How to Manage an Angel Portfolio Like an Investment Professional

Part of Our Research Series for Angel Investors

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Angel Investors deal with a lot of uncertainty. In fact, perhaps the best way to characterize what early stage investors do is put a dollar amount to uncertainty probabilities.

What does this mean? It means that there is a lot outside the control of investors — so managing this uncertainty within the investment process and management of the portfolio is a critical risk management practice for Angel Investors. How can investors do this? It starts with developing a portfolio management process that has a professionalized approach. There are a few areas to consider:

• Level of Selectivity: How many investments are made given how many are seen
• Level of Diversification: The total number of investments made in total, and per year across sectors and exit time horizons
• Level of Intensity: The combination of selectivity and diversification, i.e. the level of activity and potential risks from concentration

An alternative way to view risk is through a Brinson-type attribution model:

• Allocation: The level of risk from exposures across industries, geographies, or other types of groupings
• Selection: The level of risk from exposures to specific company dynamics, such as company stage, estimated market size, exit event type and horizon or other idiosyncratic risk factors.

Unique to early-stage investing is the J-curve effect: given early stage companies tend to fail fast (i.e. early), Angel Investment portfolios are often subject to sustained losses in the early-going before seeing positive returns accumulate as the few winners emerge and begin to grow (often rapidly).

The J-curve in effect explains why the average portfolio holding for an Angel Investor is measured in years — and requires patience. The lack of liquidity is a specific type of risk that is common to all private investors, whether that’s hedge funds, private equity, direct investments in real estate, or startups. This is also why it’s important to acknowledge the primary risks associated with these types of investments and build in risk mitigation strategies.

Lastly, it is assumed that for Angel Investors, these investments represent only one type of investment within the broader investment portfolio. By that we mean before making higher-risk investments, investors should have adequate invested capital across less risky asset classes such as traditional equity and bond markets, real estate, emergency cash reserves, etc. A discussion with a financial advisor is a prudent first step to ensuring that an investor can sustain the types of losses that are common with private investments — and help decide on appropriate allocations to these investments so that other return objectives are not at risk.

Angel Allocations

A good first step to managing portfolio risk is to ensure that the capital an Angel has set aside to be invested in startups is both sufficient enough to take a meaningful equity stake, allows for follow-on investment, and doesn’t significantly affect an investor’s overall investment portfolio. Let’s start with the last part. Angel investors often write checks in the amount of $1,000-$50,000 or as high as $100,000. This amount should be determined by the investor by getting to a dollar amount they are comfortable with losing entirely.

Let’s assume the investor has $5M of investable assets, all of which, for the sake of this example, is liquid and invested across various retirement accounts that are invested in cash, stocks, and bonds. For illustrative purposes only, let’s say that a fair amount to be invested in this high-risk asset class is 2% of the portfolio/year. That means for the upcoming year, the investor is able to invest 2% of the $5M, or $100,000. The investor’s deal flow volume and diligence process will determine how much of that capital is actually invested of course, but we now have a capped annual amount.

Another way to look at it is by backing out a number from the total return objective. Let’s again assume the investor has a $5M portfolio with an annualized total return objective of 4%. The financial advisor estimates that the portfolio will generate a return of 6% over the next 12 months as-is. This means there is a surplus of capital to be invested:

• Starting Value = $5M
• Projected Ending Value = $5M x 1.06 = $5.3M
• Required Ending Value = $5M x 1.04 = $5.2M
• Surplus = $5.3M — $5.2M = $100,000

It may also be the case that an investor or advisor is looking to invest in startups to boost the portfolio returns. We can rearrange the numbers above. Let’s assume instead that the investor requires an annual portfolio return of 6% but is only projected to generate 4% in the coming year, a 2% gap. How could Angel Investments boost returns? Well, based on historical data, an advisor sees that Angel Investments or other private investments generate an annualized return of 25% (note: this is hypothetical and as mentioned above, cash returns are not often realized for several years). The investor may choose to allocate a specific amount to Angel Investments as such:

• Starting Value = $5M
• Projected Ending Value = $5M x 1.04 =$ 5.2M
• Required Ending Value = $5M x 1.06 = $5.3M
• Return Gap = $5.3M — $5.2M = $100,000k = 2%
• Current Allocation = 100% Retirement Assets x 4% Return) = 4% Total Return
• Proposed Allocation = (X% Retirement Assets x 4% Return) + (Y% Angel Investments x 25% Return) = 6% Total Return

Solving for the allocations above yields an optimal allocation to existing retirement assets of approximately 90.4% ($4.52M) and Angel Investments of approximately 9.6%, or about $480,000.

