OK, the title of this post has ensured that I’ve gone and blown any shreds of suspense. But I’m writing this to get feedback from all of you, so feel free to pick apart my logic.
Angel investing itself is 100% bottom-up, i.e., picking the right companies. However, in order to figure out how much I have to spend, I need to think top-down, or macro. I start by figuring out how much is a proper amount to go into illiquid assets, and after subtracting housing and existing private equity (which includes my remaining stake in my old startup), I then determine what’s left over to go into early stage. Finally, I need to figure out a time period.
I started investing in startups (not including my own) in early 2009, which was a great time to invest…but the size of the investment pie to split up was smaller because of the stock market crash. The logic for jumping in then was two-fold. As liquidity was drying up, private equity should be scarcer, and thus be able to get higher returns on less risk than usual. (First disclaimer: while we won’t know the side by side results for years, it’s hard to argue that I shouldn’t have put EVERYTHING into the public markets from a risk-reward point of view. With public markets up 50% in general off the lows, I’m betting the average public manager will have done better in 2009 than the average VC cohort, without sweating over the risks of illiquidity.) Second part of the thesis was the observation that many of the best startups are funded in bad economic times, given the ability to assemble a great team of workers who otherwise have few prospects.
The plan was to try out 3-4 investments, and if I wasn’t spooked by the process, to go on to acquire stakes in 20-30 companies in the next 30 months. I figured that that volume was the bare prudent minimum for diversification…and even then realizing that an uncomfortable amount of return would be up to chance. Like Brad Feld here and Sim Simeonov here and here say, it pays to be promiscuous by making lots of bets. (It should be noted that over time, as my initial investments have been getting more frequent, they are getting smaller, while I’m reserving more for follow-ons.) Since I see that startup valuations are going the wrong way—higher and frothier—my hunch is that I am better off investing more and sooner rather than dollar-cost averaging over, say, a year-longer period. If the markets stay frothy, then I should have some exits and the ability to re-invest again, should I so choose.
So far, so good. 2 exits (CardMunch, and an unnamed medical device company) already this year, with no angel investments yet on life support. My very first angel investment went on to a fair-sized B round injection from Bain Venture Capital; while that might seem like a good sign, personally I prefer aiming for 3-5x early exits as opposed to holding out for the 20x mega-hits required by large VC firm math. (See Basil Peters’ terrific book Early Exits for more on this topic.)
Believing that a) diversification is good; and b) I don’t have all the answers; I’ve also committed to three commingled early stage funds: CommonAngels Fund III; Project 11 Fund I; and TechStars Boston Funds 2011-14. (I should note that this mixing direct angel investments with investments in early stage funds is copied from a few successful angels I admire, including John Landry.) However, I’ve passed on the chance to diversify in several other well-respected seed funds. I passed late last year on an attractive secondary opportunity in a small VC fund where I could have bought into some old positions at par, even with the knowledge that there was at least 1 good sized winner in there. My rationalization, which may be dumb from a financial point of view, was that even though that investment probably will offer more return than what I will achieve with that same money, I wouldn’t learn as much or have nearly as much fun as I would by investing directly—when did you ever hear of a minor LP getting in to talk strategy with a VC’s portfolio companies? Instead, I am able to invest in another 10 startups. And in the two other cases I passed on that had lower minimums, the investments previously made in those funds just didn’t resonate with me, in spite of their logic. While the funds in which I did invest didn’t have any such “free look”, I really liked the philosophy, resources and backgrounds of all of those managers. The bonus: along with the potential investment return comes the terrific opportunity to get that much closer to both the funds’ managers, but also to their underlying portfolio companies. The negative—all three are in the same geographic area, in more or less the same sectors.
Which is why I still am probably going to make one more pooled fund investment, and then probably call it a day. Being overweighted in Boston, both by funds and in individual companies, I want to diversify geographically and get more insights into the Montreal scene. So as soon as they open up their Fund 2, I’m hoping to invest in the next fund started at Year One Labs. Philosophically, I consider Year One Labs as identical to Project 11, just dressed in an anorak and a toque. While I think highly of the folks at Real Ventures, another Montreal startup fund, I favor Y1Labs for 3 reasons: the smaller scale, mentors, and existing portfolio. Raymond Luk talks with Daniel Drouet about Year1Labs in this video.
