Five Ways To Avoid Losing Money as An Angel Investor

3/10/14Follow @geshwiler

I have an angel investor friend—let’s call this friend “Alex.” Alex has great deal flow and works hard to pick the best opportunities for investment. Alex has been frustrated over the past several years, however, because she doesn’t seem to be making any money. This is despite solid operational performance by several of the companies and several exits, including one that was quite notable.

Recently, Alex and I sat down and discussed investment process and portfolio. Overall, it was up a little, but it was also clear he could have done quite a bit better. We found five ways that money was “lost” in his case, and we can apply these same ways to the overall market as we evaluate how angels often lose money even when they are great at finding and evaluating opportunities. Below is a list of too-common pitfalls of angel investing that cause money to be left on the table.

1. No Plan to Make Money. Alex didn’t start angel investing with a model or strategy to make money, which was a bit ironic since one of his regular pieces of advice to startups is to have a considered business plan and financial model to do just that. Very few angels whom I’ve seen actually model out their own business plans, so they don’t have a particular strategy for making money. Alex and I created a simplified model based on staging capital, which is a stripped-down version of the one we use at CommonAngels for our early stage software and technology investments. The key elements: staging capital, triage, and concentration in the winners.

2. One-and-Done. Following on the last point, Alex tended to invest in a company’s first financing round and not subsequent rounds. After all, this was the “angel’s place” on the cap table. However, if a 10-company portfolio has one or two companies that return 10x, two to three others that get a little money back, and the remainder that fail, being one-and-done means the best Alex might do is end up being 2x on a portfolio. But if the best performer is only 5x, Alex could easily end up in the red despite having half his portfolio return a profit. There are so many angels that invest like Alex—and some VCs that choose this strategy as well (see point 4 below)–but it’s hard to see mathematically how it works consistently.

3. Too Small a Portfolio. Alex did OK in this regard, with more than 10 investments, but he could have done better. Sim Simeonov’s research shows that if angels make fewer than five investments, they stand more than a 50 percent chance of losing money. Various analyses using portfolio theory suggest angel portfolios should have two or three dozen companies. Some analytic investors such as Correlation Ventures have proposed portfolios of 50-75 companies, but that’s at the venture capital stage. And some prolific seed investors like Dave McClure of 500Startups have argued for much larger seed-stage portfolios of more than 100 companies.

4. Content Being the Small Fry. Because so few of these companies break out and become big winners, everyone wants a piece of them once they seem like they’re about to take off. Institutional investors know this and typically write a “Major Investor” clause, which means “not you.” Major Investors have better information and follow-on investment rights, which means they know when things are going well and they get to pile-on. Unfortunately, on a couple of the perceived winners, Alex wasn’t a “Major Investor” and didn’t get an opportunity to participate in the Series A or the Series B. This is a key clause to watch and negotiate so it applies to you.

5. Fail to Value Time. This was the elephant in the room that created an awkward moment. Alex could barely add up all the time spent over the past year going to events, networking, reviewing plans, and calling and trying to follow up with companies—all of which do help locate and identify strong investment prospects. Unfortunately, the cost of time seemed quite large once we began even a rough accounting.

Here’s some simplified math: for a portfolio of four companies with $25K in each, two fail, 1 breaks even, and one gets lucky for a 5x return, returning $150K on $100K invested (just to keep it simple). To get to those four companies, the investor probably had to look at a minimum of 50 opportunities (but more likely 200, maybe even 400) to use typical industry ratios of a 1-4 percent yield rate. Assuming a time investment of 20 minutes per deal to source and evaluate opportunities, it took 60-140 hours just make these investments, never mind monitor them, possibly assist the teams, and yield an exit. Even assuming someone else performs all these functions, that $50K profit is now cut in about half at any reasonable consulting rate, and completely wiped out on a premium rate. Even Alex had to acknowledge diminishing returns on the non-quantitative metrics of staying current about technology and giving back to the community. At some point, it was a high tax that could have been managed by putting more money to work—in other words, investing more in each deal—to offset the overhead.

The good news: all of the above pitfalls are manageable with an intentional plan and model. Sure, angel investing is risky. Angels aren’t here just to assume risk, however. As investors, our job is to manage it. Managing can be done through modeling, analysis, and refinement over time, but starts with understanding these five key ways that angel investors can leave money on the table.

James Geshwiler, a managing director at CommonAngels for more than 10 years, has financed over 40 software and Internet companies and worked with them through over 100 rounds of investment and related changes in boards of directors. [Editor's note: CommonAngels is the lead investor in Xconomy.] Follow @geshwiler

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  • Adam

    This is an interesting model. You could also model startup employees as investing in common stock on a relatively small portfolio of startups which they work at serially. This would have interesting implications for startup employee mobility.

  • http://www.commonangels.com James Geshwiler

    Adam, interesting observation. I certainly have heard some startup team members speak of their career moves in ways that made me think of a hedging strategy. Specifically, I’ve known ones who stay at a company for a couple years, consciously recruit their successor and then move to another gig. It can be a good model, since companies’ needs change so quickly. Everyone can win.

  • Ron Thompson

    Angel investing is a high risk business for many reasons – some of which you have identified in this article. Further, for venture investing to be a sustainable activity, a high ROI is needed . Otherwise, Investors tire of the issues, time, financial demands, etc. since the rewards aren’t commensurate with the effort. Because of this, it’s critical Angels be sophisticated in business when supporting entrepreneurship by adding meaningful value to improve the probability of venture success and be skilled at prudently managing risk.

    Ron Thompson

  • David S. Jackson

    Great illustration of the value of investor
    time, James. I have some clients who charge consulting fees in addition to
    taking equity in early stage ventures just for this reason.