5 Common Mistakes Angels Make

Angel investing is new territory for many investors. Paul Holliman, Angel Investor and startup mentor, dives into a few common mistakes new angel investors make and key insights to avoid these mistakes. 

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Angel investing and venture capital are two distinct approaches to investment. Angel investing involves personally investing your own money in private companies at an early stage in exchange for equity. This type of investment presents an opportunity for substantial returns and the potential to build generational wealth. An early stage company might have a product, an idea, a little bit of growth, and a fairly low valuation, because they may not even really have customers yet.  By investing early, individuals acquire ownership stake in the company, which can increase in value as the company grows.

Angel investing is a long-term and illiquid investment strategy. Expect your funds to be tied up for a considerable period, ranging from seven to thirteen years, with ten years being a common timeframe. The outcome of this investment is primarily dependent on the success of the invested companies and the subsequent realization of returns.

Portfolio Construction: How to Maximize your Chances for Success

Investment Thesis

Developing an investment thesis is crucial  as you begin your journey of becoming an angel investor. Angel investing is a long-term commitment, typically spanning 10 to 13 years, so when constructing an investment thesis, consider factors including stage and sector of the companies you want to invest in. You may want to focus on specific areas such as climate change, women founders, underrepresented founders, or healthcare, depending on personal interests or areas of expertise. Select a topic that aligns with your value or expertise. This will help you gain a competitive edge and make informed investment decisions.

Investment Plan

As you create an investment plan, think of it like building a budget. Allocate a certain percentage of your investable capital to different asset classes and devise a plan for executing the investments. 

For example, a family office that earned their wealth in the oil and gas industry may decide to allocate a small portion of their overall investment portfolio to a high-risk, high-reward asset class. By doing so, they recognize the potential for substantial returns. To structure their investments, they set a yearly budget and plan to invest around $2 million annually over a period of three to five years, with the intention of making four investments each year. This strategy acknowledges that investing is a numbers game, adhering to a power law model and portfolio theory. 

Making a limited number of investments carries higher risk, as any failures could significantly impact the overall portfolio. By diversifying and making multiple investments, the risk is mitigated, and the potential for success increases.

Follow-on investments

Consider the stage at which you prefer to invest. You can choose to focus on early-stage investments, such as pre-seed or seed rounds. Alternatively, you may opt for later-stage investments, such as follow-on rounds, Series A, or Series B, which occur after a company has already achieved some level of success and aims to fuel further growth. 

Other Considerations

When building your investment plan as an angel investor, there are several important considerations to keep in mind. Access to deals is crucial, and you can acquire it through various means. Direct investments, which involve making independent investments after learning about a company through channels like demo days, introductions, or cold outreach, allow you to negotiate terms and become listed as an investor on the cap table.

Other ways to access deals include syndicates or angel groups which can be beneficial for de-risking your portfolio. Syndicates offer fractional investments facilitated by a syndicate lead who is going to raise funds from their network of investors. While syndicate investors are not listed on the cap table, they gain access to a diverse range of companies at a lower investment level. Angel groups are the most common way people invest and provide support, diligence, sourcing, and education opportunities.

Common Mistakes 

Making just a few investments 

Portfolio theory and the power law of return profiles play a significant role in angel investing. Angel investing has the potential for tremendous returns on a relatively small investment, often referred to as “unicorns” with valuations exceeding a billion dollars. To increase the likelihood of capturing such high-growth companies, be sure to have a diversified portfolio with numerous investments. By having more “shots on goal,” you maximize your chances of hitting a major success. Making too few investments is considered a risk, as it reduces the probability of securing one of these significant winners.

Writing Checks that are too large

Making a large number of investments with some diversification is a way to take some risk out of writing too large checks. Let’s say for example a company that you plan to invest $2 million annually and write $250,000 checks into a single vertical. While this approach may work well for them depending on their risk appetite and desired outcome, it leans towards the riskier side. Some investors may approach it  differently by considering splitting the investment amount into smaller increments and making around 10 investments per year. The rationale behind this strategy is to mitigate risk and achieve diversification. 

Lack of diligence or high quality co-investors 

You wouldn’t buy a car without a test drive, and you probably wouldn’t buy a house without an inspection. Have that mentality when making an investment into a brand new company. It’s important to conduct research, sometimes extensive research depending on the amount and approach. Founders typically make the diligence process easier by providing access to a data room containing relevant information. When making a direct investment, you have the opportunity to interview the founders, potentially talk to customers, verify contracts, and ensure everything is in order. 

In cases where investments are made through funds or syndicates, diligence is typically performed by the fund or syndicate lead. In those situations, it is essential to interview the lead and understand their diligence process. Requesting a copy of their diligence checklist can provide insight into what they look for in a company. This checklist helps ensure that all necessary factors are considered, providing peace of mind when wiring the investment funds. Through diligent research, you may uncover hidden debts or previous co-founders with significant ownership stakes, which can impact the investment’s viability.

No pro-rata or information rights

Within the investment contract, pro rata rights grant investors the opportunity to maintain their ownership percentage by investing additional funds. This strategy, often referred to as “doubling down on your winners,” allows investors to place additional bets on companies that are performing well. It is a valuable approach to capitalize on successful ventures. 

On the other hand, private companies are not obligated to provide regular updates or annual reports, which can be frustrating for investors who have made substantial investments. The lack of information can raise concerns about the company’s progress or potential issues. To address this, discuss information rights with the founders. While it is rarely part of the contract, a side letter can be used to establish a certain frequency of updates and specific information that will be shared. This regular communication not only provides valuable insights into the company’s performance but also allows investors to potentially offer assistance and guidance if needed. By having access to information, investors can stay involved in the process, identify any deviations from the plan, and actively contribute to the company’s success.

Companies that are not venture scale 

If you talk to any investor looking at investment opportunities, they will probably list 3 crucial factors: the team, the product and the potential market size. Market size is one that shouldn’t be underestimated. Investors, especially venture firms, seek significant returns for their limited partners, aiming for companies with the potential to reach valuations close to or exceeding a billion dollars. As an angel investor, you may not know precisely how large the market will become or how well the company will execute its plan to achieve such substantial growth and valuation. 

Occasionally, investors may dismiss certain pitches, categorizing them as products rather than companies. In reality, this dismissal often implies that the investment opportunity may not be sizable enough to warrant their attention. While a $100 million company is a commendable achievement, it may not align with the goals of building a fund and attaining significant returns.

Angel investing presents a unique opportunity for individuals to invest in early-stage companies and potentially achieve substantial returns. Navigating this asset class requires thoughtful strategy and consideration. With a well-defined investment thesis, thoughtful planning, and an understanding of these common mistakes, angel investors can increase their chances for success in this dynamic and potentially lucrative field.

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