Benjamin Joffe

@benjaminjoffe

The Hacker Guide To Angel Investing

February 12th 2018

This post is intended for aspiring or beginning angel investors.

‘I’m an angel investor’. It can be a serious endeavor, a path to fortune or merely am expensive hobby (like racing cars on weekends). Is it a hard-won Purple Heart, or a chocolate medal? And are there better ways to succeed?

No worries: it’s vegan.

The type of angel you are is your own choice. Some people invest because they like it, while others like Tucker Max or Tim Ferriss pretty much stopped to ‘make better use of their time’.

I did my first angel investment 10 years ago — sort of ‘before it went mainstream’ — and am mostly ‘mission-driven’: I only invested in startups whose mission and founders I was proud to support.

Since then, I’ve invested in ‘only’ a dozen companies and have ‘on paper’ a positive ROI (I just chose not to sell shares that would have made it a net positive). None has fully exited, but I sold some shares at up to 75x. So far, 1/3 are doing great, 1/3 are closed and 1/3 are ‘in-between’ with uncertain futures. This is not so common for any type of investment (as an asset class, VC are said to be underperforming), and even rarer for angels.

The focus of this post is to help new angels understand the social side effects and market dynamics, so they know better than I did what they’re getting into (though I’ve been fortunate enough I can’t complain).

Why Is Angel Investing Appealing?

In no particular order, here are some of the benefits.

  • First, it suggests that you have significant disposable income
    In the U.S. you generally need to be an ‘accredited investor’ (= $1M in assets, or income >$200k). But it might be cheaper than you think!
  • Second, it puts you in a position of power
    People ask you for your money, or advice (smart founders ask for advice first and get both). It’s a flattering position to be in.
Great power can lead to abusive behavior
  • Third, as it gives you status
    And access to people and networks.
  • Fourth, it lasts for years
    Since more startups need many years to succeed after their first round (and generally at least 2 years to die), you can peddle the story for a while.
Precogs can’t wait 10 years to know if they’re right
  • Fifth, you will learn about the real life of startups

As Itai Damti, an angel investor and entrepreneur friend who grew his fintech company to 100 staff, reminded me of, what you get is a whole lot of learning:

Angel investing is a priceless way for entrepreneurs or executives to get to know the other side. In the age of being able to invest 5–10k, most tech leaders with money should do it at least once.”— Itai Damti

The $5k Angel

Yes, you can call yourself an angel investor with a single $5,000 investment! Instead of buying a foreclosed house or a Bengal cat, give yourself the ultimate gift! And if you want to max out on ‘angel investment theatre’ you could have a 10-companies portfolio for $50k. Wow.

Half a Bitcoin won’t give you as much class

How do you do that?

Minimalist angel gear costs $1.89 on Taobao

With AngelList syndicates, equity crowdfunding, and now ICOs of entire accelerator batches, it can even be as low as $1,000 for one company, or $5,000 for a whopping… 30 companies!

So you can go el cheapo…or be the real deal and do like Fabrice Grinda: invest bigger checks into over 100 startups on the side of your startup founder job before turning pro.

Can it make money?

Note that if you’re very lucky (it happened to me) or are a certified precog, even a tiny investment can turn into something significant if:

  • Done very early (generally a valuation sub $5M. $1M-$2M is best)
  • … With a startup that executes superbly
  • … And avoids excessive dilution (it is quite common for angel shares to be already diluted to 50% after seed A +seed B + series A).

For example, to get $1M out of $5k (200x), it requires a startup to go from — dilution included — a $2M valuation to… $800M (2x200x2). Not so common in a world where a 10x return on a single deal is celebrated ^^

The reality — you’ve heard it before — is rather to:

‘Assume you’ll lose everything. Because you probably will’ — Itai Damti

All About Signals

Angels will rarely give precise figures about portfolio returns. It’s all about the “logo”!

Uh oh. You’re sending me mixed signals.

Multiples Masquerade #1: You will hear about multiples, but only of ‘successful’ (though illiquid) individual deals.

It’s just like financial analysts who repeat endlessly the one prediction they got right to gain social proof, and never mention again the many they got wrong.

This would come in handy

Multiples Masquerade #2: Even multiples are sometimes meaningless if based on the last valuation but not today’s fair value.

