Angel Investing — rules, checklists and mental models

12 min readFeb 23, 2019

“If you can’t invent the future, the next best thing is to fund it”
- John Doerr, Kleiner Perkins

Angel Investments is one of the most exciting, yet most risky asset classes. It’s investing in deep out-of-the money, illiquid options with paucity of data. But it’s also very intellectually rewarding — like getting a front row seat in an invigorating theatre of passionate entrepreneurship. And when done right, can yield attractive returns.

Over the last 2.5 years, we have built syndicates with business angels to invest in promising, highly scalable businesses. The learning curve is steep and we have gone out of our ways to gather as much knowledge as possible on how to do it right — learning on someone else’s mistakes is quicker and cheaper. Thankfully, most angels, superangels and experienced VC investors are masters of knowledge sharing and there are numerous books, blogs, podcasts and interviews where they talk about things that they have already figured out. We list some of these sources further in this text, which in itself is a distillation of frameworks and mental models we find useful in angel investing.

Angel Investing — Simple Rules Hard To Follow

Returns distribution and angel investing rules are somewhat difficult to internalize — there are many people who expect quick wins and prompt liquidity. If you are looking to become a successful angel, the basic requirements are:

Patience and willingness to have a long horizon
Being able to stomach a loss on ~half of your investments and
be undeterred by the J-curve your portfolio will inevitably go through
Tolerance for illiquidity
A discipline to follow a structured, diligent process of building a portfolio and not get carried away by hypes, herd mentality or FOMO
A ‘moonshot investing’ mindset driven by focusing on what can go right and „believing when others don’t yet understand” (h/t Josh Wolfe)
Building a reputation of a valuable investor by actively supporting the founders

Returns: 22–27% IRR

In 2016 The Angel Resource Institute published a comprehensive report on angel returns in the US:

The TL;DR version:

The overall cash on cash multiple is estimated at 2.5X Capital.
The holding period is 4.5 years on average.
Average gross IRR is 22%.
10% of all exits generated 85% of all cash.
The failure rate (exits at less than 1X) climbed to 70%.
Homerun exits still represent about 10% of all outcomes which kept the overall multiple at 2.5X.

In Europe, Fiban.org regularly publishes data on finnish angels (see snapshot below:

Detailed data on UK angel investments can be found here.

Source: Siding with Angels, Robert E. Wiltbank, 2009

Superangels

The most successful angel investors out there have become institutions in themselves, attracting best dealflow and being able to build syndicates effortlessly. Everyone can get lucky, but some of these superangels have been early investors in several unicorns — something more appropriately attributable to skill and a good selection process (also fantastic dealflow and reputation — feedback loop, anyone?).

Znalezione obrazy dla zapytania jason calacanis — Jason Calacanis — investor in Uber, Evernote, Robinhood, Tumblr, Thumbtack, Wealthfront, Cafe X

„Focus on not just what could go wrong with a business but what could go right.”
— Jason Calacanis (jason)

Fabrice Grinda — investor in OLX, Alibaba, Uber, Wish, BlaBlaCar, Dropbox, Stripe, Klarna, LendingClub

„By the standards of most investors, I’m probably a little bit crazy, if not probably a lot crazy. So every year I invest in about 75 new startups. We see every week about a 100 startups (…).”
— Fabrice Grinda

Naval Ravikant — investor in Twitter, Uber, Wish, Thumbtack, Postmates, Kraken, Yammer, Stack Overflow, OpenDoor

„There has to be some reason why people will take your money instead of somebody else’s. Otherwise at the end of the day, you are commoditized and you get bid out of the game.”
— Naval Ravikant

Cyan Banister — investor in Facebook, PayPal, Uber, SpaceX, Thumbtack, Postmates, Buffer, OpenDoor, Slide

“I have a chance to play in a new arena and stretch myself intellectually,”
— Cyan Banister

Mental Models

1. Power Law

Source: https://www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing

Normal (gaussian) distribution doesn’t apply in angel investing or the venture world. Returns are governed by break-out companies that allow investors to pay back their entire portfolio with one deal (ideally, a few times over). That’s why you should only invest in companies that have that potential. And be prepared to lose a lot before some of your companies reach escape velocity.

Source: https://www.sethlevine.com/archives/2014/08/venture-outcomes-are-even-more-skewed-than-you-think.html

2. Optionality / Convexity / Assymetry

Angel Investing is about looking for highly convex opportunities — those with a huge asymetry between potential upside (preferably unlimited) and correspondingly limited downside (preferably small). Ideas that have this characteristic usually seem too far-fetched at first.

