Who are angel investors?
The profiles of angel investors are very diverse: they range from ‘exited’ entrepreneurs – successful business owners who have sold their companies – to corporate executives and high-income City professionals (investment bankers, asset managers, etc.). These are the main categories, but you will also find angels who are lawyers, consultants, marketing executives and even the odd professional gambler.
Angel investing is gaining popularity, and although angels are still more likely to be middle-aged men, we are increasingly seeing younger and female investors getting involved as well.
What do successful angel investors have in common and how do they operate?
At SFC Capital, we are fortunate to run one of the most active angel investor networks in the UK, with over 500 private investors who have invested together in more than 220 young companies. This gives us a unique insight into how these angel investors operate.
There are as many different strategies as there are angel investors. They have different goals depending on their wealth, the richest investors might even see investing as a form of entertainment. However, the vast majority of angels would put their capital at risk because they are hoping to generate a significant financial return.
Angel investors have very different profiles, so it is not easy to identify common tactics between such different people. One of my favourite books on angel investing and venture capital is “Startup Wealth” by Josh Maher, which compiles interviews of some of the best and most successful angel investors in the US (think those who invested in Google before their search engine had even launched).
It’s a very entertaining read, but also quite confusing: the strategies these investors deploy are often very different, if not contradictory. Some are highly analytical and focus on numbers, while others tell you that metrics don’t matter until much later; some encourage you to become actively involved in the management of the companies you invest in, while others recommend being as hands-off as possible. They’re all equally successful, so who do you trust?
Fortunately, there are some constant truths in business and observable common traits in successful angel investors.
What are the five golden rules of angel investing?
1. Focus on people, their incentives and team dynamics
Being an angel investor is more akin to talent recruiting than traditional types of investing. Similarly to hiring new employees, you are entering into a long-term relationship with a person or a team whose performance will determine the success of a business.
Unfortunately, it is very difficult to judge people you only know superficially. You have to rely on first impressions, references and whatever information the entrepreneurs give you. This variable is why beginner angel investors typically overlook people when evaluating an investment opportunity in favour of other common criteria such as early metrics, the vision, or the market dynamics.
But experienced angel investors know how to identify red flags in entrepreneurs and how to make sure that the people they invest in have the right attitude, mindset and incentives.
First – are you investing in a team or a sole founder? Although there are some counter-examples, it is extremely difficult to survive the first years of a business alone. Make sure that you invest in a team of complimentary individuals who ideally have collaborated on similar projects before.
Second – you want to see entrepreneurs who present the right mix of insight into their market, skill, grit, vision and persistence. Passion is not enough – you want entrepreneurs who are obsessed with solving a particular problem and building a successful company around that solution. Building a business is incredibly challenging and often painstakingly slow – are the founders ready for the ride or are they expecting a quick exit? Do they have skin in the game – are they taking personal risks to start this company or are they just having a good time with their investors’ money?
Third – beware of the “wannabe entrepreneurs,” a growing species! Although it is great to see entrepreneurship being widely celebrated and encouraged, one should be reminded that, by definition, only a minority will make it. The problem with the current hype and the growing supply of capital is that it attracts people who probably should not start companies. Young graduates might do it because it’s the cool thing to do after university. Bored executives coming from the corporate world try to experience the "startup thrill," but are often used to support systems that they don't even perceive exist. Experienced angel investors know how to spot and avoid wannabe entrepreneurs – those that "need money to make any progress," lacking the ability to “go out of the building” and gain customers early on, etc. Good entrepreneurs generally don't wait for investment to start building something.
2. Have a portfolio approach
Every investor knows about the portfolio theory and how to apply it to their traditional investment portfolio (stocks, bonds, etc.). However, there is a tendency to forget the diversification principle when it comes to angel investing, which is a critical mistake. You might get excited about a particular startup and overweigh your investment or only invest in a specific sector that you know best.
But diversification is absolutely essential in angel investing. If successful angel investors have one thing in common this is it: they have invested in a LOT of companies. This was necessary to pick the few stars that made them rich. Considering that only 5-10% of deals generate large multiple returns, a portfolio of angel investments should typically include at least 20 companies. A lot of angels stop at 5-10, which is not enough to get a decent chance of hitting a big win.
