Note: This article is the third 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.
In our discussion on the basics of building an angel portfolio, we shared our thinking on some key questions related to how many investments you need in your portfolio of startup companies. 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.
Q: 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.
Q: 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.
Q: 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.
Q: 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.
Q: 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 enough to launch me into the ranks of the Forbes Billionaire List, but it is enough to keep me going 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.
Q: What about Crowdfunding platforms… can’t I just invest a few thousand dollars using them?
Crowdfunding platforms have features like syndicates that allow you to write smaller checks, and they allow people in areas with less deal flow to gain access to deals they might not otherwise see. But these advantages need to be balanced against two key countervailing issues.
First is the fact that the above advantages relate to the financial capital side of the ledger. In angel investing, the human capital side of the ledger is equally important, if not more important. Some critical issues to keep in mind include:
- The financial capital advantages must be weighed against the fact that you are not meeting the teams and making any kind of direct assessment;
- You do not know whether anyone did any real diligence, or if done, who did the diligence;
- You do not know the quality of the deal lead:
- You do not know who, if anyone, is putting in coaching, mentoring, and advising work;
- Your class of investors may not be getting a board seat, or if they are, you do not have any connection to the person taking the seat, nor any ability to asses the value they bring;
- You do not know if the deal lead has any rational plan in terms of staging capital into the company over the long term; and
- You do not know what company updates or information will filter down to you, making the absolutely critical question of whether to follow on nearly impossible to assess.
Second is the fact that many of these platform systems have the added risk of potential "adverse selection" - the phenomenon whereby the good deals may already be filled before they get to the platform. The issue here is that for a given company, the theoretically lowest cost of capital is a quick local round filled by quality investors from your community who know and trust you and each other. The farther the company has to go from that theoretical ideal, and the more it has to pay in fees, time, and work to access capital, the more difficulty it may be presumed to have had raising the lower-cost capital. There are exceptions to this, but as a general matter, if some companies are going to platforms to "fill out their rounds" doesn't that mean that the converse is also true? That companies who were able to fill their rounds are not on the platform? If so, does that make you the person filling out rounds that are having trouble getting filled? There is a potential risk somewhere in here, and it is compounded by the lack of direct connection to the company as described in the preceding paragraph.
So, while you can use platforms to diversify (especially geographically) and write far smaller checks, it is foolish to think there are any shortcuts in this very labor-intensive asset class. As my partner Christopher likes to point out, angel investing really is not something that can be done properly with a mouse, while sitting at home wearing your bunny slippers.
Want to learn more about building an angel portfolio and developing the key skills needed to make great investments? Download Angel 101: A Primer for Angel Investors and Angel 201: The 4 Critical Skills Every Angel Should Master, or purchase our books at Amazon.com.