“If you are doing it right, you are continuously investing in things that are non-consensus at the time of investment. And let me translate ‘nonconsensus’: in sort of practical terms, it translates to crazy.”
— Marc Andreessen, Andreessen Horowitz

3. Babe Ruth Effect

In VC, focusing on investment opportunities with potentially extraordinary gains eventually outperforms choosing investments that yield „normal” returns. Babe Ruth (a legendary baseball player) effect in VC means that it’s better to take more risks to get the best returns, rather then playing safe. Best funds return more by being brave and having more very big hits, not by having fewer failures.

https://www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing

„I swing big, with everything I’ve got. I hit big or I miss big.”
— Babe Ruth

How To Start — Key Challenges

Spending money is easy, but for the angel investing not to be a financially disappointing short term adventure, you need to set your expectations right and understand the importance of dealflow, project selection, portfolio dynamics and deal structuring. Key problems here:

1.Most investors don’t know how to get access to quality dealflow

2.Most investors don’t have the time and process in place to do even first level selection and due diligence of deals

3. Successful public markets investors don’t understand the specifics of venture investing (horizon, illiquidity, startups survival rate, portfolio approach) and have unreasonable expectations

4.Lemons rot faster than plums ripen — i.e. the bad picks flame out much faster, than the great ones scale — many investors can’t stomach the portfolio J-curve

5.Most investors don’t know how to structure deals that will be attractive for future institutional VCs

The remedy for most of these is to start by investing in an established group of more experienced angel investors and gradually built their knowledge, portfolio and reputation.

„If failure is not an option, than neither is success”
— Seth Godin

Investing in Angel Groups

Investing in angel groups (syndicates) allow for pooling and sharing of:

Dealflow+Network+Skills & Expertise

Joining an angel syndicate decreases your investment risk and pushes you up the learning curve much faster. This is because by being a part of a pack, you can enjoy:

Collective dealflow
Access to larger deals
Ability to build a wider portfolio
Better Due Diligence
Better value creation
Shared transaction costs
Great networking and knowledge sharing

For the founders of target companies having multiple, but organized angel investors onboard guarantees a more streamlined funding process, centralized investor relations, access to wider pool of expertise and a larger network of strategic contacts.

„The best angels run in packs. They share deals. They love to work together. They don’t feel obligated to invest in each others’ stuff, but they often do. And they communicate with each other”. — Brad Feld, Foundry Group

Dealflow (is King)

Returns are highly correlated with the quality of dealflow. Great dealflow = better overall selection = higher returns.
Pipeline. The ability of “seeing” the best opportunities is the strongest indicator of future success. Not all best deals are widely known, some of them get funded before they even hit the market.
Reputation. Good dealflow usually confirms reputation, which can only be achieved by being referenced by other entrepreneurs, angels and VCs.
Midas touch. Success stories act as a magnet — everyone wants to do business with winners.
Selection. The best founders have the luxury of choosing Investors that they want to work with. The key is to be always on the short list.

„You lose 100% of the deals you don’t see. I rather see 100% of the top seed opportunities and win 50% than see 50% and win 100%.”
— Hunter Walk, Homebrew

Startup evaluation process

If you find checklists useful, we find the following list of criteria (Market, Team, Product, Distribution) a good framework for evaluating startups.

1. Market

What is the size of total addressable market? Maybe it’s big but crowded? But maybe it’s also opaque with complacent incumbents that are not customer-centric? Maybe it’s small but growing very fast?
What is the competitive landscape? Are the barriers to entry high? Do market participants have moats?
Is the timing right?
Is the market following a strong macro- or megatrend?
Are client personas known and well analyzed? Is it expensive to acquire clients? How much are they worth? How long is the sales process?

„When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens”
— Marc Andreessen, Andreessen Horowitz

2. Team

Why are the founders doing this? What motivates them, what is their goal and horizon? Is it compatible with ours?
Domain expertise — founders should have an inside-out knowledge of the industry and have a fanatical focus on the needs and pains of the customer
Technical skills — the ability to develop the product should rather be in-house
Good, complete mix of charismatic storytellers and doers/executors that like to work with each other
Social intelligence — to effectively attract new capital, early clients and recruit great talent
Skin in the game — are the founders „all in” or is it a side project?
Grit — things never go as planned, founders need to have grit to persevere and adapt fast
Numeracy — founders should know their numbers e.g. in terms of metrics, unit economics, market data
Velocity — of getting things done e.g. product iterations, testing hypotheses or new channels
Coachability — can founders internalize feedback, learn and apply to their business?
Accountability — how effectively were they spending money so far?
Focus — can the team radically focus, rather then get lost in a myriad of options?
Trust — Can we empathize with each other and build mutual trust?

