Like Moths to Light: Why Angel Investors Seek Certain Types of Companies

Angel investing deals
Image by Peter Miller

A group of angels turns up their nose at a company making a useful, well-targeted and well-validated computer peripheral product. The smart entrepreneur behind the company asks a pretty fundamental question in response: “Why do angel investors often turn up their noses at real, down-to-earth physical product companies and instead chase ethereal web and process flow services businesses?”

It’s a very good question, and one that comes up frequently.  To understand it, you need to understand the angel’s perspective. Angel investors look at the world differently than VCs. VCs generally have huge funds that they need to put to work, so they are looking for outsized opportunities in which they can invest lots of money and get it growing for them. Finding “venture scale opportunities” is their main focus.

Some angel investors similarly focus on finding the next Google or Facebook, but most angels think a little differently. Many angels think more like runners trying to steal bases. They want to make progress and score runs without getting out. When contrasted with VC funds, angels are like two-legged evergreen funds. Since they are using their own money, they don’t have at-bats to waste – realistically they can only write so many checks a year, and put so much money to work in a month, a year, a lifetime.

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As a result, angels view a company’s capital efficiency as paramount. They want companies which will get something done with their money – achieve some milestone that will significantly de-risk the business. Angels want to invest in runners who can get on base and drive runs in. Big home runs are surely sexier, and many angels will swing for the fence every once in a while, but for the most part, they are trying to get on base and coax home the runs. And they look for ways to stretch their dollars, mainly by focusing on businesses they know something about and where they can help out with advice and introductions.

As a side note, this is probably a good spot to acknowledge that angel investors are sometimes criticized by VCs for not thinking big enough. The idea behind this criticism is that it takes a real VC to build a game-changing company and boys and girls in short pants shouldn’t mess around with a grown man’s [woman's] game.

Most of that silly posturing is easy to ignore, but one inference sometimes made is worth refuting: VCs will sometimes imply that working with angels can hurt a company by reducing the scope of its ambitions. This is plainly nonsense when you consider that it is much easier to put extra money into a company at any time it suddenly becomes necessary, than it is to take excess money out if it. Over-capitalizing companies is at least as pernicious as under-capitalizing them (for the entrepreneur as well as the company), but at least under-capitalizing is quick and easy to fix. Thus, we have the angel focus on putting in the resources needed to get on base, and then reevaluating the field position once you are there - there is no real cost to approaching that way (except, perhaps, in certain consumer web companies where barriers are low and time is of the essence), and there can be some real benefits in terms of alignment with entrepreneurs who want time to create value between rounds to minimize dilution.

How does that translate into preferences in terms of types of investments? It’s pretty straight-forward equation. Since every company makes lots of mistakes in the early days and inevitably takes more time than expected to achieve their forecasts, the basic and fundamental nature of the business they are pursuing has a lot to do with how much cash they consume while they thrash and iterate. If you build a web-based business and you don’t quite get the product right, it takes two pizzas, a six pack of beer, and a weekend to modify it. If the business you are in requires you to build a factory and a supply chain and crank out enough widgets to fill a distribution chain before you can discover the error of your ways, you have burned a lot more money in the process. Though as Adrian Gonzalez notes in a follow-up piece to this post, outsourcing can reduce those costs significantly.

As a result, angel investors are drawn to businesses that require relatively little capital. And within that category, they are especially drawn toward businesses with the potential for rapid expansion of margins as the company grows and scales. Why? Again, because they don’t want to get thrown out at second base. If the company burns more money than the angels can provide before it has created something of real value, it is game over – you are looking at either a total write-off or a cram-down distress financing where later investors badly dilute the earlier investors. Businesses with inherently expansionary margins quite simply provide more room for error. Even a little sales success gives meaningful relief in terms of the capital burn. The supply chain is simpler. Distribution over the web is virtually free rather than having to go through tiers of distribution. Factors like these drive the powerful capital efficiency the angels crave.

To illustrate the point, let’s look at a business at the opposite end of the margin expansion spectrum, a professional services business. These people-based businesses have their costs grow linearly with their revenue because, to grow, you need to add people. (From an attractiveness perspective, it doesn’t help that their main assets can quit any time they want, either.) Companies which manufacture products fall in the middle, but still contain some scary aspects. They need to put together longer and more complex supply and manufacturing chains. They have to carry inventory which has high costs and huge risks of obsolescence in the event of a necessary pivot, and they have to figure out and pay for distribution, which further erodes margins.

Web services and software products, in contrast, cost relatively little to get started. And then once you produce the first “copy” of your product or deliver service to your first customer through the site, the second and subsequent copies and customers are so much less expensive as to be virtually free. It is pretty typical to see even the old traditional pre-SaaS packaged software companies with product gross margins as high as 95%.

It is true that these electron-based businesses sometimes seem fluffy and trivial. And since they are relatively easy to start, they are not always focusing on solving the weightiest of problems. But they can iterate and evolve extremely quickly and many of them go on to become pretty important. Who could have foreseen that a service initially derided as a platform for broadcasting what you had for lunch and a system for “poking” your friends and “liking” your favorite brand of soda pop would have ended up contributing to the downfall of repressive regimes in the Middle East?

So even if these electron-based businesses seem lighter-weight in comparison to solid, down-to-earth product businesses with real assets, they are not necessarily more risky on an adjusted basis. When you factor in the cost of mistakes, even a really solid, obvious, useful product like this actually ends up representing as much capital risk as the seemingly riskier, flimsier, web-services company. The no-asset, electron-based web services company may seem higher risk, but (i) it consumes less capital which (ii) gives it more room for error which (iii) it has a higher alpha: if it does work, it works big, its margins expand explosively and it generates a big return on the modest capital invested. With that in mind, it is not hard to see why angels chase them.