Six Dos and Don'ts for Potential Angel Investors

Angel investors provide funds to private businesses with the expectation of earning well above-average returns. While potential returns from successful angel investing are high, so are the risks and potential losses. Here are 6 dos and don'ts for potential angel investors.

1. Do be sure that you can afford to lose your entire investment. Angel investors usually fund start-up businesses with limited track records. Often these businesses are too small and too immature to attract venture capital money and too risky to obtain a bank loan (especially from today's risk-averse banks). Almost by definition, such investments have relatively high risk and a relatively large percentage of them will never pay off. Therefore, you shouldn't even consider making an angel investment unless you can afford to lose every penny.

2. Don't make an angel investment unless you can afford to have your money tied up for an extended period of time. Your angel investment will be illiquid, since there is no ready market for angel investments (such as the stock market for equity investments in established companies) if you find that you need to cash out quickly.

3. Don't expect a quick return. Angel investors must have a reasonably long investment time horizon. A successful angel investment may take years to pay off. If it happens sooner, great, but you can avoid disappointment is you are realistic about the investment time frame right from the start.

4. Do take the time to do extensive due diligence on any potential angel investment before taking the plunge. Successful angel investors need to be able to look beyond the enthusiasm and charisma of an entrepreneur with a business idea that may be the next Facebook and to analyze the company's business plan, evaluate its market potential, judge the strength of its management team, understand its competition, and dig into its financial projections. Doing your homework won't guarantee a successful angel investment but it can help you eliminate obvious losers and improve the odds that your investment will pay off.

5. Do seek investments in companies where you have more to offer than just money. Your financial knowhow, industry savvy, entrepreneurial experience or professional relationships can be as important (or, in some cases, more important) to a young company as your investment. As a result, be prepared to invest some time staying up to date on the progress of the business once you have made an investment and providing advice and support to the management team, perhaps as an unpaid consultant or member of the board of directors.

6. Don't go it alone. You will need professional help if you decide to become an angel investor. At the least, you will need legal and accounting support. An alternative to angel investing on your own is to join an accredited angel investor network, which pools expertise and provides professional services for an annual fee (which can be thousands of dollars) and perhaps a management fee of 1% to 2%.

Sources:

David Amis and Howard Stevenson, hbswk.hbs.edu, How to Be an Angel Investor - HBS Working KnowledgeJason Zweig, online.wsj.com, Heavenly Returns for Angel Investors? - WSJ.com