3. Angel Investing 101 (David S. Rose)

Nick: Today we have David S Rose with us. He is founder and chairman emeritus of New York Angels, managing partner of Rose Tech Ventures, CEO of gust.com, and author of the new book called Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups. That’s a mouthful—you must be a busy guy, David.

David: Well, I don’t sleep, so what else is new?

N: So before we launch into the topic “Introduction to Angel Investing,” I wanted you to sort of give us a rundown of how you got into the venture space and how you first began angel investing.

D: Sure. Well, the 2 sides of the coin are entrepreneurship, which is starting up companies, and angel investing, which is financing those startup companies. I’m a third-generation entrepreneur—my grandfather and his brother started several companies, and my father has been very active. Back in the dot-com bust, I was a finalist for the E & Y Entrepreneur of the Year Award in New York; my father won it seven years ago, and he’s now 84. So he’s a very active entrepreneur; he’s currently developing shopping centers in Ghana—very interesting guy. So I’m a third-generation entrepreneur, but I’m also, interestingly, a third-generation angel investor, and that may be unique in the world. My great-uncle—my grandfather’s brother, the one after whom I was named and to whom I dedicated my book—decided in the later stages of his life that he could really help society by being what he called an “innovation catalyst,” and he would go find interesting innovators and inventors and ideas, and he would provide them the initial seed funding to get going. He was the angel investor behind the portable kidney dialysis unit, vascular stapling, hyperbaric operating chambers, and desalination projects in the Middle East—extraordinary guy, and I would hear about what he was doing and I was fascinated. Everybody else thought he was crazy because the term “angel investor” actually hadn’t been applied to what he was doing yet, but I was very interested. Since I am, at heart, an entrepreneur, I started my first company when I was 10 or 12 and then started companies throughout high school and college, and I’ve now started about half a dozen in my career. One of them during the dot-com boom raised a ton of venture capital, and then the dot-com crash came along and that was the end of that story. So that’s how I got into angel investing and started New York Angels, which, for a number of years, has been the most active angel group in the country, if not the world. Then I started Gust, which is the infrastructure platform that powers virtually all of the world’s angel groups. SO that’s my brief history.

N: Wow. You know, I’ve met a lot of VC people and angels, but never heard a legacy quite like that. So we’re going to jump into the topic and start at the beginning, so tell us about the difference between an angel and a VC.

D: Well, many people, including entrepreneurs and people who watch Shark Tank will say without spaces, “Oh, you’re an angel or VC,” or, “Yeah, I’m going to raise money from angels and VCs.” But in actuality, angels and VCs are very different. A VC is a money manager who goes out and raises large pool of money from institutions and really rich people. Institutional investors are things like university endowments, pension funds, or insurance companies—institutions that have a large pile of cash and want to get a positive return. They’ll typically invest in stocks or hedge funds or bonds for security. But then they’ll take maybe 10% of their portfolio and put it into riskier, but maybe higher-return, things called venture capital funds. VCs raise funds that could range from $25 million to $1 or $2 billion, and they invest it into companies that are still private hoping for a high return. Now, because they’re investing so much money, they tend to go in chunks of several million dollars, and they tend to go for the later stage, not so much the startup stage. Only a small percentage of their investments are at the startup stage. In contrast, angel investors are individual people, not VCs or professional money managers, who take money out of their own pockets and put it into companies. They don’t have a manager—they’re responsible for choosing the companies themselves, and they work closely with those companies. So VCs are people who manage other people’s money and are compensated by receiving a portion of the money they’re managing and a hefty portion of the profits. An angel investor is a person investing their own money who keeps 100% of the profits.

N: Got it. SO before you get into angel investing—before I started—you have to make sure you’re accredited. Can you walk us through what accreditation is, how you get it, and if it’s necessary to invest in startups?

