Is Angel Investing a Good Idea?

Most people will be aware of the term angel investing or angel investor, but what’s less well known is what this actually entails in reality, how it differs from regular investing, in the stock market for example, and even less is known about how to actually go about it, including the risks and benefits, potential outcomes and the work the investor would be expected to do themselves. In this guide we will explain the basics, in case you are interested in potentially being the guardian angel for the next big thing.

Quite simply, angel investing consists of investing in startups or at the early stages of established, but still very much up and coming, companies. In return you will be given equity in that company, at a glance, that’s all it is. A handy reference point is to think of the TV show Shark Tank (known as dragons den in the UK). The entire premise of this show is that high value individuals invest their money, time and expertise in company ideas, startups and more importantly, individuals, who are in need of cash investment to help their business grow. If you have seen the show, you will already have an idea of the basic process, which is that in return for this investment, the angel investor will receive a very high stake in the business, sometimes as much as 50%, although the average will sit in the 20%-40% range. They will then help the company grow through their direct support, advice and indeed, their own precious time, as they have such a large stake in the company eventually succeeding.

These early stage companies will still be privately owned companies, in many cases still wholly owned by the entrepreneurs themselves, or perhaps with some even earlier seed phase investor, such as a parent or friend owning a portion. They have not yet reached the stage where they are ready to offer shares or commit to an IPO, which is the largest difference with traditional stock market investing. As early stage businesses, they have a hard time seeking more traditional funding such as with bank loans, as they have little proven assets or cash flow, and also may be unfamiliar with the market or lack the ability and clout to get meetings or be taken seriously by the other players in the industry. This is a key point for companies seeking angel investors, most are not just interested in the cash injection, (Although that is a large part of it) they are interested in the expertise, support and connections that an angel investor can bring.

Angel investors are basically looking to maximize their profits. Despite the name, they are not doing it out of the goodness of their hearts, and will only invest because they expect to get a return on their cash. As the angel investor is investing at such an early stage, they are looking for companies that have a high growth potential, a product that they really believe in, a good team/founder that they can trust to back, or a seemingly poorly exploited market. The dream for an angel investor, with their high equity, is that they end up with enormous gains by backing the next Uber, Airbnb, Waze, or Mobileye for example.

Less frequently, but perhaps becoming more important over time, is the angel investors whose motivations extend beyond purely money, and wish to be part of an exciting project, to play and active role in its growth, and who treat angel investing like a job. They may have a up to 50 different companies they are investing in, and some of them even spend the majority or all of their professional time managing and supporting their angel invested companies, essentially becoming a full time angel investor. Others use the opportunity to choose and select companies that inspire them or fit their values, for example only investing in women only or women led startups, or black or minority owned startups. Others wish to invest because they can help solve social or environmental issues important to them personally, at the same time as potentially making money, by investing in green startups for example.

Angel investing is particularly attractive to investors in the current financial climate, due to the continuing low interest rates, and sky-high inflation, with America seeing an eye watering 40 year high of 7.5% at the beginning of the year. This renders traditional safe investments like fixed income securities money losing, and is a volatile time for traditional stock market investing. However, the average return on angel investments has been estimated at 2.5X on the initial investment, with an average holding period (where no money is gained, as the business grows) being 4.5years, leading to a gross IRR of 22%, which is extremely profitable at any time, but particularly in the current climate.

The other main benefit is simply a case of diversification. A high performing angel investment acts as a kind of fail-safe against wider market downturns, which can allow you to continue to be profitable, even if your stock market investments are not performing well. Finally, due to the potential for absolutely enormous gains (over 30x is definitely achievable), simply having a few angel investments in your portfolio is something akin to playing the lottery. Like the lottery you may make unbelievable amounts of money, but you need to buy a ticket to stand a chance of winning, and this kind of investing has a certain appeal to investors who are prepared to lose their investment for a chance at a big win.

Although, as seen above, average gains seem very attractive, these must be understood in context, they are average gains, and investing in any individual company at this early stage is exceedingly high risk. For example the Angel returns study of 2016 estimated that only 10% of companies provided 85% of the returns, with 70% of companies exiting at less that 1X, meaning the angel will lose money on their investment, and many of these being 0X, so all money would be lost. Forbes calculated that a full 90% of startups go on to fail, so the risk of losing all or some of your money is unfortunately much higher than other forms of investing.

