Angel investing misnomers
This post is adapted from Josh Maher’s blog.
I hear a lot of misnomers about angel investing. Some are grounded and some are far from grounded. Before you completely discount angel investing or early stage investments from your investment portfolio — read through these and let me know what other misnomers are out there…
I’m a great financial analyst and therefore I’ll be a great angel investor — sorry, one does not follow the other. You may be a great financial analyst AND a great angel investor, but often there is limited financial detail to analyze at the stage of investments that angels participate in. There is certainly a requirement to understand the capitalization of the business, how many rounds will be required, and who will invest in those rounds — but there is very limited current financial analysis involved
It’s called angel investing because I am giving my money away — don’t confuse angel investing with philanthropy. One thing the majority of the fifty or so top angel investors I interviewed from my book agree on is a broad diverse portfolio is important for angel investors. Meaning you have to have enough investments to make the power law work for you. Granted, investing in public markets generally does not require the same type of strategy because it is easier to invest in five public companies that consistently return a specific amount. In early stage investing, there will be a lot of losers so the thought of “throwing money away” is grounded. It is the ones that aren’t losers that provide outsized returns that make all the difference though, these return more than enough to make up for the losers. The term “angel” comes from the need these businesses have to be saved — they are continually on deaths bed at the early stages, spending every last dime to grow the company. Angels are swooping in to provide capital, mentorship, connections, and sometimes hands-on work. The more expertise or support an angel can provide to the company the less likely the investment will be thrown away.
I like to build or turn around businesses so I am going to angel invest — whoa… slow down a little, try your hand at private equity — not angel investing. Unfortunately many angel investors think they will have deep hands on roles in the businesses they invest in. In some cases this is true, more often the involvement is from a mentorship point of view or from a connections point of view (connections to customers, partners, employees). The majority end up being very hands off though, most angel investors are relatively passive in their activities even though they do get regular updates and opportunities to provide feedback and make connections. If you really want to be operational, look harder at being an employee, consultant, or enter into a private equity relationship where you are buying a controlling stake for the purpose of operations. If you would rather provide assistance as needed and have something of value to offer on a couple hours a week basis, angel investing is suitable. If you want to be passive, build in a great portfolio management strategy such as investing in a curated (pre-screened) list of startups or following great investors into deals.
I don’t know enough about startups to be an angel investor — well you know more than you think. Especially if you are investing in deals with other investors (whether that be curated (pre-screened) deals or following top investors). If you have quality deals to select from you really can look at the companies where you understand the industry or the business model and make investments based on that information.
Investing in the public markets is safer — this is what everyone said about real estate right? Honestly though, it is more about managing your portfolio than it is about investing 100% in early stage companies. Yes these are risky, yes there is an opportunity for outsized returns. Many investors only invest 3–10% of their portfolio and understand that they could lose the entire amount. That small percentage of your portfolio should really be invested in 25+ companies to be properly diversified. If you are at the low end of the accredited investor qualification you are probably only investing $1k-$10k per investment to get that many companies into your portfolio. In this way you are relying on the effect of a power law where a couple of those 25 companies will make up the entire return for your early stage investment. When you plug the numbers into a spreadsheet you are risking 10% of your entire portfolio for the opportunity to return 27% IRR or 2.6x return on 10% of your portfolio. You should be making similar calculations with every other asset you allocate towards in your portfolio and can do the math to see how safe or not safe the investment really is.
Only the wealthiest people in the world are angel investors — I think we need to define wealthy a little more precisely. Accredited investors only have $1m in net-worth, this is actually a huge number of households (especially considering how few do invest). That said, the median wealth of accredited investors is $2.5m so not that much higher considering angel investing can return 27% IRR when done properly.
What other reasons have you heard or said yourself about angel investing?
Check out my blog for more thoughts about including early stage companies in your portfolio.