Article adapted from Seraf: Portfolio Management for Early-Stage Investors
Many often wonder, how many investments do you need in your portfolio of startup companies? And, that leads next to a great discussion — “How much money are we talking about allocating to angel investing?”.
Since Ham is the finance guy at Launchpad (he was a Computer Scientist and I was an English major, so I let him do the math), it’s my turn to ask the questions.
Ham, after 15 years as an active angel investor, how much of your overall investment portfolio is allocated to angel investments? Should it be more? Should it be less?
When I started investing many years ago, I decided to go at a measured pace. So it’s taken me close to 15 years to grow my angel portfolio to about 15% of my overall investment portfolio. Public companies, REITs, and ETFs make up the majority of my investments. They provide me with a stable source of income and flexibility because they are dividend generating, liquid investments. I can buy and sell them whenever I like. As you know, investing in early stage companies doesn’t provide any current income and the investments are not liquid. It’s extremely difficult to sell these securities.
The answer to your question about should it be more or less is a very personal choice. The way I look at it is I have financial responsibilities to my family. Being a more aggressive angel investor would limit our choices as a family in the near term. I’m not willing to make those sacrifices right now. But, a 15% allocation to angel investing means I am deeply involved in this asset class and I am able to build a portfolio that is reasonably large at 30+ companies.
How do angel investments differ from investments in public companies?
There are major differences between angel investments and investments in traditional public company stocks, mutual funds and ETFs. Let’s look at some key differences:
Angel investments possess a few very unique and positive attributes:
- Size of Stake – Unlike a large public company, where even a very substantial investment might yield you 1/1000th of a percent of the company, with angel investing, you are investing so early and at such a low valuation you can own a very meaningful chunk of the company. It is not uncommon for individual angels to own and hang onto 1% or more of a company. For example, a $30,000 check into a company with a post-money of $3M will net you 1% ownership. If that company goes on to someday earn a billion dollar market cap, a 1% stake could be worth $10M.
- Ability to Know and Evaluate the Team – Very active public company investors might read analysts reports or even listen in to quarterly earnings calls to hear the management teams voices. But, they are not going to know or have any relationship with the management team. Active angels may know a startup management team very well as part of the evaluation and investment process and may have regular communications with the team.
- Ability to Help – As a by product of knowing the startup team well, angel investors have an opportunity to sit on boards or advisory boards, give advice, answer questions, and make introductions, assist with sales, assist with hiring and assist with the ultimate sale of the company.
- Access to Growth Markets – Big companies tend not to bother with new markets until they have been proven to exist and grown a bit. By the time big companies take a new market seriously, much if not all of the “hyper growth” may already have happened. Start-ups are often there at the beginning because they are willing to risk entering new markets.
- Potential for Unparalleled Returns – When you consider the incredibly early stage of investment, the low valuation, the high ownership percentage, the long holding period and the ability to help out, all of this nets out to the potential for a small fraction of your angel investments to deliver massive returns of the type you will almost never see in the public markets. You have to take some risk and show some patience to get there, but when an angel investment hits big, it hits really big.
Angel investments also have a lot of very serious drawbacks:
- Liquidity – Angel investments are totally and completely illiquid while you hold them. The stock you receive is unregistered stock issued via an SEC exemption, and as such it could not be sold even if there was a ready market for it, which there is not.
- Transferability – As noted above, your ability to transfer the stock or securities you receive as part of an angel investments is extremely limited. Not only do you have to comply with SEC prohibitions on transfer, most investment documents contractually prohibit it, save for narrow exceptions for tax, estate and family planning purposes.
- Holding Period – Not only are these securities illiquid and non-transferrable, they typically need to be held for many years before your returns are generated. Most often this is by exit through acquisition by a bigger company and very seldom by an IPO which can take even longer. Being acquired by a larger company can take years of value creation and planning. As a result, most angels would be very pleased to have a positive outcome in less than 5 years and many expect the big winners to take 7 or more years.
