I’ll be attending Angel Boot Camp II in Boston on June 14. It’s a terrific event run by Jon Pierce, with lots of opportunities for talking strategies, meeting lots of angels and VCs, and even seeing a few select companies. (Anyone interested, it’s free but you must register.) I’ll be at a breakout session with Sim Simeonov, former VC at Polaris, current angel and born-again entrepreneur with FastIgnite and Shopximity. Last year Sim gave a great talk on the diversification needed to shift the odds in your favor on investing, but I’m going to do something more prosaic here…run through a fictional case study which lays out a groundwork for a high net worth individual who wants to know how much she can invest in startups. I’m going to present a framework for each reader to be able to adopt as they wish, but I hope any real angels out there take out the spreadsheet and re-calculate what they should be doing.
For my math, I’m going to assume new angel Angela has a net worth of $10 million, of which $2mm is in restricted, non-liquid stock in her company or employer, an income equal to her expenditures, and $2mm in other illiquid assets (house, art, cars, etc.,) leaving $6 million in liquid securities. She has a taste for risk, having been an entrepreneur and is considered a sophisticated investor. Best of all, she has experience, street smarts and wants to become an active angel and mentor. Great! The question is, how much should she be investing and at what pace? (It goes without saying that I’m not giving any financial advice to anyone specifically, just laying out a framework for thinking about angel investing.)
How much can Angela dedicate to investing in startups?
This is an answer that keeps changing as markets fluctuate, and as her own experience increases. However, no matter how much she enjoys angel investing, there’s no denying it is a very risky business, with the majority of angel investments according to at least one study ending up as a total loss. While there are many hedging techniques to reduce losses that can be used by institutional money managers in public securities markets, they just don’t apply to private equity, VC and angel investing. No short selling, option writing, liquid indices, anything that can give protection in down markets. So the first rule is “Don’t invest more than you can lose.” Most startups fail, even startups good enough to get outside funding as a majority lose money. Two of my favorite VC bloggers, Brad Feld and Mark Suster, lay out their suggestions for angel investing here and here, and both talk extensively about risk. So, the maximum you can bet is the maximum you can lose. Angela has sufficient funds set aside for her retirement plans, but I’m going to bet that her restricted stock in her own company is better considered as a highly concentrated, high beta, illiquid investment…so she should discount it highly in her own private valuation. I’ll still argue that she could lose more than $1.5mm in her net worth without great worry. Since she has more than that at risk in her illiquid stock, does that freeze her out? No, but it’s just a cautionary sign to take it slower than she should if she was 100% in liquid securities. I’m not in a position to judge anyone’s capacity for risk, but let’s in this instance say that we’ll limit her maximum investment in angel investing to $1mm. (Side note—lots of folks in their mind write up the value of their angel investing to reflect higher priced rounds and make them feel good. For this exercise, you should not do so, and just look at your cash outlay, and when valuing your holdings, use lower of cost or market.) Now, $1mm in my opinion is still way too high for Angela to be investing in startups if she is new to this field, but I’m going to use it for this example because it makes for easier math. If you haven’t really thought hard about your financial asset allocation, take a moment to do so here. (There’s no category for illiquid securities, as this is from Vanguard, which sells low-cost index funds. Just consider your angel investment akin to a go-go high beta equity fund.) Remember the old joke: the best way to make a small fortune in private investing is to start with a large fortune. Caveat emptor.
Reserving for Follow-Ons
When I first started angel investing, I was unsure of why I should be reserving money for follow-ons. My logic was that if I picked a bad company, I shouldn’t be putting more money into it, and if I picked a good company, the price would be higher in a subsequent round. Hence, if anything, if I wanted to create an evenly-weighted portfolio with, say, 20 companies, shouldn’t I dedicate all 5% (or $50k) into the company at the start? The quick answer is no.
