How Angel Investors Get Their Wings

Backing entrepreneurs with good ideas can be a moneymaker for these daring investors who go where venture capitalists fear to tread

Illustrations by Sonia Roy

by Chris Farrell

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Not only can John Reid claim to have been visited by angels, he is one. The 61-year-old entrepreneur founded his Parkers Prairie (Minn.) medical-device company, AbbeyMoor Medical, in 1997 with seed money from so-called angel investors. Such people invest in promising startups too young and raw to attract the attention and money of professional venture capitalists. Reid has also helped fund several early-stage ventures, on his own and with fellow angels.

The credit crunch and economic downturn have some angels feeling skittish. But others see opportunity: Studies show that the best time to start a business is when the economy is down. That's because entrepreneurs with good ideas will find cheaper land, labor, supplier contracts, and other ingredients that go into starting a business. Angels that back such ventures can earn impressive long-term returns—one study cites a rate of return of about 27%, on average, or 2.6 times the investment in 3.5 years. The risks, of course, are steep. Still, 258,200 angels pumped $26 billion into 57,120 ventures last year, according to the University of New Hampshire's Center for Venture Research.

Any angel will tell you there's a significant learning curve. But a big transformation in angel investing is making it easier to move up that curve: the rise of more formal angel investing groups. It wasn't all that long ago that angels largely hooked up with entrepreneurs through ad-hoc social networks, friendships created over the years, perhaps at the country club or local philanthropic events. Since the latter part of the 1990s there has been a proliferation of more professionally organized groups—usually with a Web site—that screen investments and pool money on a local and regional level. Estimates of the number of angel groups in the U.S. and Canada go as high as 275. The groups even have their own trade-and-education association in Washington, the Angel Capital Assn.

While many angels are current or former entrepreneurs, and that background can prove invaluable, they also need to develop investing skills. The successful angel adheres to the same disciplines that make for a good investor, from Berkshire Hathaway's ("BRK-A") Warren Buffett to Yale University's David Swensen. Understand the risks. Follow an intellectual framework. Have a well-thought-out methodology for buying and selling. Do due diligence. Diversify. "Angel investing isn't easy, and it's very high risk," says Tony Stanco, executive director of both the National Council of Entrepreneurial Tech Transfer and of Angel Investors of Greater Washington. "But it's high reward."

Experienced angels recommend that investors create a diverse portfolio as a buttress against inevitable failures. After all, these are companies with little cash flow and no operating history. Angel groups funded, on average, about seven companies in 2007. Only a small percentage of an angel's capital should be at risk—no more than 10% of investable wealth, counsels Susan Preston, currently general partner of the California Clean Energy Fund's Angel Fund, a public investment fund that takes equity stakes in alternative energy ventures. Longtime angel Richard Holdren, a Houston-based serial entrepreneur who has founded or invested in over 26 health-care startups, adds that it's critical to keep emotions in check. "You make money in angel investing by killing off your losses early, as quickly as possible," he says. "The entrepreneur really believes that success is just around the corner, and you'll quickly go broke investing for 'just-around-the-corner.'"

Angels rightly tend to focus their efforts in the industry they know. Stanco, for example, was formerly an attorney at the Securities & Exchange Commission working with the software and computer group. His investments are concentrated in software. Reid is well-schooled in the medical technology business.