Angel Investing Is Highly Risky-But Is So Rewarding -

Among the successful companies, 9 per cent provide investors with returns of 10 times their investments.

As an angel investor, it is important to construct a portfolio and not just place a few bets and hope for the best. Or worse: putting all your money in one basket and essentially gambling with your funds.

The chances of your sourcing and investing in the next Uber (and make a 50 or 100 times on your investment) are close to zero and there’s no playbook for finding those kinds of companies.

However, that doesn’t mean that with a lot of research and hard work you can’t achieve amazing returns (substantially outperforming the markets while getting the satisfaction of being part of growing a successful business).

The emphasis is on ‘hard work and research’ though, if you are not willing to put in the time & money, angel investing might not be right for you.

Why is angel investing risky and rewarding?

The reason that angel investing is so risky is that most startups do not achieve their founders’ goals and are closed. Among the successful companies, nine per cent provide investors with returns of 10 times their investments (home run), which compensates for failed investments.

Angel investing is both an art and a science.

The nine-per-cent-rule and other numbers mentioned in this article are by no means true for each and every portfolio. They merely reflect averages as measured in developed markets.

And so this article is not meant to preach an exact science and needs to be read as (realistic) considerations one can have when building a portfolio. Also, it is important to understand that you will still need to master the art after you understand science.

Do VCs have home runs?

Within VC funds the percentage of home runs is around five. Typically VC invests in later stages (less risky) where the valuations are higher and the company has more traction, so the chances of hitting of home runs are smaller.

However, the absolute returns might be higher as they have more resources to diversify and get broader exposure in order to generate bigger home runs.

We will speak about diversification for angels in another article as we think this is a great method to try and amplify returns.

What did we learn ourselves?

With HH Investments VC we have been investing in early-stage (Seed/Angel and pre-Series A) companies with a focus on mainly Southeast Asia and we are seeing similar results in our own portfolio. This gives us confidence that the metrics and expectations as described in this article are correct.

Next to the nine per cent, data from our own portfolio shows us that 50 per cent of the investments is a write-off (simply because 50 per cent of new companies don’t make it) and the remaining 41 per cent return somewhere between three to five times (we will take the average of four times for sake of calculations).

Write-offs don’t matter

We don’t have to worry too much about whether those numbers on write-offs and mediocre returns reflect that of a successful angel or the averages for that matter. The best performing (seed & VC) funds actually have more loss-making deals than the average funds, as you can see in the below graph.

Conventional financial portfolio management strategy assumes that asset returns are normally distributed where the bulk of the portfolio generates its returns evenly across the board. Moving away from public markets and towards angel investing this wisdom does not apply.

Having the nine per cent that returns 10 times (or more) is the main thing that matters if you construct your portfolio properly. Below provides a tangible example of the Pareto Principle 80/20 law:

We know that better funds have more home runs (and as we’ve seen above, more write-offs too), but they also have even bigger home runs.

Investing in a unicorn

The chances of you as an angel hitting a 50 times returning investment in a unicorn company are slim. The probabilities range from 0.07-2 per cent. As this seems to be more a game of luck (‘spray and pray’: an angle followed by many accelerators) rather than strategy we are not including those types of returns as a realistic expectation while building our portfolio.

Fundamental portfolio strategy

Let’s have a look at two different portfolio strategies which I have named ‘active-passive’ and ‘active’.

Active-passive in Portfolio 1, because after you have deployed your funds you will essentially be passive while waiting for returns. Portfolio 2 on the contrary will need an ‘active’ approach and solid decision-making during the whole lifecycle of the fund.

Portfolio 1 (active-passive)

Let’s assume you invest evenly a total of US$1 million in 11 early-stage companies (US$90,000 per company) using the nine per cent benchmark and you don’t reinvest any of the returns:

1 will be a home run and will return you US$90,000 * 10x = US$900,000
5.5 will be a write-off so you will lose US$90000 * 5.5= US$495,000
4.50 will give you a mediocre return of4x: (US$90,000 * 4.50) * 4 = US$1,620,600

Total return: US$2.5 million on US$1,000,000. The average return of a good performing angel portfolio is 2.6 times the original investment, hence with the above strategy we are slightly underperforming the statistics and because of that, we have no room for mistakes.

Portfolio 2 (active)

Let’s assume you invest a total of US$1 million in the same 11 early-stage companies, again using the nine per cent benchmark.

This time you only invest US$500,000 in the first stage (US$45,000 per company) and you reserve the other half for the home run company that might develop within your portfolio (we are still not reinvesting our returns, so there’s no compounding which could amplify our returns even further):

1 will be a home run and will return you US$45,000 * 10 + USD$500,000 * 5 (the return multiple is adjusted as the US$500.000 was invested later so you will have to pay a higher valuation) = US$2,950,000
5.5 will be a write-off so you will lose US$45.000 * 5.5= US$247,500
4.50 will give you a mediocre return of 4x: (US$45,000 * 4.5) * 4 = USD$810,000

Total ROI: US$3.7 million on USD$1 million invested, a stunning return of 3.8 times. Again, the average return of a good performing angel portfolio is 2.6 times the original investment, hence in the above example we are outperforming while even keeping a margin of safety allowing us to have a worse performance and still be better than average.

