10 is Not Enough

10 is Not Enough

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According to the, the American Angel Survey[1] the typical angel investor has a portfolio of just seven companies.

This despite a general perceived wisdom that “best practice” requires that because an investor is likely to lose their entire investment in any single start-up company, they should spread their money across at least ten different companies. Data suggests that as many as 70% of Angel backed companies fail to return capital (not all of the 70% enter liquidation. The worst ones continue to hang about the portfolio as zombies).

It turns out that while the typical angel investor is not apparently following perceived best practice, even to do so, and have a portfolio of 10, is not sufficient.

Launchpad Venture Group (https://www.launchpadventuregroup.com/analysed) anonymized individual investment returns for 278 individual Launchpad members over the past 20 years. They looked at their current Total IRR (including both realized and unrealized returns). The results highlighted the need for a diversified portfolio, and showed that to maximise returns more than 10 investments are needed.

Individual returns from investing in only one or two companies ranged from +100% to -100%. Median returns for such portfolios were relatively low, and the standard deviation of returns dwarfed the median return, meaning you are about as likely to lose money as make money this way. It seems that the return on such portfolios is largely driven by pure luck.

Increasing the number of companies in a portfolio to 5-10 bumped median IRR up by a factor of 3-4x. Only a few individuals suffered aggregate portfolio losses with this level of diversification. More is definitely better.

Real diversification however takes more than the 10 companies of conventional wisdom. it is only once you get beyond 15-25 companies in the portfolio that median IRR comes out at around 4.5x what it was with just 1-4 companies.

So – 4.5 times better return if you have a portfolio of 15-25 companies rather than just 1-4.

How do you build a portfolio of 15-25?

  • Work with an angel group, and create large syndicates at the first round.
  • Even if just one or two of you could do the deal – open it up to a wider initial investor base. Don’t invest £100,000 by yourself in round one – invest £10,000 with 10 friends.
  • Follow in with additional funding into those that are actually crating value. Remember it’s your ownership percentage at Exit, not round one, that will drive your returns. So, keep 4 times your initial investment for follow on.
  • Accept that some companies will fail – and let them do so without wasting more time or cash on them. Divert that cash to new investments – and sustaining to good ones.

[1] http://media.wix.com/ugd/ecd9be_8e208b2da3e343509cd4957fb9521b27.pdf

The Valuation Myth – Part 2

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The biggest driver of valuation is not the quality of the management team or the size of the market. There should influence the investment decision in a binary manner – if you don’t have a good team, or a big market, you don’t reduce the valuation – you just DON’T DO THE DEAL!

The biggest driver of valuation is Geography. Where is the company operating?

And specifically – how much it costs to do stuff in that location?

By ‘Stuff’ we mean something achieving a millstone that in the eye of the next round funder or exit partner adds real value. (The biggest value drivers are usually related to customer engagement / evidence that customers value the product – not tech ‘features’).

So valuations look higher in say San Francisco than Ohio simply because you have to put 4x the cash into the Valley company to do the same stuff that costs so much less to do in Ohio (salaries and rent are now almost prohibitively expensive for startups in the Valley now) – but you can’t take 4x the equity, or you would own more than 100%!

A resent analysis of valuations for Tech Coast Angels suggested they were 50% higher than the rest of the USA – due to geography.

Valuation of early stage companies is not really valuations at all. It’s not like valuing a house, or a picture, or even a traded stock market investment – all of which can be relatively easily turned into cash if you need to do so.

Early stage company valuation is really a way of expressing how the cake is being divided between the investors and the founders.

Angel investors, who are putting their time and reputations into deals, not just their cash, look for a sizable ownership percentage on an initial investment. This reflects both the perception of present risk – but also critically the level of future dilution they face as the company takes on more and more rounds of funding. It’s the ownership they have at Exit that is critical, not the ownership on initial investment.

The specific numbers will vary a bit from case to case, but for any meaningful amount of funding (say $200,000 or more), the early investor(s) will likely look for between 25% and 30% ownership.

10% – 15% will be put aside for share option incentives in the futures, leaving the founders with between 65% and 55%.

And the numbers don’t really change much whether it’s a $200,000 investment, or $500,000, or (for my groups most resent investment $800,000).