Your returns will also be long term, again, as already mentioned, many of the gains to be made, even on a successful startup, will take a long time to realize, in the region of multiple years. This is because the likely exit will be an IPO or buyout by a larger company, both of which can take a long time. Mobileye took 15 years before its first IPO for example. On a related note, during this time your money will be extremely illiquid, as it will be difficult to find buyers for your equity if you wish to cash out early with the company not listed on an established exchange like NASDAQ etc. where shares can be traded in seconds.

Another risk, which you can ameliorate somewhat if you are savvy, is the emotional attachment you may develop towards a company, as you are more heavily involved than most other investments, and perhaps even on personal, friendly terms with the CEO. Most angel investors expect to invest more money after the initial investment, perhaps only initialing investing 25% of what they are eventually prepared to invest. This is risky because there is a tendency to throw good money after bad to attempt to save a failing company. Fred Wilson likened successful early stage investing to poker, where you have to know when a hand, or in this case, a company, is worth continuing with, or whether its better to ‘fold,’ take your losses and move on. While easy to do this in a game of poker, it’s harder to do this with a company that you are emotionally invested in, but due to the high failure rate of companies, it’s something good angel investors must learn to be pragmatic about.

As might be obvious by now, the golden rule of angel investing is diversification. As the whole strategy relies on a small number of companies striking lucky, and the rest striking out, the more players in the game the better, with the caveat that you have a limited amount of time in order to manage these investments. Luis Villalobos of Tech Coast angels developed a Monte Carlo simulation which suggested the sweet spot is 25 companies, although most experts seem to believe that fewer companies is also acceptable, but with a hard minimum of at least 10. Full time angel investors will be looking at even higher numbers than this, with Christopher Mirable, a self-professed full time angel, investing in around 50 companies at any one time.

Another thing you should be prepared for is to invest your time, not just your money. You should remember that the success of the startup is directly linked to your success too, and act accordingly. According to a study by Dr. Robert Wiltbank and Dr. Warren Boeker’s, angels who interacted with their startups more than once a month saw multiples of 3.7X over four years, while those that checked up on their startups only a few times a year saw returns of 1.3X over 3.6 years. This interaction should take the form of offering their startups connections, business advice, and mentorship to help their investments succeed, especially as many of the CEOs of these fledgling companies will be relatively inexperienced in their field.

Related to this is that, where possible, though not essential, especially if you are investing in 20+ companies, you should be investing in a field where you have some direct experience, or at least connections in the industry. This will allow you to both aid the company in a more productive way down the line, and be able to better choose the companies to invest in in the first place, with the same Wiltbank study showing positive material gains for investors already familiar with the space they were investing in.

This dovetails nicely with what should be common knowledge, in that with investing, due diligence is key. As seen in previous statistics, the vast majority of companies will fail, and prove to be totally or partially loss making. This risk, while always present, can be greatly reduced by serious due diligence on each deal. While the particulars may vary, a strong deck, multiple interviews with the founders, and the presence of concrete business plans/second round funding proposals can all ameliorate this risk, with the Wiltbank study showing gains of 7.1X vs 1.1X for investors who spent more than 40hours on due diligence for each investment.

In any economic environment, but particularly the current climate of low interest and high inflation, angel investing offers a more attractive rate of return for investors than any other traditional investment style. It also offers investors a chance to become actively engaged with exciting, potentially world changing new companies, and perhaps to build relationships with some young, revolutionary entrepreneurs and who knows, maybe even become the mentor to the next Elon Musk or Peter Thiel. Saying that, it is a high risk, high reward game, and expectations need to be managed. Many investments will yield nothing, it is an inescapable part of the game, and if it’s beyond your comfort level, a more stable, low risk investment strategy might be better for you. However, there are ways you can offset these risks, and the very active nature of this investment style can bring its own rewards to those so inclined. They say that everyone has their own guardian angel, but are you ready to be someone else’s?

DigitalRain

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