D: Sure. After the stock market crash of 1929 where you had a lot of people investing money into stock and things that weren’t real, the government decided it needed to bring some kind of order into the wild west of investing in companies. So the Securities and Exchange Commission was created and made some fundamental laws about the buying and selling of stocks and other equities. The idea was that in order for a market to be efficient, there has to be transparency. There are no rules about what you can and can’t invest in, but if you’re trying to get people to invest in your company, you have to disclose everything. You have to disclose your financials and what you’re paying your executives, and who own what of the company, and things like that. The idea is that with all of this information published, even amateur investors can read it and understand the risks of the company and what it’s actually doing. That’s why the public stock market was created, for the buying and selling of stocks. If you live in the country, you can buy shares of a publicly traded company—you can buy shares of Google or Apple today; just call up your broker. There are no requirements for that. So if you are a company and you want people to buy shares of your stock, you have to go public. But there’s an exception: if you don’t want to go public and have all of that transparency and share your financials and things like that, you can sell shares of your stock to a person provided they are an accredited investor, or a qualified investor. The SEC says that means the person has to have enough money that if they lose it all they can still survive, and hopefully they are sophisticated enough to know what they’re getting into. So to be an accredited investor, you either have to have at least $1 million, not including the value of you primary residence, your home, or you have to have an annual income of at least $200,000, have had that for the last few years, and have a reasonable expectation of that continuing going forward—or, if you’re filing jointly with your spouse, a total of $300,000 a year. If you have either of those two things, you are automatically considered to be an accredited investor. There’s no certificate you get; you don’t sign anything; it’s just a definition. The other exemption is what’s called a qualified investor—someone who manages money, over $5 million for other people, and so on and so forth. The majority of angel investors qualify as accredited investors, so that’s what that’s all about.

N: Got it. So it’s more of a self-disclosure; it’s not something you apply for.

D: Correct. If you meet one of those two definitions, you are automatically an accredited investor and you can invest in private companies that have not gone public and released all of that information. And interestingly, the penalties do not fall on you as the investor. It doesn’t say you can’t invest in companies; it says the companies can’t take money from an unaccredited investor. That’s why companies are so careful about whom they take money from. When you’re investing in a company, there’s a 6- or 8-page document that basically says, “I hereby declare that I am an accredited investor based on this definition—income and so forth—and therefore I know what I’m getting into.” The reason the company does that is because if they take money from someone who is not an accredited investor and it was their job to make sure you’re accredited, the whole deal and can unwind, and they’ll have to pay everyone back. No company want to do that, so the company’s lawyers will tell them to make sure you’re an accredited investor.

N: Right. Often I’ve found with placements that there’s a form—if your assets are over $1 million, or if you’re making more than $200,000 a year, you sign it, and in rare cases they will ask for copies of your bank statements and whatnot.

D: Well, that’s actually an interesting change. Since September 23rd of last year, 2013, and still continuing today, if you raise money from people that’s fine; they just have to self-certify and say, “I am an accredited investor.” However, until last year, companies could take money in from accredited investors, but they couldn’t tell anyone that they were actually raising money. SO that put them in an interesting catch-22. They could raise money from accredited investors, they just couldn’t tell them they were raising money; as you can imagine, that caused huge problems for the whole angel investing industry. But when the JOBS act was passed last year, SEC finally said, “Okay, companies, you can now generally solicit—tell anyone in the world you’re raising money—as long as you only actually take money form accredited investors.” That’s a much more logical and rational position—you can tell anyone you’re raising money as long as you only take money from accrediteds. The only loophole is that the SEC said that if you are generally soliciting, the company has to take reasonable precautions to make sure the person actually is accredited, and they can do that by looking at, for example, your tax returns or you W-2s or getting a signed statement from your banker or your lawyer, and that’s getting a little hairy, because a lot of investors don’t necessarily feel like disclosing their tax returns to a startup company in which they’re investing. If they don’t generally solicit, they don’t have to do that, and there’s now a lot of discussion going back and forth about how to handle what’s called the verification process of your accreditation for companies that do generally solicit.

N: Right. So you mentioned the JOBS act, and I don’t want to go too deep on this because that’s a topic for another day, but can you talk about opportunities for the non-accredited currently and in the near future? Regulation is changing, and it seems to be evolving in a way that may create a different environment.

