With all the new Securities and Exchange Commission (SEC) regulations around the updated definition of “Accredited Investor” and low interest rates, unpredictable stock market investors are increasingly looking towards investing in private companies. Having access to this new asset class can be exciting. Platforms, such as Angellist, Republic, and many others, make it easier than ever before for any interested individual to become an angel investor.
As a career VC, I have invested across many top tier funds including my own, array.vc. I have accumulated a decade worth of investing experience as both an angel investor and a venture capitalist. I’ve been fortunate to have exits to Fortune 500 companies including Apple, PayPal, and ServiceNow. What I am sharing here is something you should know sooner rather than later. Often investors will invest and assume things and there is a mismatch of expectations.
Answering questions about angel investing often makes my anxiety levels rise, because of how dangerous a game it can be for many people. If you are simply trying to create high returns, but don’t understand the actual mechanics of how an angel invests, you are at risk of losing a lot more than you make. With this post, I am listing things you should consider before you decide you want to invest in startups.
If you have spare change that you don’t mind losing and never seeing it again only then you should consider angel investing. If you do then this post can hopefully help provide some structure and direction in regards to where you should invest it.
Here are some need-to-know basics to get you started:
First, decide how much of your own capital you would want to invest in total to this asset class. What percent of your saving are you willing to lose? Everytime you invest in a company, it’s best to assume you will lose ALL your money, since the majority of companies don’t succeed.
Think about investing in a good number of companies, over the course of a few years. That’s what funds typically do. Since you are most likely going to invest in pre-seed and seed stages, it’s really difficult to predict which companies are going to out-execute the rest and succeed. All your start-ups will seem amazing (otherwise you wouldn’t invest your money and time into them); however, not everyone gets to win in the long run. So, the key is to invest in 15+ companies over 2–3 years and allocate your investments almost equally across those companies.
In venture capital, you can’t simply “pull your money out”, unlike some other kinds of investments, like hedge funds.
Even if the company is successful, you may not get your money back until the company exits. Exits, traditionally, only mean 2 things: IPO (going public) and M&A (getting bought by another company either in cash or through stock). The tricky part with stock is that, unless the acquirer is already public, you can only sell it when the private company exits.
A large part of angel investing is patience. It takes years before you can have a meaningful exit or before your seed will grow into a fruit bearing plant. Technology companies, on average, take 13 years to go public, assuming things are going well with the company. As we discuss these exit options, there is no way to “take your money out” before these exit events occur. You can’t call it back; you can’t sell the shares when you like (we can go into secondary markets in another post). These are not public shares that have value and can be traded freely. So years after your investment, if you need this money, you can only wait or assume it’s gone. Then, one fine day, years after you forget about it, you might hit a jackpot! …Or you might get an email from a lawyer to sign dissolution documents and no word from the founders.
While there are still some convertible debt instruments where you accrue interest on paper, those are increasingly becoming things of the past. SAFE’s and traditional equity rounds are more common. But, unfortunately, unlike in real estate investment, early stage investments won’t earn dividends.
The best you can hope for is a great return on your investment, a few years after making the deal. The second best is a write off of that investment, but there are never dividends.
The only real indicators of gradual success are if the company sees revenue growth, keeps raising more capital at good terms, and scales the team each round to keep up with the growth.
IRR and other numbers can be interpreted in a lot of ways, but it’s not how private companies really reflect their progress.
You will not get much information on your companies, especially in their first few years. Founders stop giving updates, especially to non majority board members, which generally includes angel investors.
Ownership & Dilution:
Your ownership will become diluted, meaning the number of shares you own of your companies will decrease over time. For example, if you start with 100 shares that represent 1% of the company you can expect it to be around .05% ownership when the company exits, unless you keep investing more, which isn’t always a possibility as an angel investor.
On the bright side, just think of it this way — would you rather own 1% shares of a company going nowhere worth $10M or .05% of a really high growth startup worth a lot more than your original investment maybe around $1B?
Perhaps you are lucky and find your neighbor’s kid is working on some really awesome company you want to invest in; however, most amazing deals don’t always show up at your door. You have to work on building your network to get good deal flow. On average, VCs meet with thousands of companies each year and only make 5–10 aggregate deals across the firm. The percentage of companies you invest in should be very small compared to how many you look at. If your network isn’t strong, then you might not get a chance to get into good deals.
The Upside Of Angel Investing
The chances of success for startups on average are very low: The success rate is at best 5–8% and that’s on the higher end. Why do even both angel investing then if there are so many risks?
When it works, the returns are really “outsized” and make up for all the other failures in the portfolio. This phenomenon is referred to as power law in venture capital.
The learning along the way can’t be replicated anywhere else. You get to learn about the startup journey of various companies from the ground up as they get built.
You learn about different industries over time.
You get to diversify your investments, after you have invested in the stock market, bonds, real estate, etc.
Most importantly, angels like to invest in companies where they think they can help the founders in their early days and make a profound difference for them.
Although, while angel investing is fun, finding good deals is not easy. And if you find a good deal it’s not guaranteed you can get into the deal. Very few angels can get access to good startups. Rounds are usually very competitive even during this pandemic.
For that reason and many others, I actually recommend most angels put money in venture capital funds. This is a whole another topic I’ll cover in a separate post.
**Share this post with your friends who are beginning to think about angel investing. **
Subscribe to my newsletter here to learn more about startups, investing, and building a career in venture capital. Feel free to suggest other topics to cover.
Thanks to Jonathan Wolter, Dev Nag, and Gigi Nibbelink for helping me with the edits.