- Risk/Failure Modes – When a public company investment “doesn’t work out” that generally means it did not go up as much as you expected, or even went down a little. So perhaps you walk away with 95 cents on the dollar or 110 cents on the dollar when you had been expecting a bigger return. When an angel investment “doesn’t work out” it typically means the company has completely imploded for one reason or another (insufficient capital, product failure, market didn’t materialize, management team didn’t work out) and you are looking at 0 cents on the dollar. Sure, there are times when angels will salvage a bit of their money back from a failed investment, and you can often get a tax write-off. But the point is that a total and complete wipe out of your invested basis is always a possibility and relatively common, whereas that is virtually unheard of with blue chip public equities.
- Reporting – Public companies are required to make regular annual reports on Form 10-K, quarterly reports on Form 10-Q, material development updates on Form 8-K, and provide detailed disclosure of compensation and other issues via their annual proxy on Form 14A. Startups face no such requirements, so it is up to management to determine the frequency and form of reporting to shareholders. Despite investment agreements typically requiring regularity, this reporting can be quite variable – from excellent to non-existent. Professional investors can demand that delinquent CEOs do better, but at the end of the day, you cannot make a horse drink water if it doesn’t want to.
When you net it all out, angel investments are clearly not suited for every type of investor risk profile or portfolio. Yet, for some investors they are a critical part of their portfolio returns strategy as well as a vehicle for very satisfying hands-on investing work. Despite the drawbacks, angel investments remain attractive overall, primarily because they have the potential to deliver outsized returns.
How do angel investments differ from investments in assets like collectables, real estate or commodities?
There are similarities (and differences) with each of those categories, and at the end of the day, what you prefer depends on your skills and interests. But there are some important subtleties here, so let’s take a look. The biggest differences with angel investing compared to assets like collectibles, real estate and commodities, are that:
- Stasis vs. Change. The angel investing asset, a start-up, is changing all the time, and often very quickly, whereas a building, a collectible Ferrari or a block of gold would not change much at all over the same timespan. Sure, the building and the car would decay slowly over time, and admittedly part of the fun of (or financial edge associated with) investing in those categories for some people is that they may need restoration, but overall they are relatively static in comparison to startups.
- Hard Asset vs. Soft Asset. Collectibles, real estate and commodities are hard assets, by which I mean they have intrinsic value, set by a market. Their value might fluctuate somewhat with economic conditions or changing investor tastes, but it is typically going to be within a relatively narrow range. These assets are not going to drop to zero overnight. And they also have some liquidity while you hold them. Commodities are almost perfectly liquid, and real estate has some near term liquidity (as well as the potential to deliver real-time cash flow). Even collectibles can be sold if you have a little time or are willing to take a slight loss to move them quickly. Angel investments, by contrast, are a type of “asset” with absolutely zero liquidity and no “intrinsic” value. If the startup cannot build the product, the market does not materialize, the team has a falling out, the company cannot secure needed growth capital or any other of myriad startup meltdown scenarios occur, the value of the investment in the startup drops essentially to zero, essentially overnight. There might be some intellectual property that can be salvaged or some other minor assets which can be liquidated, but broadly speaking it is just a puff of smoke and its gone. And, in contrast to the liquidity of collectibles, real estate and commodities, with startups, even if the startup is doing very well, in the early years your ability to sell your stake is tightly restricted, even if you could find a buyer.
Given those somewhat stark differences, you might ask “why would someone in their right mind invest in a startup?” Obviously, they would have to be attracted by something, and part of that something is the risk-reward offered by the the startup asset class. Collectibles, real estate and commodities may steadily go up, even sharply at times, but they are never going to have the potential to deliver you a 100x or even a 1000x return on your investment in a 10 year period the way investing early in a breakout startup could (consider, for example, that the earliest investors in Google received over a 1000x return or that the earliest investors in eBay received a 1500x return – extreme examples, but they illustrate the point.) It is that potential for outsized returns which allows angel investing to compete with other asset classes.
But potential returns is not the only factor in selecting where to focus your alternative asset investing strategy. While an appetite for a certain risk-reward relationship is clearly part of the equation for people choosing angel investing, the final piece is probably a function of your personal skills and interests.
