A Primer on Angel Investment Portfolio Theory by IrishAngels
At 220 members, IrishAngels is among the largest angel networks in the country. Some of these individuals had exposure to angel investing prior to joining the network, but for others, IrishAngels is their first foray into early-stage venture investing. It’s typical that many angel groups serve as platforms that provide not only deal flow but also angel investment education to their investors. The American Angel, a recent study that evaluated angel investors, found that 25% of current angel investors have been investing for less than three years.
As we onboard new members, a common question that we receive is how to build an angel portfolio. IrishAngels hosted a portfolio theory webinar for its members in 2017; this article includes a summary of key takeaways as well as some new research on this topic.
Angel and venture capital investing receives attention for exhibiting high returns on an average portfolio. The Angel Resource Institute reports that angel portfolios can earn a 2.5x cash-on-cash return over an average four and a half year holding period. What these numbers don’t convey is that angel investing is inherently risky, and in fact, many angel investments will return no capital at all. In order to maximize the chances of hitting or exceeding the industry benchmark, angels must be intentional about building their portfolios.
How Much to Invest
The first step in building an angel portfolio is determining how much capital should be allocated to angel investing. This is a personal decision based on financial situation and risk tolerance; recommendations vary from 5–15% of total investable assets. The American Angel found that more experienced angel investors devote a higher percentage of their total investment portfolio to angel deals than new angel investors do.
IrishAngels encourages new angel investors to discuss their financial goals and investment strategies with a financial advisor to determine the appropriate percentage of investable assets to allocate to angel deals.
Number of Deals
Once an angel determines how much capital he or she is willing to allocate to angel investing, the next step is to determine how many companies in which to invest. This is where diversification is important. The conventional wisdom is that in an angel portfolio, approximately half of all investments will fail, returning no capital to investors. Several companies may return the investors’ original investment or a modest multiple above that. Only 10–20% of investments will provide a meaningful return for investors. These companies are the “home runs”; since such a high percentage of investments will fail, these companies need to return enough capital to both cover losses and generate portfolio gains. With this in mind, IrishAngels investment thesis is built on investing in companies that could reasonably yield a 10x cash-on-cash return.
Can an angel investor make one investment and hit a home run? Yes. Is this likely? No. To increase the odds of receiving a 2.5x cash-on-cash return in this asset class, experts recommend a portfolio of at least 10 investments, though we believe that 15 to 25 over a three to five year period is a more appropriate number of total investments for an angel. The chart below depicts 500 Startups Monte Carlo Simulation of Angel Investing. As the number of deals increases, the median exit multiple approaches the mean, and the risk (as represented by standard deviation) declines.
Initial Versus Follow-on
As experienced angels will tell you, many portfolio companies will come back to investors for more capital. This is called a follow-on investment. Some angels reserve up to 50–70% of total capital for these follow-on investments. This “dry powder” allows investors to reinvest in portfolio companies that are doing well. However, investors must be cautious of throwing good money after bad so it is critical to be diligent with the review of any investment opportunity, whether that is an initial or a follow-on investment.
A diversified portfolio is not built overnight. First, a new angel must establish deal flow. Many individuals turn to angel groups to provide access to new investment opportunities; others may build a portfolio through personal networks. The American Angel reports that nearly 90% of angel investors find investment opportunities through angel groups, 52% through friends and colleagues, and 58% through direct contact with an entrepreneur.
Even once angels find deals, the Angel Capital Association reports that many investors take six to seven months to make an initial investment; this time is typically spent evaluating potential opportunities and building an investment thesis.
Portfolio Theory Example
Now that we know the basics, let’s put it into practice. John Smith, a new angel investor, decides that he would like to commit $500,000 to build a portfolio over the next three years. He chooses to reserve 50% of this for follow-on opportunities. This leaves $250,000 for first time investments into portfolio companies.
John joins IrishAngels to build his pipeline of investment opportunities. He knows that IrishAngels will present three investment opportunities each quarter and that the minimum investment amount per company is $10,000.
John has options on how to deploy his capital. He may invest in 25 portfolio companies with a $10,000 investment in each. He might invest in 10 portfolio companies with a $25,000 investment in each. Or, he could decide on a strategy between the two, investing variable check sizes in 10–25 companies as he builds his portfolio.
Portfolio theory is key to increasing the likelihood of receiving average industry returns on an angel portfolio. Additional factors have also been identified to be correlated with higher returns.
The Angel Capital Association reviewed investment returns and found in its sample that higher returns were correlated with additional hours of due diligence. In the table below, returns are compared between investments with fewer than 20 hours of due diligence and investments with more than 20 hours of due diligence.
After the check, investors can also influence their returns by providing valuable advice and connections to portfolio companies. The Angel Capital Education Foundation found that investments in which angels had high participation (defined as advising the company one or two times per month) outperformed investments where angels had low participation (defined as advising a company one or two times per year). The results are depicted below.
Angel investing can provide attractive returns for investors. However, this is an inherently risky asset class, and investors should be prepared to lose all of the money they invest. Investors can increase their odds of achieving returns by determining a portfolio strategy that includes a set amount of capital to be deployed into 10 to 25 companies, both in initial as well as promising follow-on rounds. At the end of the day, identifying and then remaining disciplined to a specific angel investment strategy is the most important thing an angel should do as they get started in the world of early-stage venture investing.