Angel Investing: The Real Make-or-Break Issue
Posted by Bob Rice on January 23rd, 2012
We’ll get there, but let’s start here: I don’t believe in “angel portfolio theory,” which applies Wall Street’s favorite myth to the early stage world. According to this approach, the “smart” way to do angel investing is massive diversification, with scores of early stage bets.
There are several reasons that this common wisdom is more the former than the latter, but let’s start with an indisputable fact. Even assuming portfolio theory works for public markets (it doesn’t), the idea rests on the premise of an efficient market: liquid, broad and transparent, with distributed information, educated investors, structural consistencies, and reliable reporting. Does that sound like the startup world to you?
Moreover, while “diversification” can be attractive in the abstract, angel investing takes a lot more work than its public securities counterpart, if only because of the massive diligence it demands. So unless you have quite a staff at your disposal, investing bazooka-style is likely to be hazardous to your sanity as well as your wealth: just try chasing down those scores of non-responsive entrepreneurs to see what’s happening with your money.
So, how does one intelligently invest in a limited number of startups, when we all know how unpredictable their outcomes may be? My personal answer is: force the results to be less random by only investing where you can take a semi-active role. This certainly doesn’t mean that you must join the board or participate in every decision. But it does mean you should be in a position to help make strategic connections; provide feedback on tech, or marketing, or something; maintain some basic relationship with management; and have a sense of your own about how the company is progressing over time. That last point is really critical, because here it is: the make or break issue in angel investing is not the first check; it’s whether, and for how long, to make the inevitable follow-on investments. And you simply can’t make intelligent decisions about that without knowing the evolving story of the company quite well.
For me, the sweet spot is about 8 active deals at a time. I stick with them, keep working, participate in follow-on rounds, help identify what’s working, understand that pivots are part of the deal, and look for exits. To this particular angel investor, that approach is a lot more promising, and ultimately satisfying, than “spray and pray.”
All opinions expressed are those of the author, and do not necessarily represent those of Gust.
Written by Bob Rice
Bob Rice
Managing Partner,Tangent Capital
Bob is Managing Partner of Tangent Capital, a registered broker-dealer and merchant bank focused on alternative assets and strategies. He is the resident industry expert on early stage and other private investments for Bloomberg TV, appearing daily as Contributing Editor on “Money Moves.” Bob is a Director of asset management companies with over $2 billion in AUM. Bob began his career as a trial attorney at the U.S. Department of Justice and then became a partner at Milbank, Tweed, Hadley & McCloy, where his practice centered on financial products. He left the law in 1996 to found a 3D graphics technology startup that eventually became the publicly traded Viewpoint, provider of the web’s first “rich media” advertising platform. He has been an active angel investor and startup mentor since 2004. Along the way, Bob also served as the Commissioner of the Professional Chess Association and authored the business strategy book Three Moves Ahead.
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Great post, Bob-
I’ve been angel investing since 1980 having made about fifty investments in three decades. But I seldom have more than ten active investments. As you know, the failure rate is about 50% and the failures tend to happen quickly (<3 years). In fact, I know very few angels who have more than eight active (current) investments.
Super Angels, on the other hand, seem to be making about ten investments per year, many more than the typical angel investor.
I'm sure you are aware of Rob Wiltbank's 2007 study of angels investing with groups. His study suggests a few outcomes relevant to your post: (1) ROI for angels improves with their familiarity with the business sector, (2) Angels who are actively engaged with portfolio companies have better ROIs than those who are totally passive and (3) ROI for deals in which angels do follow-on investment are lower than for those in which they make only one investment. This last point seem counter-intuitive, but it may be indicative of some angels "throwing good money after bad."
Your observations are instructive for all of us who are investing as angels.
Bill