Note: This article is the twelfth in an ongoing series on valuation and capitalization. To learn more about the financial mechanics of early stage investing, download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.
When I began making angel investments almost twenty years ago, I had no concept of what it meant to build a portfolio of early stage tech company investments. It wasn’t because I lacked financial savvy. I considered myself a fairly knowledgeable investor in the public markets. I understood key investing concepts like portfolio diversification, risk-adjusted investment return, market capitalization, and staging capital. However, I didn’t have a grasp on those terms in the context of making angel investments.
For the first few years as an active angel, I invested in a variety of companies. I didn’t put any thought into traditional investment concepts like building a diverse portfolio that would result in solid financial returns given the risk I was taking investing in illiquid, high risk, early stage technology stocks.
Lucky for me, I live in Boston where there is a vibrant investment community of VCs and public company fund managers. A number of these investors were willing to help me understand the importance of thinking about my investments working together in the context of a portfolio of investments instead of just a random collection of companies. It took many conversations, a lot of study, and a bunch of reflecting on experiences to wrap my head around this approach to angel investing.
When I first met Christopher in 2009, I passed along some of my well-earned knowledge of angel investing to help him shape his portfolio. Since that time we have refined our thinking across investments in dozens and dozens of companies and continued conversations with our financially experienced colleagues in Boston and around the US. Our experience has led us to believe that for any angel investor to have long term success investing in early stage companies, they must construct a well-thought-out portfolio.
Christopher, what are some of the key investing concepts an angel investor needs to understand in order to build their portfolio?
Angel investing as an “asset class” exists in a market along with many alternatives for putting your money to work. Like every investment, it has a risk/return profile that needs to be understood. Angel investing is somewhat unique in that your behavior as an active investor can actually affect company performance. Unlike a Wall Street trader, an angel investor can help the companies in her portfolio with advice and introductions. Nevertheless, the angel asset class has an overall risk/return profile. This article will give you a perspective on the returns side of it. And as you might guess from the observation about getting involved, it also has its own effort/reward profile too - angel investing can be a lot of work, but also the most fun thing you have ever done in a professional context.
Another unique aspect of angel investing, and a critical concept to understand, is the theory of follow-on investing. As we pointed out in our discussion of methods for valuing startups, the first round of investment in a company is generally over-priced in order to make the founder economics work. A big part of why you overpay is you are buying an information advantage that you can leverage to deploy additional capital in the future more intelligently.
As you watch the company put your money to work, you can see if the CEO is a good steward of capital, whether she gets good results, how she communicates, how customers react to the value proposition and all manner of subtle intangibles picked up along the way. If you have other companies and CEOs to compare to, you can quickly develop a sense of which of your companies are likely to be winners. These insights allow you to follow-on with smarter money in later rounds.
Yes, the valuation will have gone up for those later rounds, but your visibility into performance and remaining risk will also have gone way up. And, the company will be much more established, so even though the valuation is higher, your overall risk/return ratio on the money may be far better than from your first check. In fact, even if the cash-on-cash return multiple on that later round is lower, it may still have a higher IRR.
The final foundational concept is the concept of angel portfolio diversification. Just like in mainstream investments in the traditional liquid part of your portfolio, diversification with angel investing is key to your returns. There are two key differences with angel investing, however:
With angel investing, diversification has many different dimensions besides just quantity of different holdings
Given how much labor is involved with the different aspects of these deals and company pathways, it is much, much harder to get diversified into quality deals as an angel investor.
Okay, that’s a nice summary. I’d like to dig a bit deeper into each of these concepts. What are some key takeaways that investors should think about in the case of Risk vs. Return?
As a very smart investor we work with, Bob Gervis, has correctly observed, investing is about evaluating return and risk together, in context. As a general matter, asset classes may differ, but your investment processes should stay the same. In every asset class you are looking to understand the overall risks and expected returns for the class, so you can recognize opportunities with the potential to deliver excess returns for the risks presented.
Different investors will vary in how they tackle this challenge. Many angel investors take the view that it is very hard at the earliest stages to really assess risks and as a result feel they must adopt a “low conviction, low concentration” approach. In other words, they hedge risk by making a large number of relatively low conviction bets and avoid having any one investment represent a big concentration of their portfolio. At its most extreme, this approach is sometimes referred to derisively as a “spray and pray” approach, but it should not be dismissed out of hand. Sometimes this approach pays quite well because it increases the chances of hitting one big winner, and in angel investing, one big winner can dwarf the impact of all your small winners put together.
