Super Angels and Seed Funds: Sim Simeonov’s Advice for Investors and Entrepreneurs
Angel investors have good reasons for passing on your startup company. But they should make more, not fewer investments over the long run, in order to maximize their returns. That’s what I took away from Sim Simeonov’s guest analysis in PE Hub last week. But it turns out there’s much more to the story.
Simeonov, a noted entrepreneur, angel, and former venture capitalist, cited a study of angel investing performance conducted by the Kauffman Foundation. Restricting the data set to first-round investments in early-stage tech companies—56 angels with exits from 112 companies—he concluded that two-thirds of the angels made less than what they invested; nearly half generated no return; and 6 percent of the angels accounted for 68 percent of the total returns. (Wade reported on some of this at the Angel Boot Camp last month.)
Intrigued by these results, Simeonov decided to push it further. Being a technical guy—computer scientist, Macromedia and Allaire veteran, former technology partner at Polaris Venture Partners, and founder of FastIgnite—he programmed a “Monte Carlo” computer simulation of angel investing, making some assumptions about the statistics of portfolio companies (based on the above 112 companies). Then he ran the simulation to calculate the hypothetical returns, varying things like the number of companies in an investor’s portfolio.
He found that median returns increased substantially with portfolio size—the more companies, the better you do. The exact numbers aren’t as important (it’s a simulation, not real data), but Simeonov wrote, “Playing like a super angel or an active seed fund as opposed to dabbling with the occasional angel investment is a key strategy to consider if financial returns are important. The data also call into question the behavior of some angel groups that do just a few investments per year.”
I connected with Simeonov over e-mail this week, and asked him a few follow-up questions about his analysis, his advice to entrepreneurs and angels, and how he thinks the early-stage funding environment will play out for tech startups. Here’s the transcript of our Q&A:
Xconomy: What was the most surprising finding from your angel portfolio simulation, and why?
Sim Simeonov: The most surprising finding was not the fact that there is a portfolio effect (expected returns increase with larger portfolio sizes), but the magnitude of the portfolio effect. For example, the fact that the median expected return increases by more than 50 percent between portfolios of 5 vs. 10 companies, and by more than 100 percent between 5 vs. 20 company portfolios. Or that the probability of making a cash-on-cash return of over 2x (getting more than 100 percent over what an angel invests in companies in aggregate) goes up by more than 50 percent when a portfolio grows from 5 to 20 companies. These are big numbers that can have a very meaningful impact on angel returns.
X: Does the analysis affect how you, or others you know, will make investments?
SS: Two key points come to mind.
First, the analysis leads to the inevitable conclusion that angel investing for financial returns, as opposed to non-monetary types of utility, must be done thoughtfully and consistently over a period of years to take advantage of portfolio effects. It isn’t something to casually engage with. Many angels have told me they are looking to change their investment approach to something that’s a bit less ad hoc as a result of these findings.
Angels should start by asking themselves the following question: “How much can I consistently invest in startup companies for at least five years, regardless of what the public markets do?” Then, they should take this amount and look for ways to invest in 5 or more companies per year.
Second, I have to point out that the analysis is very sensitive to the assumptions about the distribution of returns. I’d like to think that starting with detailed return data, assembled by researchers such as Dr. Wiltbank from Willamette University through a Kauffman Foundation grant, is far better than starting with pure guesses. Unfortunately, even the Kauffman data set does not have great coverage of high-return, long-tail exits. The simulations are also quite simplistic at this stage. For example, they don’t take important effects, such as branding, into account, which have significant impact both on quality of deal flow and the ability to win deals. I am working on a more realistic Monte Carlo study, based on my experience as an angel, entrepreneur, and VC.
My ultimate objective is to empower many people in the tech sector with the knowledge and means to become successful angel investors. This, of course, can be difficult as not that many people have the time or wealth to benefit from the portfolio effect of angel investing. It’s a structural issue with angel investing that I’m working with some smart people to try to understand better and address. I certainly don’t think the answer is for every interested angel to join as an LP [limited partner] in one of the many seed funds being launched every month.
X: What one piece of advice would you give to angel groups, and to entrepreneurs looking for early-stage funding?
SS: During the recession, seed stage capital became very expensive. Angels and seed-stage funds who were active could make some very attractive investments. Some of these investors and investments have been extensively covered in the press, creating a very unrealistic but attractive image of what it’s like to be an angel. From conversations I’ve had with casual angels, it seems that this perception—more so than the reality of the changing capital requirements and the exit environment for technology companies—is the cause of the increased interest in angel investing. In short, we are experiencing a somewhat “irrational exuberance” with regards to angel investing.
On one hand, this is good for startups as the increased supply of cash lowers the cost of capital. On the other hand, it means a lot more early stage competition without a real change in the exit environment. My advice for entrepreneurs is to look beyond the cash to what else the investors can really bring to the table. Really diligence this as some of the most active seed-stage investors are too busy to spend much time with their portfolio companies. Also, look at traditional VCs for seed-stage capital…Good VCs have a habit of actively helping early stage companies.
My advice to angel investors is to look beyond the portfolio effect. It is necessary but most likely not sufficient. It is not a panacea, especially in a world where there are more and more sources of seed-stage capital. Good deal flow and the ability to win deals will matter more and more in the coming years. Developing real differentiation above and beyond being able to write a quick check is the key.
X: In the long run, how do you see the angel-VC ecosystem playing out, as some VCs move toward smaller, earlier-stage funds?
SS: VCs have an opportunity to play a very positive role in the changing landscape if they are willing to develop new models for working with very early stage startups. If they don’t, they’ll find themselves dis-intermediated from quality deal flow, having little leverage to use against upstream seed-stage investors…The good news is that a number of VC firms I know are making meaningful changes. I can’t stress enough how much entrepreneurs are missing out by not understanding how to engage super angels, seed funds, and traditional VCs together in their early stage fundraising.