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 II: Risky Business
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 6% of their hundreds of investments have generated 60% of their total returns since 1985. Professor William Sahlman of Harvard Business School is quoted saying, “80% of a VC Fund’s returns are generated by 20% of its investments.” The Angel Resource Institute published an Angel Returns Study in 2016 which reported that 10% of all exits generated 85% of all cash. They also reported that the failure rate (exits at less than 1X) of startups in their study climbed to 70% (from 52%). Forbes claims that 90% of new businesses fail, with 50% failing within the first four years, according to the U.S. Bureau of Labor Statistics.
Exit 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 rationales.
Dry Powder & Follow-Ons
Successful angels usually invest between 25-50% 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 (Staging Capital: Angel Follow-on Theory).
Be Prepared to Lose
Startup investors hope for the best while expecting the worst. The worst generally means losing your entire investment. Fred Wilson likens investing in VCs to poker, where it’s not about the number of hands that you win, it’s about winning your best hands. Folding hands is an essential prerequisite to finding the best hands to go ”all-in” on, meaning its 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% of returns are concentrated in less than 20% 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.
That said, in 2015, Forbes and WSJ both quoted a recent 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 focuses 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.
Do you have any risk-taking stories of your own to share? Leave your questions and comments below!