Why Diversity?

To understand angel investing is to  understand the clear stages a company goes through on its way to dramatic success and the risks and rewards at each stage.  There are several stages to a “start-up.” The first stage is the Inception Stage when an idea is generated and the entrepreneur begins diligence. Few, if any, will invest at this stage outside of the entrepreneur and friends and family. The next stage is the Seed Stage. At the seed stage, the entrepreneur has qualified the idea as a bonafide opportunity. At this stage, largely only friends and family will invest, but some angels will venture into these waters. There are few true Seed Stage venture capital companies left.  The next stage is the true start-up phase. At this point, the entrepreneur should have a functional prototype of the product or service and early adopters willing to buy and adopt the product once introduced to market. This is the first stage at which most angel investors will consider a given business as a candidate for investment. The following two stages are Growth and Scaling to Exit. These are the traditional realm of venture capital funds, but angels are stretching their wings into this area spurred on by books such as Early Exits by Basile Peters and the need to fund their investments further in the life cycle as venture capital has continue to move upstream.

People invest in people in markets they like and understand. Unless all these things line up in order, investment does not happen.  Ultimately, the single largest factor for angels to invest is the management team. This is why friends and family will invest before professional investors. The irony is, outside of psychometric tools (which are becoming more prevalent) and prior experience, we have few tools to judge the team and must perform diligence on the plans, strategies, and business model produced by the team as a proxy. In all, there are between 80 and 100 basic independent variables that can practically be quantified and evaluate a startup. These can then be compared to historical data to predict the success of the business, but not of a team. It is common in the industry to say an A team with a B product has a greater chance of success than a B team with an A product. This has borne out repeatedly over time. And, the name of the game is betting the odds.

It must be understood that angel investing is risky. That is why the returns can be so great. According to the Center for Venture Research, angel capital returned a 27% IRR in 2010, the height of the recession. That was almost 2.5 times the S&P 500. The mindset behind angel investing is simple. This is the high risk/high reward portion of your portfolio. Between 3 and 5 of every 10 investments will fail resulting in a total loss of capital. The gains are expected to pay for it all many times over.  And, those losses offset gains in the rest of a balanced portfolio. So, a well planned and executed angel investing strategy should return capital and provide you great stories to tell your family and friends.

The question comes down to what is a “well planned and executed” strategy. The answer to this is we must quantify what we can about a startup to realistically size up the risk and reward (e.g. “MoneyBall”) then spend our quality time with the team and the business model. Ultimately, a deep understanding of both is required.  A 2007 study found that angel investments in which at least 20 hours of due diligence was performed were five times more likely to have a positive return than investments made with less due diligence time: http://www.angelcapitalassociation.org/data/Documents/Resources/AngelGroupResarch/1d%20-%20Resources%20-%20Research/6%20RSCH_-_ACEF_-_Returns_to_Angel_Investor_in_Groups.pdf.

There is a recent move in the professional angel investing market toward playing “MoneyBall” to quantify and manage risk. Statistically, using historical data, it can be demonstrated that putting smaller amounts of money in larger numbers of companies increases your likelihood of positive return on your investment. According to Kevin Dick of Right Side Capital Management, with 60 investments you have a 97% chance of getting your money back, with 75 investments you have a 90% chance of doubling your money, and with 150 investments you have a 75% chance of tripling your money. All these statistics are based on the historical AIPP database of startups.

If you want to be the best angel investor you can be, join an angel group.  There truly is safety in numbers!  This is especially true if you are new to angel investing.  Learn from those who have been successful.  By sharing expertise, knowledge, and experience, a group can minimize risk by making the diligence process maximally revealing.  And, it is a lot of fun!  There are numerous reputable groups around the country and can be found through the Angel Capital Association.

We at Angel Capital Group believe that the second key to creating a diverse portfolio is geography.  With very few exceptions, no one area or city will generate enough deal flow to create the kind of diversity that we seek.  In other words, to be be the best investor you can be, not only should you invest across multiple industry segments, but you should also seek geographic diversity to leverage the strengths of different cities and areas of the country.  To do that, an angel syndicate is mandatory.  With this model, you can invest alongside other great investors across the country who have a vested interest in the success of the mutual portfolio company.  Reciprocation is the repayment.

The smart money in angel investing today is following the strategies that can be gleaned from the Center for Venture Research’s findings and those in the marketplace today by applying statistics to analyze risk, making smaller bets in more companies, analyzing companies over multiple industry segments, and sharing deal flow over a large geography. As portfolio theory tells us, a diverse portfolio adds protection against market shifts.

When deciding if angel capital investing is for you, be realistic about your tolerance for risk first. When evaluating a company for investment, make sure the company has the maturity to match your risk tolerance and you like and understand the team and the business model. Once you have done your diligence, it must still feel right.  Then, bet the odds.

Copyright Eric L. Dobson, 2016

@edobson865 | @angelcapitalgr | www.linkedin.com/in/ericdobsontnwww.facebook/angelcapitalgroup

Recent Posts

Leave a Comment