Article adapted from Seraf: Portfolio Management for Early-Stage Investors
I believe building a diverse portfolio is critical to success as an angel investor. But when I first sat down to write an article on diversification of angel investments, I knew right away I was facing a serious challenge. Numerous articles have been written on aspects of this topic:
“Data Driven Patterns For Successful Angel Investing” —Sim Simeonov
“How Many Angel Investments?” —Kevin Dick
“A Simulation of Angel Investing (Parts 1 and 2)” —Jeff Miller
“Why Angel Investors Don’t Make Money… And Advice For People Who Are Going To Become Angels Anyway” —Andy Rachleff
“Angel Investors Do Make Money, Data Shows 2.5x Returns Overall” —Robert Wiltbank
Each of these articles (along with dozens of others), tries to enumerate the best way to build a successful angel investment portfolio. Much ink has been spilled and computer cycles burned on discussing and simulating the optimally-sized angel investment portfolio. The results ranged anywhere from 10 companies on the low end to a portfolio of several hundred investments being recommended at the high end.
Instead of diving right into this pool of portfolio diversification theory, I’d like to broaden the aperture a little and break the problem down into manageable, bite size pieces that you can use to help construct a reasonable, and hopefully, very profitable angel portfolio.
Dimensions of Diversification – It’s not just about the number of investments
The first thing to understand is that it is not just about numbers. A portfolio consisting of 1,000 nearly identical companies is not diverse. Yet much of the public discourse on portfolio diversification focuses on just this one dimension – the number of investments. While this is a very important part of diversification, it’s just the beginning. I am a firm believer in owning a large portfolio of companies. Based on my experience of angel investing over the past 20 years, you do need many investments to improve your chances of success. Anything less than 15 to 20 companies puts your overall investment strategy at risk.
Of course, it must be acknowledged early on in any discussion that luck plays a role here: I know angels who invested in just a few companies and did very well, and I know angels who have dozens of investments and are still waiting for their first exit. But the overall point of the numbers game is to reduce the influence of bad luck and reduce the reliance on good luck.
So what other dimensions should an angel investor think about when creating a diverse portfolio? Let’s start the discussion with the following three areas:
- Type of Entrepreneur
- Stage of Company
In future articles we will examine other areas, but let me break these three down a little here.
Many seed investors and venture capitalists understandably like to focus on one industry where they feel they have deep industry knowledge, and therefore, a competitive advantage in their investing. Although this isn’t a bad approach to investing, it is very limiting. Would you choose to have only energy companies in your public company portfolio? I don’t think so. So why should you limit your early stage investing to just one industry?
There are a number of ways to categorize the types of entrepreneur. For instance, there are serial entrepreneurs who built many companies and first time entrepreneurs who are building their first company. We have young and old entrepreneurs. We have male and female entrepreneurs. And, we have all different races and religions. In my portfolio, I have a wide range of entrepreneur type. However, they all have a few characteristics in common. And it is critically important to match the type of entrepreneur to the type of opportunity.
While the stage of company most common for angels to invest is at the seed stage, it’s important for portfolio diversity to consider other stages. If you have access to interesting deals where a company is at a major growth inflection point, you should consider making an investment.
Capital Requirements – How much money do you need?
How do you calculate the financial requirements for building a diverse portfolio? Not counting the time dimension, which I discuss below, there are three key variables in the equation.
- Number of Companies
- Typical investment size for a company
- Amount of follow-on investment for a company
Let’s start with the low end for portfolio diversification and assume you will build a portfolio of 15 companies. The typical investment size varies quite a bit. Through crowdfunding sites you can invest as little as $1,000 per company. For most angel investors, the typical first round investment is between $10,000 and $25,000. If we take the low end of this range, you are talking about $150,000 needed for your first 15 investments.
However, there is one additional variable you need to factor in. How much capital do you need to reserve for follow-on investments in your portfolio? I advise seed investors to reserve somewhere between $0.50 and $4 for every dollar they invest in the first round of financing. The overall amount reserved depends on company stage, type of company and how well the company executes on their plan. That said, on average, you should reserve $1 for each $1 of initial investment. So, that $150,000 portfolio increases in size to $300,000.
If that number is beyond your appetite at this time, you should consider investing through an angel fund and let the fund help you build a diverse portfolio at a lower investment threshold.
Time – Patience is a virtue, especially for angel investors!
Angel investing is more like a marathon than a sprint. If you are planning on quick returns, you’ve come to the wrong place. When an entrepreneur tells you to expect her company will be acquired in two years, don’t believe her. More likely, the quick exits you have in your portfolio will be due to failure of the company.
Angel investing is an avocation for the patient investor. Building a portfolio of 15 or more companies takes time. I like to invest at a pace of 4 to 6 new companies a year. So it took me 3 years or so to create an initial, diverse portfolio. I do know some angels who make me look like a snail with my investing pace. I have colleagues who make 10+ investments a year. And, there are prolific super angels who invest in 50+ companies a year. But they are at the extreme and spend 100% of their time focused on angel investing. They also need to expand their geographical reach to ensure quality opportunities, and must necessarily reduce their involvement with each company, but that trade-off is a topic for another day.
When training for a marathon, coaches impress upon their athletes the importance of pace and the stamina needed for the long duration of the race. You need to be aware that the majority of exits in an angel portfolio take at least 6 years and in many cases more than 10 years. As an investor, make sure you pace yourself so that your capital doesn’t run out too early, and you are prepared for the time it takes to gain liquidity in your portfolio. One final piece of advice, be prepared to invest in both Bear and Bull Markets. Two of my best investments were made during the Bear Market of 2009. If I hadn’t invested in seed stage deals due to the downturn in my public equities portfolio, I would have missed out on some incredible returns.
So that is a quick introduction to the concept of diversification. And the key take-away there is that it is more than just numbers. In future installments, we will look at the question of access to the right deals, the role of due diligence in further reducing the influence of bad luck, and investment structures to name a few other key topics. But for now, let’s agree that diversification is probably slightly more complicated than people make it out to be.