“I invest in people, not ideas […] If you can find good people, if they are wrong about the product, they’ll make a switch, so what good is it to understand the product that they are making in the first place?”
— Arthur Rock (Apple and Intel early investor)

3. Product

Added value — is the product solving an actual clients’ problem or itch? Is it a „must have”? Check for customer validation (if available)
Unfair advantage — is there a unique edge or handicap inherent in the whole business, that is unavailable to competitors?
Moat — if not present, is it possible to build defensibility quickly?
Works early — is it attractive to early adopters, despite still being unfinished / crude / buggy?
Scalability — is the business highly scalable and therefore fits the VC funding model?
Unit economics — are they already known and healthy? Will they hold at scale?
10x — is the product much better than competition in at least one key aspect?
Stickiness — is it possible to lock-in users or generated data?
Brand — is it possible to build one and not get commoditized away?
Customer success — is the product being developed using Customer Success feedback loops?
Getting to „a-ha! moment” — how quickly is the product adopted by the user and becomes hard to part with?

“In the early days what matters when it comes to technology is the trajectory, not the current status of the company. Hence, i) knowing how to prioritize between product features, ii) releasing often, iii) being able to integrate user feedback fast and iv) working on weekly product sprints is a great advantage in the early days.” — Louis Coppey, Point Nine Capital

4. Distribution

Channels — how many have been identified as viable for distribution?
Incentives — what incentive schemes (financial and non-financial) are set up for actors in each channel?
Product Led Growth — can the product usage serve as a driver for user acquisition? How likely is it that the product will be getting „pulled” by the market instead of being “pushed” with paid marketing and sales?
Externalities — are Network Effects or Data Network Effects possible?
Organic growth — are there first signs of healthy organic growth, or will the business be a slave to paid customer acquisition and the rising costs thereof?

“This product is so good that it sells itself”. This is almost never true. Poor distribution — not product — is the number one cause of failure.”
— Peter Thiel, Founders Fund

Smart Money

Some things are more important than money. The key areas where founders need your help:

Networking with strategic contacts
Recruitment of best talent
Consulting where you have expertise

You’re doing it right if you start being referenced by other entrepreneurs and getting invited into the most interesting deals. This takes time and you can only get there by being an investor that actively supports value creation in his portfolio companies.

„A good VC is available for her portfolio companies almost 24/7. If a portfolio founder needs her, she will do everything she can — roll up her sleeves, use her social capital, get on a plane — to help. A good VC is sometimes a recruiter, sometimes a beta tester, sometimes a personal mentor, and isn’t afraid of getting her hands dirty.” — Christoph Janz, Point Nine Capital

Greed is Bad

A healthy captable is sine qua non for raising capital with institutional funds downstream. Demanding too much ownership or control is a frequent rookie business angel mistake and a shot in the foot. Taking too much equity handicaps the startup’s ability to raise subsequent funding. Leave enough space for new investors and keep founders’ stakes at a level that will keep them motivated. We have made this error and fixing it is not straightforward. As per the graph below (made by Capshare who has statistics on over 10,000 startups) founders and employees of startups usually retain a majority ownership stake until the Series B stage. Full report, also on median valuations, can be found here.

Angel Investing 101

>> If there is one paragraph to take away, this is it <<

Invest only what you can afford to lose and assume an average of
5+ years to liquidity.
Build a portfolio of at least 20+ companies (preferably much more), give those statistics a chance
Invest in groups, with high-quality co-investors
Beware of hypes and herd mentality. Question consensus. Be price-sensitive, conduct due diligence
Evaluate possible exit channels
Diversify over time and industries that you or your co-investors know very well
Require pro-rata rights. Reserve 50% of assets for follow-on investments in the best companies
Share deals, knowledge, contacts. Give first.
Be useful, don’t meddle. Your reputation drives your long-term success — it gives access to best deals
Keep things professional and be empathic for the entrepreneurs you back. It’s them who are doing the heavy lifting and often put everything on the line.

„It’s not spray and pray. It’s a process.”
— Paul Singh, 500 Startups

Resources

„In my whole life, I have known no wise people who didn’t read all the time — none… ZERO”
— Charlie Munger, Berkshire Hathaway

If you are keen reader (and since you have reached this paragraph it’s safe to say you are) here are some recommended sources of knowledge on investing, decision making, mental models, technology, startup scaling and intricacies of venture capital: