Is Angel Investing Worth It? Part 2: Money and Summary

This is the second and final post in a two-part series about angel investing. In the first part, I outlined the three criteria you need to become a successful angel investor:

1. You Intrinsically Enjoy Investing in Companies
2. You Have at Least 10 Hours/week for 3-4 Years To Do The Work
3. You Have at Least $3.3M in Liquid Assets in Your Portfolio

I analyzed and explained the first two criteria in the first post. In this final post, I dig deep into the third condition: that you have at least $3.3M in liquid assets. I know angel investors that have started their portfolio with much less. You can still be successful even without $3.3M in liquid assets, but I think it’s much harder.

So with that intro, let’s dive into the overthinking.

You Have At Least $3.3M in Liquid Assets in Your Portfolio

Investing in startups is risky. Here’s how most venture capitalists expect a portfolio of 10 companies to work out after 10 years:

• 5 companies die and return 0x
• 2 return the investment and no more, for a return of 1x
• 2 return 3x
• 1 returns 22x 

Internal rate of return is tricky to calculate. In the spreadsheet linked to at the end of part 1, I made some assumptions about the timing of these returns. The good news is that it seems reasonable to assume you could realize a 20% IRR.

The important thing to understand here is that diversification is the key to hitting the 20% IRR target. To illustrate this, consider the following example.

Let’s say that you invest in 10 companies as described above. But because you’re new and don’t yet know what you’re doing, you make a couple of mistakes. First, you miss out on the one deal that could have returned 22x. Next, you miss out on a deal that would have eventually returned a much more meager 3x. Well, you can’t win ’em all. The problem is that with just those two misses, your portfolio is now expected to return a paltry 8% IRR. You would have been better off just parking your money in Vanguard and calling it day.

You might think that’s terrible, but remember that some angel investors lose 100% of their principal. It’s just a cost of doing business.

So, how can you avoid the fate of losing all your money investing in the wrong companies? You should do what the pros do and only invest a small portion of your overall portfolio.

How Much of Your Portfolio Should You Allocate to Angel Investing?

Here’s what the books I read suggested:

Everyone will have a different risk threshold, but the consensus seems to be ~10%. What’s interesting, however, is that the books don’t agree about the definition the word “portfolio.” On the extreme end, Jason Calacanis recommends up to 20% of your entire portfolio. He explicitly includes illiquid asset classes like real estate and 401ks in that number.

John Huston is on the opposite end of the scale. He founded the Ohio Tech Angels group, and brings his midwest sensibilities to angel investing. His recommendation is to not exceed 10% of your family’s cash flow. If you expect to make $100,000 this year, his suggestion would be to invest no more than $10,000 in startups.

My Approach to Angel Investing Portfolio Risk

So, there are some pretty different ideas of how much risk is too much. I prefer to take a compromise between those two extremes. I thinkg that would-be angel investors should allocate no more than 15% of their liquid invested assets in startups. What do I mean by liquid invested assets? I mean cash, stocks, and bonds that are not held in a retirement vehicle like a 401k, Roth IRA, or in an asset class that penalizes early withdrawal (CDs for instance). 

To take a concrete example, let’s say your total net worth is $5M, but $500,000 is locked up in home equity, $300,000 is tied up in investment properties, and another $200,000 is in your 401k. I would say you have a liquid portfolio of $5,000,000 – $500,000 – $300,000 – $200,000 = $4M. 

Why exclude all those otherwise normal assets? Because they are costly to access and those costs can dramatically erode your upside potential. Many 401k plans, for instance, require the owners to take a 10% penalty if funds are withdrawn early. That 10% comes right out of your investing profits and is difficult to make back. Although it is possible to earn enough to cover the cost of early withdrawal penalties, I wouldn’t count on it.

How Much Should You Invest in Each Company?

Okay, so now we need to figure out how much you should invest in each company. Should be pretty simple, right? Nope.

There are at least two parts to any successful angel investment: initial and follow-on capital. The first category is pretty straight forward. This is the amount of money you write on your first check to the founders. It’s the second part that’s tricky. Investors refer to the money you intentionally hold back for future rounds as reserve capital. Some angel investors only ever write checks for initial investments. That’s certainly simpler, but from what I’ve read, avoiding follow-on investments will substantially limit your portfolio returns. The reason is that you can’t benefit disproportionately from the bets you get right.

According to several industry surveys, the average investment per per company is $25k. That $25k includes participation in follow-on rounds. This suggests that initial investments made by most angels fall in the $15-20k range.

Several of the authors I read recommend holding 100% of the initially invested capital in reserve for every investment. To illustrate how this would work, let’s say you go with a $15k initial investment. You follow the industry advice and hold $15k in reserve in case the company does well. That means you need $30k per investment.

Investment Size to Minimum Angel Investing Portfolio

In the first part of this series, we established that you need to build a portfolio of at least 20 companies. $30,000 x 20 = $600,000.

This is almost certainly too high, though. Most startups (~50%) die outright. Of the remaining companies, only a fraction will have appealing deal terms or space on their cap table. It’s not precise, but I round down by $100,000 to take into account the large number of companies that don’t need follow-on funds. This leaves us with a lower bound of $500,000 required to build a minimum viable angel portfolio.

If you are responsible and only invest ~15% of your portfolio in startups, then the minimum liquid portfolio size is given by the following formula:

Amount Required to Invest in 20 Companies / Maximum Amount of Portfolio Allocated to Angel Investing = Minimum Liquid Portfolio Size

$500,000 / .15 = $3,300,000. 

So, you need at least $3.3M in liquid invested assets to get started.

What is Your Time Worth?

Another way to think about the minimum size of your liquid portfolio is to calculate the expected hourly wage. Savvy investors will have a good sense what their time is worth per hour. 

This part gets a little complicated because internal rate of return isn’t super easy to calculate. It involves the present value of cash, inflation, and uneven returns over time. Luckily for you, I’ve done the math in my calculator!

My findings suggest that most investors that follow my guidance above will earn a healthy $720/hr for their time. This is probably a fairly good rate of return for most people in this wealth and income class. You can tweak the calculator below:

Tweak the Formula with My Calculator

But What About the Prestige and Connections?

I think that if you like investing in companies, have at least 10 hours/week, and have a liquid portfolio of at least $3.3M, angel investing can be fun and lucrative.

But of course not all angel investors are in it to make a buck. Some are altruistic, preferring to give money to companies as a way to support people like themselves. Some angel investors want to further advancements in a particular area of research. Other angels are drawn to the prestige of networking with the rich and powerful. 

None of these reasons are bad, provided you relax the assumption that you will earn market returns on your investments. For the person who just wants to look good at parties, it doesn’t matter whether you earn 20% IRR on your invested capital. All that matters for that person is to appear prestigious. I think it’s pretty easy to get that aura of prestige, even if you don’t make any profit.

So, if you say to yourself “you know what, I actually just want to help out entrepreneurs because I relate with their struggles, and it’s not a financial problem for me to do it” then who cares about any of the above? Go and invest in some companies.

Similarly, if you do a little introspection and decide that your primary motivation is to meet interesting people, who cares about the rate of return? You, too, can disregard my advice.

Finally, if you are already rich or famous, it seems likely that none of this blog post applies to you. Tim Ferriss doesn’t have to work to generate deal flow, it comes to him. Rich and famous people have networks of highly knowledgeable friends and acquaintances. Those people can easily help you vet deals, check out business model assumptions, and get intros.

Conclusion

You may have gotten to this point and concluded you aren’t interested in angel investing after all. The picture that I’ve painted is certainly darker than lots of other books and articles. And I think that’s justified. Starting out as an angel is a humbling experience. You won’t get access to the best deals. You’ll try to give companies your money and get rejected. You’ll have to negotiate against absurd valuations. And if you’re lucky, you’ll earn 20% IRR for your efforts. If you have a liquid portfolio of $3.3M, that amounts to a healthy $720/hr. That’s a great wage, but it’s certainly not free or passive income. 

As I mentioned in the opening paragraph, I failed the “intrinsic motivation” part of the equation. So I never even got to the point where I was comparing my desired vs realized hourly wage. But for anyone interested, it’s a sobering realization that even experienced angel investors are only one or two mistakes away from earning nothing at all.

Happy overthinking!

Sources

Articles

1. Active vs Passive Investing – AVC
2. After 20 years: Updating the Berkus Method of valuation – Dave Berkus
3. How I Invest – Mark Suster
4. How to Become an Angel Investor – Upstate Business Journal, 2016
5. Guide, Don’t Control – FeldThoughts
6. Staging Capital: Angel Follow-on Theory – Christopher Mirabile (Seraph blog)
7. Approximations, Assumptions and Aspirations: Methods For Valuing Startups [Part I] – Christopher Mirabile (Seraph blog)
8. Approximations, Assumptions and Aspirations: Methods For Valuing Startups [Part II] – 

Christopher Mirabile (Seraph blog)

1. Startups Are Risk Bundles – Coding VC
2. For a fraction of the price, angel investors can pay huge dividends – The Globe and Mail
3. New Data on Angel Investor and Angel Fund Returns – AngelBlog 
4. Stop the Merry-Go-Round, I Want to Get Off: An Introduction to Angels and Exits – Seraph Blog
5. Angel Investors Do Make Money, Data Shows 2.5x Returns Overall – TechCrunch
6. What Returns Can I Expect from Startup Investing? – Forbes
7. In-Depth Angel Investor Survey Sheds Light On Angel Success – Forbes
8. Prediction and control under uncertainty: Outcomes in angel investing – Robert Wiltbank
9. How to join an Angel Investor Group – Investopedia
10. Top 3 ways to Getting started with Angel investing in less than 30 minutes
11. The Mechanics of AngelList Syndicates – Hackernoon
12. The Good, Bad, and Ugly of AngelList Syndicates – Inc.com
13. An angel investor’s ultimate guide to AngelList Syndicates – VentureBeat
14. My Angel Investor Checklist – TechCrunch
15. How To Invest In Startups – Sam Altman
16. How to be An Angel Investor – Paul Graham

Books

1. Angel: How to Invest in Technology Startups–Timeless Advice from an Angel Investor  by Jason Calacanis (288 pages)
2. Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups by David Rose (304 pages)
3. Fool’s Gold?: The Truth Behind Angel Investing in America by Scott Shane (288 pages)

Fundamentals of Angel Investing by Hambleton Lord and Christopher Mirabile (192 pages)