Family Offices Rush In Where Angel Investors Dare To Tread ¹

For over a decade a VC fund with just single-digit returns could qualify as a “top quartile fund.” During that same period, seed stage investments have generated 27% ROI. ²

So it’s no mystery why family offices want to do more direct angel investing. The only problem is, they often don’t have the experience they need to do it right. Here’s a typical example of what happens:

1. A family office decides it wants to get into angel investing.
2. One of the investment professionals goes to a few meetups and generally gets the word out that he is in the market for interesting startups.
3. He starts getting pitched (directly, via LinkedIn, etc.) by a host of “investment advisors” representing “hot startups”.
4. A few of these startups look pretty good so the family office invests.
5. These investments fail miserably.
6. The family office decides that startups are a “bad investment” and goes back to what it was investing in previously.

Hint: Step 3 is where things ran off the rails. I’ll get back to that in a moment.

Why family offices are ill-equipped for angel investing

The more sophisticated family offices employ investment professionals who have deep experience analyzing the strategies and returns of public equities, hedge funds, private equity funds, etc. These are all well defined instruments, within generally limited investment universes, for which substantial data is available. Even if you are considering seeding a hedge fund or committing to a newly minted PE/VC fund, you can still mine the managers’ track record at his prior funds for a fair number of data points. Furthermore, there are well-established channels for learning about new opportunities (e.g., “capital introduction” dinners) in these spaces.

Angel investing is the exact opposite of everything mentioned above. Every halfway decent startup opportunity is unique, solving unmet needs in different industries — sometimes in industries that don’t even yet exist. There are no registries or directories of startups, no associations to join. And you can forget about data entirely with a pre-revenue company. At best, the founders have one or two reasonably successful prior ventures under their belts. Furthermore, the best way to find great startups to invest in is to know other great startups so if you aren’t already deep in that community, you are already disadvantaged.

Also, bear in mind that angel investing is a numbers game. Most startups will fail and many of the rest will be modest successes. You have to invest in many, many startups to have a reasonable chance of a few of your investments being home runs. There’s a reason Dave McClure named his “500 Startups.”

So how does a family office with little presence in the startup space get that volume of deal flow? Enter the investment advisor.

Since most family offices don’t realize how fundamentally different angel investing is from other alternative asset investments, they don’t see anything amiss when investment adviser brings them startups to invest in. (I told you I’d get back to step 3.) They are used to meeting emerging hedge fund managers that way so why shouldn’t they find great startups that way too?

Because the best startups never, ever use investment advisors.

Think about it. VCs are the most networked people on the face of the earth. VC present at panels or judge pitch events practically every week. They meet dozens of entrepreneurs every week and know — and have often co-invested with — virtually every other VC in their area. If a startup founder can’t network his way into a warm introduction to a VC or active angel, how is he going to find customers or key strategic partners? Is this advisor going to be holding his hand then too, after your check has cleared? Plus, the very fact that the founder thinks he can waive his hand and simply have someone else take something this crucial to his business for him is huge red flag in and of itself. So any startup that has an investment advisor fundraising for them is already automatically suspect. In practice, the deals the family offices are being shown by these advisors are the hairy, old, over-shopped deals that every VC and halfway serious angel have already turned down. So it’s no wonder those deals fail miserably.

It’s not that these deals are obviously horrible. To the untrained eye they actually look pretty good. Perhaps they have a cool piece of adtech that could take agencies by storm. You have to really know the industry to understand why agencies turned them down two years ago when they first tried shopping their solution around. That fantastic social media marketing tool you just met? It’s so wonderful that five other companies are already doing it and they are all making better progress (and are better funded) than the startup who pitched you. But if you aren’t seeing dozens of startups each month, you just don’t have the data to recognize these patterns and pitfalls.

So what’s a family office to do?

In theory, a family office could hire a seasoned angel investor to invest on their behalf. Good luck finding one. Many angels are running their own businesses and/or are entrepreneurs who had a large exit and have no interest in working for a family office.

Some of these seasoned angels have taken their track records and used them to raise seed funds. There is a very good argument to be made for family offices finding these “emerging managers” and investing in those funds. But for the family offices who want to learn how to do direct angel investing properly, this is not much help.

