angel investments case study unit 5

Case Study_Angel Investments

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Angel Investing: Innovation Within The Establishment

This is an “industry note” introducing Angel Investing as a concept and discussing recent developments in the industry. Angel Investing has been a long standing practice, dating back to Broadway play financiers at the turn of the 20th century, and including wealthy benefactors of burgeoning business, like Laurance Rockefeller in the 1930s. Angel Investing experienced high profile success in the 1980s, and memorably in the dot.com economy of the late 1990s. After the dot.com fall out in 1999-2000, Angel Investing took hard punches and many angels retreated from active investing. The next generation of angels had different expectations, different experiences, and different practices – this note focuses on the “new generation” of angel investors and the steps taken on both sides of the investing equation to mitigate the risks inherent in the relationship.

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CASE at Duke

Angel Networks In Emerging Markets

Entrepreneurship is a key driver of economic development – when new businesses launch and grow, they create jobs, address customer needs through market-based solutions, and drive demand for other products and services from a supply chain. With this knowledge in mind, the United States Agency for International Development (USAID) and other development institutions have increasingly dedicated resources to bolstering entrepreneurial ecosystems in order to fuel these economic ripple effects.

A critical component of strong entrepreneurial ecosystems are angel investors – individual investors who make relatively small, private investments to support enterprises through their more high-risk early stages. While angel investors often invest individually, they may collaborate with each other through angel networks , which bring together member investors for mutual benefit.

In 2018, USAID’s Partnering to Accelerate Entrepreneurship (PACE) Initiative engaged CASE to investigate angel network models to analyze strategies and best practices, as well as make recommendations for how development institutions can leverage angel networks to reach their economic development goals. CASE was happy to partner with Millbrook Impact and the Bertha Centre for Social Innovation and Entrepreneurship at the University of Cape Town Graduate School of Business on this initiative. The research team explored angel networks in parts of Latin America, Middle East/North Africa, and Sub-Saharan Africa.

The results of this project are:

• Angel Networks in Emerging Markets: A Guide For Development Institutions , which provides the framework and tools for USAID and other development institutions to assess angel investor networks, gauge their strengths and strategies, understand challenges they face, and identify how to support them.
• Five Angel Network Spotlights – case studies of angel networks to provide concrete illustrations of network variables, business models, strategies in action, and opportunities for support.

This work aims to go beyond simply sharing knowledge about angel networks. We hope this guide and case studies galvanize development institutions and other funders to select from a set of specific support mechanisms to help angel networks succeed.

Angel Networks In Emerging Markets: A Guide for Development Institutions

Provides five specific recommendations and three tools for USAID, development institutions, bilateral and multilateral donors, and other investors to engage with and support angel networks in emerging markets in order to leverage local, private capital to fuel early-stage enterprises. Read the full guide

Angel Network Spotlights

Angels Nest

Angels Nest operates one of the most active angel networks in Latin America. With no membership fees, an online platform for angels, and international partnerships that activate additional capital, it lowers entry barriers to angel investing and aligns its goals and revenue with the interests of investors and entrepreneurs. Read the case study

Colaborativo

Colaborativo runs several, connected entrepreneurial services to promote sustainable development in Latin America – an accelerator, an online community platform, an angel network, and a recently launched fund. Read the case study

Lagos Angel Network (LAN)

Lagos Angel Network was founded by high-profile Nigerian entrepreneurs and angel investors. With the help of development funding and key partnerships, they have leveraged their reputations and skills to build one of the most active angel investor networks on the continent. Read the case study

iungo capital

Born out of ViKtoria Ventures, a start-up supporter in East Africa, VBAN uses its deep networks to attract angel network members and build quaiungo capital’s innovative approach aligns the motivations of a for-profit fund, non-profit technical assistance provider, and local angel investors to meet the finance and support needs of East African Small and Medium Enterprises (SMEs).  Read the case study

ViKtoria Business Angel Network (VBAN)

Born out of ViKtoria Ventures, a start-up supporter in East Africa, VBAN uses its deep networks to attract angel network members and build quality pipeline for investors. With a dedicated Network Manager, VBAN provides hands-on support to members at every step of the investment process. Read the case study

• Corpus ID: 110513898

ANGEL INVESTING: A CASE STUDY OF THE PROCESSES, RISK, AND INTERNAL RATE OF RETURN

• Geoff Roach
• Published 2008
• Business, Economics

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One Citation

Entrepreneurial finance: angel investing as a source of funding high-growth start-up firms, 155 references, angel finance: the other venture capital.

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• 16 Excerpts

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Investor Insights Blog | Angel Investing 101: 10 Steps to a Promising Early-Stage Venture Deal

Private Equity and Entity Investing

Angel Investing 101: 10 Steps to a Promising Early-Stage Venture Deal

February 17, 2021

The following was written by guest blogger Dave Stech.

Have you ever had a phone call, or an early-stage venture “deal” hit your inbox, and you didn’t know what to do or even where to start? Welcome to the club; we all start there.

Early-stage venture investing can be a rewarding endeavor, but it’s not nearly as straightforward to evaluate as real estate or private lending. If you don’t understand it, you are at material risk of getting it wrong, especially since early-stage deals are often pre-product, pre-revenue, and pre-results.

Our family office invests in only three things: real estate, private lending on real estate, and early-stage venture capital or private equity deals, mostly disruptive technology companies. Having done a lot of all three and realizing that private equity investing is the least understood, we put together a simple, yet powerful framework for assessing deals. We hope you become a better-informed investor and find the deals with the best likelihood of success and eventual return on investment, both money and time.

