by Manuel Stagars, CFA, CAIA, ERP

Angel investors have the reputation of being the better VCs. Less greedy and complicated when it comes down to due diligence, deal terms, checking up on progress, and altogether more willing to open their wallet. An ideal scenario for first-time entrepreneurs, but the story of most angel capital is unfortunate. It begins with high hopes and ends without a return. How about investing fifty thousand and getting a return of two hundred million? Wishful thinking, I’m afraid to say. But that is not all. Early funding also gives entrepreneurs a false impression of what it means to run a company. The first line of business is not scrambling for capital, it is testing whether there is a business first. Startups do this with a simple prototype to collect feedback from potential customers. If the results show that enough people in the market need the product and are willing to pay for it, then investment makes sense. Before, it is often unnecessary and harmful.

If tech entrepreneurs just had an exit, they may become angels. Celebrities may become angels. Successful local business people may become angels. They often do this to stay connected with young entrepreneurs. Some invest purely for the fun of it, so they get to coach startups to avoid the mistakes they may have made themselves when they started out. Angels would love to see a profit on their investment. However, a large part of angel investing is “giving back,” much more so than VC investing, which always aims at a financial payoff.

Most of the recipients of angel capital are first time entrepreneurs with no proven track record. The FFF round (capital from friends, family, and fools) has ended, but the project is just too small to attract venture capital. Larger tech hubs, such as San Francisco or Austin in the United States, already have large angel networks that entrepreneurs can tap into. They fund usually below one hundred thousand dollars, mainly to cover upfront business expenses. Recently, angels networks are sprouting up all around the globe.

As we already mentioned, such early capital investments often don’t do anything good for the entrepreneur. Yes, it’s possible to hire that killer coder who is in-between jobs for a reduced fee of 50k. And it’s finally possible to rent office space in the Mission district to hold meetings. The founders are not required to work a day job for a few months. This is all convenient, but what’s entirely missing in such a startup is constraints. In my opinion, constraints in both time and capital (human and financial) are the lifeblood of innovation. They force entrepreneurs to be profitable early on. They must remove anything that is not sustainable. If they cannot do that, they have to shut down the business and move on to the next idea. It’s often as simple as that.

While it’s almost obvious to entrepreneurs that they cannot get VC money just with an idea, they still speculate on angel investment. Angels are not quite as hard-nosed in due diligence as VCs. They might not spot obvious problems in the operations, such as complete lack of product. And they may open their wallet when you just pitch them a great disruptive idea. Regardless, when things start to get hairy, they will micromanage your startup just as much as any venture capitalist. You want to avoid this at all cost.

In a nutshell, entrepreneurs have to reach a level of “Ramen profitability” before starting to fret about raising VC or angel capital. It’s obviously much cooler to have funding than working in a garage on a shoestring. Nevertheless, if they forget about raising capital, much more time will be available for the founders to work on their idea. Many profitable businesses that you never heard about have been built this way. Stop thinking about VC money and angel capital, and start building a prototype today. You will find yourself in good company.