D: Sure. So, since the SEC promulgated its rules 80 years ago, the only people who could invest in private companies were accredited investors. The JOBS act had 3 major provisions. The first one, Title I, made it easier for companies to stay private longer—Facebook, for example, went public because it had to. The other thing Title I did was made it easier for companies to go public when they decide to go public. So Title I went in, and it was non-controversial. Title II was the general solicitation, which said companies could tell people they were raising money as long as they only took money from accredited investors and verified that they were accredited, and that went into effect September 23rd of 2013. The third part of the JOBS act, Title III, is where all the discussion and press coverage has been, and it would allow, for the very first time, something called crowdfunding. It would allow people who are not accredited investors to invest in private companies. But there are a lot of regulators and legislators and government officials and so on who are very concerned about that, and so there are a lot of regulations being proposed. As a result, if you are not an accredited investor, you still may not invest in the equity of a company. Under Title III, which will probably go into effect sometime in 2014, unaccredited investors will be able to invest in private companies, but inly in very controlled circumstances. It will only happen on certain online platforms that have registered with the SEC and across all companies, it can only be some part of your income, which I believe is 10%. There are a lot of regulations in place. But today, Title III is not in effect, and so an unaccredited investor may not invest in a private company. There are a lot of tweaks that can be done technically, but in practice, no. What people who are not accredited investors can do is traditional project-based crowdfunding, and that’s things like Kickstarter or Indiegogo, where youdonate to help a project or a product or a film come into fruition. That’s called “rewards-based” crowdfunding, or “product-based crowdfunding,” and you’re basically buying a copy of the product in advance. You don’t have any equity in the company, but you do get whatever they’re building. There was a very interesting case of this recently where a company called Oculus Rift crowdfunded the making of a 3D headset for gamers, and it was a very sexy product. It was so popular that even before the first round was finished, the company was acquired for over $1 billion. However, since those people were not equity investors, none of them got to share in the billion dollars. They will, of course, get what they bargained for, but none of them gets to share in the equity.

N: Good deal. And—a distinction for the audience—we’re going to be talking about crowdfunding a little bit today and in the future. As Davis mentioned, there’s a clear distinction between crowdfunding for equity, where you’re giving money for equity, and crowdfunding that is a donation for a product, which is your traditional Kickstarter and Indiegogo. Okay, moving on. David, walk us through the characteristics required to be a successful angel investor.

D: Well, the first one is patience, because angel investing is unlike any other kind of investing. If you invest in stocks, for example, it’s liquid, and you can sell any day—just call up your broker. If you put money in a bank, it’s liquid, and even if you lock it up in a CD, you can sacrifice some part of the interest and take it out any day. If you put money in a home, it’s real property, but in theory you can sell it if you have to. Once you put money in those private startup companies, there is no exit until the end of the game. The typical holding time for an angel investor in the United States is 9 years on companies that eventually return a large amount of money. When you invest, you have to wait years or even decade, so you can’t think about the money being in your pocket. It’s just there and it’ll come back, if it ever comes back, when it comes back. You also have to have a personality that can stand to lose things. If you are definitely afraid of losing, don’t be an angel investor, because you will lose something. Around half of all angel investors fail completely—you lose all of your money. If you go out and invest in only one deal, odds are you’ll lose. And even if you’re a great angel investor with a huge portfolio and enormous returns, the odds are still that half the companies are going to fail. The ability to tolerate risk, and even enjoy risk, is necessary. Because these are volatile companies and stuff happens, you also need to have an even temperament. You can’t fly off the handle or yell at your entrepreneurs if bad thing happen, because bad things will happen. Typically these entrepreneurs are Type A personalities, so you’ve got to have decent people skills, or no one will want you investing in their company. You’ve got to have self-discipline, becuase as I write in the book, angel investing is about placing a rational number of bets into companies at rational amounts because at the end of the day, the economics work. You can’t place bets on the first company you see, and you cant put $1 million into one deal and $1,000 into another. You have to have the willingness to learn—from experience, from experienced angels, from podcasts like this or books like mine. There’s a lot of stuff about best practices, and if you just go galloping off into the distance without understanding where you’re going, you will absolutely get in trouble. And finally, you need to really love startups and entrepreneurs. You’re putting your money into a startup for a very long time here, and you’re working with these entrepreneurs who are trying to come up with something that no one’s ever seen before. You have to really love the world of startups with all its uncertainties and craziness such as it is. Every angel needs that stuff. If you’re going to be an active angel who’s really involved with the company, there are a bunch of things you need on top of that, thing like the ability to mentor—you’re typically more mature than these young entrepreneurs—providing expertise in the domain, experience running a business—you may have a lot more than the entrepreneur, and they may look to you for guidance. Financial savvy and the ability to connect them with the right people—investors or people in the industry or clients—are important. You need all of those qualities to be an angel, but if you do have them, and you like it, it can be extraordinarily enjoyable.

