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How and Why To Be an Angel Investor

Dave Kerpen, founder and CEO of Likeable Local, just published an interview with me on Linkedin, which I’ve included below .  (He’s the #1 LinkedIn Influencer of all time in page views, ahead of Bill Gates, Jack Welch, Mark Cuban, and President Barack Obama.  Incidentally, this is a great example of why it’s helpful to move to new platforms quickly.  Obama slightly outranks Dave in influence and visibility, but Dave became active on Linkedin first.)

Enter Dave:

Angel investing is a great way to make a lot of money. It’s also a fast way to lose all your money. Either way, angel investing is on the rise! The “Shark Tank” TV show and over a dozen websites increasingly have people thinking about investing their hard-earned dollars. How do you decide if it’s right for you?

Q: How popular is angel investing ?

A: Over the past decade, angels have invested at a healthy pace, averaging more than $20 billion annually in the US (see graph below). That’s a sizeable amount, especially in comparison to the US venture capital industry, which similarly invests over $20 billion annually.  In 2013, 298,800 angels invested in 70,730 entrepreneurial ventures, according to the 2013 Angel Market Analysis by the Center for Venture Research at the University of New Hampshire.  However, those angels constitute only about 4% of the estimated 7.1 million households in the US with a net worth of $1 million or more.

U.S. Angel Investment Activity, 2002-2013

 

Source: Center for Venture Research – Angel Market Analysis Report

Q: What is the typical profile of angel investors?

Angel investors are generally former entrepreneurs and/or executives, who invest in privately-held, early-stage companies. These companies can range from tech startups to food trucks to retail stores.

Q: Why do people become angel investors?

First and foremost, angels believe that they can achieve a strong return on their investment. Angel returns have historically been difficult to pin down given that there are hundreds of thousands of active angels at any given time, none of whom are bound to legal reporting requirements on their investments beyond filing tax returns. Despite the difficulties in gathering it, angel return data has gradually accumulated over time and the verdict is in: we’ve looked at a dozen different studies of angel returns, and they show returns ranging from 18% to 54%.

 

Average Angel Returns Over Time

Geo Time Period Study Total Investments Exited Investments IRR
US 1994 – present Band of Angels Website FAQ 240+ 63 54.0%
US 2010-11 Sohl: “The Angel Investor Market in 2011: The Recovery Continues” Unknown Unknown 18-28%
US 2009-10 Sohl: “The Angel Investor Market in 2010: A Market on the Rebound” Unknown Unknown 24-36%
US 2008-09 Sohl: “The Angel Investor Market in 2009: Holding Steady but Changes in Seed and Startup Investments” Unknown Unknown 23-38%
US approx 2004-09 DeGennaro & Dwyer: “Expected Returns to Angel Investors” 603 434 33.0%
UK 2000-08 Wiltbank: “Siding with the Angels: Business angel investing – promising outcomes and effective strategies” 1080 406 24.6%
US 2007-08 Sohl: “The Angel Investor Market in 2008: A Down Year in Investment Dollars But Not in Deals” Unknown Unknown 22.0%
US 2006-07 Sohl: “The Angel Investor Market in 2007: Mixed Signs of Growth” Unknown Unknown 27.7%
US 1990-07 Wiltbank & Boeker: “Returns to Angel Investors in Groups” 3,097 1,137 31.4%
US approx 1999-07 Villalobos & Payne: “Startup Pre-Money Valuation: The Keystone to Return on Investment” 117 117 24.3%
UK 1961- 1996 Mason & Harrison: “Is it worth it? The rates of return from informal venture capital investments” 372 128 37.4%

I’m not aware of any other asset class with returns at that level.  Since the angel space has one of the widest return dispersions available to investors, individual investors are likely to see great variation from the mean. Even so, detailed exit analysis has revealed that angels have robust rates of “home run” (5x or more) investments, while maintaining a decisively lower level of risk than venture capital firms.[1]

Q: What are the risks of angel investing, and how do you mitigate them?

With the potential for returns like this come significant risks. Relatively untested early-stage ventures are less predictable and more prone to failure than established companies. Angels are likely to lose some or all of their money on any given investment. More than 90% of startups fail.[2] Smart angels are not only prepared for failure—they expect it. To succeed in the space, angels must have a high risk tolerance, a large bank account to weather losses, and most important, a diverse enough portfolio to handle losing money on most of your investments.  You should build to a bare minimum of 20 angel investments over time to create adequate diversity.

Another important quality for angels to possess is patience. Angel investments are illiquid commitments that typically last 6-10 years before exit, assuming there is an exit. The winning investments take longer to exit than the losing ones. In the first few years of investing, angels have to explain to spouses (most important!), family, and friends why they lost most of their money this year, why the same will likely happen next year, and why they’re going to continue investing anyway.

By investing relatively small amounts in a wide range of companies, these angels also achieve a broad and diversified exposure to the economy that has minimal correlation to other major asset classes.  Of course, investing in a diversified portfolio is a significant time commitment. Top performers conduct 40 hours or more of due diligence per investment and stick with companies as active advisors.[3]

Q: What are the other perks of angel investing?

Not all reasons for angel investing are financial. Angels relish the opportunity to invest in passionate and driven entrepreneurs with ambitious visions of the future – who doesn’t want to be part of the next wave of innovation?  John Frankel started as an individual angel investor in New York in 1999.  Based on his track record, by 2008 he was able to found ff Venture Capital, an institutional angel investment firm (where I am a Partner).  John observed to me, “I have the best job in the world, because I spend my time with brilliant entrepreneurs who are working to create the future, and are changing the way millions of people behave.  And in some cases, I can help them to create that change.”

Unsurprisingly, many angels have a difficult time with full-time retirement. After years of leading busy and productive lives, lying on the beach and sipping cocktails just does not cut it. Many pursue an “active” retirement where they can not only keep up-to-date with current trends in their areas of interest, but also make use of their experience and networks to provide operational expertise, general management advice, and critical introductions. They have the opportunity to experience the exhilarating highs and lows of building and growing companies, but on a part-time basis and from the relatively safe confines of the sidelines.

Lastly, angels want to serve as mentors to the next generation of entrepreneurs. Many are former entrepreneurs themselves and have deep empathy for the perpetually sleep-deprived, over-worked entrepreneur. They understand the difficulties of building lasting companies and they draw immense satisfaction from being able to share their hard-learned lessons and give back to the community. They are both coach and cheerleader.

For those angels who invest to generate superior returns, however, enthusiasm is not enough. The research suggests that successful angels need a high risk tolerance, a large bank account, patience, time, discipline, expertise, and diversification. If you lack any of these advantages, the odds are against you.

Q: Where can I learn more about angel investing?

To learn more about angel investing, I suggest visit :

– Center for Venture Research
– Angel Capital Association
– The Angel Resource Institute
– ff Venture Capital, an institutional angel investor
– Paul Graham, How to be an Angel Investor
– Harvard Business School Working Knowledge, How to be an Angel Investor
– David Teten, Introduction to Angel Investing

(Thanks to interns Yong Kwon; Matt Joyce; and Rikki Novetsky for help researching my responses.)

[1] Angel Investor Performance Project, Kauffman Foundation & Ongoing Research, Harvard Business School

[2] Report on Premature Scaling, Startup Genome Project

[3] Returns to Angel Investors in Groups, Kauffman Foundation

Photo: Lucas Pozzi, 500px

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