The startup raised a series C at $100M? Great! It’s about to close doors? Not so great. VCs and LPs report fair value. Angels? It’s often more freestyle.

Millionnaire on paper

Multiples Masquerade #3: The fine print might bite you. For instance, I recently sold some shares in one startup to a new investor at 1/3 the price of the last valuation (not the new one).

Why? Because I had early shares with less privileges than later shares (and thus were less valuable). But also because most startups don’t really have a secondary market, so the buyer names its price!

Many angels would say “I invested at X valuation and now it’s Y” and let you miscalculate, not mentioning dilution, or bad terms. Optics rule!

Don’t worry!

Multiples Masquerade #4: Some angels might even — like some VCs do — ‘buy the logo’ late, at series B/C/D/E, and still call themselves ‘angels’ since they put in a personal check.

The trick is that it suggests they were smart enough / had the clout to get in early (it might still be non-trivial to come in at later stages, but it’s not the same level of heroism), where they in fact didn’t.

She has the logos but the car doors don’t open quite right yet

What you really want to know is the cash-on-cash return on their portfolio, or an estimate with fair valuations. Social norms and taboos help people obfuscate it.

The Real Reason Why You Need Over 10 Investments To Do Well (it’s not what you think)

This is what you often hear about angel investments.

The reason is NOT a general “spread risk” or “gain experience”. Those are mere correlations to something more important: improving your deal flow.

The first deals are the cost of getting access to better deals

It is NOT the cost of getting ‘smarter’ as in ‘better at picking deals’.

Again, the problem is NOT how good you are at finding the needle in the haystack, but rather:

  • Are you looking in the right haystack
  • How many needles there are

How the game is really played

The new companies started by the top dogs and serial entrepreneurs in Silicon Valley (and elsewhere) are generally filled with money from their inner circle.

Most angels won’t see those deals.

So as an angel you will start with deals everyone else has passed on, or from founders who have no network. They are the riskiest out there.

Lots of needles = better results

In fact, thinking you’re good at picking is probably the #1 risk.

Your effort is better spent seeking the better haystacks, making sure they’re full of needles, and tagging along with experienced needle-finders!

Sadly, you can’t seat at this table

Then, as you start broadcasting your angel investor activity, maybe you will establish some deal flow and a bit of expertise in a domain or geography, and you will gradually see better deals.

That’s what happened to me. I found my best deals at the source. In accelerators, or via high-profile networks that it took me years to build via goodwill, information exchange, and by maintaining as good a reputation as possible in the markets I operated in.

Hacking Your Way To Angel Investment Success

If I was doing it all over again, I would recommend to my younger self to:

  • Team up with experienced investors
    Their deal flow will help you, they will sort out all the legal stuff, negotiate a price, etc.
They know what they’re doing
  • Be an LP
    Itai Damti had an even cleverer idea (if you can afford it): why be a mere angel when for a little more you can be like a God? Become an LP!
Especially in niche markets that you believe in (hardware & crypto, for example). If you know someone well enough you might get access with $50k–$100k, which is what you would put on 2–3 deals anyway. They’re going to do a better job than you do (although I’m not saying they’ll provide a great return…) — Itai Damti

Also, ‘I’m an LP in a16z’ sounds 1,000x more baller than ‘I co-invested with a16z’.

Regardless of returns, you’ll get data room access, private newsletters, and will be invited to all those cool LP parties where they do all those cool things. The info and network alone might be worth it — better than your local Country Club or Church group!