Keep in mind that in both portfolios we invested in the same companies and we never hit a ‘unicorn’. However, the difference in returns by applying a different portfolio strategy is staggering.

I didn’t take into account any tax benefits you might have while writing off your losses.

Do you see the challenges and why this is hard but rewarding work?

Both portfolios: every investment must be made with a separate mentality of whether it can be a home run deal while sticking to the portfolio strategy. Note: it would be a mistake to invest smaller tickets in companies that you think have less potential than others. You simply should not invest and wait for a deal that matches your expectations.
Portfolio 2: this portfolio is not just generating a higher return (3.8 times vs. 2.5 times), the downside is also lower as the losses are only half (USD$247,500 vs. USD$495,000) the size of portfolio 1, giving effectively a bigger margin of safety in case things don’t fully work out with the home run or we pick too many write-offs
Both portfolios: had we invested in less than 11 companies we would likely have made a loss on our invested USD$1,000,000 as it would be hard for the statistics to work out and find a home run
Both portfolios: it would have been better to increase the number of companies (up from 11) and leave more room for the statistics to work out. This we could have accomplished by decreasing the average ticket size per company or by increasing our total fund size.
Portfolio 1: we didn’t invest enough in the home run and we were too concentrated on balancing our money evenly across our investments. Instead, it’s better to invest less money in each company and then double down on the winner as proven in Portfolio 2.
Both portfolios: how to find 11 companies that all individuals have the potential to deliver a 10x on your investment?
Both portfolios: we could have tried to control the downside and have even fewer write-offs by trying to pick better, or maybe we would have picked the wrong companies and have even more write-offs. The bottom line is that it doesn’t matter. We needed the one big home run in both portfolios to get a decent return.
Portfolio 2: how do we know who is going to be a home run and when to double down? This is an art more than science and we will discuss it in another article.
Portfolio 2: it might not always be possible to invest more money. The company might not have given you ‘preemptive rights’ or even if you have them you might not be able to invest as much as you’d like as these rights are typically connected to the percentage of ownership

Can I not have a portfolio that is smaller than USD$1 million and/or invest less in each company?

You can. You could invest the same USD$45.000 from Portfolio 2 in less than 11 companies or you could invest smaller tickets per company.

However, there are a few challenges with doing that:

The companies that are at an “investable stage” (we will discuss in another article what we think that is) might not let you invest less than US$45,000 (rule of thumb: successful companies don’t need your money, you’ll have to fight to get on the cap table and bring experience rather than only money), and;
Even if they do allow you to join, they might consider your investment not substantial enough to give you the preemptive rights to re-invest more money later on, and;
If you go ‘very’ early stage with smaller tickets you’ll find companies that are still in the idea stage and I personally think you’ll be taking an unnecessary risk of the company not even being able to launch a product or service. Instead, there are sufficient good companies with traction out there with at least 6 months of data that we should focus on
If you choose to invest in fewer companies than suggested, it brings us back to the problem where we can’t let the statistics work properly and you might not find a home run

Obviously, you do not need to have US$1 million in cash right now to get started. It will take you time to find the right companies and the follow-on investment for the home runs might also only happen one or two years after you’ve made the initial investment. Commit to being an angel for the next 10–15 years.

How about a bigger fund?

You could increase your fund and invest bigger tickets in each company. Assuming you are still looking for the same companies as in our example above, I would still recommend to not only increase the ticket size but also the number of companies you will invest in so you can substantially increase the chances of hitting home runs.

At the same time, you should ask yourself if you can still handle this by yourself or it’s time to build a team or perhaps work together with other angels.

Do the above strategies apply if I’m just getting started as an angel?

If you are just getting starting as an angel investor, I do not recommend you to immediately implement the portfolio strategies as described in this article. I suggest you participate in an angel network or syndicate first and do at least three deals investing small tickets (US$10,000–US$20,000 per deal).

The main reason for this is that you will take less risk while trying to understand the dynamics and learn from other angels.

Getting exposure to home runs matters most
An active approach during the whole lifecycle of your fund matters. Generating good returns is a combination of science & art
You will need to create enough (diversified) exposure and allow statistics to work in your favour
Be prepared to lose all your money on half of your angel investments
Hard work and research is needed to set yourself up for success

I will go more in-depth in the next article on how to actually start building your own portfolio and discuss topics such as qualifying potential deals, compounding, balance and diversification, the art of follow-on funding & setting yourself up for a home run.

Source: e27

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Angel Investing Is Highly Risky-But Is So Rewarding