This results in ($4.52M x 1.04) + (480k x 1.25) = $5.3M

The last two examples are similar to some ways in which institutional investors execute allocation decisions across asset classes of different risk profiles. We’re already developing a stronger risk management strategy than most Angel Investors — and we have yet to even consider any opportunities!

We’ve discussed this problem through the lens of the overall portfolio, but what if investment returns relative to a portfolio are not a consideration? What if this money is purely discretionary? How should an investor think about the correct number of investments to make?

If you talk to any VC or Angel Investor, odds are strong they will say they invest in a small or minority amount of deals they see. This is because there is an assumed failure rate baked into the process. If you assume 30–50% of your investments will end up at $0, then you shouldn’t make a lot of investments — you should hold out for those with the best chance of success.

The problem? Investors overestimate their ability to judge success. This can be tracked historically (obviously — most venture-backed companies fail, and they all had investors, so logically implies this, otherwise it means investors went into the deal assuming it would fail, which would be crazy). Investors are also subject to behavioral biases such as recency bias, overconfidence bias, availability bias, and more that cloud logical judgment.

How else might we determine an appropriate number of investments to make? We can look at the estimated failure and success rate. Let’s assume that, based on available anecdotal evidence, that one out of every ten companies become successful enough to adequately generate capital to earn a return on the investments across each ten.

This means that at a minimum, an investor needs to invest in at least ten companies. Even with ten, it assumes that the one success is a significant one — which is unlikely to be the case. So we need to diversify enough across winners to improve the probability of investing in a home run. So how many winners are home runs? Let’s again assume it is one of ten, so now we’re at one out of one hundred (1/10 x 1/10) — so now we’re looking at a minimum of 100 companies!

This of course is just a hypothetical exercise. The point here is that while many investors insist they invest in a select few opportunities with the highest conviction, the numbers work against this claim. Investors need to think in terms of probabilities.

The Opportunity Cost of Not Investing May Be the Biggest Risk

The point of all this is to question the effectiveness of the “review lots, invest in few” approach. One of the greatest risks to investors is not what you invested in, but what you didn’t invest in — the opportunity cost of selectivity.

AngelList did research on thousands of investments and concluded that the best investment strategy was simply to invest in as many high quality deals as possible. Spread your bets and leverage the law of large numbers. This is especially relevant given the historical breakdown of investment returns in the space — the vast majority of returns come from a select few companies over the investor’s time horizon. The cost of not investing could be enormous.

With that in mind, let’s look at how to determine the right amount of capital to invest across opportunities — few or many.

Allocation Sizes

Now that we’ve established a framework for the amount of total investable cash on an annual basis, we need to determine how much to invest in any one company. Most investors can simply divide this money up evenly or let the companies dictate the amounts as needed and the investor can invest until the capital is entirely allocated.

While these two options may seem like perfect substitutes for one another, they are not. While investing the same dollar amounts in every opportunity may sound like a naive risk management strategy, when compared to more ad hoc approaches, it may represent the more prudent one.

Let’s say for example that Investor A allocates $100,000 to be spent over the next 12 months — and does so by investing $10,000 each into 10 companies. Now compare this to investor B whose first three companies require minimum investments of $20k each, two with $10k, and the remainder are invested in four companies evenly at $5k each.

Compared to Investor A, Investor B’s initial portfolio is skewed towards specific companies. Does this matter? It depends.

If Investor B has intimate knowledge and conviction in these companies then it may be wholly appropriate to invest additional capital upfront in specific companies. The challenge here is the unknown unknowns that are so prevalent in the early stage investing.

Unlike investing in the stock market, which benefits from much greater transparency and liquidity, there is so much uncertainty in early stage companies that it is hard to argue investors have a greater ability to forecast outcomes, so taking egregious company-specific bets at the earliest stages of investing or at the first round of financing can expose investors to unrewarded risks.

However, over time as companies fail and/or grow, the proportion of their value within an investor’s overall portfolio will grow smaller or larger. Again, unlike the stock market where investors can simply buy additional shares or sell shares in order to rebalance the portfolio allocations, private investors are not granted that privilege, so managing risk through diversification and a sound follow-on strategy are critical components of risk management.

