How to Angel Invest: Understanding Risk
By Vela Wood
Before you begin throwing money at startups, it’s important to understand the risk involved with investing. Venture capitalist, Sammy Abdullah, believes “angel investing is the absolute hardest thing to do in investing.” Angel investing can be fun and exciting, but like any investment, you’re not guaranteed a return. Here are a few considerations:
Starting a business is tough, and sometimes receiving capital is not enough to succeed. In his book, Angel Investing, David Rose estimates that 50% of the startups you invest in will go out of business. However, Abdullah thinks angel investors can give themselves a fighting chance by investing in funds and letting a professional control the search and vetting process.
Clearing the cap table
Not all early investors get to reap the benefits of a company in its later stages. Sometimes when companies continue to raise money, institutional investors decide to clear the cap table by paying off the angel investors. While you may get your money back (with interest), you miss out on the lucrative upside that you might have hoped for.
Writing multiple checks
It is rare that you only need to write one check for a company to succeed. As a company grows, follow-on financing is often required, so get your wallet ready.
As follow-on financing is required, if you choose not to continue investing, your stake in the company will drop accordingly. Thus, maintaining your percentage of the company may require more money than you are comfortable investing.
Although you helped finance the company, investing doesn’t guarantee you a seat at the table when strategic decisions are being made. Founders usually have many investors, so it would be difficult to reconcile all of their advice. This makes the due diligence phase of investing so important because you are determining who you want in the driver’s seat when things get difficult.
Especially if you lead a round, you will be expected to serve as an advocate for the company to recruit other investors. Or, a company may want you to serve on their board (which will likely require a few hours each month).
Not making billions from one investment
Some investments may yield fantastic returns, but do not expect every profitable investment to be so fantastic. According to Angel Investing, a reasonable goal for your angel portfolio is an annualized IRR of 25%.
Don’t let this discourage you. There is still money to be made with this asset class. You can talk to your investment advisor to see if angel investing can be incorporated into your investment strategy.
Special thanks to Vela Wood law clerk, Ikenna Okoro, for his assistance with this series.