In my last post, I explored how diversification minimizes nonsystematic risk (risk that is unique to each investment in a portfolio) and concluded that investing in approximately 15 startups at an early stage significantly reduces this risk.

While important, diversification is only part of the total-risk equation. Figuratively, and literally.

Total Risk = (Beta × Systematic Risk) + Nonsystematic Risk

In this essay, I’m going to try and answer the question How much should I invest in each of those 15 companies. To make a proper attempt at this, let’s first set the stage.

Systematic Risk

The risk inherent to the entire market or an entire market segment. Systematic risk, also known as “undiversifiable risk”, “volatility”, or “market risk”, affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the right asset allocation strategy.

Systemic Risk — Investopedia.

Systematic risk, for the purpose of our conversation, is the risk that one takes on by investing in startups in general. Variables like the funding environment (how much LPs allocating to Venture Capital), legislation, corporate governance, the cost of capital, and liquidity (among others). In other words, the ever present risk premium that you assume just to participate in this market segment.

A Piece of the Puzzle

Limited Partners (LPs) consider Venture Capital (investing in startups) a sub asset class of the broader alternative investment category to which they allocate some 10-20% of their overall investment.

The reason I point out the LPs is because of the incredible amount of research they have poured into evaluating the effect of alternative investments on the efficient frontier. Deutsche Asset & Wealth Management explains it pretty well here.

Chart from All-in-one exposure to alternative asset classes

Angel Investors should view investing in early stage startups the same way. That is, an Angel Investor should consider their allocation to early stage companies to be an alternative investment class.

Can You Invest Too Little?

So, now we know two pieces of the equation. We know we need to invest in roughly 15 companies, and we know that total investment shouldn’t exceed 10-20% of an overall portfolio. If you have a million dollar portfolio, the answer might be starting to emerge. 10% of $1,000,000 is $100,000, divided by 15 companies is about $6,600 in each company, but, there are a few reasons why this might not be enough.

Prior to the JOBS Act, AngelList Syndicates, and the boom of Crowdfunding services, the minimum amount to invest in an early stage startup was popularly believed to around $25,000 — $100,000. Going back a bit further, it was common for Angel investments to be $300,000 to $500,000. Most angels are investing in companies which, they feel, can, one day, produce some $50 million in annual revenue and that are valued around $500k. The belief was that, an investment, with the amounts listed above, would get the investor into a meaningful position in the type of companies that have the best chance of succeeding at the abovementioned goal. This isn’t necessarily true post JOBS Act.

Without getting into a detailed discussion of how the JOBS Act, AngelList Syndicates, and Crowdfunding services are changing the landscape, suffice it to say that they are making it easier to invest in early stage startups at lower amounts. From a macro standpoint, I believe this is good but, Angels should be careful in thinking that lower is better with respect to building their portfolio.

A New Class of Investor

The JOBS act introduced a new class of investor.

Right now, the annual VC investment market is roughly $30 Billion. The non-accredited investor market has the long term potential to actually dwarf the existing VC market, just by the massive number of new investors, who will be allowed to participate in early stage investing, for the first time in over 80 years. A new wave of capital is set to be unleashed by Title III and will come into the U.S. investing market, which, some estimates, will grow to a $300 billion market.

JOBS Act Title III: Investment Being Democratized, Moving Online — Forbes

A new market has developed for early stage startups to raise from. The combination of limitations and marketplaces are driving the per-company minimum investment down. At first glance, this would appear to be a good thing, but, let’s dig a little deeper.

In order to raise money from this class of investor, startups have additional corporate governance requirements.

For fundraising from Non-Accredited Investors, a company has the following restrictions and requirements for disclosure:

• Limited to raising no more than $1,000,000/year under the Title III exemption.
• Disclose financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.
• Disclose information about officers and directors as well as owners of 20 percent or more of the company.
• Disclose the price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.
• Companies relying on the Title III exemption to offer and sell securities, would be required to file an annual report with the SEC and provide it to investors.

JOBS Act Title III: Investment Being Democratized, Moving Online — Forbes.

This offers the thesis that the better companies (at least the companies that can raise money more easily) will not to attempt to raise via a Title III fundraising if they can avoid it. By limiting their raise to accredited investors, they have less corporate governance. Most Crowdfunding sites like WeFunder operate solely with these Title III type raises, (though they do claim to allow for both).

Knowing this may help you apply an initial filter to your consideration set.

The Best of Both Worlds

One solution which seems to be simultaneously lowering Angel Investment minimums, providing investment guidance, and addressing the Title III raising bias is AngelList Syndicates. Syndicates allow investors to pledge amounts of money to be invested alongside Syndicate Leads. A Syndicate Lead is presumably someone that has more experience, or insight into the world of Angel Investing, than the backer. Syndicates Leads shape up to be the first investment advisors for the private market.

Many of the Syndicates have typical investment amounts falling into that $25,000 — $100,000 range but, quite a few are creeping down towards $10,000.

Ok, so how much?

All of this says that, the question of how much should I invest in each company comes down to part strategy and part math. Strategy, from the standpoint of getting into the highest quality deals you can, and math, from the standpoint of how much that will cost you and the resulting position it makes in your overall allocation.

Going back to our investor example from above, if we have 1 million dollars in investable assets with a decided-upon exposure of $100k for alternative investments, then, perhaps, 15 investments of 10k puts us at a 15% exposure to alternative investments. I’ll leave it up to you, and your financial advisor, to figure out how to specifically integrate this equation. But, my hope is that, this would provide a framework by which, you can evaluate your exposure to this volatile market and attempt to make it consistent with your overall risk tolerance and investment objectives.

What’s Next?

In the next piece, I’ll be taking a look at what an Angel Investor should expect, in terms of overall portfolio performance, from the addition of this asset class and ultimately answering the question Is angel investing worth it.