On this episode of The Full Ratchet Nick covers part 2 of Best Practices for Seed Investing including:
Overview of Seed Investing- Developing an Angel Investor Strategy
- Identifying startups: Deal-flow
- Evaluation & picking startups
- Structuring the Deal
Today we cover how to develop an angel investor strategy and next time we will address #3, deal-flow.
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Section 2: Developing an Angel Investor Strategy / “Rifles vs. Shotguns”
- Motivation / Goals
- Investment Strategy & Portfolio
- Seed & Follow-ons
- The Thesis
- Team Sport
- Target Return
- Investor-Grade
- The Gambler’s Ruin
- Target Ownership Percentage (Valuation & Investment Amount)
- Reputation & Contribution
HIDE/SHOW Section 2: Developing an Angel Investor Strategy
- Motivation / Goals: Decide why you want to be an angel. Making money, status, ran a company and don’t want to again, want to support the startup ecosystem, want to forward innovation… many different reasons for being an angel. Not everyone is focused on getting a return and that’s okay. This guide and my focus is on being a catalyst for growth and innovation WITH a successful financial outcome as well. Ultimately, I can only keep doing this as long as I’m doing it well.
- Investment Strategy & Portfolio: Most of your money should be in lower-risk asset classes. A small % may be allocated ti high-risk areas. Most advise that no more than 10% of your net worth should be allocated to venture. Allocate the amount that you will invest in venture over the next few years. Decide if you will do seed investments only or seed investments and follow-ons (remember our many discussion on pressing your winners, or not). Choose the total number of investments you’d like to make to diversify your portfolio. Divide your total amount by this and that will be your target investment amount.
- Example:
- $ allocated for Angel Investing: $500k
- Target # of seed investments over three years: 20
- Follow-ons: Yes, equal amount reserved for follow-ons
- Amount for seed investments: $250k
- Amount for follow-ons: $250k
- Target $ amount / investment: $12.5k ($250k / 20)
- Considering this is less than the usual minimum direct investment of $25k, it would be smart to partner with another angel, series of angels, join an angel group or maybe even invest in a fund
- Seed / Follow-ons: As mentioned in the example, investors must decide whether they will do Seed-only deals or Seed + Follow-ons. Seemingly, the argument against follow-ons is that they require more active monitoring of progress and risk reduction. They also will consume a portion of your total available capital, which clearly reduces the number of investments one can make on seed deals. The argument for follow-ons is that, as an investor, you should have better information than anyone else. This is an opportunity for you to double-down on your best investments. Certainly if you were an early investor in Facebook, you would not be passing on a follow-on opportunity. If an Angel does decide to include follow-ons as part of their strategy, they often reserve 1x-2x of their seed capital for follow-ons.
- The Thesis: Many recommend to develop a thesis or investment focus. Without it, there’s often too much deal-flow to filter. With it, you can quickly eliminate 80%+ of the deal-flow and focus on evaluating what you want. Here are some of the dimensions by which investors choose their thesis/focus:
- Geography
- Industry Vertical or Sector
- Horizontal skill set or expertise
- Position in Value Chain and/or Stack
- Revenue Model
- B2B vs. B2C
- Software vs. Hardware
- Macro Trends, Market Drivers or “Thermals”
- It is prudent when starting out to consider each, decide if a choice is appropriate and then make the choices that optimize your time spent and decisions made.
- Team Sport: If you’re just starting out and don’t join a group, find a friend who is well connected and has his own syndicate. One can learn a great deal from high quality co-investors. In general, groups have more brain power, more bargaining power, the ability to get into better deals with smaller amounts, speed (in some cases), typically more appropriate terms, and better ongoing governance (ability to get board seats). Personally, I put together an investment thesis for every planned investment and circulate to a small group, each member of which has veto power.