N: Great, and I think you covered a couple questions there. Very good answer and very exhaustive, there David. Thank you. Moving on, can you explain to us what the investment J-curve is? I came across this in your book and thought it was an interesting chapter, so I’d like to hear your thoughts on this.

D: Sure. The J-curve is typical in these new companies before they’ve become profitable, and it’s typical of the venture capital industry. What it means is that when you look at the value of your investment, it makes the shape of the letter J. When you put money into a company, the value of your investment immediately goes down because they start spending it. These companies don’t have revenues yet and they’re not profitable. So across your portfolio, the companies that are successful will be eating up money, and the companies that aren’t successful will be going bankrupt and falling by the wayside. The minute you start investing, the value of your portfolio goes down. Imagine time going out on the x-axis; as you put your money in, it goes down. Now, in 1 to 3 years, the companies that are going to fail have done so already, and the companies that are going to be potentially successful have begun to stabilize, so you’re at the bottom of the J. In the out years, years 4 to 9, the companies have starting to become successful. They have the product built and they have customers. They have revenues and they’re starting to get bigger, and so the companies that stay around for years 6 to 9 are generating millions of dollars every year in revenues and they have customer bases, and at that point the value of your portfolio begins to skyrocket, or at least get very high. So if you look at the x-axis, your portfolio goes down, then comes up a little bit and then goes up very fast and it looks like a J, and that’s the J-curve, which applies to both venture capital and angel investing.

N: So let’s talk a little bit about organized angel investing. I know you run an angel group, or an angel syndicate, as some people call them. What are they, how do they work, and how do they add value?

D: Well, since angel investors are individual people and not big funds, they’re not investing as much as VCs. So where a typical VC investment is in the millions of dollars, typically angel investors are not investing millions of dollars into any one company. Rarely do they even put hundreds of thousands of dollars to work. The typical investment per company per angel is about $25,000 to $30,000. But a company may need a couple hundred thousand dollars to get started, so typically a couple people are investing at once, and that’s syndicated. You can either have the company itself going around and finding lots of angels, or you can have a group of investors who get together in a syndicate to multiply their power. That’s what professional angel groups are all about. The first ones started in the late 1980s to early 1990s, and a lot of them got hammered in the dot-com crash. A lot of them returned in the early 2000s, and they’ve been growing ever since. A lot of them belong to the Angel Capital Association in the United States, and Gust, the platform a lot of groups use to manage their collaboration, has well over 800 angel groups now around the world. The reason to join an angel group is so you can pool your capital with other people, to pool deal flow—you might see 1 or 2 interesting companies, and so might the next person, but put it together and you’re now seeing 4 or 8 or dozens of interesting companies—and you have an entity that can now say, “Hey, bring us your interesting opportunities!” So New York Angels, the group that I founded, gets well over 1,000 applications for funding, and no individual angel ever sees that. You also share your due diligence expertise. If I have expertise in one area and you have expertise in another, that means we can both look at things intelligently that neither of us could do alone. The combination of pooling money and wisdom and deal flow makes it very attractive to join a group, and some groups will invest together. When you join a group, you’ll put your money upfront into a fund, and then when companies present to the group, the group will vote on whether they should invest or not from the pool of $1 million or $2 million or $5 million. In other funds, called pledge funds, everybody pledges to invest a certain amount into opportunities that are presented to the group. When the members come to the meeting and see companies present, everybody will decide individually whether they want to invest in these companies. Typically those companies have a very structured process: they’ll welcome applications and screen those applications, then bring maybe 10 or 20% in to meet with group members, and then the screening committee will narrow it down to maybe 2 or 3 or 4 companies out of 25 or 50 or 100 that applied throughout the month. Those couple of companies meet with the group members and the group members decide whether to invest, and if they do, they all do so together on the same terms. So that’s an angel group. What we’re now seeing is what’s called angel syndicates, which are groups, informal or otherwise, based around a single person. So I might have a group around me of people who are not really angel investors, but they have some extra money and want to get out there, so they’ll say, “If you think this is a good idea, I’ll invest along with you.” That allows me as the lead investor to leverage my investment with a lot more money from other people. There are a lot of platforms now online that allow you to automatically get behind a person, and just agree to back them up, so these are informal syndicates. Some angels will just say, “Great,” and invite you to join them. Some investors will charge what’s called a carried interest, where they take some portion of the profits on anything that’s successful. So this whole world of group investing is just beginning to shake out, but that’s what a group is and that’s what a syndicate is.

