Return on Investment

What is Capital Risk for Angel Investors?

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Few Investors (or founders) look beyond the immediate funding round in any detail (if at all). Yet Assessing Capital Risk is critically important when assessing if this is a deal you should do – even if every other indicator is screaming “Yes”.

Every deal I have ever seen has needed more than one round of funding to reach a successful exit. Most need multiple rounds of funding – perhaps 5 to 8 is typical, over 5 to 10 years.

If that follow on funding is not going to be available, or you don’t build something the next round funder will invest in, you are not building a bridge to a profitable exit, you are building a pier to nowhere.

So, asses what is the Capital Model for this deal going forward, and get answers to the fooling questions:

  • How much additional cash will company need?
  • Where will that cash come from?
  • On what terms can we get it?
  • What will Funding environment be like in 18 months?
  • Will we need a VC partner?
  • What terms will the VC offer?
  • What does this company have to have / look like (users, customers, data etc.) to be of interest to those VC’s? Can we achieve any of that on the funds we are about to invest? Is the target of the business plan to achieve those key requirements?
  • Will they need so much capital that follow-on VCs will wipe us out? (Dilution + Preferential Returns).
  • How big an exit will we need to hit Our Target Return – if this company is successful, can it get close to that number?

Risk – Embrace it – It’s where the Profits Are.

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Risk is impossible to avoid in any business. For Angel investors looking at the first rounds of funding going into a start-up the risks are particularly significant.

Angel investors make decisions to invest under conditions of extreme uncertainty. Angel investors face cases in which uncertainty is so extreme that it qualifies as unknowable. They decide on investments in ideas for markets that often do not yet exist, and they propose new products and services without knowing whether they will work.

For experienced Angel investors rather than being undesirable, unknowable risks are deliberately sought. It is by investing in companies with unknowable risks that they can find the most attractive, most profitable investments.

Experienced Angels do not seek to maximize each decision but instead seek potentially extraordinarily profitable opportunities and accept what may seem like a high failure rate. They rely on building a large portfolio to spread risk and accept that the overall failure rate, by number of investments, may be as high as 70%, even in the most developed capital markets[1]. Typically 85% of all returns come from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

It is critical to understand that for Angels a ‘fail’ is not a company in liquidation. It’s a company that fails to return the investment capital and an investment return on top. Indeed, depending upon the local tax regulation a zombie company – one that keeps going but with no likely prospect of an exit for the investors – is worse financially than the liquidated company. At least if a company is liquidated I get to offset the loss in my tax return.

Angels use Due Diligence to assess risk. A due diligence process therefore needs to cover the key risk categories –

  • Management Risk
  • Technical Risk             
  • Competitive Risk      
  • Market Risk              
  • Intellectual Property Risk
  • Regulatory Risk
  • Team Risk

Many Angels however do not spend enough time looking at the two most critical risks – that will kill a return on investment even if everything else is as close to perfect as can be –

  • Capital Risk – how much follow on cash is this company going to need – can it get it, and on what terms?
  • Exit Risk – is anyone ever likely to want to purchase this company – and at what price?

[1] 2016 Angel Returns Study, Angel Resource Institute, 2016.

Angel Investing – Not Just for the Supper Wealthy (who are usually not very good at it anyway).

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The Best way to be an Angel Investor? Become a member of an established Angel Group of Network and join in lots of deals with other members, investing just a little initially in each one. Let’s say a company was looking to secure £250,000. That should be provided not by one of two really rich individuals, but by 10 or more individuals each investing between £10,000 and £40,000. Why? Because Angel investing is very risky – as many as 70% of the Angel backed companies in the USA fail to provide a return to the investor – so the reality is, however good that pitch looked, no one, however experienced they are, can pick the winners.

Angel investing can be highly profitable, with organised angels with a portfolio investing strategy achieving IRR returns of 25% (and one Angel friend showing a 101% IRR!). But you must do a lot of deals. Less than 6, and the probability is you will not get any return. You need to be planning to do 15 to 20 new investments over say a 5 year period, recognising that many will not manage to develop as planned. Then be prepared to provide follow on funding only to those that do show real development and in particular customer traction. Don’t keep funding the ones that don’t perform (and they will likely be the majority!). It’s only after the company has been actually operating for a few years that you will have any chance of starting to see which ones are likely to be the real winners.

And the only practical way to be able to invest the necessary cash, and time, across such a large number of investments is to do it as a “team sport”, investing with as many other Angels as you can, providing small amounts of initial funding each, and then building on the successes with more capital. A good rule of thumb is that for every £1 you provide as an initial investment, you need to plan on providing another £3 for follow on into the “good” ones.

Being part of a group has many other advantages.  Usually better access to deal flow as the Group will be better known than individuals, certainly more people and brain power to do screening and due diligence and access to much more post investment support.

And why are the Supper Wealthy usually not very good at it? They don’t share the deals, and put too much money into too few companies, and don’t have the time to provide adequate post investment support into a properly sized portfolio. Better to be a team player.