The valuation driver is the amount of cash going in – the size of the cake.

If the investment is $200,000 the valuation is likely based on the lower end of the ownership band – 25% – so a valuation of $600,000. If the cash going in is $800,000, then the higher end of the ownership range will be used – 30%, so a valuation of $1.8 million.

So quite different ‘valuations’ for the identical company. The difference driven by how much cash needs to be put in to achieve key millstones (what needs to be done to get the next round funding, or an exit).

Now benchmark that valuation against likely exit values (using exits in the location of your company) – a $1.8 million value today needs a credible likely exit value of $18 million – without the company taking on any more funding (the investors not suffering any dilution), to archive a potential 10x return – needed to get a potential 2.5x – 3x return at a portfolio level, when you account for the companies that will return zero.

Perhaps investors should be encouraged to study Geography, not Maths, to get an understudying of valuation.

The Valuation Myth – Part 1

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I was asked recently to provide some feedback on possible valuation benchmarks for a company raising its first external equity funding.

Of course the funder has been looking at valuations from Silicon Valley. Largely one suspects because they are larger than the local ones in Latvia.

The use of comparatives is a sensible way to benchmark valuations – what valuations have been achieved by similar companies?

But they are usually used badly – because the definition of what is ‘similar’ is too narrow.

Similar is not only (or indeed primarily) those in a similar industry or tech vertical.  

What is more critical are factors such as:

  • Achievements to date – critically customer engagement and meaningful revenue generation.
  • Levels of actual Intellectual property (patents applied for, granted and freedom to operate reports).
  • Experience of the management team – have they previously successfully built and exited a company?

Comparatives ignore the most critical influencers of future value for early investors.  For investors the return on investment is driven by three factors:

  • How much ownership of the company you have at initial investment (the outcome of the initial valuation).
  • How much ownership you have at exit – a function of dilution – how much more money will the company need to get to an exit, and how much of that will the initial investors be able to provide?
  • The actual exit value achieved.

Investors who only look at the first of these – the initial valuation, are likely to do badly in the end.

Providing $200,000 for 10% of the company (which gives a pre money valuation of $1.8 million, is meaningless, unless we know what future dilution we will suffer. Say the company needs $100 million of VC money to get to the exit – what ownership will you then have? And even if you have say 1%, if the VC’s have just a 1x preference, then unless the company sells for at least $100m, you will not get one penny back (did I mention that most successful exits are for around $25m – $35m?).

Valuation is not about what a company is worth today – or indeed what it is going to be worth on exit – but what ownership percentage you will have at the time of exit, and what the terms of that exit are. Those terms will not be set by you – but by the provider of the last round of funding.

Valuation therefore begins with a deep analysis of Comparatives – the comparative of EXIT values and the total funding that has been required to achieve them.

Is it Angel Training – or Angel Education?

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I have received some comments from experienced Angel investors challenging whether the use of the word “training” is appropriate in the context of developing business Angel investment skills and knowledge.

It is suggested that the use of the word may actually be off putting to individuals who regard themselves as extremely successful business people.

However, the principal challenge to the use of the word ‘training’ relates to the impression it may give that on completion of a “training course” a novice will be fully skilled in all matters required to be a successful investor.

In practice the most significant impactful elements of Angel learning occur as a result of new Angel investors learning from experienced Angel investors while processing a live investment opportunity.

Angel investing is a practical rather than a theoretical activity. The term “training” often seems associated with learning that is done by rote and is somewhat prescriptive. i.e. There is a “right and a wrong” way of doing things.  Such prescription does not apply to the Angel investment environment, where there are many areas of disagreement, even between the most experienced Angel investors.

When Angels gather together there will be frequent discussions, and disagreements, as to the most appropriate forms of valuation (and the extent to which valuation is critically important or not in the investment process) the key factors of due diligence (typically between business opportunity and management team) and forms of investment (convertible notes versus preference stock) to name just a few areas of potential discord.

A preferred term may be “education”, which has a connotation of a continuing (lifelong) process, where the learners are encouraged to think about the concepts presented, and where appropriate to challenge them. Any point is open to discussion.