What is venture capital?

Let’s start with the basics. Venture capital (vc) is a type of private equity and is typically provided by outside investors to new businesses that show promise for rapid expansion and valuable enterprise. These investments are often high-risk, especially in their early stage, yet offer the potential of high reward.

It’s also important to note that venture capital is long-term investing, meaning it doesn’t produce regular cash flow. In the early stages, the opportunity for high net worth investors (often called accredited investors) is greatest. These high net worth investors are often referred to as “angel investors” in the earliest stage of investing.

Private equity, the root of venture capital, can be traced back to the 19th century. Venture capital itself became an industry after the Second World War when a Harvard Business School professor, Georges Doriot, began raising funds for the American Research and Development Corporation. He raised $3.5 million to find companies that were commercializing technology developed during the war.

Stages of a venture deal

Seed Stage: The first stage of a vc deal is the seed stage, and sometimes pre-seed. This is the stage of a company that is pre revenue and pre-product. You’re investing in an idea and a great founding team. This is the highest risk stage because it’s speculation, which is why the founding team is so important. This stage is all about developing a product and getting traction.

Series A: The next stage is Series A. This is the stage where, typically, the product is built and there is some traction in the form of revenue. There’s still a significant risk at this stage, though less than the seed stage. This stage is about scalability of the established product. Benchmarks such as how the unit of production looks and revenue will be key here.

Series B: This stage is often when a business has meaningful revenue and growth. This is the point at which the downside has been materially de-risked.

There will always be risk, however there is compelling evidence that the business model is viable. The risk at this stage is much smaller and capital will be used for further growth—either in the core business or product line expansion.

Series C and Beyond: And then there’s Series C and all the way to G. We treat C-G as one large category. Consider this the “add capital” phase. The business is working, the core product is working, and the unit economics look good (or there’s a clear path to it). The team is impressive, there’s tremendous opportunity in front of them. They simply require the capital to realize it. Series C and beyond is really about taking a viable, stable business model to the next level.

We personally like to invest our money in pre-seed, seed, or Series A. We’ve found that with these early stages, the small dollars can create big returns as long as you can manage risk.

That’s why we’ve put together a 10-Point Framework, and we’re willing to share it with you so that you can be a better-informed investor and properly evaluate a deal that is early-stage.

The 10 steps to evaluate an early-stage venture capital deal

1. The problem

When evaluating a deal, this is the first question you should be asking yourself. What is the pain point that needs to be solved, and why does it even exist? From this reference point, you’ll be ready to hear the answer to the obvious next question.

2. The solution

How does the product or service proposed solve for the pain point? How thorough and logical is the solution being proposed? Not only should the proposed product fit that criteria, it should also feel novel. Research whether this has been done before and what the results were.

3. Market size

Think about the Total Addressable Market (TAM) for this product. TAM is an acronym used frequently in venture capital. Get clear on the market size of this product—how many people experience this problem and truly need the solution? Then ask yourself, what is the market share of incumbents? Is it a highly fragmented market (a lot of small players and thus easier to compete) or is this market “owned” by big companies?

4. The advantage

The next question you should be asking is: what advantage will this business or product create over time? Let the founders convince you that the idea is defensible (a “moat”) and that someone can’t come in and simply duplicate the idea. This has to be a viable, long-term business.

[Related: 5 Elements of Private Equity]

5. Execution

This is our favorite, though perhaps not the most important, point in the framework (unless you’re in a late-stage investment). How much traction does this business have? How well are they executing their plan and, if they aren’t at that stage, how do they plan to execute?

It’s important not to let the conversation stop at, “We haven’t started yet.” In the earliest stage of the deal, it’s unlikely that the team has started at all, yet it’s important that they at least have a playbook.

Ideas are a dime a dozen. It’s all about execution.

6. The outcome

Without a vision, it’s hard to launch a business. This is where the rubber really meets the road.

Find out what success looks like to this management team. What will the outcome be, and what is their intended business plan moving forward? Do they have benchmarks for revenue, growth rate, and expected market share? You need to feel comfortable that they have thought not only about the business, but also about the results (which you will be a part of).

7. The team

When investing in venture capital, the team is arguably everything. Who is running the show—founders, key members, creators? Make sure that they can identify why they are the perfect team to pull this off, and what their strengths and weaknesses are. The members of the team will tell you a lot about the expected outcome and likelihood of success of the company.

8. The risks

This is a key component, and one that the team should be aware of. What are the potential risks in this deal, and does this team know and understand what those risks are? Consider the top three to five risks of this venture. Then assess how this team is planning to mitigate these risks.

How much is this team asking for, and how do they plan to invest the money? What will they use the proceeds for? What is their valuation and why?

10. Other investors

Beyond the core team members of the venture, who is around the table with them? What other investors are involved, who is leading the round, and who are their advisors? If there are other angel investors, who are they? Are they just writing a check or are they strategic investors (can add value beyond the money)?

One of the strongest validation signals of a good investment is when other seasoned angel investors are piling into the deal.

Video: Investing in Private Entities in Your IRA

Research and education: the key to successful private equity investing

Despite the risks, private equity and early-stage venture investing can be some of your most rewarding investments, as long as you get educated and do your research. The above framework is meant to help you identify the strengths and weaknesses of a deal.

Not only will this 10-Point Framework help you better identify whether a deal suits your investing DNA, it will help you determine how confident you are in the deal in which you’re investing. Confidence is huge in investing in anything.

Founding teams that can confidently answer these questions without getting stumped have put the time and effort into creating an idea and business model that deserves investors’ attention.

