Being an Angel is far from Theatrical
THE WORLD OF ANGELS INVESTORS
The term “angel investors” or “business angel” was first coined in 1978 when the term was used regarding individuals who finance early-stage businesses. The term is taken from the word “angel” who were patrons of Broadway theatre in New York that would put money from their own pockets to support productions. What a long way this important cog in the financing and support of start-up businesses has come since then…
ANGELS AMONGST US
Whether you are reading this blog as an entrepreneur, a VC partner or an angel investor; I hope that you appreciate the growing importance that the angel investor plays in funding the stages of growth of start-ups between the Friends & Family round and the point at which VCs become interested in investing (which as we all know is drifting up the value/maturity curve).
Testimony to the relevance of the angel is the fact there is over 750,000 of them in the United States – and the number is growing. With an estimated 7 million accredited (sophisticated) investors in that country, it means that over 10% of them that have decided to fund high-risk ventures as part of their investment portfolio. But surely it should be more than one well-off individual in every nine?! Here in Australia, where data is harder to come by, the number will be much lower. Unfortunately!
As an angel investor myself, I have had many conversations with friends and acquaintances about the fact they should get into start-up funding with me. Almost every chat ends with them wondering why they would do that: “But that’s just a bit too alternative for me, and I wouldn’t know where to start!”. This might be a fair, yet disappointing statement, but where is their money today? In investment property (of course!), cash, massively volatile equity, bond and FX markets. There is certainly not much in the way of alternative investments in that lot, and all are inexorably linked to the success (or otherwise!) of the Australian economy.
ANYONE FOR DARTS?
Whether you invest directly into a series of start-ups, or via a fund, it would make sense to put 5-10% of one’s wealth into riskier investments – as long as it forms part of a broader portfolio, and you are able to build up a small sub-portfolio of investments in early-stage businesses. Whether that start-up portfolio needs to be eight, or twenty, or more investments is something that is always debated; despite the fact that the BEST investment strategy would (at face value) be to find and invest in the ONE start-up that is going to exit (soon) and at a multiple of 30x plus!
That said, perhaps the portfolio strategy that should be pursued by angels is not the one of risk diversification (equities v cash, pro-cyclical v counter-cyclical, etc.)...rather; should it be a tactic somewhat akin to throwing lots of darts at a dartboard and hoping that one hits the bullseye?
Why is that, I hear you say..? Well, diversification works in perfect (or near-perfect markets), where a market, stock, and/or investors act in a rationale manner and respond as one might expect to factors such as information, relative performance etc. The fact that money flows easily around the US$300 trillion of financial assets (1) in the world is evidence of shifts in sentiment responding to near-perfect markets.
As we know, the start-up world is not like that:
- there is no such thing as free-flow or readily available information, and even if it does exist, its accuracy is often questionable given the nascent nature of the business;
- there is a very limited (if it exists at all) secondary market for shares in start-ups to be freely traded, and they need to therefore be considered an illiquid asset class;
- massive performance swings are part of the DNA of any early-stage business;
- it is nigh impossible to build a well-diversified portfolio of innovative businesses that could be construed as being balanced across a market, range of sectors, etc.
That is the dilemma of any angel investor as they try to build a book of early-stage businesses that do not end up being dilutive to the overall risk:reward balance of a broader portfolio of investments.
So is the answer just to get a bunch of start-up names and to throw darts at them to see which ones are going to get investment from the angels?!
THE ANSWER…MANNA FROM HEAVEN
So what is the answer, if it is true that an investor should put some money to work in innovative early-stage businesses, but that there may be no better approach to choice than leaving the investment decisions entirely to chance?
Quality investment fund vehicles focussing on start-ups are the answer to this dilemma: those fund managers that are awesome at driving disciplined approaches to choosing which early-stage businesses to back – “Efficient Frontier” (2) investing!
But hang on, have I not just said that there is no such thing as a perfect market in the innovation space? Am I not arguing against myself? Well, no, I am not…
BEST OF THE BUNCH
Three recent studies (3) over the past ten years have shown that angel investors enjoy returns of up to 2.5x over an average period of 3.6 – 4.5 years (IRR of 22-27%).
If we agree that there will always be some nascent businesses that excel in building traction, in disrupting markets, and exiting successfully; then being the best at picking them, no matter how inefficient the market is, should always be part of a portfolio approach. If an angel investor is able to achieve that, then the returns from this part of their portfolio should exceed an IRR of 20%; hugely attractive in a world of moribund interest rates and near-deflation.
It is one thing to have:
- perfect information; and,
- for markets to behave rationally.
It is quite another to have:
- a disciplined approach to choosing the BEST start-ups to support financially based on particular investment criteria an investor chooses to use – be that team, sector, or a combination of several.
So, if you want to dip your toe into angel investing, either set up your own office of analysts to conduct exhaustive due diligence on start-up deal flow and be ready for hundreds of hours of meetings with founders; or outsource all the work to a set of professionals who pool monies from investors and conduct disciplined approaches to finding the stars of tomorrow through an early-stage venture fund. This is the way to find your alpha returns as an angel.
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- McKinsey Global Institute, Haver, BIS, Deutsche Bank estimates
- Markowitz, H.M. (March 1952). "Portfolio Selection". The Journal of Finance
- Returns to Angel Investors in Groups, Robert Wiltbank & Warren Boeker, November 2007; Siding with the Angels, NESTA Robert Wiltbank, May 2009; The Angel Resource Institute (ARI), Williamette University, May 2016