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Entrepreneurs Can Pay It Forward Through Angel Investing This type of startup financing gets you in on the ground floor with companies of your choosing.

By Brenton Hayden Edited by Jason Fell

entrepreneur daily

Opinions expressed by Entrepreneur contributors are their own.

Small businesses play a vital role in fueling the economy, making critical contributions that help to keep our country alive. They're crucial for job creation, responsible for two out of every three net new jobs in the country and pay for more than 44 percent of the U.S. private payroll.

But in recent years, small businesses have taken a tremendous hit. While small companies are drivers of the U.S. economy, contributing a significant amount through payroll and taxes and providing the lion's share of job opportunities, they were among the ones to be impacted the most by the recession. They have also been the slowest to recover. The credit crisis hit small companies especially hard and because of this, banks are still reluctant to approve financing for small businesses. It's difficult for startup founders to get the funding needed to launch.

Related: 4 Steps to Bolster Your Retirement Egg With Peer Lending

Enter angel investors: the modern alternative to traditional funding. Where banks and venture capitalists are falling back, angel investors are stepping up, and proving to be invaluable for small companies and the economy. In 2011, angel investors invested more than $22 billion in approximately 65,000 companies, compared with venture capitalists, which only invested in about 3,700 companies. Angel investors fund more than 16 times as many businesses as venture capitalists, a huge percentage that only continues to grow. Angels generally invest smaller amounts of capital in companies, often at much earlier stages than venture capitalists.

In many cases, a small influx of initial funding is exactly what a startup needs. Thanks to a $3,000 loan from my dad, I was able to start my company. While it wasn't a tremendous amount, it was exactly what I needed to take a real estate course, which is what allowed me to found Renters Warehouse.

Angel investors can be professionals such as doctor or lawyers, or entrepreneurs who are interested in helping the next generation of up-and-coming startup founders. This is an area that I personally have been privileged to be a part of, and investing in new companies and young entrepreneurs is a cause that's close to home for me.

Aside from the chance to be a part of something tremendously exciting, the opportunity to help a new business get off the ground, and the option to grow in a new industry, angel investing offers some tremendous financial rewards as well. As with any investment though, it's important to enter into angel investing with both eyes open.

If you're interested in getting in on the action, or looking to learn more about angel investing, here's what you should know.

1. Only invest if you can afford it.

Before investing, it's important to weigh up the pros and cons. Angel investing offers significant returns, but it's also an extremely high-risk venture. Only invest if you can truly afford to lose 100 percent of your investment. It's also worth noting that angel investing is very much a long-term opportunity, and you most likely won't see a return for a number of years. If you're in, you're in for the long haul.

2. Make sure you truly believe in the startup team.

If you don't feel right about the investment opportunity, don't invest. On the other hand, if you truly believe in the idea and even more important, if you believe in the startup team, then go ahead and take the leap. At the end of the day, ideas can change, and concepts come and go. The team is what will matter most, and it's important for you to be able to trust their sense of judgment and ability to make important business decisions.

Related: Answer These 6 Questions Before Sinking Money Into Some Entrepreneur's Great Idea

3. Look at the returns.

In addition to gauging the viability of the idea, and the startup, it's important to look at the projected return on investment. Angel investors typically look for opportunities that can return 10 times their initial investment within five years. Look for an option that holds significant potential to make the investment worth your time and effort.

4. Help dominate in a niche-area.

It's ideal to stick to investments within your niche as you already have a considerable advantage given your experience in that field and your ability to better gauge the likelihood of the investment's success. You'll also be able to contribute valuable guidance, and insight to the startup, since you will have been there yourself. I'm primarily interested in investing in young entrepreneurs. It's an area I have personal experience in and is something that I'm passionate about.

5. Diversify.

One of the main rules when investing: try not to put all of your eggs in one basket. It's better to spread things out to help reduce risk and maximize returns. Investing in a handful of different startups will often provide the best returns for an angel investor. Out of 10 investments, there's a good chance that one or two companies will be responsible for 100 percent of your returns. So choose wisely, and try to diversify.

6. Do your homework.

The founder's goal is to get you excited about the company, but don't be blindsided by pure enthusiasm. While it may sound counterintuitive, it's important to always be skeptical. This means taking the time to do some digging on your own. Make sure you conduct your own independent research to confirm the validity of the investment. Instead of basing everything on the founder's pitch, search out the facts yourself.

According to a study of angel investment returns, which analyzed results from 86 organized angel investor groups throughout the U.S., angels achieved an average 27 percent internal rate of return on their investments.

Investing in startups, while high-risk, can also offer tremendous rewards and is a great opportunity if you prefer hands-on investing rather than taking a backseat approach. For entrepreneurs especially, who have relevant knowledge on new markets and firsthand experience with running startups, angel investing can be an especially rewarding opportunity. By choosing your startup carefully, and making contributions through mentoring or by taking an advisory role, the chance of your investment generating significant returns will be even higher.

One of the best things about angel investing is that it gives you a chance to interact with the startup founders, allowing you to directly influence the success of your investment. That's something that you just don't have when dealing with many traditional investments.

Give a small business a leg up, and help boost the economy, while generating returns on your investment. Are you ready to get involved?

What do you think? Are angel investors the future of startup financing? Share your thoughts in the comments section below.

Related: Thriving in Finance Requires Patience and Humility

Brenton Hayden

Founder of Renters Warehouse

Brenton Hayden is the founder and chairman of the board of Renters Warehouse. A Harvard Business School and MIT Sloan School of Business graduate, Hayden leads a team of over 140 employees and franchises in 21 states with a portfolio of managed properties valued at just under $1 billion.

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