Diversification Throughout the Portfolio’s Lifetime

As alluded to, if companies become successful, their valuation will grow — and that $10k check might now be worth 50K — and so too will the exposure to that company within the Angel portfolio. Let’s stick with investor A from the above and assume that of the 10 companies that were invested in during that year, three failed, four have seen valuations double, two have seen flat valuations, and one has 10x’d it’s valuation over the subsequent year. We assume here no additional investments have been made.

Here’s how the portfolio looks now:

Not bad — the portfolio is now worth $200,000 but Portco 10 is now 50% of the value! This is an inherent risk when investing in illiquid, early stage, private companies. This is compounded by the fact that, as we will discuss below, success breeds the need for additional capital raises and therefore subsequent investments — meaning portfolio positions grow larger as a percentage of the total. Of course, this can be partially offset by making additional investments in subsequent time periods. But, is this type of concentration a bad thing within these types of asset classes?

The flip side of this is the positive risks that come from this — the risk that is associated with reward: Portco 10 is garnering a higher valuation because it’s deemed a higher probability of success. This brings a key difference between private investments like this and public ones like stocks and bonds — whereas the latter often tries to diversify risk by limiting the exposure to any single company, private investors may actually benefit from diversification when it arises due to higher probabilities of success, which warrant higher conviction and therefore more exposure. This solves the behavioral bias that tends to plague investors — buy high and sell low — by instead selling losers (i.e. they go to zero) and riding winners.

This can be done through intelligent follow on strategies.

Active Management

Once the money is transferred from the investor’s bank account to that startup’s, the real work begins. For Angel Investors who invested through a syndicate or intend to be passive investors, there is obviously less to do, while for some Angels, investments involve actively participating in adding and creating value to the company.

Most, however, will fall somewhere between these extremes and will be able to work with the founders on issues and maintain ongoing dialogue with recurring (quarterly or annual) progress reports. The newer the company, the more status updates you should expect to receive as founders are making sense of the uncertainty they face.

For founders, platforms such as Gust and AngelSpan can assist in tracking all relevant information, including share issuances, cap tables, tax reporting documents, and financial statements. Angel Investors would be wise to make sure founders use these platforms as they create transparency and a professional approach to company management.

How involved and in exactly what areas likely depends on the strengths of the Angel and the perceived relative weaknesses or areas of need with the founding team — and it’s on both sides to cultivate a healthy and working relationship where information flows freely and challenges can be resolved together as needed.

Follow-On Strategies

Angel Investing is rarely a “write one check and wait patiently” type of investment — it’s not a buy once and hold experience. This is because as companies grow, until they can self-sustain expenses with revenues, they will need to support this growth with additional funding. In future rounds, founders will often look to their current investors to provide capital for all or some of the sought financing.

The economics of these investments are non-standard and depend highly on the company, the market and valuation, and the number of potential investors. Still, Angel Investors should develop a strong follow-on strategy as it pertains to managing risk. For this discussion, the process of follow-on due diligence and valuation is out of scope. Please refer to our guides on both topics for additional details.

Let’s say you have a company that you’ve invested in that has done well over the past 18 months and is looking to raise financing from VCs and other investors.

Before we get into the technicalities of deal economics, the first question should be “Do I want to invest additional capital?” and if so, how much. For many investors, these are simple questions because there is significant momentum behind the company and limited time to decide. Prudent, rational investors, however, follow a strategy and decision making framework.

Let’s use an example: A company is seeking a potential new round (Series B) with investors adding $10M of convertible preferred stock and a current investor is putting in $2M as a follow-up investment. There are few ways to structure this, depending on the perceived health of the company and the preferences of all investors:

• Re-Open the Last Round: Here all investors agree to re-open the Series A round with the same valuation and equity issuances. This works well if the time between rounds is generally short and the current investor owns all the prior round (A round) shares, making it a clean scenario. This makes the liquidation preferences pari passu (meaning they are equal in terms of liquidation preference with all other investors).
• Open A New Flat Round: Here the company opens the Series B and issues convertible preferred stocks that are identical to the A round stock but it has a liquidation preference above the A round. This would be used if the current investor in the A round does not own all the shares issued in that round.
• Open a New Up Round: Here the company opens the Series B round and because it has performed well, issued convertible preferred shares identical to the A round except for its higher liquidation preference (and obviously higher per share price across the board).
• Open a New Down Round: If the company has underperformed but does not appear to be headed towards extinction (there is still future value), investors may be confident enough to provide financing but the new round (B round here) but at a lower price per share (and company valuation). It is likely that prior round investors will be protected through antidilution clauses to partially offset this on-paper loss, with the common shareholders bearing the brunt of the hit.