  • Keep your checks balanced across deals. Mine had some significant differences. Paradoxically, the tinier checks yielded the best returns (if startups have the same level of risk, keep in mind that $10k at $1M is the same share as $50k at $5M, but 10x on $1M is much easier than 10x on $5M). I wish I had invested less into the larger deals, and more into the smaller ones. Itai had some further thoughts on this:
The first checks have to be small. It took me 4 years to expand my network to people like the fintech partners at 500 who have access to deals I really want to back (even in small scale). I spent a little too much on the way there.
It’s also easy for these checks to add up to a significant sum. Never put more than 10% of your net worth into this, no matter how good it makes you feel. And if you choose to do it, I recommend to spread it along 5 years: 1%, 1%, 2%, 3%, 3%. It’s very easy to invest 10% of your net worth into startups in 1 year. It’s a terrible mistake. — Itai Damti
  • Exit partially every couple of rounds rather than keep risk all the way to the end.
    That’s my view today. Many startups can pass seed and A but never get to the end (look at the stats). As an angel you generally can’t play like a VC (with a 10-year timeframe) and follow-on or double-down (it’s not your game). What you can do is sometimes take money off the table before the table disappears. If you invest $20k at $2M into a startup that raises an A at $20M, selling half your shares will bag $100k (discounted to 50% with dilution + terms). And you still have half of your shares! Unlike VCs, you don’t need a unicorn to get returns, and your carry is 100%!
De-risk your deals by taking some early partial exits
  • Make sure the business model is straightforward, scalable and that unit economics work
    Some companies can handle numerous pivots before sorting those out, but most die trying.
  • Grit and resourcefulness > Branded degrees and experience 
    Beware of fancy offices and Silicon Valley costs. Frugality also improves odds of survival during tough times. Maybe Sequoia’s Mike Moritz had a point there.
  • Your best investments likely won’t need you
    And those who do might make you wonder how you’ve come to pay them to even … work for them for free! I only was relevant to my best investment with my initial check (I helped with a bit of credibility and knowledge), and… 5 years later when they were already 100 times bigger.
  • ‘Buy logos’ early
    I’m not a fan of this but it does work. In fact, many VCs (especially new entrants) do it too. If you can, put some tiny money into trendy startups. Regardless of their results you will be able to trade on their reputation to access better deals for some time. If they tank later you’ll already be onto the new trendy deals. Hopefully one of them will work out, and you only need one to look like a genius (like early investors in Skype, Facebook, Twitter, Xiaomi, etc.). I turned down a few opportunities to invest in iconic companies I didn’t believe in at an early-ish or later stage. They didn’t end up doing well but had I invested, my network would have grown and my profile risen to give me access to more ‘inner circle’ deals. Maybe I missed out on good deal flow by turning down some ‘logos’.
  • You only need one
    A truly successful investment can bring you wealth (though it’s hard). Buying a famous logo can get you a reputation (less hard).

Optics Are Deceptive

From the above, it is probably plenty clear that optics matter, and can be deceptive.

Such big wings must fly for real!
  • Some people who appear successful might get their fame from one deal and their fortune from another. Or simply not have a fortune.
  • I know of angels in famous startups who came in late at high valuations, had no role in the companies, but get invited on TV as if they had prediction powers (they might still be smart / interesting people, but their success does not stem from the qualities people assume they have, and ask them about).
  • I also know of entrepreneurs whose ‘successful exits’ brought them $0, while a passive angel investment they did elsewhere made them multi-millionaires — and everyone assumes their fortune comes from their own startup. But, in a way, they spent years building with their startup building their networks and made themselves valuable enough to get invited to the table. One could argue their startup efforts was the price for a seat at that table. Half the job is showing up, as some say.
  • Maybe you can try to follow the path of Jason Calacanis, who wrote a book about angel investing. This path might involve selling a first company for millions in the dot-com boom, networking for 2 decades, and running a popular podcast ;)

VCs And Angels

I sometimes read that angels ‘compete with VCs’.

My take is that ‘it’s complicated’.

One the one hand, rank-and-file angels fund the messy super-risky early stages of startups who don’t have the network to raise from VCs or more experienced angels. Mathematically, the average return of such deals can’t be good (as an asset class, even professional VCs have negative returns).

VCs pick up the startups that survive, and tolerate/welcome angels unless they have too large shares (a frequent problem in emerging markets where early investors are sometimes very aggressive).

So angels could — by and large — be considered the foot soldiers of investment, while VCs have the armored vehicles (or air strikes).

Angels take risks

There are less risky paths when working with VCs: some angels help scout deals for VCs, or organize syndicates. AngelList even offers to help founders to become angels.

Yet, angels sometimes do compete with VCs. For instance, if angels pour millions in an immature startup, it might make it unattractive to seed-stage VCs. Then if the startup doesn’t clear key milestones using this angel funding, it might also discourage later stage VCs. Too much angel money too early can be dangerous, especially if said angels can’t give support toward the next milestones, nor top up during hard times (your investors are your first calls when money might run out).

Do It If You Like It

Voila! I hope that with a better understanding of angel investing dynamics, you might do better than without :)

A lovely angel-themed animation

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