A number of years ago, while sitting in a bar in Manhattan, I heard a guy in a suit next to me talking about how he was a part owner of the establishment. Turned out he was an investment banker and regular customer and had put some money in as an investor.
No doubt it was an ego boost to be able to brag to other patrons about being an “owner” of the establishment. Maybe he got a few free drinks when he came in. But what kind of return did he make from his investment?
Angel investing seems cool. Everyone wants to get in on the hot new startup. It’s fun to talk about innovative companies over drinks. But how does it fit into your overall investment strategy?
According to a study by the University of New Hampshire Center for Venture Research, angel investment in 2020 totaled more than $25 billion in more than 64,000 early-stage companies, “with angels as the leading source of seed and start-up capital”. But angel investing is about the riskiest form of investing there is, except maybe investing in cryptocurrencies.
I always thought angel investing was cool too. I felt good supporting fellow entrepreneurs and excited by the prospect of hitting it big. I made my first angel investment in 1998 in a company called AmericasDoctor.com, a precursor to WebMD, that became a major health content provider for the original AOL internet service. The company seemed to have great promise as the demand for online content was exploding.
But after rejecting an offer for a strategic investment from a major media company, AmericasDoctor.com's IPO window slammed shut. Within a couple of years, the company ended up selling for far less than the amount of capital investors had put into it. At their peak, my shares had reached a notional value of $2 million. In the end, they were worthless. Maybe I should have learned my lesson, but that was not the last angel investment I made that lost money.
Angel investing has great allure, but is fraught with peril at every turn. This is particularly true if you are considering investing directly in individual companies rather than through an angel group where there may be more safety in numbers and the opportunity to diversify.
To be clear, when I'm referring to angel investing, I'm not talking about investments by so-called "Family Offices", the investment operations of the super wealthy. Those operations function similarly to venture capital firms, investing large sums, and often employ investment professionals to manage the process.
I'm referring to your everyday millionaire, individuals who are looking to invest $25,000 to $250,000 in a given deal. Those investors often lack the access, scale, clout and resources to do justice to the investment process or influence the company's results over time.
Here are nine reasons why:
- Adverse Selection of Deals. Deal flow is a key success factor for venture capitalists. But they reject up to 99% of companies they look at. We all know that startups prefer taking money from established, brand name investors to provide credibility. Deals that you have access to as an angel may have already been rejected by more established investors. To paraphrase Groucho Marx, “you might not want to join a club that would have you as a member.”
- Lack of Market Knowledge. Angel investors are by definition wealthy and theoretically sophisticated investors. But just because you have money doesn’t mean you know everything about everything. That amazing idea you are so excited about may have tons of competition or may have even already been patented by someone else. If you’re considering investing in a company in a sector in which you have no expertise, how do you know what you don’t know?
- Poor Due Diligence. In most cases, individual angels conduct minimal due diligence on companies they’re investing in. If your investment is a small percentage of an early round, the company will certainly answer some questions about their plans. But being able to subject the company to full blown due diligence like a VC would is unlikely. And most investors don't have the bandwidth to do it anyway. In many startup and seed stage rounds, there may not even be a lead investor you can rely on to ask all of the hard questions. Few angels hire a lawyer to vet the documents. They just take a leap of faith.
- Suboptimal Deal Terms. A VC friend once told me that 60% of the deal value creation is in the price you pay for the stock. Not sure it's that quantifiable, but you get the point. VCs set the terms on the deals they invest in. Angels usually don't. If you’re not leading the round or investing a significant amount, you will have little say on valuation, governance, or deal structure. The company will set the terms and you’ll be stuck with the no-haggle price. It's take it or leave it.
- Maximum Risk. Seed stage investments take place in companies that often have little more than an idea, maybe a prototype. The technology is unproven. Product-market fit doesn’t exist yet. The team isn't built out. A common belief by founders is that “if you build it, they will come”. But there’s no guarantee. VCs invest later, once the product and early market risks have been reduced. As an angel, you’re investing at a time when there are endless hurdles to overcome, any of which could trip up the company and derail the investment.
- Lack of Reporting. Once you have made the investment, the fun is just beginning. Small investors don’t get much management attention, and your attempts to get information are often seen as a nuisance. Unless there are clear reporting requirements in the investment documents, don’t expect much transparency as to what is going on. So you will be left wondering month after month what happened to your investment and whether you will ever see it again. At best, maybe you can find an insider who is willing to share information, but months and even years may go by when you have no visibility.
- Lack of Control. As a minor investor, you may only be able to exert influence if you have a pre-existing personal relationship with the founders. Otherwise, your small ownership stake will afford you little to no control over important decisions. You won't get a board seat or board observer status. You can try to be helpful with introductions or advice, endearing yourself to the founders, and maybe use persuasion to help guide the company. But you don’t really have a meaningful vote. Whatever the company or later, larger investors say goes. You just get to watch and hope.
- Risk of Dilution. Other than employees who hold options on common stock, angel investors are on the lowest rung of the ladder on the company's cap table. Especially in difficult funding markets such as we are currently experiencing, institutional investors coming in after the seed round may demand preferential treatment. Many angels don’t have deep enough pockets to keep up with subsequent investments as companies mature. So unless you invest your pro rata each round, you will see your ownership percentage keep shrinking. Your only hope is that the company can keep making sufficient progress that the valuation grows fast enough to keep price per share rising despite your ownership dilution.
- Lack of Liquidity. In 2003, I invested in a startup bank. I finally got my money out of the deal in 2021, 18 years later! My annualized return was a paltry 3.5%--not nearly enough to compensate for the risk, but at least I got my money back and a little more. That isn't always the case. Invest in public securities, and you can sell anytime. You can take profits or curtail losses. Not so in angel deals. If you're really lucky, you might be able to cash out through a secondary offering that takes out early investors. That's how I got out of the bank deal. But more often than not, for better or worse, you’re along for the whole ride through sale or shut down.
Despite the pitfalls, angels remains a robust source of startup capital. I personally decided that I was going to confine my direct angel investing to companies where I have a close personal relationship with the founder or am personally involved in the company to help influence the outcome. That's certainly no guarantee of success, as many of the hazards still apply. But I concluded that there are too many uncertainties to take a blind leap of faith backing companies and individuals I don’t know.
For those who do want to participate in the seed-stage economy, the best way to do so may be by joining an established angel network or fund. Preferably a fund that pools capital from many angels and invests in a portfolio of companies rather than simply presenting deals for investors to invest in individually through a syndicate.
Partnering with other angels will provide greater access to better deals and more clout in setting deal terms and influencing the company. You will benefit from joining forces with other investors who may have relevant expertise and can conduct more robust due diligence as a group. And considering seed stage companies as an asset class, you are much better off taking a portfolio approach and improving your odds that some of the companies will find success, covering the inevitable losses from the others.
If you want to learn about angel investing, I highly recommend you read Every Business Needs an Angel, by John May and Cal Simmons, two of the pioneers of angel investing groups in the Mid-Atlantic. While the book was written primarily to help entrepreneurs attract early stage capital, it provides a comprehensive and insightful view of the angel investing process.
The pooled capital approach facilitated by angel groups essentially mirrors the venture capital model, with shared risk by all participants and built-in diversification across a portfolio of companies. It's like betting on "red" or "black" on a roulette wheel rather than on an individual number. If you win, your upside is not as great, but your odds of losing your entire bet will be far lower.
Gus Bessalel is a former Inc. 500 CEO and 30-year veteran of startup life. He has a BA and MBA from Harvard University and started his career in management consulting at Bain & Co. He writes about startups, among other eclectic topics.
