Angel Investors’ Path To Improved Profitability

A mini guide to potent startup investing from a venture capitalist

I am often surprised that many Business Angels I talk to, even those investing professionally full time, have ended up investing in startups based on only a few meetings with the founder teams.

In failing to spend time with founders, you won’t get to know them. And perhaps just as important: founders won’t get to know you either!

The result is likely a lack of mutual compatibility, which can hinder you in establishing true alignment with the team before investing.

Since the average Angel investment is longer than the average American marriage (8.2yrs), shouldn’t you then make sure to know your comrades?

… Yes you should! Let me give you a short introduction to why that is.

In 1983, Bill Wetzel coined the term “Angel” after completing a study on how private individuals invest in early-stage startups.

What he found was that Angels were often motivated by non-financial rewards in their investing. And I can see why: if you’re an entrepreneurial veteran, you would probably enjoy giving back to the startup community.

Angel investing is very much about passion, indeed. Angels get involved in risky ventures because they enjoy the mentoring, the support and the development of an emerging business.

But it can mean good business too: the average Angel return stands at 27% IRR and compares favourably with other types of private equity investments. Returns have also shown to be uncorrelated with public and housing markets, which benefits Angels through macroeconomic cycles.

Yet, being the first investor on the captable requires money, time and business acumen — coupled with a strong risk tolerance, of course. Investing in small private companies is nothing like stocks or real estate.

A daring asset class

The world of an Angel investor can be fast-paced, exciting and perilous. They operate in a hidden economy of investors, advisors, venture capitalists, lawyers, universities and entrepreneurs that is rich with grandiose success stories and unfortunate failures.

Many Angels exist today. It is estimated that around 1% of the adult populations of most western countries are potential Angels and that 0.1% are active Angels. In the US alone there are more than 335,000 Angels who invest roughly $25 billion in 70,000 startups on an annual basis.

For most of these Angels however, their startup investing do not deliver great results. Remember the 27% IRR figure? That’s the average return on Angel investing. It doesn’t take into account the true return characteristics of startup investing which conveys a skewed return distribution.

In reality, and I’m sure you know this, Angel investment returns just like those of venture capital resemble a power law curve with few deals representing the majority of investment returns. What are the implications?

Two-thirds of Angels make less than what they invested; nearly half generate no return; and 6% of them account for 68% of total returns, according to Kauffman Foundation. This means that the median Angel investor actually loses money on startup investing!

Diversification is not enough

Traditionally, the response among Angels (and VCs) has been to increase diversification rates by investing in more startups and hedging their exposure across founder personas, industries, technologies, business models (and geographies). Some Angels have portfolios of 100+ investments.

However, while more diversification improves Angels’ relative exposure and therefore investment performance through portfolio effects (expected returns increase with larger portfolio sizes), it also inflates their absolute risk as they allocate more capital to a high-risk/high-reward asset class.

“If you love taking risks and don’t mind being locked up for a decade, I could see you putting 10 to 20 percent of your bankroll into angel investing. If you can tolerate risk, but don’t love it, and you can handle being illiquid for a decade, I could see you putting 5 percent of your bankroll.” — Jason Calacanis

What is the optimal number of companies in an Angel portfolio then? General advice is to not let startup investing take up more than 10% of one’s total net worth due to sound risk management principles. Depending on your net worth and dealflow, this might be 5, 12, 20, 30, 50, or 100 startups.

Opinions vary on optimal portfolio size and statistical results are ambiguous, but prior studies find that Angels with 12 investments over a period of 5 years have a 75% chance of a 2.6x return on their investment.

This seems to indicate that Angels with a financial objective to maximize profits would need to make sure that they have the available capital and time to invest in at least 10–12 companies.

With the median Angel investment ticket being $36k, such Angels would deploy roughly $432k into startups which would require them to have a net worth of approximately $4.3m, assuming that they obey the 10%-rule.

Obviously, Angels with much less net worth have collected extraordinary returns from their investing, perhaps because their ticket sizes were much lower than $36k. But this is not to say smaller tickets is a good thing: it can cause Angels to have less influence and lose out on protective terms.

