What is Angel Investing? How Does it Work and Who Should be an Angel Investor?
In his book, Angel: How to Invest in Technology Startups — Timeless Advice from an Angel Investor Who Turned $100,000 into $100,000,000, Jason Calacanis argues that since the beginning of the 21st century, household income has not kept pace with the rate of inflation and the overall growth in the economy, which has only contributed to ever-widening income inequality.
While the 50s through the 70s saw a white-collar worker able to afford to enjoy the benefits of owning a house, having the latest car and sending their children to college — this scenario has become more of a luxury than the norm for today’s typical worker. Today’s average worker is more often than not, perpetually drowning in student loans and struggling to earn enough to afford a suitable home for their family. Making ends meet today means that families tend to need both partners in the workforce, earning steady incomes. These same individuals are also forced to wait longer and longer to retire, despite their dual incomes.
In light of this, Calacanis proposed a new method of wealth creation for the modern worker: Angel Investing. He suggests that one deploy up to 10% of one’s net worth in Angel investing.
He also writes that you need to invest in at least 50 startups to see outsized returns.
While he tries to address how one can start angel investing without already having a 7–8 figure net worth. His argument leaves much to be desired; however, that will be a conversation for another day.
Throughout the 20th century, great wealth was created for many by way of the innovation of the industrial revolution. And it was via investment and initiative in both technology and communications infrastructure that drove a majority of wealth creation. This included the pioneering railroad magnates, rubber barons and steel tycoons.
While the leaders of that generation certainly drove the creation of tremendous wealth, the amount of wealth that has been generated in the past 20 years actually dwarfs that of the 20th century, even in real terms.
This is good news, because it demonstrates that there are a plethora of opportunities for today’s modern wealth seeker. And it is not just the entrepreneurs that will benefit from wealth creation, but all parties that truly contribute to the ecosystem of innovation — including the angel investor.
It is thus wholly reasonable to define a strategy of wealth creation by investing in those entrepreneurs who will (hopefully) define this new era of technological innovation and the pioneers who will in turn invest in these founders and enjoy outsized returns.
However, the problem with this argument is that in order for the average person to participate, they would likely be writing relatively small checks. It is improbable for example to say that the average person would write fifty $50,000 checks — so diversification becomes increasingly important.
Below I will try to quantify what a typical $50,000 check would get an investor, and given a conservative batting average, what sort of returns that investor could expect from the winners in the portfolio. The crux of the matter clearly is whether the returns generated from the winners in a portfolio supersede the losses that will undoubtedly be sustained with the non-performing companies in the portfolio.
The problem with Mr. Calacanis’ argument arises when one considers angel investing for the normal person, who typically doesn’t have a great deal of excess cash at their disposal. For this population, this would entail writing relativelysmall checks in a variety of high-tech startup sectors to diversify and minimize risk.
Playing to Win Doesn’t Mean Every Bet is a Winner
One of the most successful entrepreneurs-turned-VCs in Silicon Valley is Peter Thiel, who when talking about venture capital as a capital allocation business model, has repeatedly pointed to the power law distribution and its implication: the 80–20 rule. This rule when applied to an investment fund implies that 20% of the fund is responsible for 80% of all returns generated. When looking at an Angel fund or VC fund this is much closer to a 5%-95% distribution as Marc Andreessen of Andreessen Horowitz points out here.
The truth is that VCs often write off over 50% of their investments. Of the remaining 50%, most will return very little or might even lose money, while the remainder will return a multiple on the original investment.
However, there are very few that show such outsize returns that would qualify them as “hyper-performers”. Hyper-performers compensate for losses in the portfolio and will generate a return on the overall value of the total funds invested. These outcomes are unlikely, but extremely high-value.
The above implies two rules for VCs as well as Angel Investors: “First only invest in companies that have the potential to return the value of the entire fund…” Second rule states that the first rule is so paramount that there could no other rules![1]
A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It’s true that in theory, the math works out the same you try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets.
-Peter Thiel
This is where I believe the idea of investing one’s savings in technology startups as an Angel Investor is a very risky and borderline reckless proposition for the general public. While the allure of finding the next Google, Facebook or Uber might be very tempting the reality is these are anomalies amongst tens of thousands of failures that you may never have heard of and unfortunately, the countless individuals from accredited investors to friends and families of founders who have supported them have ultimately parted with their capital for good.