N: I’m a member of an angel group myself, so thanks for giving us a good overview of that. David, historically, why do you think people have been hesitant to get involved in angel investing?

D: Well, imagine walking down the street, going up to a random person, and saying, “Hey! How would you like to invest you money into some crazy startup you’ve never heard of before?” Think of all the challenges of doing that. The only people who can really do that are accredited investors, and you have to invest a particular chunk of cash in there, so that sort of cuts it down. Then you have to understand that you actually can invest. You hear all these stories about companies that were initially funded by angel investors, but if you ask the average person, they wouldn’t have a clue as to how you actually can do it. So then you know how to do it, and you have to find deals and opportunities. They’re not typically posted on street corners yet.

D: So you either have to find people who know people or join an angel group, or with platforms like Gust, you can see what companies are raising cash. Well, then if you know what angel investing is and you have the cash, you have to figure out how to do it. So there’s the legal aspect and all the paperwork. And then there’s the economics, and the “Should I do it?” and you have to look at how much you’re going to get and how much risk you’re taking. What are the conditions and terms? How can I track what’s going on? This is a completely foreign thing to most people, so historically, it’s been very hard to do it. What the last decade has seen, and the reason I wrote the book, is that it’s getting much easier to do. Angel groups like the ones you and I belong to; books like the one I wrote; the laws; online platforms like Gust—all of these make it much easier to do it.

N: That segues well into the next question. What do you think is the best way for someone that’s interested in startup investing as an angel investor—what would you recommend is the best way to get involved?

D: Well, speaking completely objectively, I can say there’s a wonderful book called Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups.

N: I haven’t heard of that one.

D: It’s by this wonderful guy named David S Rose who really knows what to do. What I tried to do in the book is really lay out for the first time what angel investing is, how to do it, and all those things we just talked about—where to find deals, how to raise your profile, how to find fellow investors, how to structure deals, how to handle valuations, how to add value; all that kind of stuff. So if someone is really serious about angel investing, the book is a wonderful place to start. In fact, the European Business Angel Network just decided they want to make this the standard instructional guide for all of their angels. I’d recommend that first. There are also lots of websites that have really interesting resources about angel investing. The Angel Research Institute is the nonprofit sister organization to the Angel Capital Organization, and they have lots of training programs and material online about angel investing. But the best thing I think people should do is join angel groups like the ones you and I belong to, because they’re really designed to mentor people through the process. They have deal flow and experienced angels. They have regulations and processes instead of the guesswork and challenges, and it’s a really great way to get your feet wet. You can hang around and watch for a couple months, or put a little bit into a deal someone else is working on. Then you can start reviewing and screening companies, and maybe you’ll have enough experience to serve as a co-lead on a deal with a more experienced angel. You’ll learn as you do, and then maybe in a year or so you’ll be able to take the lead on an investor and the valuations and things, and at that point you’ll have several investments in your portfolio. And then from there, you can stay with the angel group, but you’ll have you own brand and the experience and deal flow that customers will come to you. Then you can become an individual angel. But an angel group that belong to the
Angel Capital Association in the US or another national equivalent is by far the best way to get involved in angel investing.

N: Yeah, I’ve gone down this path myself, and I think it’s very good advice. So we’ve established that you’ve got a lot of balls in the air, David. What is occupying most of your time now, and what are you most focused on?