Other investors, particularly ones with a lot of experience who are getting more confident trusting their gut, prefer a much more analytical approach with more conviction in each investment and a portfolio with fewer, more concentrated investments. The investment approach Ham and I use tends to fall toward this end of the spectrum. To do this kind of approach well unfortunately requires a lot of thought and a lot of diligence. To determine if you are looking at a potentially investable opportunity you have to start by considering traditional factors like: the management team, the market, quality of solution, whether there is any kind of moat to hold competitors at bay, and what the exit potential might be.
Then you need to gauge the types and magnitudes of risks presented. Experienced investors will tell you they tend to prefer “execution” type risks in fixable areas like go-to-market strategy, choice of vertical, or marketing strategy rather than more fundamental risks such as technical or science risks.
Once you understand what you are signing up for, you need to put it in context. What is an appropriate return for the risks presented? Generally with zero liquidity, long term, high risk investments like angel deals, the appropriate return will be much higher than the typical returns you could get in a fully liquid investment class like blue chip stocks or mutual funds. To understand the likely returns, you need to analyze the capital structure, future capital requirements, exit potential, and other factors in order to determine the current valuation necessary to deliver minimum required return to compensate for risks presented (or, the size of exit required to provide an adequate return at the indicated valuation).
And finally if the expected risk-adjusted return ratio looks attractive, then two final tests are necessary:
Deal particulars - are there any things about the deal that are off? Is the board solid? Is there good governance? Are there any red flags in the investing syndicate?
Follow-on options - will this deal allow you to “stage” capital by making additional, much larger, much smarter bets over time? If not, is it worth the trouble and risk to make just this one investment?
When you are making a decision on investing in a company, are there financial risks that you aren’t willing to take, and why?
As you may have gleaned from reading our discussion about valuing companies, it typically does not make a ton of sense for angels to invest in deals which are truly overpriced or which have massive financing risk down the road.
If a deal is over-priced, or priced for perfect execution (as I like to say, has no room for error in the plan), your return is not only going to suffer in a win, but your risk of failure actually goes up. Companies fail all the time because they get way ahead on their post-money valuation and they cannot raise new money on attractive terms and things suddenly curdle and fall apart.
That slight adjustment down in returns and up in risk has a MASSIVE impact on the risk/return ratio. It does not make sense to invest in these deals. You might get out alive with a mediocre return, but you will not be paid adequately for the risks and illiquidity you undertook in the process (let alone the work and anxiety). This recognition is part of the reason why you see year to year variability in the rate at which angel groups like Launchpad Venture Group add new deals to our portfolio. In times when deals are relatively over-priced (such as 2000-2001 or the 2015-2017 period), we tend to concentrate more on follow-on investing into companies who can really support their valuation than on aggressively adding new deals that may prove to be totally over-priced.
Similarly, another financial risk we are are careful about is capital intensity. Companies which are clearly going to need tons and tons of additional financing are dangerous ground for angels unless the source of financing is already identified. Too much can go wrong. Companies like Uber and Tesla that gobble up tons of cash certainly can work out and pay off pretty handsomely, but more often they don’t. It does not take a very big hiccup in results or shift in the macro-economic climate to make deals like that which need access to a steady stream of big capital at attractive prices come tumbling down like a house of cards. That game is best left to VCs and private equity teams with billions of dry powder under management.
Now, I’d like to take a closer look at Portfolio Diversification. What are some of the important dimensions that angel investors should consider when building a diverse portfolio?
There are many different elements to diversification beyond just simple quantity of companies. Here are some of the big ones:
Having companies in different industries or sectors
Having companies at different stages of development - some which will “pop” early and some which will take a longer path
Having companies led by different types of entrepreneurs
Having companies which are undertaking different kinds of key risks
Having some companies which allow you to be very involved and leverage your expertise, and having some where you can afford to be more passive.
As you are putting together your portfolio, you are trying to make sure you are broad enough to have balance. For every weight, you want a counter-weight. For example, you want to be in several different industries, so that if one industry starts to slow down, others can help pick up the slack. Similarly, you are looking to have some very early stage companies on longer timelines as well as some later stage companies which can be expected to exit sooner and return capital to the portfolio in the near term.
Investing in different types of entrepreneurs is also important. You don’t want all late career entrepreneurs any more than you want all millennials as company CEO. You don’t want all men or all women. You don’t want all engineers or all marketing types. You don’t want people who are all from the same social, educational or cultural background. You want to make sure you are investing in a mix of people and that each one (or each total team) has appropriate skills for the opportunity at hand.
