “This would reduce your risk and stress because they already have legal structures in place to vet each investment. You also use their expertise to invest in the best startups.”

On the other hand, Peter Oriaifo doesn't think that it's such a lucrative endeavor in Africa:

“I think that part where it’s tough to bridge especially in Africa is that net, angel investing hasn’t really been lucrative for said angels en mass. I know folks get excited for Uber like 1,000x returns but those just aren’t the reality in our market,” Oriaifo said. “I’d hazard to guess most successful angel outcomes in Africa hover around 10x or less which is cool still profit but hard to reconcile vs principal risk being taken.”He argued.

Nonetheless, investing is both an art and a science, requiring a balance of calculated risks and strategic decisions. De-risking investments as an angel investor hinge on meticulous due diligence and comprehensive contractual arrangements.

By thoroughly assessing startups and crafting well-structured contracts, with the guidance of an experienced tech lawyer or firm, investors can navigate the intricate startup ecosystem with greater confidence. The synergy between due diligence and effective contracts empowers angel investors to foster innovation while safeguarding their financial interests in a dynamic and ever-evolving investment landscape.