Angel Investing: A Guide to Investing in Early-Stage Venture
What is Angel Investing?
An Angel investor is defined as an high net wealth individual (HWNI) who provides financial backing to a start-up founded by an entrepreneur, mostly for ownership equity in the company. Ideally an angel investor provides value to the entrepreneur beyond the cash, either in the form of expertise or network.
Angels are typically the first external investors in a company as they tend to participate at an earlier stage than VC investors.
This makes the upside potential very lucrative but also a very risky investment. Similar to VC investors, angel investors should accept that out of 10 investments, 9 might lose money but the one that makes it, can make-up in gains for the losses on the others. For example, Shawn Fanning wrote a $25,000 cheque to Uber in their seed round which was worth $124,137,000 at the IPO in 2019.
How to Start Angel Investing?
One the most important aspects of angel investing is having a network that will find you the best deals.
There are two places to find deals. Firstly, you can find them publicly on equity crowdfunding websites, however these are usually of lower quality as they have been passed off from private investors who didn’t find the lucrative.
Secondly, you can find deals privately depending on your background and network. People that are generally working in technology space will have better access to angel deals as they are plugged into the eco-system. Another channel is an angel syndicate, more details below.
2. Angel Syndicate
A syndicate is an alliance of individuals that join forces to co-invest in a deal and is a great source of deal flow if you aren’t plugged into the tech eco-system.
There is usually a ‘lead’ investor in a syndicate, who’s role is to negotiate the terms with the start-up and do the due diligence on behalf of other investors.
Some of the well-known syndicates in the region are Riyadh Angels, Saudi Angel Investors, Dubai Angel Investors and WAIN
3. Legal and Accounting issues
If you’re going solo, it’s imperative to have a commercial lawyer look over the details of your first deals. Although this will be an additional cost, the savings could be huge in the long term. An advantage of investing with an angel syndicate is that they could assist you with these matters.
Angel Investment in Start-ups
Investing in startups benefits the economy and encourages innovation. UK has done tremendous jobs with the SEIS scheme – The Seed Enterprise Investment Scheme.
This offers great tax efficient benefits to investors in return for investment in small and early-stage startup businesses in the UK, where a company can receive up to receive a maximum of £150,000 through SEIS investments.
Although in the Middle East there are no income tax, incentives can be structured in other way to incentives individuals to invest in start-ups.
Is Angel Investing Halal?
In Islam, it is encouraged to invest in enterprises and assets. Some reasons as to why include:
It increases the wealth of the investor;
It increases the wealth of others, so helps in distributing wealth; and
It stimulates the economy
However, the investment must adhere to the principles of Shariah. The Shariah prohibits certain financial activities. Some of these include riba & usury, gharar, qimar & maisir and haram activities/commodities.
Consider the following questions for shariah compliance:
The nature of the business
The structure of the deal
1. The nature of the business
The question to ask here is if the business is halal. The start-up should not engage in haram activities, such as alcohol or gambling.
Another thing to be aware of is that the business could be halal, such as buying property, but involve haram activities, such as haram financing. This would be impermissible – more on this below
2.The structure of the deal
The business may be halal, but how is it funded?
It is possible for a start-up to have taken some form of harm financing, such as interest-bearing debt. If they haven’t now, they may intend to do so in the future, or another funder might encourage this. So, it is important from the beginning to clarify how they intend to finance the business in the long-term.
However, the structuring concern doesn’t stop here. Preference shares, preferred return and convertible shares are very prevalent in early-stage finance, and it is important to give these a closer look.
This is a popular instrument for early-stage start-ups who are seeking funding. Convertibles are structured as loans with the intention of converting to equity. The outstanding balance of the loan is automatically converted to equity at a specific milestone. This is often at the valuation of a later round and is done with the intent to delay establishing a valuation for the company at this early stage. The investors are often protected by a valuation cap and further incentives by a discount on the next round.
There are a few issues with these notes. In particular, Mufti Yousuf Sultan points out two:
These contracts could include interest-based bearing loans, although it is less common nowadays
Even if financing or the note has no riba, it is still attached to future equity at a discounted price - either by a discount rate or a valuation cap. In either of these situations, it is a benefit attached to the loan. In Shariah, a qard or loan contract cannot be in any way combined with another contract that may bring benefit to the lender. Any additional benefit obtained through a loan is deemed riba.
Recently, a Saudi-based angel network, Oqal, has launched a Sharia compliant instrument that aims to solve the above-mentioned challenges.
Preferred return or Hurdle Rate
The preferred return is more commonly known as the hurdle rate. This is the minimum return investors in the fund (limited partners) must earn before the operators of the fund (general partner) can collect their shares.
The AAOIFI allow a difference in split between two different portions of the profit. However, they don’t allow the fund manager to be entirely cut out of profit in a particular portion of the profit. In practice, AAOIFI requires that at least a small fraction of the first X% of profits accrues to the fund manager – say 5-10%.
Generally there are two types of shares: common shares - which are permissible and preference shares which are not permissible).. This is because preference shares can be interpreted as a hybrid between debt and equity.
On the stock market you are most like to come across common shares whereas in PE and VC transaction, preference shares are prevalent.
Preference share are company stock which pays dividends to its preferred shareholders in advance of ordinary shareholders. If the company faces bankruptcy, preferred stock shareholders also have a right to be paid first. Preference shares usually pay a fixed dividend. In contrast, common stocks do not.
They are not permissible due to the imbalance of risk. Preferred shareholders have less risk but gain greater profit. The fixed dividend from the share has an element of riba, making the shares impermissible if they involve guaranteed payment of capital or of a certain amount of fixed profit.
Angel investing is one of the most enjoyable and rewarding ways to invest. The excitement of being part of the potential next world-changing start-up is unlike any other form of investment. However, it does come with risks as there are certainly more failures than successes.
Angel investing falls under the alternative asset classes as it is technically private equity in very early-stage companies in which you have a minority stake.
From a portfolio construction point of view, alternatives should make up a smaller portion of one’s portfolio when compared to equities and fixed income. That being said, your target exposure for a single angel investment should be in the low single digits.
Most importantly, angel investing is like all other types of investing – in that it’s important to know the differences between a halal and haram transaction, otherwise, ultimately, the profits will be of no benefit.
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