In fact, when we advise entrepreneurs, this is the framework we encourage them to use to create their pitch deck. Having a clear vision and a viable game plan that can confidently be executed upon will make or break their ability to attract capital.

Discover more about private equity investing in an IRA .

About Dave Stech

Dave Stech is an angel investor in many early-stage disruptive technology companies, including “unicorns,” one of which his son was founding partner of in private lending (fintech). In 2020, Dave launched a private equity venture capital fund for 99 percent of investors who lack the one thing they really need as a private equity investor: access.

Dave is best known as a real estate market timer. He predicted the 2007 housing collapse at Harvard in 2005; in 2009 he went “all-in” on real estate in Las Vegas; in 2011 he forecasted the bottom of the real estate market; and in 2019 he predicted a recession in 2020.

Dave heads Stech Family Office with his two sons, in which they personally invest in only three things: real estate, private lending, and early-stage technology companies – all using their Roth IRAs.

Dave graduated from the London School of Economics and speaks at Harvard Business School and other conferences where he shares his annual State of the Union for Real Estate and Technology Investors: What’s Happening NOW and What’s Coming NEXT?

Can my IRA invest in a newly formed entity that will invest in real estate?

Yes. Investments in newly formed private entities, such as limited partnerships, limited liability companies, C corporations or land trusts, are permissible under the Internal Revenue Code, with the exceptions of subchapter S corporations.

Dave Stech is not an employee of Equity Trust Company. Opinions or ideas expressed are not necessarily those of Equity Trust Company nor do they reflect their views or endorsement. These materials are for informational purposes only. Equity Trust Company, and their affiliates, representatives and officers do not provide legal or tax advice. Investing involves risk, including possible loss of principal.

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How Does Angel Investing Work? The Ultimate Guide

There are many possible sources of funding when running a small business, from crowdfunding to business loans. Once your startup gains enough traction and momentum, you might also receive interest from an angel investor or two.

But what is angel investing, and how does angel investing work? In this article, we’ll explain angel investing from the ground up, from the fundamentals to term sheets, so that you can be fully prepared to seek funding from angel investors.

What is angel investing?

Angel investors are individuals who provide capital for business ventures and startups in need of funding. These are typically wealthy individuals, who are often business founders & CEO s themselves, and exchange their own money for a share of the company they are investing in.

Shows such as “Shark Tank,” in which entrepreneurs pitch their business plan to a panel of potential investors, have helped popularize the concept of angel investing to a wider audience (although the concept has been highly dramatized for TV).

According to the Center for Venture Research, total angel investments in the United States increased by 6% from 2019 to 2020 , reaching $25.6 billion. The deal size, the number of deals, and the number of angel investors also increased year-over-year.

What are the benefits of angel investing?

When done right, angel investing has benefits for both the investors and the business owners of angel-funded startups.

By making an initial investment in a business, angel investors are predicting that their stake in the company will eventually be worth more than the funding they provided. Meanwhile, startups that receive angel investing can use this money to hire more employees, expand their operations or products, or launch new marketing campaigns.

Why choose an angel investor?

For startup owners, angel investors have certain advantages over other sources of business funding:

• Angel investors offer a personal touch to the startup funding process. They often take a proactive, interested role in making your company a success.
• With the right connections, raising funds from individual angel investors can be easier than getting the attention of large VC firms. If you select the right co-founders, they can help introduce you to angels in the startup community, which is one major difference between founder and co-founder .
• Angel investments are less risky than business loans. If your startup fails, angel investors won’t expect you to repay the funds they gave you. On the other hand, you’ll still have to pay back the loans you took out, which can be a major financial burden.

What’s the difference between a VC and an angel?

Like angel investors, venture capitalists are a common source of funding for startups and small businesses. The essential difference between VCs and angel investors is:

• Angel investors are high-net-worth individuals who invest their own money in startups.
• Venture capitalists are employees of VC firms, who invest the capital of other individuals, corporations, and pension funds.

This difference has multiple repercussions in practice. Angel investors typically invest at earlier stages, and invest smaller amounts of money than venture capitalists.

How much do angel investors typically invest?

According to the U.S. Small Business Administration, the average angel investment is $330,000. (In comparison, the average venture capital investment is $11.7 million.)

However, this figure is likely distorted by larger angel investments, which can go as high as $1 million and typically come from angel investing syndicates. Individual angel investors usually invest more modestly, between $10,000 and $200,000 in funding. A standard angel funding round may thus seek to raise $100,000 to $300,000 from 2 to 10 people.

What is an angel investing syndicate?

An angel investing syndicate is a group of angel investors that join forces to provide funding for startups and small businesses. Syndicates such as AngelList Syndicates make the world of angel investing accessible to a wider pool of individuals.

Syndicates may have anywhere from a few dozen to a few hundred members, and are headed by a syndicate leader tasked with sourcing new investments. In exchange for this work, syndicate members agree to pay a percentage of their profits (known as the “carry”) to the leader.

What stage of companies do angel investors invest in?

Angel investors typically look to invest during a startup’s early stages, before it has received significant funding from other investors. As such, angel investing is inherently a high-risk, high-reward activity: it offers an opportunity for investors to get in on the ground floor and claim a sizable stake before the company strikes it rich.

However, you should be well past the stage where you’re wondering things like “ What is a co-founder ?” before seeking angel investments. This means having some proof of concept such as a compelling business idea, a minimum viable product, or major customers or partnerships. Angel investors are often the next round of funding after the startup’s founders have raised initial capital (e.g. through crowdfunding or their own savings).

Are angel investors accredited investors?