- Target Return: There are better measures of real return than cash-on-cash multiple, such as TVIP, DVIP and IRR, but you’ll most often-hear investors discuss return this way. And one should aim for a minimum return of 10x , while many target 20, 30, or 50x returns. If there’s no large potential upside, most angels say no deal. While difficult to get these returns in later rounds, it is possible with seed investing. Recall David S. Rose mentioned that with a professionally-manged, long-term, rational, angel portfolio, the returns can be north of a 25% IRR. But on average…
- 5 out of 10 investments fail
- 2 out of 10 return your money
- 2 are solid successes… maybe returning 2-3x your money and
- there will often be only 1 big success that will yield the return for the entire portfolio
- Recall that venture investments resemble a power law… the most successful startup exits account for the bulk of dollars returned. And true unicorns ($1B+) exits are very rare. Aim high but realize that exits in the hundreds of millions may be the best outcome based on where you are and what you invest in. Considering this, attention to terms, valuation and follow-ons becomes critical in attaining the return that you are targeting.
- Investor-Grade: Related to the last point on target return, we hear this term “investor-grade,” which is often defined as startups with a return >10x in five years. And I like to adapt it and refer to it as “venture investable.” There are many startups, especially on a local scale or services businesses, that will not have the opportunity to scale, have a large exit or IPO. But it doesn’t mean that these are not investable businesses, they are just not “venture investable” with the traditional priced-round or convertible. I know many colleagues that are happy to invest in these businesses with debt, profit-sharing or other types of instruments. There are also many platforms that have launched, specifically focused on linking investors with small and localized business, if this is a better fit for you.
- The Gambler’s ruin (aka the Angel’s Ruin)… How to avoid it:
- Recall our discussion of the Gambler’s Ruin from Episode 20. There are four elements.
- Keep a standard investment amount, regardless of how much you love the company.
- Use your pro-rata right on your winners. You have better information than outside investors and should know whether a follow-on investment is a good or bad decision.
- Establish an investment size that is small enough to build a portfolio. Recall the diversification point earlier that most target a minimum portfolio size of 10 investments.
- Abandon betting strategies that are no-longer working. If you have a thesis and a sector focus, it should be based on external drivers or trends in the greater marketplace. Things evolve and these drivers change over time. One must adapt their thesis and/or sector as the world around them changes.
- Target Ownership Percentage (Valuation & Investment Amount): Related to #1 in the Gambler’s Ruin, when choosing a standard bet size, valuation amount is critical to consider here. There is a common complaint with escalating valuations, let’s say a $5M seed valuation instead of a $2.5M, that your return amount, effectively, will be cut in half. But another way that I look at it, is that it’s doubling your cost to get in. For example… let’s say I’m evaluating two startups, progress and potential outcome are directionally similar for each… one is raising at a $2.5M valuation and the other is at a $1.25M valuation, if both of these companies ultimately have equivalent exits, I only needed to invest half the amount in the second company for an equivalent $ outcome. Clearly if you’re investing half as much, you can place a lot more bets. So back to Jerry’s point about setting a standard bet size, I agree that this is necessary. But the correlary is that if your target companies have similar progress-to-date and similar potential outsized-outcomes, then the amount you bet should adjust with valuation. Logic would say, the cheaper the price, the more money you should get in… but remember that at bats are the most critical element. As Rob Go said, the single best strategy is to invest all of your capital in the company with the largest exit… but ultimately you don’t know which those will be, so diversification is required. The other helpful element to this valuation adjust investment size approach is that the higher the valuation is, the more you are required to invest. This helps me, in that it forces me to be disciplined about valuation. If my standard bet size is $50k and I need to invest $150k b/c the valuation is, let’s say around $7.5M, this escalation forces me to pass. I’d much rather have three bets on non-concensus startups instead of one bet on a concensus world beater. Another way to look at this is having a target ownership percentage. Maybe you’ve heard angels or VCs say that they have target ownership percentage of 1% or 2%, for instance. While I used to have trouble understanding why this would be the case because it is the return on your money that matters more than how much ownership one has. This effectively accomplishes the same valuation adjusted investment amount. If one really falls in love w/ a $10M valuation seed company, they’ll have to pay $100k for their 1%. So you can see that setting a target ownership percentage can help one stay disciplined about the amount of money they invest and the valuation & stage of companies they’re investing in. I can’t tell you how many times I’ve heard the comment, “when the company exits for $100M, you’re not going to care if you paid a premium in the seed round.” And while that may be true, if your seed ceiling is $2.5M and you push to $5M or your ceiling is $4M and you push to $8M… to get the same return on exit, you must double your bet size… thus you are, effectively, halving the number of bets you can make. Having an appropriate amount of deal-flow, of course, is necessary, as if you have only one choice, you really don’t have any choice. And assuming you do have the deal-flow, would you rather have two shots with like-startups, or one?
