Startup Investing 101: Angel Investing: A Three-part Guide to Earning your Wings - Risky Business (Pt. II)

Angel investors dream of finding and investing early in the next Uber, Airbnb, Waze, or Mobileye. While it’s easy to get seduced by the hype, serial startup investors know it is hard to be successful in this asset class. With the help of members of OurCrowd’s experienced investment team and other industry resources, we have put together a quick, three-part guide to ‘earning your wings’. These articles highlight essential terms and strategies while referencing accepted industry best practices; with these basics in hand, getting started in startup investing can be a lot smoother.

Part 1: The Basics | Part 2: Risky Business | Part 3: Strategy

Understand the Risk

The distribution of returns within a VC portfolio typically follows the power law curve. According to Horsley Bridge, if you take a longtime limited partner in VC funds who has been collecting data on VC returns since 1983, you’ll find that just six percent of their hundreds of investments have generated approximately 60 percent of their total returns since 1985. William Sahlman, professor emeritus of Harvard Business School said, “80 percent of a VC fund’s returns are generated by 20 percent of its investments.” The Angel Resource Institute published an annual report in 2021 that showed that angels are turning toward new startups, such as Web.3 and 'Deep Networks' as well as toward global opportunities, making their portfolio more diverse, hence, strengthening this assumption. The 2016 study commented on this specific case while reporting that 10 percent of all exits generated 85 percent of all cash. They also reported that the failure rate (exits at less than 1X) of startups in their study climbed to 70 percent (from 52 percent). According to the US Bureau of Labor Statistics, 90 percent of new businesses fail, while 50 percent fold within the first four years.

Exits Can Take a Long Time

Unlike equities listed on public exchange like NASDAQ and NYSE, which have a robust market of buyers and sellers, startups are long-term, illiquid investments. Investments can remain illiquid for many years, while early investors need to remain patient and hopeful for an M&A or IPO. Mobileye was a private company for almost 15 years before it went public. Much ink has been spilled pointing out a trend whereby startups are staying private longer for a myriad of reasons.

Dry Powder and Follow-ons

Successful angels usually invest between 25-50 percent of the total money they plan on putting in the company in the first round of funding, reserving significant “Dry Powder” for follow-on rounds.

Be Prepared to Lose

Startup investors hope for the best while expecting the worst. The worst generally means losing your entire investment. American venture capitalist Fred Wilson likened investing in VCs to poker, where it is not about the number of hands that you win, it is about winning your best hands. Folding hands is an essential prerequisite to finding the best hands to go ”all-in” on, meaning it is actually advantageous that some of your startups fail so that you can focus all of your time on a few “winners.”

Read more on CB Insights and Top 4 Reasons Startups Fail for some further statistics and anecdotes about the most common reasons startups go under. Even companies that raise tens and hundreds of millions of dollars, and become “unicorns,” still die (Unicorns That Lost It All). While a loss may sound like the worst case scenario, Hayden Adams from Charles Schwab explains how claiming a loss actually lowers your tax liability, and saves you money.

When to Hold ‘em, When to Fold ‘em

While it can make sense to use capital to protect against loss, there is an opportunity cost for every dollar, or every minute spent on an investment that is not utilized for another. Folding your hand is essential to focusing an investor’s resources on the highest potential and best performing companies. For more on this topic, read this previous article on the importance of follow-on investments.

A common investing axiom is “don’t throw good money after bad.” The sunk cost fallacy says that we should make rational decisions based on the future value of investments, but we let emotional investments taint our decisions, and end up losing more money than is necessary.  It may be difficult to swallow, but remember, 80 percent of returns are concentrated in less than 20 percent of portfolio companies according to Horsley Bridge.

Timing is Everything

Investing focuses on long term gain, speculation focuses on the short term. It usually takes less time for a company to fail. The ubiquity and cheapness of cloud computing, machine learning, and AI has made it cheaper, easier, and more possible to create exponentially valuable startups. While it generally takes a long time to build a big, successful company, there are some exceptions to this rule.

In 2015, Forbes and the Wall Street Journal (WSJ) both quoted a study claiming that “Israeli startups were acquired at a faster pace than ever, within an average of four years, compared to a period of 5.5 years before acquisition in 2013 and 8.6 years in 2009.” The Angel Resource Institute published the 2016 Angel Returns Study reported that in their study, the investment holding period increased by a full year, to 4.5 years on average (versus the 2007 results), with bigger wins commonly taking nine or 10 years to complete.

Successful angel investors generally focus more on finding and developing ‘rocket ships’ than performing CPR.

That concludes Part 2 of the series; be sure to check out Part 1 and Part 3. You can also learn more about startup investing terms and how the process works by reading our in-depth guide, How Startups Are Born: An Investor’s Guide for the Perplexed.