As defined by the U.S. Securities and Exchange Commission (SEC), an “accredited investor” is a person with at least $1 million in assets or an annual income of at least $200,000. Companies that receive funding from accredited investors are exempt from certain securities filings with the SEC and other regulators.

Angel investors may or may not be accredited investors. Of course, there is some correlation between the two: people with a high net worth have more funds to spend on risky ventures like angel investing. However, there is no legal requirement that angel investors be accredited.

How does the angel investing process work?

During the angel investing process, startup founders and co-founders pitch their business to potential investors, who may choose to provide or decline funding. The steps of this process include:

• Finding angel investors: Startup founders can find angel investors through their personal network, online platforms, and events in the startup community .
• Doing your research: Not every angel investor is the right match for every company. Some investors specialize in a particular domain (such as healthcare or software). Angel investors may also differ in the approach they want to take with your company—e.g. serving as a mentor vs. being totally hands-off.
• Making the pitch: Founders should prepare a pitch deck that gives a brief overview of their company and its major selling points. The pitch may be done in person, or over email to set up an in-person meeting.
• Negotiating the terms: If angel investors like the pitch, they’ll offer a deal. Like everything else in business, the terms of this deal can be negotiable. Consider discussing factors such as the amount of equity, the company’s exit strategy, and even giving investors a seat on the board.

What questions should entrepreneurs ask angels?

Presenting to angel investors isn’t a one-way street. As much as angels are assessing your business, you also need to evaluate them to make sure that it’s the right fit.

The questions you may want to ask angel investors include:

• Which other startups or companies have you worked with?
• What advice do you have for growing this business?
• What are your biggest concerns about this business or industry?
• How much do you normally invest in companies?
• What role would this company play in your portfolio?
• What role do you want to play in this company after the investment?
• What happens if this venture fails?

How can international entrepreneurs get funded?

Angel investors and founders often run in the same circles and attend the same events. This means that it’s easier for angel investors in a particular geographical location—say New York or Silicon Valley—to connect with and invest in startups in the same area.

However, international entrepreneurs aren’t entirely out of luck if they want to find U.S.-based angel investors. There are a number of organizations seeking to help international startups break into the U.S. market. For example, UpWest works specifically with Israeli companies, while the Techstars seed accelerator has launched the Global Accelerator Network (GAN) to reach founders around the world.

What is an angel investing term sheet?

In angel investing, the term sheet (also known as the letter of intent) is a document that defines the terms by which angels will make an investment in your business. The term sheet is usually a short document, no more than 10 pages in length. It typically includes details such as:

• The form of the investment (common shares, convertible preferred shares, or convertible debt)
• The investor’s voting rights (e.g. a seat on the board of directors)
• The liquidation preference (i.e. the order in which the company’s owners will be paid if the company is liquidated or sold)
• Confidentiality agreements and due diligence procedures

Term sheets are typically intended to be non-binding agreements; however, certain portions can be mutually agreed to be binding. Make sure to seek legal consultation before signing any term sheet or other document.

What do angel investors get for their investment?

In exchange for investing a certain amount of funding, angel investors receive a minority ownership stake in the company. This proportion is typically no larger than 20 to 30 percent across all investors, since the founders need to retain majority ownership and also reserve some shares for employee stock options. There are multiple ways for angel investors to take ownership, including equity and convertible debt.

What is equity vs. convertible debt?

Equity is the percentage of shares that an entity owns in a business or other asset. If you own 10% of the shares in a business, for example, then you are said to have 10% equity in the business. If the business is worth $1 million, then your equity stake can be valued at $100,000.

During an angel investment round, investors can purchase equity in the company, giving them a certain percentage of the ownership. This equity stake can then be cashed out at a later date when the company has increased in valuation, earning a profit for the investors.

Startup founders often prefer selling equity because it does not require them to go into debt to the investors. In order to sell equity in your business, however, you’ll need to have some idea of the company’s valuation, which will give you a fair price at which to sell your shares.

Convertible debt, also known as convertible notes, is a type of business loan that the holder can convert into a given number of shares in the company. The holder can also choose to exercise this debt as a traditional loan at a later date, receiving back the principal amount together with the loan’s interest.

Some founders would rather sell convertible debt because it allows them to defer the question of business valuation until later on in the funding process. The value of this convertible debt will be calculated based on the company’s future valuation, instead of its current valuation.

What are SAFE notes?

SAFE (Simple Agreement for Future Equity) notes are equity documents that are intended as an alternative to convertible debt. First created by Y Combinator in 2013, the goal of SAFE notes is to simplify the funding process.

In order to understand SAFE notes, equity, and convertible debt, you should be familiar with a few crucial concepts:

• Discount: With SAFE notes, early angel investors may receive a discount on the purchase price compared with later (e.g. Series A) investors.
• Valuation caps: SAFE notes can set a maximum cap on the company’s valuation, limiting the amount that investors will pay when buying shares at a future date.
• Early exit payback: If a company is acquired or changes hands before SAFE notes can be converted, investors can have the value of these notes paid back to them.
• Company type: Using SAFE notes usually requires the company to be listed as a C-Corp rather than an LLC. This is because SAFE instruments assume and specify that the company is a corporation, not an LLC.
• Conversion: Unlike convertible debt, which requires a specific amount of funding to be raised, SAFE notes can be converted into equity in a future round regardless of the funding amount.
• Term (maturity date): SAFE notes are not debt, which means that there is no required maturity or expiration date.
• Interest rate: Also unlike convertible debt, SAFE notes do not have an interest rate.