Other types of shorter term financing to help companies through choppy waters include bridge financing (debt financing that converts to equity shares in the future at a discount) and a pay-to-play down round (essentially when founders of a poorly performing company entice current investors to commit capital now or see their preferred shares convert to common shares — losing out on all the protective provisions — and suffer dilution should they choose not to invest, i.e. they must pay to play).

Case Study: The Kelly Criterion

What can gambling teach us about follow-on strategies? We can use the Kelly Criterion as an example. Simply put, the Kelly Criterion can be used in finance to determine how much to invest in a given company — with the output of the formula the position size an investor should take. For purposes of Angel Investing, the magnitude of the output is what’s relevant, not the exact number as it represents an ability to understand how much conviction an investor should have in the company at the current round. The actual investment will likely be dictated by the deal economics, available capital, or other factors. This exercise is about getting investors to think in terms of probabilities when making decisions.

The Kelly Criterion effectively suggests that investors should bet more when the odds are in their favor. This may sound obvious, but what’s less obvious is thinking through how to determine if the circumstances are favorable or not. Let’s use an example to develop an illustrative framework. The Kelly equation is:

K% = (Mp-f) / M

Where:

• K% = The Kelly Percentage (i.e. the allocation percentage)
• M = The Success Net Multiple on a Win*
• p = probability of winning
• f = probability of losing (i.e. 1-p)

*This is calculated as the return multiple minus one. For example, if the return multiple is 3x, the net return value is 2 because a 3:1 return ratio means $30 is returned, $10 of which is the original invested capital, netting $20.

This exercise of course relies on some knowledge of each component. Let’s say as an Angel Investor you read, observe, learn anecdotally or experience an average winning percentage on startup investments of 20%. Therefore the value of p = 0.20, and then therefore the failure probability, f, is 0.80.

The success net multiple on a win can be estimated using historical data. Let’s assume that the average expected win multiple on an investment is a 10x return, meaning that the net multiple is 10–1 = 9.

We therefore calculate the K% as (9*0.20–0.80) / 9 = 11%

So what does this mean? Well in theory, it would mean an investor should allocate 11% of their capital towards the investment. For Angel Investors, in reality this is much more complicated so this exercise can serve best as guidelines and used in comparison.

How would this look if you historically have a track record of 40% success and through your experience know that companies like this tend to exit at a valuation that would represent an 8x return on the current valuation?

The K% here becomes (7*0.40–0.60) / 7 = 31%! That’s much higher! Does it mean you should invest 31% of your capital into the company? No. Does it indicate that perhaps you should have a stronger conviction in this company? Perhaps!

This type of exercise can represent a simple and fun framework to assessing the level of conviction investors should have in their portfolio companies. This requires intimate knowledge of the company, their market, the investment landscape and many other relevant factors — all things great investors are keenly aware of.

Portfolio Risk Assessments

The last step in developing a strong risk management practice is to periodically review your current portfolio allocations — across all your investments. This includes not only your retirement accounts, but your cash savings (i.e. an emergency fund), home equity, debts, and Angel Investments. This holistic approach to managing risk is one that can help uncover potential concentrated areas of risk or opportunities to expand risk in order to generate potentially higher returns.

Thinking of your investments in terms of a portfolio instead of a series of individual investments will help you better manage them. Generally, investment managers can de-risk portfolios by investing assets that have low correlations between them (i.e. stocks vs bonds vs real estate vs commodities). Certainly startups have a low correlation to these markets, but they are also highly uncorrelated from each other. This is another unique feature of these marketplaces — they are all risky and in different ways.

This brings us to a last important point: while investors may be best served to invest across different industries, geographic, and exit event time horizons, they should also avoid investing in companies that conflict or compete with each other.

A financial advisor should be able to prepare these types of analysis quickly and easily and work with any investor to prepare an adequate allocation for private investments that fit the risk aversion levels and risk capacity for investors relative to their return objectives.

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