If you have always loved cars, are knowledgeable about them and like working on them, talking about them, being around them and going to auctions and car shows, collectable cars might be the most appealing alternative asset class for you. You might make your peace with its particular financial trade-offs. Likewise, if you have a background in the real estate industry, or like the cash flow provided by real estate, then investing in land and buildings or projects might be your focus area. And, for example, if you have a background in global financial markets or enjoy the activity of trading in commodity markets, or feel more comfortable having more liquidity, you might be drawn to commodities.
But if you have a business background, are interested in business strategy, new technology, have learned some valuable lessons over your career that you’d like to share, like people, and enjoy getting actively involved in your investments and helping drive positive outcomes, angel investing may be the most appealing of all. The fact that it offers the tantalizing possibility of the occasional massive breakout win only makes it that much more appealing.
You are a pretty active angel, how does 15% compare with other angel investors?
When new angels ask me how much they should invest in this asset class, I typically respond with a range of 5% to 10%. And, I tell them to include any investments they made in venture funds, PE funds, hedge funds or angel funds in that total allocation.
Based on my experience talking with hundreds of angels over the years, I believe most active angels invest within this range. That said, I also know angels who invest significantly more than this. In almost all of those cases, they are very high net worth individuals and angel investing is their full time job.
What advice would you give a new angel just starting out? How much capital should they expect to invest on an annual basis if they want to build a diversified portfolio?
Are you ready to do some math?? Here’s how I look at it. In a previous Angel 101 post, I asked you how many investments an angel should make to build a diversified portfolio. At the low end, you suggest that 10 is the minimum and 20 is better. Furthermore, you suggest that a pace of 3 to 5 new investments per year is a good pace. And finally, you recommend that an angel should reserve a dollar for every dollar invested in the first round.
I agree with your suggestions, so how does that translate into an annual capital commitment. Let’s make the following assumptions:
- You invest in 3 new companies per year at $10,000 each
- You invest an additional $10,000 in each company some time within 18 months of making the first investment in that company
So that will work out to $30,000 in your first year and $50,000+ in subsequent years. For someone who is investing $25,000 in each new company, the numbers look more like $75,000 in the first year and $125,000+ in subsequent years. Not everyone believes in follow-on investing, so their capital commitments will be lower on an annual basis. Without the follow-on rounds, an angel will cut their capital commitment in half.
As a side note, at Launchpad we highly recommend that new angels start out investing at the $10,000 level. It’s better to get your feet wet by doing more deals and smaller investments. We always cringe when a new member of our group writes a $50,000 check for their first investment. We feel they are setting themselves up for an unsustainable investment pace and an unavoidable case of buyer’s remorse.
How much capital should they allocate for their entire angel portfolio?
After 4 full years based on the above scenario, you will have a portfolio with approximately 12 companies (don’t forget you might have an early failure or acquisition), and you will have invested somewhere in the neighborhood of $200,000 to $250,000. Not coincidentally, I believe this is the minimum amount you should reserve for building an angel investment portfolio. Anything less than that amount and you won’t have invested in enough companies. So if you aren’t comfortable committing $250,000 to angel investing over a 4 year period, you might not want to start.
Let’s examine another scenario. If an angel builds a portfolio closer to your recommended range of 20+ companies where the investment pace is 6 new deals a year, the math works out to something like this. Assuming $25,000 for the initial round and allocating funds for follow-on rounds, an angel will invest over $1,000,000 dollars in a 4 to 5 year time frame. If you keep to the 5% to 10% of your overall investable net worth, such an angel should have an overall investment portfolio of between $10,000,000 and $20,000,000.
What do you do when one of your angel investments returns capital to you?
Since starting out as an angel investor in 2000, I’ve had quite a few exits. The positive ones range from a 2x return to an 11x return. It’s not yet enough to launch me into the ranks of the Forbes Billionaire List, but it is enough to keep me going strong as an active angel. My approach to investing is to take any returns I receive and reinvest in new startup companies. I treat my angel portfolio as an evergreen fund, and based on my exits, I am able to grow my portfolio with many more new investments.