SAFE notes can take four different forms:

• Discount and valuation cap
• Discount, but no valuation cap
• No discount, but valuation cap
• No discount and no valuation cap

What are the benefits and drawbacks of SAFE notes?

There are various pros and cons of SAFE notes over alternatives such as convertible debt. By far the greatest benefit of SAFE notes is their simplicity. SAFE notes are generally easier to work with: the document itself is only a few pages long, making negotiations shorter. Using SAFE notes also enables startups to defer the question of business valuation until later on in the process.

SAFE notes are generally more advantageous for startup founders than for their investors. This is because they lack a maturity date or interest rate, making them more flexible for startups with an uncertain growth timeline. On the other hand, because SAFE notes are not debt, investors must accept the risk that they won’t receive payment in the form of equity if the startup goes under.

In terms of disadvantages, startup founders need to consider the risk of equity dilution caused by using SAFE notes. Investors purchasing large quantities of SAFE notes can help lift the business off the ground. When these SAFE notes are converted to shares later on, however, it can seriously dilute a founder’s stake in the company, giving them less control and making it harder to attract Series A investors with the remaining shares available.

What is the average return for an angel investor?

According to a 2007 study by Robert Wiltbank and Warren Boeker, the average return on angel investments was 2.6 times the initial investment after a period of 3.5 years. This comes out to an internal rate of return (IRR) of 27%.

A meta-analysis of angel investment returns supports this estimate. Of the studies examined in this report, the average IRR of angel investors ranged from 18% on the low end to 37% on the high end.

What is the success rate of angel investing?

Although angel investing does generate positive returns on the whole, the success rate of individual ventures is mixed. The same 2007 study found that 52% of startup exits did not generate enough capital to pay for the initial angel investment—which would make for a 48% success rate.

The success of an investment isn’t determined solely by breaking even, however. Just 7% of angel investments generated returns of more than 10 times the initial investment. However, this small percentage accounted for 75% of all the returns from angel investing.

Is angel investing lucrative?

Angel investors get into the field for many reasons. Some are fascinated by the intellectual challenge of finding profitable new startups, while others are simply looking for a higher rate of return than traditional investments.

The good news is that angel investing can be a very lucrative endeavor—but like many other investments, what you get out of it is proportional to the time and effort you put in.

The 2007 study by Wiltbank and Boeker found that the profitability of angel investment depended on three factors: investors’ due diligence, their industry expertise, and their involvement with the business.

• Due diligence: Investors that performed less than 20 hours of due diligence on a company had an average return of 1.1 times their capital. Spending over 40 hours of due diligence correlated with an average return of 7.1 times their capital.
• Industry expertise: Investors with over 14 years of experience in a given industry had double the returns of investors with less experience.
• Business involvement: Investors who met with the company twice a month had average returns of 3.7 times their capital. Meeting twice a year saw average returns of only 1.3 times capital.

What does an angel investor do in their startup company?

After investing in a startup, what role does the angel investor play? Every investor will have a different answer here—from serving in an advisory role on the board of directors, to adopting a totally hands-off approach.

Of course, it’s in both parties’ best interest that the startup succeeds, so most angel investors do actively assist with the venture. If investors do choose to involve themselves in the startup, there are a number of parts they can play, including:

• Providing business advice from an external point of view
• Drawing on network connections to source new customers
• Helping recruit and hire new employees
• Offering fundraising mentorship for additional funding rounds
• Generating marketing buzz for new products

How can you end an angel investment?

Angel investments typically end in one of two ways: either the startup successfully exits and generates return for the investor, or the startup closes its doors and the investor writes it off as a loss.

Rarely, you may be able to buy back the angel investor’s equity if both sides agree to end the deal. However, if your startup has grown since the investment, be prepared to spend significantly more money than the investor originally paid for the shares.

In the best case, an angel investor’s initial investment is the start of a long-term partnership. If investors are happy with the outcome, they may choose to work with entrepreneurs again during their subsequent ventures.

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Angel Investing Taxes – A 2021 Case Study

An overlooked attraction of angel investing, compared to most other asset classes, are the fun tax rules around gains and losses on early stage investing. Sounds odd, but it’s true. 

As we discussed in our guide to angel taxes , the gains from angel investing are often tax free – thanks to the Dabo of the tax code . Following a lucrative 2021 for VentureSouth members , we have spent much of the last few weeks explaining to investors the tax consequences of their exits. We thought it might be useful to share a case study on a recent exit, as it covers the range of tax implications described in the guide. 

VentureSouth members made five investments in a company, as follows:

• priced preferred equity seed round in 2015
• a small purchase of common stock from a departing cofounder in 2017
• a convertible note in 2017; this note converted into the next round of equity in August 2018
• priced preferred equity Series A-1 round in 2018, and a further priced preferred equity Series A-2 round in 2029

…and exited when a purchaser acquired our shares in 2021. Sounds complicated, but this is a typical journey for an early-stage investor. Each of these rounds is an interesting angel investing tax scenario, so let’s take them one by one. 

1) Priced equity held more than 5 years We’ll start with the best. This first round was an investment in Qualified Small Business Stock (“QSBS”), as a a C-Corp running a real business with less than $50M in assets. This is the “base case,” a typical angel investment in a southeastern deal. As QSBS stock held for over five years, gains on this stock are exempt from capital gains taxes. 

(There are, of course, some limitations, like a max gain of 10x or $10M. There are also more…creative… methods (“stacking”, “packing”, and of course “peanut buttering” discussed here ), which do not really apply to angel investors but make for interesting reading.) So the gains on this investment were tax free for our members. Not only was this the best pre-tax return (earliest money in, at the lowest price, so the largest gain); the returns are entirely tax free. What more could you ask for? 