D: Well, my full-time job is that I’m the founder and CEO of Gust, the platform used to manage all of these groups and manage the collaboration between them. At this point Gust is used by about a quarter of a million startup companies to manage their relations with their investors. It’s used by 90 or 95 percent of all angel groups in the US and around 70 percent of all angle groups in the world. We have around 50,000 accredited investors who use the platform. Gust is a pretty big operation; we’ve got about 35 people on staff and an office in Europe. It’s used by the National Business Angel Federation in countries around the world, and we’re localized in six languages, so that’s my day job. I’m also an active investor myself and I have about 90 companies in my portfolio, and I’m on the board of many startups. I led the investment in Comixology, one of the largest comic companies in the world, and we just sold it to Amazon. So between investing in companies, serving on the boards, managing the portfolio, and running Gust, I probably spend half my time teaching. I’m on the advisory boards at Yale and Columbia, and I was mentor of the year at NYU. I also founded the economics program at Singularity University, so I lecture there. I also wrote the book and do a bunch of other stuff. As I said, I don’t sleep.

N: Well, you’ve certainly got energy, David. Wow. If we could cover any topic in venture investing, what topic would you like to hear on the podcast, and who would you like to hear speak about it?

D: Well, as I said, angel investing is very long term, with the average being 9 years. We have a deal we’re working on now that we invested in 7 or 8 years ago, which is likely in the end to return over 50 times the original investment. That’s a wonderful thing, but unfortunately it doesn’t happen all day long. That’s the one investment in the portfolio that makes all the economics work out, and the economics are very interesting. Of 10 companies an angel might invest in, probably half will fail. Of the remaining 5, maybe 2 will give you your money back at the end of the day due to an assets sale or an acqui-hire. Of the next 3, maybe 2 will give you 2 or 3 times your investment. If you could get all the companies up to that level, it would be fine, but it’s only 2 or 3, so all of the value of the portfolio is coming back to that 1 company. If you can get 1 company to return 20 or 30 times the original investment, studies of the long-term, professionally-managed, rational angel portfolio have shown you can get north of 25% IRR. That’s avery nice outcome, but the problem is that you need an exit. So one of the areas angels have increasingly focused on now is exits. You’re thinking about it from the very beginning—who’s going to buy the company and how are we going to get our money back? There’s a great book called Early Exits by an angel investor named Basil Peters in Canada, and that’s spawned a whole industry looking at that issue. So I’d love to see a podcast around exits and
rational things to expect, and thinking about it upfront. The leading guys in that space are a guy named Bill Payne, the leading trainer of angels in the world, who’s written a few books, including one called The Definitive Guide to Raising Money from Angels and he teaches a lot of the courses for the Angel Research Institute, and a guy named John Huston, who was the head founder of Ohio Tech Angels, and they’re returning something like 40% IRR—they have a whole strategy at Ohio where they talk about returns upfront with the entrepreneur and they really focus on doing that. I’d love to see a podcast focused on the exit aspect of angel investing, and I’d love to see a guy like John Huston do it.

N: Great recommendation; looking forward to connecting with those guys. So what’s the best way for listeners to connect with you?

D: Find me somewhere in the ether, because I’m rarely available in person. There’s a site called about.me, so go to about.me/davidsrose, and it lists all the contact information about me and directs you to people who can more quickly get back to you. I’m also at Gust, so david@gust.com is my email address, and you can find my profile on Gust.

N: Okay. If you don’t mind, I’m going to throw out your Twitter handle as well—give him a follow.

D: Oh. My Twitter handle is @davidsrose, and that’s actually my universal handle—LinkedIn, Facebook, and davidsrose.com. One of the places to find what I’m currently thinking about is on a site called Quora, the world’s leading question and answer site. Anybody can ask a question and anybody can answer, so I’ve taken to answering questions about angel investing and startups and entrepreneurship, so at this point I’ve got several thousand answers. That’s how the book got started—Wiley decided the time was right for a book on angel investing, and they found me on Quora and decided to turn it into a book.

N: Okay. Yeah, Quora is a great platform. We’re incredibly fortunate to have had David S Rose with us walking through the process of angel investing and doing a great intro for us. Check out his new book, Angel Investing: The Gust Guide to Making Money and Having Fun Investing In Startups; it’s a really quick and easy read, and it’s incredibly informative, so I recommend you pick that up, and of course there is gust.com; we’ve discussed that. I use it with the angel group I’m a member of here in Chicago; it’s an excellent platform, and I encourage you to check it out. David, thank you so much for your time, and we hope to have you back soon.

D: My pleasure. I look forward to it.