Angel investing isn’t for the faint of heart
You’ll have to be comfortable committing your money with little data available to investigate beforehand
July 21, 2017
Let’s say you read my column on angel investing last week and decided – despite my warnings – that you would still like to pursue it in your area. You don’t listen, do you?
Well anyway, your next step as a smart money person would involve collecting data about angel investing to educate yourself before throwing your money at a few startups.
That’s a problem.
You will find angel investing a frustrating place to gather anything more than anecdotal data.
But then again you have me. I’m here to sift through available studies on angel investing to let you know what is knowable, before you jump in.
In contrast to angel investing, we typically know extraordinarily detailed things about publicly traded companies. It’s not hard to find online which public company CEOs like to dress up like the Pope or which ones resort to spreadsheets to make perfect cupcakes.
But finding angel investing facts and data can prove elusive. Because angel investing is done at a small scale, tens of thousand of dollars to a few million, when compared to the tens millions of dollars needed for venture capital investing, we sometimes have to turn to venture capital data for comparable information.
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Key pieces of data you might want to know before investing include:
How scarce is money for entrepreneurs who need angel investments?
What percent of funded companies succeed in making money for angels?
How long will your capital be tied up?
What kind of returns can you expect from angel investing?
After presenting each piece of data I’ll do a little interpretation of the numbers. Let’s take these one at a time.
According to a report on venture and angel investments by the Ewing Marion Kauffman Foundation, 30 percent of venture capital and angel investments are located in just four metropolitan areas: Boston, San Francisco, Los Angeles and New York.
Even in those areas, only an average of 1 percent of startup firms receive the full amount of money the entrepreneur seeks, while the national average is 0.6 percent. Firms in Austin, according to the Kauffman report, successfully raise venture and angel investments at twice that rate, while entrepreneurs in other Texas cities like San Antonio, Dallas and Houston firms report success rates of 0.9, 0.9 and 0.6 percent respectively.
I interpret this data to mean that providers of angel and venture capital in areas where capital is scarce, outside of the big four cities, could conceivably be at an advantage. If you have a good investment opportunity they can’t find anywhere else, that might tilt odds and negotiating terms in your favor.
To answer the second big question – what percentage of firms actually make money for investors – we turn to the Angel Resource Institute, an industry group which publishes semi-regular data. Their 2016 report shows that 70 percent of angel-backed firms lose money, meaning 7 out of 10 angel-backed startups return less than the original investment. That’s a lot of failure.
On the other hand, we could interpret this data in baseball terms, and say that regularly batting .300 could conceivably still win the game.
Only a small percentage of angel-backed firms make money for investors, and those that do account for a disproportionate amount of the gains. Roughly 10 percent of angel-backed firms tend to make up 85 percent of the cash generated and returned for investors, according to the Angel Resource Institute. In essence, investors need a home run from one in every ten at-bats in order to make money.
The Angel Resource Institute also helps set our expectations for the third question, which is about how long an angel investment will tie up our capital. They report an average holding period – the time between investment and “liquidity event” – of 41/2 years.
The first thing I think is that that’s a long time to have money tied up in a speculative, illiquid investment. The next thing I think is that 41/2 years represents the average, so many commitments will stretch far longer than that. My friend Tom Dickerson, a venture capital firm founder, laments that many venture capital investments seem to stretch on and on, seemingly without end. Patience is both a virtue and a necessity here.
Fourth and finally, what kind of returns can you expect from angel investing? Given the difficulty of tracking angel investments, I apply the largest grains of salt to this answer. The Angel Resource Institute reports an internal rate of return from their latest survey-driven report of 22 percent. That sounds great, but please remain skeptical.
My friend Tom reminds me that “the majority of positive returns are concentrated in a handful of venture capital firms. The majority of venture capital funds actually lose money.” And yet the phenomenon known as “survivorship bias” keeps the successful venture capital firms in front of investors, while the losers disappear quietly.
In addition, the Angel Resource Institute study – while one of the better sources of data we have – has a bias toward angel-backed firms which later receive venture capital. That skews the outcomes toward larger and more successful firms in general. In addition, if only 1 in 10 angel-backed firms provide nearly all of the positive returns to investors, it’s easy to see how angel investing could provide a below-average result for many.
So, buyer beware. That’s about all the data available on the risks and rewards of angel investing.
I don’t know – maybe you like opaque, illiquid, speculative areas of investing. It raises the possibility of market inefficiency, which many believe works to their advantage.
Still, you will want to get comfortable investing with scant data if you plunge into angel investing.