- Reputation & Contribution: Beyond just money, look for startups where you can add value… Ask why a startup should take your money over another investor? Find ways to reliably add value. Are you an expert in something? Do you have a skill? there are many differing viewpoints on whether this is necessary and ultimately, it is not necessary. The ability to add tremendous value as an angel investor is limited, but that doesn’t mean you shouldn’t contribute advice and connections where appropriate. The investor and the startup will likely enjoy the journey much more and build an even stronger relationship if the investor is helping them realize their goals. Recall Glenn Gottfried’s comments on how it took him a couple of years to build his personal brand and become a resource in the community. Founders and other investors want to engage in long-term relationships with those that have a good reputation. And this can help an investor earn more referrals from their portfolio companies and partnered investors.
And with that, we wrap up section 2 of best practices on Angel Investor Strategy.
While it’s true that picking the right startups to invest in trumps all… it’s an investor’s system that gets them in position to choose, invest decisively and protect their investment.
If you’ll humor me for a bit I’m going to take a couple minutes to talk sports… The other night I was watching the 30 for 30 episode on the NFL draft that included Elway and Marino. There were a number of QBs drafted before Marino and we all know how that played out. This is a loose comparison, but it got me to thinking about how difficult it is predict a player’s success, even with a large body of video, scouting, background research, etc. There are organizations and more specifically GMs that have a very poor track record when drafting players. Conversely, there are organizations and GMs that have performed consistently well above average for many years. Do they have a crystal ball? Can they predict the future? Of course not. Can random, uncontrollable events like a career ending injury cause an excellent pick to lose 100% of it’s value? Sure. So why then are there consistent over-performers and under-performers? As Jerry Neumann mentioned, everyone’s got a system. Some have no reasonable basis for their system and use anecdote to predict all future outcomes. Many will abandon their system and rules when a flashy, exciting opportunity, with tremendous upside, becomes available. I ask myself, are the Krafts and Bill Belichick are going with their gut? It seems more likely that they have a system, they understand sources of risk, they estimate the liklihood of success by measuring those risks, and they don’t deviate from the system. Great players come and go but great coaches & GMs sustain success…
Are they truly shooting from the hip or is it like Jerry said on the show… where the best have great systems, they just usually don’t talk about them?
An analysis of the nfl draft by economist David Barry found that 88% of the time, where in the draft a players is picked, remarkably, doesn’t correlate with their ultimate performance per play. Does the 12% of the time warrant the premium one has to pay?
So circling back to Mr. Dan Marino… he was drafted with the 27th pick. He went on to become one of the greatest of all time. There were 26 opportunities to choose him before he was drafted…. ultimately, it’s just really hard to pick. Whether it’s the next Marino or the next Facebook. But if one builds a portfolio using best practices, good economics, strong risk/reward profile and gets theirself more at-bats… they’ve created the best opportunity for success.
While we spent most of today talking about the aggregated best practices on the system of angel investing… on the next episode of the Full Ratchet, we get into the fun stuff that I’ve been looking forward to. What do the best advise when evaluating and picking specific startup investments? What are the key terms and elements in a negotiated deal? All that and more on angel investing best practices part 2, coming out on Wednesday, the 12th.
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Until next time remember to overprepare, choose carefully and invest confidently… see you soon for part 2.