Angel Investing

The Gust Guide to Making Money and Having Fun Investing in Startups

David S. Rose

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118901212
• Edition: 1
• Topic: Business
• Subtopic: Investimenti e titoli
• Index: Business

Achieve annual returns of 25% or more with a well-designed angel portfolio

Written by David S. Rose, the founder of Gust—the global platform that powers the world of organized professional angel investing— Angel Investing is a comprehensive, entertaining guide that walks readers through every step of the way to becoming a successful angel investor. It is illustrated with stories from among the 90+ companies in which David has invested during a 25 year career as one of the world's most active business angels and includes instructions on how to get started, how to find and evaluate opportunities, and how to pursue and structure investments to maximize your returns.

From building your reputation as a smart investor, to negotiating fair deals, adding value to your portfolio companies and helping them implement smart exit strategies, David provides both the fundamental strategies and the specific tools you need to take full advantage of this rapidly growing asset class. He details the advantages of joining an angel group, explains how seed and venture funds can help leverage an investor's resources, and reveals how recent regulatory changes and new online platforms are making startup investing accessible to millions of Americans.

Making money is no longer about sitting back and reading stock listings, David says. It is now about being part owner of an exciting startup that can be fun and financially rewarding. Angel Investing teaches investors how to carefully select and manage investments, establish a long term view, and approach angel investing as a serious part of an alternative asset portfolio while also enjoying being an integral part of an exciting new venture.

Part I

The Basics of Angel Investing

Chapter 1
The 25 Percent Annual Return
Why Everyone with Six Figures to Invest Should Consider Angel Investing

Angel Investing in the past few years has moved from an arcane backwater of the financial world to a business arena that receives coverage in mainstream newspapers and hit television shows such as ABC's Shark Tank. Today, any sophisticated investor with a portfolio of alternate assets should consider direct, early-stage investments in private companies as one potential component of that portfolio. Why? Because multiple studies^* have shown that over the long run, carefully selected and managed portfolios of personal angel investments—even those without a giant hit such as Pinterest—produce an average annual return of over 25 percent. Compared to average annual returns of 1 percent from bank accounts, 3 percent from bonds, 7 percent from stocks, 10 percent from hedge funds, and even 15 percent from top-tier venture capital funds, that is an impressive number. See Figure 1.1.

Figure 1.1 Alternative Asset Returns

Wiltbank study (Rob Wiltbank, Willamette University): Angel IRR = 27 percent or 2.6x in 3.5 years. Sources: Venture Economics; HFRI Equity Hedge Index.

What is even more interesting about angel investing is that, unlike sitting back and clipping coupons, or reading the stock listings in the daily paper, being involved as a part owner of an exciting startup company can be a great deal of fun. You get a ringside seat at a venture that is out to change the world, direct access to company CEOs who may become the corporate magnates of tomorrow, and early access to the latest products and services before they become generally available. You may even have the opportunity to advise and mentor a company as it develops, pivots, and changes its business plan in response to real market experience.

By now, this must sound too good to be true: outsized returns and having fun—what's not to like? But here is the sobering reality: a large majority of self-proclaimed angel investors actually lose money, rather than make anything at all! How can these two facts be reconciled? Simple: those 25 percent-plus returns are “over the long run, on carefully selected and managed portfolios of angel investments.” In practice, however, most people who call themselves angel investors do not carefully select or manage their investments, do not take a long-term view, and do not have a clue about how to approach angel investing as a serious part of an alternative-asset portfolio. But you want to understand how to engage in angel investing as a serious part of your investment allocation. So let's begin with the basics.

What Exactly Is Angel Investing?

Angel investing is when individual people (as opposed to professionally-managed investment funds, corporations, governments, or other institutions) invest their personal capital in an early-stage company—often known as a startup. Angel investors are individuals who invest their own money, typically in small amounts, and typically very early in the life cycle of a company.

Angels find investment opportunities through referrals from people they know (such as CEOs of companies in which they've already invested), through attending regional or national events at which early stage companies launch their products, by being approached directly by ambitious entrepreneurs, through joining with other angel investors in organized angel groups, or, increasingly, by participating in reputable online early-stage investment platforms such as Gust. All of these techniques for identifying angel-investment opportunities, and many others, will be described in greater detail in Chapter 5.

The fact that angel investors use their money to back companies they hope will grow and bring them significant profit is not, in itself, unusual. Most mainstream investors do the same. They invest in blue-chip companies like Apple, Google, GE, and Coca-Cola, or in mutual funds that support an array of companies, hoping their money will grow as these businesses grow. The crucial difference between these mainstream investors and angel investors is that angels invest in startups—companies that are relatively new, small, and privately held (rather than publicly traded in a marketplace like the New York Stock Exchange or NASDAQ). Because these companies are like tiny plants, striving to become giant trees, the first investments in them by angels and others are often referred to as seed investments.