In developing the skills and knowledge of the Angel community it might be that encouraging education on a continuing basis, rather than suggesting Angels undergo training, which may be seen as a relatively one-off activity, would be more effective. 

Investing In Scotland Grows In 6 Months to June 2020

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Investment by LINC (the Scottish Angel Capital Association) members increased from £7.84m (41 deals) to £15.27m (58 deals) in the first six months of 2020 compared to the same period in 2019.

In addition to the £15.27m invested in the period by LINC members, their deals attracted an additional £14.60m from private co-investors, and £11m from Public co-investment funds. So a total of £40.87m into those 58 deals.

All LINC members are Business Angels – so not Venture Funds of crowed investors.

Many of these deals were of course in the pipeline before COVID issues hit, and the majority of the investments went into existing portfolio companies (typical of a mature angel market).  It may be anticipated that the second half of the year will be more challenging for companies seeking funding, especially ‘new’ companies seeking their first external Angel funding.

(data source – LINC Scotland).

The Reason Most Angel Training Misses the Mark

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The key role for “training” in emerging markets should be to provide nascent Angels with an understanding of tactics to deal with high risk, and thus confidence to join with others in making their first investments.

Technical training (Valuation, Financial Modelling, Due Diligence etc.) is a necessary but insufficient component of building this confidence. More vital are the elements that address critical risk factors.  These include the development of investment strategies that look beyond just the initial investment transaction, to the life-long funding requirements of the company, and post-investment support. We refer to this as “Strategic Angel Investing”.

Angel investing is a personal activity. Angelsinvest their own money in deals they select. They are free to conduct their investment activity in any (legal) way they wish.

A program must not try to impose a particular methodology or investment thesis, but rather find ways to support individuals to become confident to make investments in the manner that works for them. This does include using ‘best practice’ examples to demonstrate how others have become successful.

But ‘best practice is still subjective, and definitely needs to be adjusted to take into account the realities of local circumstance – the number of investors, availability of follow on and exits, the nature of deal flow and the like

Almost every aspect of Angel investing, from deal sourcing to exit, is subject to discussion about what methods, processes and techniques are most effective. The most effective learning comes from real life stories and examples, relevant to the region (tales of Silicon Valley are rarely appropriate), delivered by inspirational speakers, who are themselves experience investors. By which we mean not only that they have done some deals, but that they have taken a few companies through to a successful, profitable, exit.

An experienced and dynamic programme delivery team, who can adapt to local circumstance is the critical success factor.

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.

Strategic Angel Investing – Rarely Understood

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As an Investor your financial returns will be driven by the following factors:

  1. Initial Valuation (% of company you own)
  2. Subsequent dilution (factor of both future funding amounts and the structure of future deals – do new investors have a preference return ranking ahead of yours?)
  3. Time to Exit
  4. Exit Value

Most founders / investors spend lots of time on item 1 – and almost no time considering 2, 3 or 4.

In determining your financial return the % you have of the company at EXIT is much more important than the % you have at round one. Yet so many investors spend enormous amounts of time focused of getting that initial valuation ‘right’, and no time considering the company’s future funding needs, their ability to contribute to those needs and their resulting dilution.

There is no point in having what looks like a large % at exit, if the other investors have a preference over you. I have seen an exit at $475 million – with the angels getting zero as a result of the preferences.

Don’t let those unicorn valuations fool you. The reality is in the detail of the last finding round terms (which will not be disclosed). Frankly you can claim whatever stupidly high valuation you want – if I have a 3x preference that I will take off the exit table before anyone else gets a penny.

Archangel invests £10.9m in Scottish Companies

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For 2018 Edinburgh-based angel group Archangel invested £10.9m of its own members’ cash in ten investment rounds , along with co-investment of £9.4m.

During the year, Archangels, founded in 1992, was also recognised as Lead Investment Syndicate of the Year
by the UK Business Angels Association and Investor of the Year at the inaugural Scottish Tech Startup Awards.

The year included two profitable exits, Oregon Timber Frame Limited – one of the UK’s largest independent timber frame house manufacturers, and ZoneFox – sold to Fortinet, which secures the largest enterprise, service provider and government organisations around the world.