Almost any startup company that is worth investing in is going to want to try to scale and get big at some point, and that probably is going to require more capital. The better question is how good are they at raising funds? Unless there is an experienced, multi-time entrepreneur involved, or a deep-pocketed VC within the round, raising funds is a royal pain, hence that company is going to be coming back to you again for more money. The smaller or weaker the syndicate of initial angels, the more they will need to hit YOU up for funds to make it through to that next big milestone. This doesn’t mean it’s a bad company, it just means that in an environment where VCs are dropping like flies due to their own difficulties in raising capital, the more angels have to look to themselves to provide funding until the company gets self-sufficient from a revenue point of view. I would suggest that Angela reserve 50% of her intended investment in the company in anticipation of at least one follow-on round. This is not to say that you bail out the dogs, but rather that the companies which show that they can hit milestones be further funded. It also means that if you have no stomach, time or talent for this type of investing and get out after a year, you’ll have invested less money and hence have less ulcers. (Note, the next follow-on round may well be the best round from an ROI point of view; while the company may get a higher valuation, it also should be significantly de-risked, with major milestones cleared with some sort of exit or good product/market fit in sight.)
Will Herman, TechStars mentor and Boston angel investor, reasons:
Keep some powder dry for subsequent rounds – while the best return in a successful investment comes from investing earlier, holding some cash back to see how the company does and to play alongside any institutional money that comes into the company mitigates some risk and ensures you’re playing on the same terms as the rest of the investors.
What’s the bottom line for Angela? On that $1mm of money dedicated to angel investing, perhaps 1/2 should be made in the initial seed round investments, with the other half in reserve for follow-on. That math begs the question—how many initial investments should I be considering in my portfolio?
Diversification—what’s the minimum prudent number of investments?
Successful angels need a lot of things going for them, but the most important one probably is early luck. Hitting an early winner means you can play with house money, invest in more startups, get in better deals, and dramatically increase the odds of your success. But you need to assume that your luck (and your ability to pick winners) is not any better than the norm. So, you’ll need to diversify. What’s the right number? Everything is an educated guess, as there is a paucity of good data on the topic. Sim Simeonov did a rigorous Monte Carlo simulation using the best data he could find, and his results showed this:
Median returns vary substantially with portfolio size. Going from 5 investments to 10 investments increases median return by 68%, from right around 1x to nearly 1.7x. There are diminishing returns to growing portfolio size. Going from 10 to 15 increases median returns by another 40%. Doubling portfolio size from 15 to 30 adds another 50% but then in takes going all the way to a whopping 125 company portfolio to triple median returns compared to the 5 company portfolio. Similar conclusions apply with respect to other metrics. The probability of getting a return that’s greater than 2x doubles (from 34% to 69%) as one moves from a five company portfolio to a 50 company portfolio.
Thus, the number I used for diversification, 20 companies, should begin to get good odds. I think by planning on 20, you will be investing less money in more companies, both improving your odds of winning, but more importantly reducing your risk of losing your shirt. Again, should you decide that angel investing is not for you after investing in half a dozen deals, you will have had a cheaper education than if you had originally planned for investing just in 10. And if you continue doing angel investing, you will hopefully enjoy a better experience. More deals means more networking, more education and better future deal flow. So think more bites and smaller portions—like eating tapas instead of gorging out at an all-you-can-eat pancake breakfast.
Back to Angela: If she is going to invest $1mm, with $500k going to new companies, and she targets 20 investments over 4 or 5 years, that implies an initial check of $25k, which is fairly normal in angel world. If she only is going to invest $500k, either her check needs to get smaller (and unless you’re in via a group, I don’t think very many hot startups would want to add an investor for less than $10k ever unless they brought a lot of other value to the table) or she needs to consider rolling back her target number of companies…but if you can’t do eventually get to 10, just invest via commingled funds.
How Do You Know if You’re a Junkie?