2) A purchase of founder’s common stock The next round was a similarly strong pre-tax return, but had a less favorable tax impact. QSBS only applies to newly-issued shares in a company. If you buy existing shares – as in this case where common stock shares held by a founder were purchased in a “secondary transaction,” or more generally, like when you buy shares in a public company – QSBS does not apply. QSBS is designed to encourage new investment. While active and liquid secondary markets make investing more appealing – it’s more palatable to buy stock (and found companies) if you can sell that stock one day – QSBS is focused on rewarding new funding of startup companies, and so is limited to newly-issued shares. Even without the benefits of QSBS, though, this is still fairly appealing as a long-term capital gain taxed at capital gain tax rates. 

3) Later priced equity rounds held for less than five years Let’s disrupt the timeline by next tackling #4, the two recent priced equity rounds. Both these investments were QSBS: still a C-Corp with less than $50M in assets, still operating, selling newly-issued shares. So you might think QSBS / Section 1202 / Dabo applies. Unfortunately (from a tax perspective), this was, fortunately (from an IRR perspective), a quick win, with capital deployed and returned within five years. That means the stock was not held long enough to get the Section 1202 exemption. The good news, though, is that these proceeds are eligible for “rollover” under Section 1045 of the tax code. If the proceeds are redeployed into new QSBS within 60 days, no capital gains tax is due on the gains. Investors then face the decision: do we bank the proceeds (and pay long-term capital gains tax on the gain); or do we “roll the dice again” by reinvesting the proceeds into one or more (sensibly: more) QSBS companies? Letting tax treatment determine your investing has the tail wagging the dog, but recognizing the net, post-tax returns is a critical part of investing successfully. 

4) The convertible note round The most complicated round of all is the convertible note round in the middle. If you’re familiar with VentureSouth’s soapbox, you know we are generally not fans of convertible notes. One reasons is taxes. The original investment in the convertible note was not into stock of a C-Corp, so QSBS doesn’t apply. The QSBS “clock” only starts when the note converts – which in this case was several months later, which is typical. There are other complications too. How much of the “gain” here was from the accrued interest on the convertible note (taxable as interest?)? How much came at the conversion event? How much should each be taxed? This is a bit beyond the scope of this post, but let’s just say the tax treatment might be murkier on notes than on priced equity. 

As one hypothetical, notice that if the exit had been in January 2022, a priced round in December 2016 would have been capital gains tax free under Section 1202, but a convertible note at the same time (but that converted in June 2017) would not. (It would have been Section 1045 rolloverable based on the date of conversion, which is good, but it ties up capital for more than six years total to get the treatment you might have received after five. Not so ideal. And no guarantee that the rolled-over money would not be written off!) Not a bad outcome, of course, but one tangible example of where equity would’ve been better (post taxes) and simpler than a note. 

To sum up: One company, five rounds, four different tax treatments. Fun stuff we hope you agree! 

We think VentureSouth members benefit from having access to early stage, QSBS-eligible deals; from a steady supply of Section 1045 rollover-eligible companies so eligible proceeds can be reinvested within 60 days; and a full-time team who love explaining the tax implications of investing before and after the investment. Perhaps you will join us for the next one! 

PS – Section 1045 in action! As an interesting aside, some of our members invested into this company using proceeds from a successful exit of another VentureSouth portfolio company. The prior exit was from a QSBS company held less than five years, and so the proceeds from that exit were eligible for rollover under Section 1045. The successful investors took those proceeds, redeployed them into Company A, and made a further multiple of gain on them. First company was held for two years; second held for three; added together they passed the five years required for QSBS to apply – so all the gains became capital gains tax free. This is Section 1045 working exactly as advertised!  Double win.

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Case Study: An Angel Investor with an Agenda

• Regina E. Herzlinger
• Beatriz Muñoz-Seca

Editors’ Note: This fictionalized case study will appear in a forthcoming issue of Harvard Business Review, along with commentary from experts and readers. If you’d like your comment to be considered for publication, please be sure to include your email address. Gloria Londoño scanned the tables at the Opera restaurant. Victor Serna was sitting at […]

Editors’ Note: This fictionalized case study will appear in a forthcoming issue of Harvard Business Review, along with commentary from experts and readers. If you’d like your comment to be considered for publication, please be sure to include your email address.

• RH Regina E. Herzlinger is the Nancy R. McPherson Professor of Business Administration at Harvard Business School and the author of multiple books, including  Market-Driven Health Care (Perseus, 1997).
• BM Beatriz Muñoz-Seca is a professor of production, technology, and operations management at IESE Business School, University of Navarra.

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The state of AI in 2023: Generative AI’s breakout year

You have reached a page with older survey data. please see our 2024 survey results here ..

The latest annual McKinsey Global Survey  on the current state of AI confirms the explosive growth of generative AI (gen AI) tools . Less than a year after many of these tools debuted, one-third of our survey respondents say their organizations are using gen AI regularly in at least one business function. Amid recent advances, AI has risen from a topic relegated to tech employees to a focus of company leaders: nearly one-quarter of surveyed C-suite executives say they are personally using gen AI tools for work, and more than one-quarter of respondents from companies using AI say gen AI is already on their boards’ agendas. What’s more, 40 percent of respondents say their organizations will increase their investment in AI overall because of advances in gen AI. The findings show that these are still early days for managing gen AI–related risks, with less than half of respondents saying their organizations are mitigating even the risk they consider most relevant: inaccuracy.