I’ve come across many Angels with a net worth not much higher than that of the median Western citizen. Not having excessive funds might help explain why the median Angel investor has only 7 companies in his or her portfolio. Consequently, the small median portfolio might be the primary cause for the median Angel actually losing money on his or her startup investing! Why? Because research shows that those 10–12 portfolio companies is profit optimising, and investing in fewer companies increases your risk too much.

My advice here is to ensure that you’ve got a proper diversification as mentioned above but also to look beyond the portfolio effect: it is necessary but probably not sufficient. The ability to generate quality dealflow, win the deals, understand the market conditions, and add operational and strategic value are likely the most important drivers of investment performance.

When reduced, there are then two things to focus on: Angels’ capacity to see many deals and their ability to invest in and work with the right founders.

Much have already been written about the former, such as the importance of establishing a strong network of investors, entrepreneurs, incubators, university programs, etc. see more deals and get better access.

The remaining part of this article will therefore focus on how Angels can assess founders and what to look out for in winning founder teams.

The two laws of Angel investing

The only thing certain about startups’ forecasts is that 100% of them are wrong. No one really knows how customers, competitors, investors, etc. might accommodate your solution and how well your company will fare.

This is especially true at the earliest stage of a company’s life cycle where there’s no or little traction, which is where Angel investors come onboard.

So the general advice for Angels is to invest only in exceptional entrepreneurs; to choose people over ideas. This leads me to Jason Calacanis’ two laws of Angel investing which I think are spot on. The first rule bluntly states:

“You don’t need to know if the idea will succeed — just the person.”

Exceptional founders with bad ideas can be successful whereas the reverse is unlikely. So, how do you know if you are in talks with great founders? You need to spend time with them. Understand them. This is the second rule:

“Your success is correlated to the amount of time you give to founders.”

If you’re an active Angel investor you’ll end up spending time with the founders after you invested. But not matter if you’re an active or passive investor, you should also spend time with founders before investing to assess mutual compatibility.

Mutual compatibility is so important. It secures alignment and paves the way for a successful relationship between investors and founders.

Now, you can’t fully understand founders and assess mutual compatibility by simply having a few meetings. You need to work with the founders over a longer period and see how they handle setbacks, engage with customers, etc.

The more time you spend with founders upfront before investing, the better chance you’ll have of knowing whether they are winners or not.

10 things to look for in succesful founder teams

1. Two or more: companies with two founders grow quicker and live longer.
2. Resilience: recovering from hardships and learning from failures is key.
3. Persistence: delivering consistent hard work is a common trait too.
4. Integrity: showcasing honesty, transparency and straightforwardness.
5. Curiosity: strong founders are curious, adopt learnings, and explore.
6. Networkability: ability to win over new hires, customers, partners, etc.
7. Product vision: knowing what to build and how to communicate it.
8. Fearlessness: execution trumps knowledge any day; they just do it!
9. Resourcefulness: they are capital efficient and teach/help their team.
10. Charisma: successful founders are visionary and often charismatic.

Look out for these characteristics when you meet founders, but remember: there is no rule without exceptions! Some successful founders don’t really fit the 10 metrics above, and there may also be other things that are just as important. The most important thing is to follow your gut feeling.

The critical factor in Angel investing is to be able to assess potential in an objective and unemotional manner and to do it with a comprehensive and systematic process. Gut feeling equals emotional, so what do you do?

Following the founder team for a while to see if they win that big customer they told you about, if they get that customer acquisition cost down as they promised, and whether they were able to close those partnerships they bragged about, is the best opportunity you have to systematically assess the company’s potential in an unemotional manner, based on facts and progress!

Learning how to spend time with founders upfront before investing will give you much pleasure and joy. And you will have a much better overall investing experience.

One last thing for you! The more successful Angels acknowledge their limitations and biases and seek advice and work with others to ensure due process is followed. So pair up with experienced Angels (and VCs) and learn!

Disclaimer: The views expressed in this article are non-political, non-commercial, and solely my own. The content here is for informational purposes only and shall not be understood or construed as financial advice.

About the Author: Joachim Schelde is an Investment Associate at Scale Capital, a danish venture fund investing €1–3M in Nordic B2B tech startups at Seed/Series A and helping them win in the US.