Angel Investing: The Devil is in the Details

As you move up the career and net worth ladder, you will be presented with opportunities from generally well-meaning friends, colleagues and aquaintances about the exciting world of ‘angel investing’.   You probably already heard the words before and perhaps even imagined fantasy visions of getting a mouth-watering 100x or 1000x returns from picking the next Google, Amazon or Facebook.   Such salivating images of lucre are difficult for mere mortals like us to overcome.

Besides, who doesn’t love being called an angel?

Are you willing to be an angel?

Over the last few years, I was also presented with such opportunities, and have invested some money in start-ups as an angel investor.   For me, the learning from being an angel investor and working with starry-eyed, passionate entrepreneurs was also a big motivator, along with the promise of earning returns far in excess of what the stock market can provide.  

The promise of lucrative returns aside, there is a real devil hidden among the world of angels.  

That devil is in the details.

So, here’s my simple guide to angel investing.

1.  Avoid angel investing.   As much as you can.   Trust me when I say this, you are not missing much by not participating in this small corner of the capital markets.  Sure it sounds ‘sexy’ but due to strong survivorship bias, you only hear about the extraordinary home runs like Google, Amazon etc. and rarely about the vast majority of failures.  For every Facebook, there are at least 50 Facedowns out there. This is a very illiquid investment that pays no dividends – so, be prepared for your money being locked up for 3-5 years or more.  All your upside comes only when your shares are sold at a profit (‘liquidation event’).  There is an element of luck to every entrepreneurial success story that doesn’t get talked about.  
2. Limit to small % of your net worth.   If the exciting world of start-ups, entrepreneurs, angels, seed funding, series A, mezzanine funding and all that jargon – not to mention the dream of earning a multiple of your investment – are too attractive for you, then enter the field with a clear upper investment threshold.  I suggest no more than 5% of your net worth, at the very maximum. That too, spread it across at least 5 investments if not more, so that any one start-up failing puts your risk at 1% or less of your net worth.  Even if one of those five investments does well, the gains will make up for the losses in others.  That’s the way it works with early-stage start-ups.
3. Don’t pride on your due diligence.   You may have a top-tier MBA, have done valuations for a living, good at marketing and business development or an expert in product design and development.  No matter how good you are in your profession, you have a huge handicap in the angel investing world.  You cannot do due diligence beyond a point.  It is easy to get impressed with the potential upside without understanding the magnitude of risks along the way.   In early stage start-ups, it is ultimately about your faith on the entrepreneur and the passion he/she brings to the table that matter.  Also, did I mention luck?
4. Money with guidance is better than only money.   If you have a particular skill in the market segment or product area of the start-up, you should ask to be a mentor or Board member of that start-up in addition to being an angel investor.   This way, you play an active role in shaping the future of the start-up, you get to learn where the skeletons are buried and importantly, this increases your chances of making a profitable exit in the future. 
5. Read contracts backwards and forwards.  Even if you are investing $5000 or even less into the company, understand your rights as a minority stakeholder.   It may be expensive to hire a lawyer but that would be best if you can.  At least be familiar with shareholder agreements and share subscription agreements (read up on your local library’s books on venture capital).  Get familiar with legal terms such as liquidation preferences, seniority rights, reserved matters etc.
6. Understand you can still get screwed.  Despite all your best efforts, this can happen.  The general outlook of most start-ups is that prospective new investors are like a hot-looking model to be wooed while the previous round investors are like a spouse who has put on 30 pounds and watches TV all day.   Naturally, they will be eager to sign away your rights as a previous investor in order to meet the demands of new investors.   Also, your hope of cashing out at the next investment round can be crushed by the new investor imposing a large (40% or more) discount to the current valuation to purchase previous minority shares!  Just one clause like this is a direct hit on your ‘dream’ profits.  Expect these type of deals will happen because the last thing a new investor cares about is the profit that his investment will give you – the previous round investor.  In fact, he wants you along for the ride as long as possible so he feels reassured more people’s money is tied up in the company’s future.   This is another risk that you cannot do much about and must accept it as part of playing the ‘angel’.    

Where angels fear to tread.

I have invested modest amounts in four start-ups so far.  Two of them seem to be doing OK but others are barely treading water.   I hope to recover more than my cost when the exits happen, but I am under no illusion that I have the next Google in hand.  Forget 10x or 100x, I would be happy to have a return just about twice what a broad stock market index returns.  In the world of venture capital, that’s a tiny return.  Still, I have come to understand that forces way beyond my control can diminish even a realistic expectation.   

Despite all the risks above, there is always this dream of being the early investor in the next Uber or Facebook.   This is what drives many in the angel investing community, but for vast majority of retail investors out there, this is not an appropriate asset class.  Perhaps that’s why SEC and similar regulatory agencies in other countries restrict this to only ‘accredited’ investors – a qualification that comes with a significant income ($200,000/year) or net worth ($1 million+, not including primary residence) thresholds.   While there is no assurance the investors who qualify are any better, the government seems to think that these folks should be able to understand the risks and handle the losses that may come. 

I hope this article is useful in your understanding of a new investment class.   Being an angel sounds great, but beware of the devil!

(PS.  Today is the 16th anniversary of the 9/11 tragedy.  We all read about the heartless ‘devils’ who perpetrated that unforgivable crime.  The ‘angels’ were the first responders and countless people who helped ease the fallout of the tragedy.  I lost my college friend that day so this is personal for me – my newly married friend perished on that ill-fated United flight from Boston.  While this post is about personal finance, I nevertheless want to dedicate it to him and to all the true angels and heroes of 9/11.)

Mr. TFR

Raman Venkatesh is the founder of Ten Factorial Rocks.  Raman is a  ‘Gen X’ corporate executive in his mid 40’s.  In addition to having a Ph.D. in engineering, he has worked in almost all continents of the world.  Ten Factorial Rocks (TFR) was created to chronicle his journey towards retirement while sharing his views on the absurdities and pitfalls along the way.  The name was taken from the mathematical function 10! (ten factorial) which is equal to 10 x 9 x 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 = 3,628,800.