Five Rules Plus Three Tips for Successful Angel Investing

"You make money or lose money the moment you write the first check."

Anonymous Angel Investor

 

In our last Angel Lounge meeting we kicked around the question: How do you make money doing angel investing? This question was introduced by a venture capitalist who is now a private equity investor. He was interested in the answer to this question because he has seen what happens to angel investors after the first professional round of financing.

When the question was asked some of the experienced angels jumped right in with their principles and methodologies. The inexperienced and befuddled angels were asking some great follow-on questions. I think we walked away with an answer to angel investing that we can all apply.

Here are the Five Rules of successful Angel Investing:

Rule #1 – Group together and speak with one voice.

Angel investors generally fly solo. Angel investors generally never make money. This rule is from the guys that made money and continue to make money at angel investing. There is depth of resources and experience in a group. You don't know what you don't know applies to angels too, not just entrepreneurs. Everyone should have something they can bring to the startup to help make it successful.

And every group must have a leader. The leader of the group is the lead angel on the deal and he should be compensated in money and/or equity for doing this job. He is also the angel that calls the shots on the investment. The individual group members will be called upon to help in certain situations but the lead angel is the decision maker for the group of angel investors. As one of the successful angels said "Lead, follow or get out of the way."

Rule #2 – You must have the money in hand to get a deal done on favorable investor terms.

The solo angels are at a distinct disadvantage to the group of angels. If you are putting $10-25k into startups as a solo angel then you are a slave to the terms of the entrepreneur. As part of a group that is committing $250-1mm in funds to a startup, you are writing the terms of the deal.

To write the terms, you must have the money in hand. It is not fair to the entrepreneur for you to negotiate on behalf of a group that is making a "soft" commitment. Do you have the money or not? If you do have the money then pursue the deal and dictate favorable investment terms for the group. But if you don't have the money in hand then you are, at best, a bunch of solo investors.

Rule #3 – Invest in at least 5-10 companies

This is the VC approach and it works assuming you have the group that has the funds to invest. (If you don't have the funds in the group then go back to Rule #2). You will only invest in deals that make sense to you, deals that look from the start that will be successful.

But you must also keep in mind these are startup companies. A lot of things can happen that can make a deal go right or wrong. The external factors in startups weigh-in much more heavily than the internal controllable factors. (The biggest external factor is the market you are serving. If they decide to buy what you are selling when you are ready to sell it, you are golden.)

Rule #4 – You need enough money in reserve (dry powder) for two more rounds.

There is an old maxim in startup investing: It will always take twice as long and cost at least twice as much as you thought when you started. I can't tell you how many times I have heard this from experienced angels and how many times I said it (even to myself).

If you think the $500k you are putting into the deal will get you to positive cash-flow and it happens, great. If not, and you have no reserve, then the next investor group that comes in will crush you and your equity stake. As one of the experienced investors said, "The last investor in a deal doesn't care about anyone making money but him."

Have enough money in reserve so that you can choose to be that "last investor in the deal."

Rule #5 – Secure a major stake in the startup, preferably a controlling interest.

Angel investing in startups is a very high risk game. This is true especially if you are investing in first-time entrepreneurs. Proven entrepreneurs generally bypass angels and either fund it themselves or go directly to VC's.

To compensate for this risk you must have a formidable stake in the company. Most of these startups, if successful, will sell for less than $10mm. If only one or two of your startup investments in ten are successful then you must have a serious stake to get a risk adjusted return.

Those are the rules but here are a couple of more tips from experienced investors:

Tip #1 – Invest in what you know.

You will see a lot of startup opportunities as an angel investor. You will quickly realize how much you don't know. When you decided to invest in startups and help entrepreneurs you probably thought you were God's gift to entrepreneurs. This confidence is short-lived.

When you finally see a deal that is in your industry or experience set, you will immediately start asking better questions and adding value during the initial presentation. You gain confidence. The entrepreneur wants you in the deal. You will get a better deal and reduce your risk because of your expertise.

Tip #2 – Frugal operators are likely to provide better returns

If the first thing on an entrepreneurs mind is office space, run. You are about to give your money to someone who has the authority to spend it. Frugal operators spend money only in areas that make money. I read a great quote recently: "An entrepreneur is someone that steals office supplies from home and brings them to work."

Cash is oxygen in a startup. When you find an entrepreneur that treats cash this way then you know you have a fighting chance at success.

Tip #3 – Stay close to the company. Hold the entrepreneur accountable regularly.

I personally lost money in every single passive startup investment. I made money in the deals I stayed on top of. One of the angel investors said "Be a fellow operator."

This may be a bit strong as the entrepreneur must be "given his head." In the early stages you must meet with the entrepreneur weekly face to face with maybe some daily phone contact. After the company starts generating revenue and has what appears to be a workable economic model, you may move to monthly meeting with weekly phone calls.

Angel investing is a contact sport. You need to be involved or you'll get bloodied quickly. First time entrepreneurs are just that, first timers. They need your advice, mentoring and experienced council to succeed. If they don't believe this then pass on the deal.

Comments

[Russell Jurney]

If you secure a controlling interest in a startup as an angel, aren't you the entrepreneur and the founders are employees?

[Andy Borgmann]

Great piece Charlie.

I freely admit I know very little about VC/angel/etc...but I do know how important tip #2 is in our startup environment. Having everyone (or almost everyone) on the same page with that one has enabled us to do more with less.