Diversification is also the only factor that is fully under your control when angel investing. Everything else is so contingent on external factors, do yourself the favour of spreading your risk in an optimum way: diversify your portfolio, maintain your position in winners and cut losses on losers.
3. Keep the process simple, but make sure the right incentives are placed and interests are aligned
The corollary to doing a large number of deals is to be able to do them quickly. Good angels keep the investment process simple and don’t overdo the due diligence and legal negotiation process. The best deals tend to close very quickly (in a few weeks) and you will have to move fast if you do not want to be left behind.
When investing through a fund, you can be sure their due diligence is thorough, these Investment Committees usually having strict criteria to adhere to, but due diligence at the early-stage angel level should be fairly simple. At the startup phase, there aren’t years of financial data to review and projections are hugely speculative. Provided that you are satisfied with the quality of the team (see above), the soundness of the proposition, the short-term plan and the use of funds, you should proceed with an offer. Good angels accept the high level of contingency and don’t look for answers to questions that can’t be answered at this early stage.
The same applies to the legal terms of the deal. Valuation is key and should be negotiated carefully. Entrepreneurs tend to have inflated expectations of the value of their company, consequently, you should not necessarily accept their proposed terms at face value. Knowing that a lot of your angel investments will fail, the key question is: if this one is a winner, can it generate a 10x multiple return on your investment to make up for the losses on others?
But the rest of the legal structure of the deal should be kept simple because investors can acquire a bad reputation by insisting on onerous terms. However, make sure that key investor protections are included (such as tag and drag along rights, pre-emption rights, minority protections, etc.) and further, that interests are aligned with the management – have they created an option pool to attract future staff, how are investors repaid in case of a liquidation, etc. You also want to make sure that investors are represented and consulted on major decisions and large expenditures.
Being known as an angel investor who can move quickly as long as the terms are standard will build your profile and allow you to have access to great dealflow in the future.
4. Get involved to the right degree
Angel investing is definitely an “active” type of investment where you get to know the management of the companies you invest in and agree on ways of supporting them. The right level of involvement depends on the company, your domain expertise and how well you get along with the entrepreneurs.
Some angels are more hands-off than others but the majority look for ways to help the management teams. Investors can help put together a proper governance structure with regular board meetings to track progress, discuss the long-term strategy and keep the directors accountable. Investors should also have basic controls over the company and be able to oversee how their funds are being used. With these powers, they can help with decisions such as major hires and other strategic arrangements.
Beware of entrepreneurs who don't want you involved and make sure that investors have as little input as possible. Good entrepreneurs do the opposite, and surround themselves with good people, constantly seek advice and keep stakeholders in the loop of the business’ developments.
Nevertheless, the job of an angel is to be helpful and not to put unnecessary pressure on the entrepreneur. The angel should also avoid getting too involved in the running of the company, thereby taking responsibility away from the CEO. Investors are not operators – if you feel the need to get too involved to compensate for the shortcomings of the entrepreneurs, you probably haven’t followed rule #1 and backed the wrong team in the first place.
5. Don’t believe the hype
Last but not least – don’t jump on the bandwagon. Some sectors can be seen as the flavour of the month and will attract too many entrepreneurs building similar solutions and seeking unreasonable terms such as very high valuations.
Currently, we are seeing this dynamic in a number of domains such as artificial intelligence, blockchain and fintech, which are typically the most talked about topics in the startup world. These sectors and technologies are hugely popular with entrepreneurs and investors, and will generate a large number of companies with more or less solid business plans. Experienced angels remain cool-headed and do not forget the fundamentals of their strategy – even if the sector appears very exciting.
Successful angels also invest in rule-breaking startups that are disrupting their respective industry, where they can see no immediate direct competition – or rather, it should be at least difficult to define direct competitors. If a sector is too hot, it probably means that the wave has already passed, the competition already got funded and will have a head-start on any new entrant. An angel investor should always try to look for trends that have not gone mainstream yet, as these will be the true sources of value in the future.
Capital at risk. For professional investors only. Investment in early-stage companies involves risks such as illiquidity, lack of dividends, loss of investment and dilution.