The organizations that have already embedded AI capabilities have been the first to explore gen AI’s potential, and those seeing the most value from more traditional AI capabilities—a group we call AI high performers—are already outpacing others in their adoption of gen AI tools. 1 We define AI high performers as organizations that, according to respondents, attribute at least 20 percent of their EBIT to AI adoption.

The expected business disruption from gen AI is significant, and respondents predict meaningful changes to their workforces. They anticipate workforce cuts in certain areas and large reskilling efforts to address shifting talent needs. Yet while the use of gen AI might spur the adoption of other AI tools, we see few meaningful increases in organizations’ adoption of these technologies. The percent of organizations adopting any AI tools has held steady since 2022, and adoption remains concentrated within a small number of business functions.

Table of Contents

• It’s early days still, but use of gen AI is already widespread
• Leading companies are already ahead with gen AI
• AI-related talent needs shift, and AI’s workforce effects are expected to be substantial
• With all eyes on gen AI, AI adoption and impact remain steady

About the research

1. it’s early days still, but use of gen ai is already widespread.

The findings from the survey—which was in the field in mid-April 2023—show that, despite gen AI’s nascent public availability, experimentation with the tools  is already relatively common, and respondents expect the new capabilities to transform their industries. Gen AI has captured interest across the business population: individuals across regions, industries, and seniority levels are using gen AI for work and outside of work. Seventy-nine percent of all respondents say they’ve had at least some exposure to gen AI, either for work or outside of work, and 22 percent say they are regularly using it in their own work. While reported use is quite similar across seniority levels, it is highest among respondents working in the technology sector and those in North America.

Organizations, too, are now commonly using gen AI. One-third of all respondents say their organizations are already regularly using generative AI in at least one function—meaning that 60 percent of organizations with reported AI adoption are using gen AI. What’s more, 40 percent of those reporting AI adoption at their organizations say their companies expect to invest more in AI overall thanks to generative AI, and 28 percent say generative AI use is already on their board’s agenda. The most commonly reported business functions using these newer tools are the same as those in which AI use is most common overall: marketing and sales, product and service development, and service operations, such as customer care and back-office support. This suggests that organizations are pursuing these new tools where the most value is. In our previous research , these three areas, along with software engineering, showed the potential to deliver about 75 percent of the total annual value from generative AI use cases.

In these early days, expectations for gen AI’s impact are high : three-quarters of all respondents expect gen AI to cause significant or disruptive change in the nature of their industry’s competition in the next three years. Survey respondents working in the technology and financial-services industries are the most likely to expect disruptive change from gen AI. Our previous research shows  that, while all industries are indeed likely to see some degree of disruption, the level of impact is likely to vary. 2 “ The economic potential of generative AI: The next productivity frontier ,” McKinsey, June 14, 2023. Industries relying most heavily on knowledge work are likely to see more disruption—and potentially reap more value. While our estimates suggest that tech companies, unsurprisingly, are poised to see the highest impact from gen AI—adding value equivalent to as much as 9 percent of global industry revenue—knowledge-based industries such as banking (up to 5 percent), pharmaceuticals and medical products (also up to 5 percent), and education (up to 4 percent) could experience significant effects as well. By contrast, manufacturing-based industries, such as aerospace, automotives, and advanced electronics, could experience less disruptive effects. This stands in contrast to the impact of previous technology waves that affected manufacturing the most and is due to gen AI’s strengths in language-based activities, as opposed to those requiring physical labor.

Responses show many organizations not yet addressing potential risks from gen AI

According to the survey, few companies seem fully prepared for the widespread use of gen AI—or the business risks these tools may bring. Just 21 percent of respondents reporting AI adoption say their organizations have established policies governing employees’ use of gen AI technologies in their work. And when we asked specifically about the risks of adopting gen AI, few respondents say their companies are mitigating the most commonly cited risk with gen AI: inaccuracy. Respondents cite inaccuracy more frequently than both cybersecurity and regulatory compliance, which were the most common risks from AI overall in previous surveys. Just 32 percent say they’re mitigating inaccuracy, a smaller percentage than the 38 percent who say they mitigate cybersecurity risks. Interestingly, this figure is significantly lower than the percentage of respondents who reported mitigating AI-related cybersecurity last year (51 percent). Overall, much as we’ve seen in previous years, most respondents say their organizations are not addressing AI-related risks.

2. Leading companies are already ahead with gen AI

The survey results show that AI high performers—that is, organizations where respondents say at least 20 percent of EBIT in 2022 was attributable to AI use—are going all in on artificial intelligence, both with gen AI and more traditional AI capabilities. These organizations that achieve significant value from AI are already using gen AI in more business functions than other organizations do, especially in product and service development and risk and supply chain management. When looking at all AI capabilities—including more traditional machine learning capabilities, robotic process automation, and chatbots—AI high performers also are much more likely than others to use AI in product and service development, for uses such as product-development-cycle optimization, adding new features to existing products, and creating new AI-based products. These organizations also are using AI more often than other organizations in risk modeling and for uses within HR such as performance management and organization design and workforce deployment optimization.

AI high performers are much more likely than others to use AI in product and service development.

Another difference from their peers: high performers’ gen AI efforts are less oriented toward cost reduction, which is a top priority at other organizations. Respondents from AI high performers are twice as likely as others to say their organizations’ top objective for gen AI is to create entirely new businesses or sources of revenue—and they’re most likely to cite the increase in the value of existing offerings through new AI-based features.