The other side of the coin from diversification is over-investment. Once you have a number, stick to it. As I mentioned in this post, I have to monitor myself and slow myself down at times. There are times when you can break the rules–I, for instance, had a thesis on valuations that made me believe that liquidity could get a higher premium post market crash of 2008, so I made a conscious decision to a) wait to see the dust settle a little in 2009, but invest more in 2010-2011, and less thereafter. It was a conscious decision not to dollar-cost-average, but rather try to over- and under-weight my investments. So far the decision to stay in public markets mostly in 2009 seems to have paid off, but only time will tell if my angel investments will-outperform the far more liquid (and hence less risky by most standard definitions) public markets. So even though I’ve made a lot of investments in the past two years, I’m counting on my ability to slow it down and just say no. Make a plan, stick within the broad guidelines, and if you find yourself revising the plan to invest more and more, re-examine your assumptions and motivations. Like with any other addiction, if you find yourself where you can’t control yourself, just go through the twelve steps. Reread point one: don’t invest more than you can lose.
The Pace of Investing
You never know when you’re in a bubble except with hindsight. Even then, many great investments (like Google or Zappos) debuted nearly at the peak of the bubble. Accordingly, dollar-cost-averaging is a good rule to go by, allowing you to avoid getting walloped and also letting you stay in the game. 20 companies spread out over 5 years means 4 companies per year, which puts someone in the active, or at least serious, angel pace. But it’s almost a sure thing that your ability to judge companies will improve dramatically over your first few investments, especially if you are participating in one or more angel groups. So my first recommendation is that while you need to get your feet wet, you should make sure to see at least a half-dozen deals, and probably more, before you make any commitments, and that you consider that your first commitment be for less money than you would otherwise normally do. And that those first investments should be following on the coattails of some experienced angel investors you trust, not just your cousin or uncle promising a good opportunity. You’ll need to get your feet wet, and you need to be fairly promiscuous in order to get diversification, but kids, don’t try this at home alone. Hunt in a pack. There’s nothing you can do that will improve your odds better than sticking around savvy investors. Which is why you need to get in an established angel group, and if possible, attend events such as Angel Boot Camp.
As for me, I could be charged with being closer to the “spray and pray” approach, aiming to invest in 12-15 companies per year, which is why I belong to multiple angel groups, follow AngelList, get involved with MassChallenge, TechStars, attend or follow via streaming media conferences like Launch, TechCrunch Disrupt, etc. But concommitantly, I keep my bite size smaller, and also do not participate past A rounds. But I’ve got a strategy, and am sticking to it. There’s no guarantee that I won’t lose money, but if I stick to the discipline, I can’t lose my proverbial shirt.
One Alternative: Investing 25% of Your Angel Allocation into Commingled Angel Funds
There are several other ways to get diversification, education, proper pacing, and cocktail bragging rights as an angel, but the best one for beginners is via a commingled angel fund, sometimes called “SuperAngel” funds. These are actually like any other private equity fund, with professional management, a steep but justifiable fee structure (typically 2% per annum, plus 20% of profits after the return of capital,) and a rolling call on capital. This allows you to commit to a certain amount (let’s say $100-200k) far greater than you would put up in any one deal, but be paying it out typically over anywhere from 3-6 years. Management will take care of all paperwork, tax calculations, etc. I have invested in a few funds (CommonAngels III, Project 11, as well as investing in a well-known incubator, and am planning 1-2 more), and one of the great benefit is access to those fund managers to hear their rationale for investing. There are some other groups (e.g., Hub Angels) where the whole purpose of the group is to discuss and jointly decide on pooled investments. While I prefer personally to pull the trigger myself, investing in a fund such as this, or a “side-car” fund is a solid way to access the wisdom of fellow investors to reduce the risk of your investment decisions. One can make the case for investing in sector specific funds, funds outside of your geographical area, etc. As I mentioned here, I’ll be doing a series on analyzing and investing in commingled funds in the weeks to come, for selfish reasons. Lots more to come. Now, whether you’re an experienced angel or a novice, take out a piece of paper and a pencil and make sure your investing practice fits into a sensible framework. As all good carpenters know, measure twice and cut once.