Angel investing isn’t for faint of heart

It sounds like a surefire way to get good returns on your money: Invest small amounts across a dozen or more young companies; reap outsize rewards on one or two; repeat.

This is the simplified version of angel investing, the term given to early stage investments in companies that are long on ideas and short on capital. Angels put up the much-needed seed money to propel companies toward their goal. Or at least that is the hope.

At a time when conventional returns are low, lawyers and financial advisers say clients who wouldn’t have thought of angel investing a few years ago are looking at it now. But too often, they are not doing their due diligence.

“Smart people are doing it because they don’t know what they don’t know,” said Daniel L. Gottfried, a partner at the law firm Hinckley Allen.

“When these doctors and lawyers are doing it, they’re investing with the hope that they’re going to make lots and lots of money. It’s roulette. But unlike roulette,” he said, “there are things they can do to stack the deck in their favour.”

Gottfried, who has advised angel investors and companies seeking angel investments, said he has become skeptical of the culture of angel investing.

“This whole startup scene is a lifestyle, and there are these investors who think it’s sexy and want to be part of that lifestyle,” he said.

That is why otherwise successful professionals are succumbing to the siren song of mega-returns and blocking out the pitfalls.

“The percentage of failure to success is very minimal successes,” said Rick Marcatos, senior vice-president at UBS Wealth Management Americas. “The current environment we’re in, with ample liquidity and low interest rates, has spawned a rush of people with halfhearted business plans who have been able to raise money from unsuspecting investors.”

If you’re a sophisticated venture capitalist, you see hundreds of opportunities before making a decision. If you’re a professional with a day job, that’s not realistic. Picking from just a few may be convenient, but it is not rational.

Brin McCagg, an entrepreneur on his fourth company, has received financing from friends and family, venture capitalists and angel investors. He sought out angel investors with industry knowledge for his current company, RecruitiFi, which brings together companies looking to hire people with executive recruiters who have expertise in finding the right people.

“I’m going to people with a great idea and they happen to know the industry,” McCagg said. “They say, ‘I think you can execute and I think I can add value. Can I invest?’ That’s very different than making a half-dozen angel investments.”

McCagg brought on the former chief executive of one of the big four recruiting firms to advise the company on the art of recruiting as well as to invest. And McCagg, despite asking for angel investments, advises people to make sure they have enough money before they make an angel investment.

Aspiring angel investors should also try to gauge the time it will take for the company to bring the idea to fruition. When subsequent rounds of financing are needed, the original angel investor will need to put up more money or risk having the investment diluted.

Alan Mendelson, who ran the venture capital firm Axiom Ventures and is also an angel investor, said he looked for angel investments that did not need more than one or two rounds of financing.

“If they don’t get there, you can write off your investment,” he said. “If they do get there, you don’t have to put up three or four rounds.”