As we’ve seen in previous years , these high-performing organizations invest much more than others in AI: respondents from AI high performers are more than five times more likely than others to say they spend more than 20 percent of their digital budgets on AI. They also use AI capabilities more broadly throughout the organization. Respondents from high performers are much more likely than others to say that their organizations have adopted AI in four or more business functions and that they have embedded a higher number of AI capabilities. For example, respondents from high performers more often report embedding knowledge graphs in at least one product or business function process, in addition to gen AI and related natural-language capabilities.

While AI high performers are not immune to the challenges of capturing value from AI, the results suggest that the difficulties they face reflect their relative AI maturity, while others struggle with the more foundational, strategic elements of AI adoption. Respondents at AI high performers most often point to models and tools, such as monitoring model performance in production and retraining models as needed over time, as their top challenge. By comparison, other respondents cite strategy issues, such as setting a clearly defined AI vision that is linked with business value or finding sufficient resources.

The findings offer further evidence that even high performers haven’t mastered best practices regarding AI adoption, such as machine-learning-operations (MLOps) approaches, though they are much more likely than others to do so. For example, just 35 percent of respondents at AI high performers report that where possible, their organizations assemble existing components, rather than reinvent them, but that’s a much larger share than the 19 percent of respondents from other organizations who report that practice.

Many specialized MLOps technologies and practices  may be needed to adopt some of the more transformative uses cases that gen AI applications can deliver—and do so as safely as possible. Live-model operations is one such area, where monitoring systems and setting up instant alerts to enable rapid issue resolution can keep gen AI systems in check. High performers stand out in this respect but have room to grow: one-quarter of respondents from these organizations say their entire system is monitored and equipped with instant alerts, compared with just 12 percent of other respondents.

3. AI-related talent needs shift, and AI’s workforce effects are expected to be substantial

Our latest survey results show changes in the roles that organizations are filling to support their AI ambitions. In the past year, organizations using AI most often hired data engineers, machine learning engineers, and Al data scientists—all roles that respondents commonly reported hiring in the previous survey. But a much smaller share of respondents report hiring AI-related-software engineers—the most-hired role last year—than in the previous survey (28 percent in the latest survey, down from 39 percent). Roles in prompt engineering have recently emerged, as the need for that skill set rises alongside gen AI adoption, with 7 percent of respondents whose organizations have adopted AI reporting those hires in the past year.

The findings suggest that hiring for AI-related roles remains a challenge but has become somewhat easier over the past year, which could reflect the spate of layoffs at technology companies from late 2022 through the first half of 2023. Smaller shares of respondents than in the previous survey report difficulty hiring for roles such as AI data scientists, data engineers, and data-visualization specialists, though responses suggest that hiring machine learning engineers and AI product owners remains as much of a challenge as in the previous year.

Looking ahead to the next three years, respondents predict that the adoption of AI will reshape many roles in the workforce. Generally, they expect more employees to be reskilled than to be separated. Nearly four in ten respondents reporting AI adoption expect more than 20 percent of their companies’ workforces will be reskilled, whereas 8 percent of respondents say the size of their workforces will decrease by more than 20 percent.

Looking specifically at gen AI’s predicted impact, service operations is the only function in which most respondents expect to see a decrease in workforce size at their organizations. This finding generally aligns with what our recent research  suggests: while the emergence of gen AI increased our estimate of the percentage of worker activities that could be automated (60 to 70 percent, up from 50 percent), this doesn’t necessarily translate into the automation of an entire role.

AI high performers are expected to conduct much higher levels of reskilling than other companies are. Respondents at these organizations are over three times more likely than others to say their organizations will reskill more than 30 percent of their workforces over the next three years as a result of AI adoption.

4. With all eyes on gen AI, AI adoption and impact remain steady

While the use of gen AI tools is spreading rapidly, the survey data doesn’t show that these newer tools are propelling organizations’ overall AI adoption. The share of organizations that have adopted AI overall remains steady, at least for the moment, with 55 percent of respondents reporting that their organizations have adopted AI. Less than a third of respondents continue to say that their organizations have adopted AI in more than one business function, suggesting that AI use remains limited in scope. Product and service development and service operations continue to be the two business functions in which respondents most often report AI adoption, as was true in the previous four surveys. And overall, just 23 percent of respondents say at least 5 percent of their organizations’ EBIT last year was attributable to their use of AI—essentially flat with the previous survey—suggesting there is much more room to capture value.

Organizations continue to see returns in the business areas in which they are using AI, and they plan to increase investment in the years ahead. We see a majority of respondents reporting AI-related revenue increases within each business function using AI. And looking ahead, more than two-thirds expect their organizations to increase their AI investment over the next three years.

The online survey was in the field April 11 to 21, 2023, and garnered responses from 1,684 participants representing the full range of regions, industries, company sizes, functional specialties, and tenures. Of those respondents, 913 said their organizations had adopted AI in at least one function and were asked questions about their organizations’ AI use. To adjust for differences in response rates, the data are weighted by the contribution of each respondent’s nation to global GDP.

The survey content and analysis were developed by Michael Chui , a partner at the McKinsey Global Institute and a partner in McKinsey’s Bay Area office, where Lareina Yee is a senior partner; Bryce Hall , an associate partner in the Washington, DC, office; and senior partners Alex Singla and Alexander Sukharevsky , global leaders of QuantumBlack, AI by McKinsey, based in the Chicago and London offices, respectively.

They wish to thank Shivani Gupta, Abhisek Jena, Begum Ortaoglu, Barr Seitz, and Li Zhang for their contributions to this work.

This article was edited by Heather Hanselman, an editor in the Atlanta office.

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