Note: This article is the second in an ongoing series for angels new to investing. To learn more about building an angel portfolio, download this free eBook today Angel 101: A Primer for Angel Investors or purchase our books at Amazon.com.
Almost every time I meet a new angel investor one of the very first questions I get is a variation of “Can I make any money investing in startup companies?”. I wish there was a quick, 30 second answer to this question, but there isn’t. This seminal question is at the heart of what new angels need to understand before they jump in. Before you can answer this question, you must understand the risks you are taking. So how do you mitigate some of these risks? First, you need to understand what it takes to build a diversified portfolio of startup companies.
Over the course of seven years focused entirely on angel investing, Christopher built a substantial angel portfolio with over 40 investments. So I’m guessing that he has some interesting answers to questions that relate to building an angel portfolio.
Q: Christopher, think back to 2009 when you started angel investing. Did you have any concept of how many investments you were going to make?
Yes, and no. I had a goal of getting very diversified, and I had a target total amount of capital I wanted to allocate to the angel asset class, and I knew I wanted to focus on first round check sizes in the $10K-25K range. But what I did not know, and could not have known, are three very crucial variables:
- How many companies would merit follow-on investment?
- How much follow-on investment would they require?
- How much returned capital would I have to work with, and how quickly?
Regardless of the target angel allocation, those three variables are going to determine how many companies you can do.
Q: Why did you continue to invest in so many more new companies after you passed that threshold for diversification?
I did not have a specific threshold; the more investments you have, within the bounds of being able to manage them, the better. By manage them, I mean keep on top of them (Seraf helps a lot with that), keep current with their messaging and strategy, help them, have capital available to follow-on and be able to maintain a relationship with the CEO. There is probably an outside limit on the number of companies one can do that with, but for a full-time angel such as myself, who is passionate about the space, and energetic about putting in the time, that limit is pretty high - probably in the neighborhood of 50 companies.
Q: Looking into the future, how many companies do you expect to have in your portfolio?
Every portfolio reaches a natural plateau at maturity and the exits begin to off-set the new investments. How many active companies that plateau represents is a function of the pace at which companies are added (particularly good companies - if you have lots of “fast failures,” that will bring the numbers down). Here is how the law of plateaus works: if you assume most companies take 5-10 years to reach an exit, and 50% of your companies fail in their first three years, as the companies in the portfolio age, eventually the rate of harvest will come into approximate equilibrium with the rate of replacement and your portfolio will plateau. These are just guestimates because every portfolio is a snowflake, but if you are investing at a pace of 2-3 companies a year, you will likely plateau at 10-15 companies, if you invest in 4-6 companies a year, you will plateau in the 15-30 range, and 7-10 companies a year, you will probably plateau in the 30-50 company range.
Q: If you were giving advice to a new angel investor, what do you think is the minimum number of investments needed to have any real diversification in their angel portfolio?
You might get a lot of nice little wins along the way, but the majority of your returns are going to come from a tiny fraction of your investments. Massive wins are really rare, no matter who you are, and no matter where you are. Given that you are relying on big, rare wins to power the bulk of your returns, it stands to reason that you want to maximize your chance of hitting those. Being good at picking great companies is important, helping your companies succeed is important, and following on in your early breakouts is important, but at the end of the day, the most influential factor is having enough mathematical chances to even be in a big winner at all. If you invest in 10 companies you have 5 companies that might be big. If you invest in 20 companies you are fishing out of a pond of 10. And so on. So as far as I am concerned, baseline absolute minimum diversification starts at 10 investments, but this is a case where more is definitely better (again, subject to your ability to manage them as noted above.) Analysts have done Monte Carlo simulations that show that median returns increase substantially with portfolio size. So, while your mileage may vary, it is pretty safe to say that 20 companies is better than 10 and 50 is better than 20.
Q: What is a good pace for making new investments on an annual basis? At that pace, how many investments should an angel expect to have in a mature portfolio?
I think the best thing you can do is to keep the pace of investments relatively high as you are starting out so you can get up the diversification and learning curves quickly, but keep the average first round check size modest so that you have the capital to sustain your pace over the long term, including follow-ons. Follow-on investing is a really big factor in capital use. Getting more money into winners as they start to break out is critical to good returns. Not all of your companies will merit follow-on investing and the amount of capital required will vary, but a good rule of thumb is to set aside one dollar in follow-on money for every dollar of first round investment. You want to pick a pace that allows you to keep adding companies, covering your follow-ons and getting into the experienced end of the learning curve where you are presumably going to make better decisions. When you net it out, if you have the capital, and the time, and the quality deal flow, a good pace of investments is probably around 5-7 deals a year. If you have less time, less capital, and less deal flow, I still think you should be shooting for 3-4.
Q: You spent most of your career in the Enterprise Software industry. Do you make most of your investments in Enterprise Software companies?
No. The industry you know is certainly your comfort zone and your zone of greatest self-sufficiency, but the beauty of angel investing is that, unlike making a career bet where you have to bet it all on one particular job, you can diversify yourself into different industries by collaborating with other investors who have complimentary skill sets. So I definitely invest outside of enterprise software. The closer a company is to that kind of business, the easier it is, and the farther away it is, the harder it is, but my portfolio is well over half outside of enterprise software. One note of caution here is that some industries like life sciences are so radically different due to regulatory issues, IP issues, company development paths, and exit dynamics, that if you don’t have a background in it, you really need to work closely with expert co-investors for a long time before you can do it on your own. For example, although I have been looking at a lot of life science deals for the last 5 years or so, and I have invested in a few, I feel that I am still years away from being able to do that kind of investing competently on my own. A second note I would make, this time a positive one, is that if you are fascinated in an area and tend to think about it and pay attention to it in your free time, through general reading, networking and other activities, you can greatly shorten the time it takes to get up to speed in that area.
Q: How confidently do you invest in companies that are outside your area of expertise?
That’s a trick question! Start-ups invent new and innovative ways to fail every day, so I am never objectively confident in any investment I make. You need to have the humility to realize you are going to get burned on a number of them. But that said, many of them fail because of familiar and recognizable issues, and with practice you can spot those issues looming. Also, the quality of the team is a universally important driver in all companies, and some aspects of that team evaluation have common denominators across all industries. So there are some obvious issues you can learn to avoid, some key attributes you can learn to look for, and some personal industry experience you can rely on. As a result, as I have become more experienced, I have grown a bit more confident, or at least a little more trusting of my gut.
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