Fortunately, there’s a better option: Startup Accelerators.

Accelerators ³ are the boot camps of the startup ecosystem. Companies accepted into top accelerators are the very best, earliest stage startups in the world. The top accelerators typically get hundreds of applicants for just ~10 spots. Having run four accelerator cycles for Dreamit and been involved in the screening process for several more, I can personally attest that this is no exaggeration. You have better odds of getting into Harvard than of being accepted into Dreamit.

note: Only the very top accelerators (e.g., YCombinator, TechStars, 500 Startups… and of course, Dreamit) have the reputation to be this selective.

Traditional pre-seed accelerators give the startups a little cash ($20k-$100K on average), co-working space for the duration of the program (typically 3–4 months), and extensive mentoring, coaching, and introductions. Finally, on “Demo Day” the startups graduate by pitching their business to an audience of hundreds of active angel investors hand-picked by their accelerator. In exchange for all this, the accelerator gets equity in the startup (usually 6–8%) and the right to co-invest in the startup’s seed round.

sidebar: Dreamit is a little different than most other top accelerators. It currently works with more mature startups who are typically post-seed and on their way to raising their Series A rounds, focusing on Edtech & Digital Health. Dreamit invests only after the program and takes no upfront equity.

From the perspective of the family office, accelerators can be the capital introduction dinners for startups. Unlike the shady investment advisors discussed above, accelerators are personally invested in the startups they accept. Accelerators do not get commissions on the money they help their startups raise; they only profit when their portfolio companies have an exit so their incentives are aligned with the other angel investors.

But they are more than just a trusted recommendation from a fellow angel investor. Accelerators invest in dozens of startups each year and can bring a structure and rigor to the investment process that few angel investors have. Established accelerators bring unparalleled networks and reputation to the table enabling them to source the very best new companies out there.

But wait. Can’t I just co-invest alongside a really good VC fund?

VC funds have high volumes of deal flow and tight, structured due diligence processes too. In these, investing alongside a good, seed stage VC fund should work too. Unfortunately, it’s not that simple. Even the most co-investment friendly VCs make their portfolio investments available to LPs only if they are unable or unwilling to invest their full pro rata. If it’s a great portfolio company, the VC will continue to invest until it runs out of powder or starts bumping up against position caps. Conversely, if a VC is able to but does not exercise its full pro rata investment rights, what does that tell you about their confidence in that startup? In both cases, the VC eats first and the LPs get leftovers.

Accelerators on the other hand, rarely take more than a small fraction of the portfolio company’s seed round. As I mentioned above, early stage investing is a numbers game so it is simply not feasible for them to take most or all of the seed (or in Dreamit’s case, the Series A) round. As a result, 75% or more of the round goes to outside investors.

Think about that for a moment. Here’s an entity that filters out 98% of the startups they see, takes the top 2% and gives them all the help a young company could ask for, and then willingly steps aside and lets any other investors invest in those elite new ventures. Wow.

If all a family office did was establish relationships with the top 4 or 5 accelerators, that deal flow alone would give them a high quality, highly filtered set of potential early stage investments with no additional effort required.

So let’s re-write the family office story:

1. A family office decides it wants to get into angel investing.
2. It researches the various accelerators and attends their Demo Days (or in Dreamit’s case, joins its Investor Roadshow network)
3. The family office even invests in 1 or 2 of the accelerators funds as a way to gain even more insight into the recruiting and filtering process and to ensure access to the hottest deals.
4. As it gains confidence, the family office invests directly in a some of the accelerated startups.
5. The diversified portfolio does well
6. The family office makes disciplined, intelligent, efficient angel investing a formal part of its allocation strategy

Now how’s that for a happy ending?

¹ Just in case you were wondering, “For fools rush in where angels fear to tread” was first written by Alexander Pope in his poem An Essay on Criticism.

² Right Side Capital analysis of eight large studies of historical angel investing returns in the US & UK (http://rightsidecapital.com/assets/documents/HistoricalAngelReturn.pdf)

³ Sometimes called incubators, although incubators are more often shared co-working spaces with some additional services that are of value to startups. Unlike accelerators who rigorously screen their applicants, incubators are generally open to all, space permitting, as long as they can pay the rent.