We discussed the type of risk being undertaken here and elsewhere often enough to not want to repeat it here as a diversification factor beyond acknowledging that type of risk is one important dimension of diversification. Instead, I will focus on a final, more subtle, issue, the issue of effort. Different angel investments will require different amounts of your time and effort. Some deals are clearly “projects” but you take them on because you have specific expertise that can really help. Other deals will have someone else who is a better suited person in the lead position and therefore require minimal input and supervision from you. The deals requiring lots of involvement can be lots of fun, but you obviously cannot build a large portfolio full of high-effort deals. You will burn yourself out long before you reap any financial returns. It is far better to invest in a mix of active and passive deals. A good way to think about it is to look realistically at your schedule and when you are at your maximum capacity, do not take on another “project” deal until one has exited or at least moved out of the diapers stage!
Let’s say you have ten companies in your portfolio. Ultimately, do you end up investing the exact same amount of money in each company?
No. Even if you start out with the exact same first check size, if you are applying good follow-on theory, you will end up with less money in some and quite a bit more in others. As I noted above, with your first investment, you are buying an informational advantage. You have a front row seat to see how the company does. As the losers become obvious, you should fight the urge to throw good money after bad. As the winners become apparent, you begin following on with smarter money as your conviction builds, leading to a higher portfolio concentration for those winning investments (even on just a cost basis before accounting for the fact that their growing value further increases their share of the portfolio pie). One good way to gauge how you are doing on this is to look at the average amount of money invested in all your losers and the average amount of money invested in your winners. Hopefully, you should see a ratio of at least 2:1 more money into winners, but if you have serious capital, it could reach 5:1 or even 10:1.
That kind of aggressive following-on in winners is sometimes referred to as playing offense. When you see a winner you try to at least maintain if not increase your percentage ownership. Of course there are situations where you need to play defense as well. Sometimes a company gets into a jam and, even though they are not setting the world on fire, you choose to invest a bit more. Why might you put money into a company which is not doing all that well? Because doing so allows you at least a chance of salvaging some or all of your investment in the company. There are situations where investor abandonment would mean a sure and certain write-off of everything invested. If investors put a bit more in they may enable the company to finish a product, or gain enough sales traction to be sold, or do an orderly dismantling that brings in enough to cover the investor preference stack. One other reason you might put money into a struggling company is because some deals present “pay to play” situations where new rescue money says they will only come in if all investors invest their pro-rata, or include provisions which aggressively and disproportionately dilute investors who do not follow-on.
Defensive situations can be especially tough because making a rational decision requires first admitting the original investment was a mistake, and then taking a sober and clear-eyed approach to your defense strategy. Each case is different and should be evaluated carefully. Although there are situations where defensive investing makes good sense, more often than not, it is probably smarter to admit your failings and take the write-off. It is a different kind of mindset and a different kind of analysis. Often people making defensive investments either don’t realize that is what they are doing (because they still hope the company will get back on track and it is all going to work out) or they don’t realize it is a lost cause and that losing $25K now is better than losing $50K in two years.
So those are the decision factors for clearly offensive and clearly defensive situations. If only it were so easy. One of the persistent difficulties with following on is that many times it is not clear whether you are playing offense or defense. Frequently, it is not easy to determine if you are looking at a winner or a loser by the time a company needs more money. Forgive the gambling analogy, but if you have ever played Texas Hold’em, you will understand the concept of paying ante just to see the next card. In angel investing often you need to decide whether to put more money in before you can be reasonably sure, let alone absolutely certain, that the company is a winner.
In those situations, the best course of action is to have a long term capital staging plan for the company and add an incremental amount of additional capital toward your target amount. Your initial check might represent 10% or maybe 25% of your end goal for money into the company and in these situations you put another similar or even smaller amount in. You are hedging your bet - it is not yet time to significantly ratchet up your commitment, but it is also clearly too early to write things off. So you often just bite the bullet and invest.
But before you do write that second check, you should review the company’s stewardship of the first capital it was entrusted with. Did the company perform as well as could be expected given the circumstances which developed? Were there any red flags about the team, the market, the competition? If there were, perhaps this is a case where you choose to allocate that money to a new company instead. But if there are not any red flags, then put in another small sized check reflecting medium conviction rather than bumping up the check size yet. Or in Texas Hold ’em parlance, ante up, but don’t raise.
Next up on this series: Tent Poles and Toads: The Mix of a Winning Startup Portfolio.
Want to learn more about the financial mechanics of early stage investing? Download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.