You’ll get more out of this series if you’ve read part 1 (high-level angel investing guidelines), part 2 (debt, equity, and key terms), part 3 (company stages), part 4 (deal flow), part 5 (good founder qualities and red flags), part 6 (market and due diligence), and part 7 (filtering, day-to-day, and syndicates).
There are two broad ways in which a company has an exit and in which you make money as an angel investor: IPOs and acquisitions.
In an IPO (stands for “initial public offering”), the company offers its stock to the public to buy. When that happens, the company is switching from being private to public. When you see an IPO for a tech company, it usually means that that company has established itself as a leader in a certain industry with years of demonstrated growth and success. The IPO process is time-consuming, expensive, and difficult, and few companies cross this threshold.
Acquisitions are far likelier outcomes for startups. You can see an acquisition to bring on a team of people (called an “acqui-hire” where a bigger company buys a smaller or struggling one for the people more than for the product), to merge competitors, to bring innovation into a larger and slower-moving company, and many other reasons.
Waterfalls and getting paid back
In investing, a “waterfall” refers to the order in which investors get paid back after a low exit. That means that the returns are less than the amount raised. Typically, payback happens in this order:
1. First to debt holders, like banks and other lenders (venture debt providers fall in this category);
2. Then to preferred shareholders, outside investors like angels and VC firms;
3. And lastly to common shareholders, the founders and employees themselves.
Most of the time that a company has a profitable exit, however, preferred shareholders convert to common shares. This is called converting on a one-to-one basis. Once everyone has common stock, they get returns on their investment based on how much of the company they own.
Returns
Returns on your investment are often stated as multiples. Let’s say you put $20k into a startup, which sells for $200M later. You ended up owning 0.25% after all other rounds, so you got $500k. That’s 25x your original investment. That’s an incredible outcome. A return of 10–50x or better is considered a win for an angel.
Carried interest, or “carry”
Normally investors make money on the percentage of the company that they own — e.g., taking 1% of the selling price if they own 1%. A new compensation mechanism comes into play when syndicates or VC funds are involved, called carried interest or “carry” for short.
Carry is expressed as a percentage of a profit. AngelList takes 5% carry for running the back office of Syndicates that take place on its platform. An angel lead typically takes 15–20% carry for doing the majority of the work in sourcing, evaluating, and making an investment.
Carry is only relevant when a company has a successful exit or starts paying back investors. Think of it as profit-sharing. The first step is always to pay back investors in full (refer to the waterfall section above). Once the company has paid back investors, carry starts to generate. In syndicates, backers pay carry to the lead for any profitable investment. It’s a reward for making a good pick.
Let’s say you’re a syndicate lead who championed an investment in a startup, and you’re getting 15% carry on the deal. You lead a $100k syndicate. The company sells for $100M after raising $25M. You own 5%. Your profit is $4.9M (the $5M representing your 5% from the sale, minus the initial $100k that your syndicate invested). 15% of that $4.9M ($735k) goes to you as the lead; that is your carry. 80% of that $4.9M ($3.92M) goes to your backers, distributed based on how much each of them personally invested. 5% ($245k) goes to AngelList.
Check out this carry calculator on AngelList to try some examples.
We’ll tie it all together in part 9 with some example exit scenarios. Questions or comments? I’m sarah(at)accomplice(dot)co and @SarahADowney on twitter.