I was fortunate to visit Year One earlier during an Investor Day, in which they paraded out their 5 current companies in their current (first) fund. While the portfolio companies were great (especially LOCALMIND! and the game company PLEASE STAY CALM!, both of which moved to Montreal to take advantage of the YearOneLab program,) just as attractive to me was the list of mentors they have brought together. Just as I adore being involved with TechStars mentor program, being able to sit in and watch and learn from the great TechStar Boston mentors, it’s the same at YearOneLabs. Virtually all of their mentors have successfully founded one or more successful businesses, with most having exits as well. Interestingly, a good number of these Y1L mentors travel into Montreal from Ottawa and Toronto, giving them longer commutes in than I have from Burlington, VT. Lastly, while TechStars is pretty large (80 mentors just in Boston), and Project 11 itself is a small startup, YearOneLabs has that Goldilocks “just right” feel. It’s more intimate than, say, Real Ventures in Montreal, which has more than $50 million in dry powder, with much of that raised via governmental mandates as opposed to angels. I haven’t figured out whether that’s good or, as one Montreal entrepreneur who left for Silicon Valley, believes, bad; with no such debates, I’ll instead be lining up at the YearOneLab queue when it opens up its second fund.
Which leaves angel investments. I’m slowing down my direct investment pace as I slowly have established some diversification in my angel holdings. And as my available discretionary funds begin to draw down just as my deal flow is ramping up, I need to be pickier going forward.
So, what to choose? First, I anticipate investing in 1 or more companies in this year’s TechStars Boston class. (Technically, I’m investing in a teensy-weensy fraction in all of them via my TechStars Fund exposure, but I mean a specific, targeted investments, not in the class as a whole.) There are 12 companies currently in the program, and I’m fortunate to be able to have a front-row seat as they work through product-market fit issues. Being a mentor allows me terrific access (effectively, better diligence and possibly a better investment) to see which companies I want to spend the next several years with as an investor. Many talented companies I’ll pass on, just because I don’t understand their product or field. Still, being able to receive weekly updates and data from each of the ones that interest me is truly a blessing—I can foresee where a significant percentage of any seed round raised comes just from mentors. That access is an edge I normally will never have as just some angel group member. How will I choose among the last 3-4? For me, a big factor will be the momentum each establishes over the three month program, and how wisely they use that time to make meaningful connections. By the way, at this point I just don’t think of this allocation as another Massachusetts investment. The companies come from Estonia, Israel, England, Memphis, Texas, San Francisco–all over. So who knows….
I also have joined Anges Quebec. If I’m serious about the investment opportunities in Quebec (other than those sourced at Year One Labs), I’m going to need good guides. And when the leading Quebec angel group has raised a $20mm sidecar fund to co-invest in the companies they back (such that I know that any dollar I invest is matched by two other dollars), a lot of future funding risk is lowered. So à partir de maintenant, je suis fier d’être membre.
I will continue to see deals from North Country Angels and AngelList, which are the largest deal sources for me to date with 6 and 5 deals respectively. Plus my favorite angel group, Open Angel Forum. But I expect their percentages to drop as I get increasingly picky.
Now for my favorites: there are two other companies who haven’t come to market yet who I’m saving ammo for, one of whom I know well from the MassChallenge 2010 class. (Yes, you guys know who you are.)
So, that makes for some tough math: if I want to keep my discipline and keep it down to 8 more individual deals in 2011, and I’ve already soft-circled 3 in the pipeline, and I expect another 1 or 2 from TechStars, that only leaves 3-4 deals left in 2011 from all other sources. I’m going to have to be very, very choosy. David Rose, CEO of AngelSoft, discusses this well on Quora. I could perhaps do more deals if I chose not to participate in follow-on rounds, but for now I’m reserving 75% of my initial purchases for those, assuming a doubling down on ¾ of the deals, and passing on ¼. But I’m not going to blow my discipline. The old joke still applies: How do you make a small fortune in angel investing? Start with a larger one.
So, that’s the playbook as it stands now. I’m not considering cold deals from over the transom, although I feel obligated to give a response to any entrepreneur who asks. And while I know a lot depends on luck, I am trying to bring some institutional logic and discipline to a field where frankly, most people lose money, and most deserve to lose it.
Now I’m asking you, readers, to give me some hints on where my macro logic needs some retuning. What percentage do you feel is appropriate to put into angel investments? For ease of math, start with a $10mm liquid portfolio, assuming no other appreciation over time. How much should be sold and allocated to startups? How much of that gets allocated to funds, with better diversification—and perhaps management—but higher fees? What time frame do you now feel is appropriate to assume for an average life until exit of the companies that remain viable? (I’m using 8 years on average, expecting at least one of the hoped-for winners to take more than 12 years to exit, and I expect to rolling reinvest any proceeds.) What should be the average pre-money valuation for the portfolio, and what’s the top price you’d pay? (I personally no longer consider investing companies above $4mm pre-money valuations, and expect to sit out the cycle when that happens…and it looks like it’s already happening on the West Coast.) And lastly, would you opt for smaller than average size investments, perhaps getting shut out of some more competitive deals, in order to spread the same amount of money on more bets?
Fire away in the comments section below or just email me directly if you want anonymity.