Becoming a new angel investor is a Catch-22. You need experience to be a good angel investor, but you can’t gain the experience until you actually invest.
New angels can really benefit from experienced angels for insider tips to start their angel journey. One great resource is Troy Knauss, vice chair of the Angel Resource Institute. He presented an ACA webinar on what new angels need to know before their first investment.
Knauss’s first angel investment came about in the late 1980s, before there was much research to drawn on. So he did what others tend to do—go with their gut. He had the chance to invest in a wood composite decking material company and/or a plastic toy company.
Knauss decided to invest all his $100,000 into the wood composite company. Unfortunately, after many years, he ended up with a $0 return on investment. The other company, K’NEX, would have made him $10 million. Ouch.
If only he knew then what he knows now. New angels can learn from this.
“What I learned at that moment was portfolio diversification and the value of putting a little bit of money to work in a lot of deals. If I would have put $50,000 in each company, I still would have walked away with $5 million.”
All experienced angels have made mistakes along the way. Sometimes it takes a failure to learn what to do well. For new angel investors hoping to side step a few missteps, here are five key things to know before writing your first checks.
Know the Risks
Getting to know your entrepreneur's background and motivation is key to predicting whether the company will later produce a return on investment. So ask him/her a few key questions:
“Are you looking for personal income this year or greater wealth down the road?” If they are looking for wealth, they are in it to make money long-term, a good indicator of potential ROI for an angel.
“Is raising money just as important as the idea?” Another way to put this is “Are you interested in building a high growth business?” If the answer is yes, then as an angel you know this entrepreneur has the vision to bring the idea to fruition, another good indicator of ROI for an angel.
Additional questions to assess risk:
- Is the entrepreneur willing to give up control/ ownership of the company?
- Will the company have significant revenues in three to seven years?
- Is there potential for a significant return for investors? (strive for 10-20 times investment)
- Is the entrepreneur coachable and willing to listen?
- Is there a good exit strategy in three to seven years?
Understand Your Own Risk Tolerance
What amount of risk (or loss) can you - and your spouse - handle? If you can’t afford to lose all of the money, don’t do the deal.
An allocation of 3 to 10% of an angel’s net worth toward angel investing is common. Since the majority of angels have a net worth of $1 to 2.5 million, then that puts about $100,000 to $250,000 on the table for investing.
Of course, that doesn’t mean you should put all your investment into one company.
Diversify for a Better ROI
A study of over 500 angels showed that only about one-third of the investments ended with strong exits, another one-third resulted in zero return, and the other one-third offered a one to five times return. In other words, chances are not great that there will be a good return on investment.
Even among experienced angels, a large percentage of deals fail. But we can use this information to make wise investment decisions. It tells us we should be doing multiple deals.
Consider how a mutual fund words; it doesn’t put all the investment into one stock. To minimize risk it spreads it over a broad spectrum of stocks.
Allocation Per Deal
Once you understand the need for diversification, you also need to determine how many deals to do, how much money to invest in each deal, and where you’re going to find enough quality deal flow to invest in. Angel groups are helpful to new angels for many reasons and can help you address these issues. You can also draw from the experience of other angel group members to build your set of insider angel tools. Thankfully there are many angel groups to join.
“We recommend you take a portion of your funds, and join an angel fund or a network in your region so you can spread your risk and write smaller dollars in order to get involved,” Knauss said. “Most angel groups write eight to 12 deals within a tight geographical region.”
Knauss is a member of the Ohio Tech Angels and the Piedmont Angel Network, and he has invested in 10 deals in each group. In addition, he has 20 independent deals on his own. To him, the diversification makes sense—it lessens the risk and hopefully increases his chances for a good ROI.
One of the biggest pieces of advice experienced investors give is to be patient. Even if a company looks like a sure-fire winner, remember that there are no guarantees. Be patient and get to know the entrepreneur. Do your due diligence, and then proceed with caution.
For example, many experienced angels invest in about three to five deals a year, which is only 1 to 5% of the deals they see.
Remember Why You Invest
In the end, angel investors want to make money, but don’t forget to balance ROI with the other important reasons to invest. What is important to you? Do you want to give back to your community? Do you want to help entrepreneurs?
Over time many angels learn the benefits of offering more than just a check. They reap immense reward and increase their chances for ROI by investing time and leveraging their personal talents to find ways to help grow the business.
Getting insider tips from experienced angels isn’t quite the same thing as being an experienced angel, but it does address some of the Catch-22 of angel investing, giving you knowledge and tools to get started. I find the tips from Knauss particularly helpful. If you are a new angel or thinking about becoming one, talk to angels to learn from their mistakes and key recommendations and read up on current angel statistics and trends. When you do this, chances are your angel investments will soar.