Unlike public companies, startups are often little known. They generally do not appear on the cover of Forbes or Fortune, and you won't hear them talked about by stock analysts on cable TV or even by your favorite broker. So understanding what these startup businesses are like, where to find them, and how to identify those with significant growth potential, is one of the keys to being a successful angel investor.

The world of startups and the ways in which angels and startups work together is a fascinating topic—and one in which change is constant. The stage at which an angel would typically begin supporting a startup with a cash investment has changed over the last few years as a direct result of the decreasing cost of starting up a scalable company using current technology. In the past, when the only way to get a company going was to spend cash, early investors would often have no alternative to “taking a flyer” and supporting an entrepreneur who had only a vision and a plan.

But today, with technology providing startup businesses with virtually free hosting, bandwidth, tools, and marketing (or at least free enough to get you started), the bar for a company to be considered fundable has been raised because it is so easy for anyone to get started. Since the large majority of opportunities with which angel investors are presented already have something going for them (a finished product, initial customers or users, perhaps even revenue), it is challenging for entrepreneurs with only an idea. Why should an angel take the added execution risk if he or she doesn't have to? Derek Sivers, an entrepreneur, writer, and frequent speaker at the TED conferences, summed up the idea versus execution relationship in a seminal blog post from which I've borrowed this eye-opening table for Figure 1.2.

Figure 1.2 Ideas versus Execution

Source: Derek Sivers, http://sivers.org/multiply.

Because of this, many companies in their earliest stages are unable to attract financing from angels and other professional investors. Consequently, so-called Friends and Family rounds of investment are the most common way (other than the founder's own capital) to fund a startup, and account for nearly a third of all financings. (A further explanation in more detail of the various stages of financing a startup is in Chapter 4.) Friends and Family investors do not base their investment on the merits of the business, but rather on their support for the entrepreneur. By contrast, the professional angel investor focuses on the long-term strengths and prospects of the business, in much the same way a mainstream investor picks stocks based on an evaluation of the strengths and prospects of the companies issuing those stocks.

As with investors in public company stocks, angels are part-owners of the companies in which they invest. The difference is that $10,000 invested in Google might buy you 10 shares of stock, representing one 33-millionth of the company. That same $10,000 invested in a promising startup might buy you 10,000 shares of stock, representing a full 1 percent of the company's ownership.

With that low a cost of entry, it is fair to ask if one angel ever becomes the majority owner of a startup. The short answer is virtually never. While there are, indeed, individuals who have put $1 million or more into one company, the vast majority of serious angel investors play with much smaller numbers. This is because investing at the seed and early stages of a company's life cycle is risky—the large majority of such investments fail completely. Angels therefore try to invest in at least 20 to 80 companies, thereby limiting the amount that will be lost on any one.

The average individual angel puts in about $25,000 per company, typically with 5 or 10 angels joining together to make up the investment round. (Many angels participate in angel groups or syndicates of various kinds. It's a very effective way to pool insights, ideas, connections, and other resources, and it enables angels to invest more powerfully than they could as individuals.) A 2009 survey^* showed that the average total round size for an angel group is about $275,000…although increasingly groups are joining together to syndicate deals in order to raise larger rounds.

Outside of that context, the range is wide, with solo angels investing anywhere from $5,000 to $500,000 (or more) in a given company. “Super Angels,” a misnomer usually applied to experienced investors who manage micro-venture funds, seem to average about $100,000 to $200,000 per investment. It is only when you get into the territory in which venture capital funds operate that you'll find early-stage investments getting close to $1 million from a single source.

So, in a nutshell, an angel investor is a private individual who invests significant, but modest sums, usually in five figures, in a variety of startup businesses. These investments collectively form a portfolio that, over time, will likely include both winners and losers. The key to being a successful angel is to have enough winners to more than offset the losers.

Can You Really Make 25 Percent a Year?

The essence of successful angel investing begins with recognizing and accepting one hard fact: your chance of making a profit by investing in startups is somewhere between very, very slim and almost negligible if you're talking about investing a very small amount in one company. Those odds increase significantly once you diversify your investments (even if they are relatively small) in dozens of companies.

Why is this the case? It is because a majority of all new, angel-backed companies fail completely, so if you invest in only one company, the odds are that you will lose all your money, not just “not make a profit.” But when a company succeeds, it has the chance to really succeed, and return many times the initial investment. This is known as a “hits business.”

So how much of a return does an average angel investor earn?

The data needed to answer this question doesn't really exist. because (1) there is no such thing as an average angel investor, and (2) there is currently no way to track the activities or record of individual investors.

That said, a rough summary of key statistics from Gust describing the activities of typical professional angel investors would be as follows:

• Individual angel investors receive anywhere from zero to 50 pitches a month, depending on how actively they promote their availability and how accessible they make themselves.
• Organized angel investment groups similar...