People often ask me how angel investing compares to investing in the stock market. As someone who invests in both private and public companies, here are my thoughts.
A general misconception about angel investing is that all private (non-publicly traded) stock investments are angel investments. In reality, only a small fraction of private investments are considered angel investments. A typical angel investment is an investment into an infant company that consists of brilliant founders, a half-baked product, and non-existent sales. Angel investors invest in these ugly ducklings because they believe in the founders and the future they could build. If things go well, the company will progress to have a more complete product, customers, and revenue. At that point, venture capital steps in and individual angel investors most likely will not have the opportunity to invest in these lower risk and highly lucrative institutional deals. After multiple rounds of venture and growth capital, the company will eventually IPO or get acquired.
Did you want to invest in Airbnb back in 2016? I did; but, I couldn’t. Most individual investors would not have had access to pre-IPO AirBnB. The only ways most investors could invest in AirBnB are either after their IPO or when they were still selling Obama cereal boxes.
From what I just described, it is probably not hard for people to figure out the main difference between angel investments and stocks. I would say the biggest difference is that you do not have data to crunch on for angel investments. There are no sales, no profits, no EBITA (earnings before interest, taxes, and amortization), no growth rate, no P/E (price to earnings) ratio, etc. The only data points you will have are the monthly burn rate, which is an important sustainability metric to look at, and the valuation.
To evaluate an angel investing opportunity, a different framework from public stock investing is necessary. Different investors do it differently. Personally, I take a founder centric approach to evaluate a deal. But, before evaluating the founding team, I would start with understanding the product they are trying to build by examining the technical risk and the market risk.
Technical Risk: the risk in successfully building and launching the product
Market Risk: the risk in successfully marketing and selling the product
Examples of Risk Evaluation
Cancer therapy is an example of a high technical risk and low market risk product. If a company could successfully develop a therapy to cure small cell lung cancer or glioblastoma, they will not have trouble finding customers. But the real risk is if they can successfully pull that off.
A hot sauce brand is an example of a low technical risk and high market risk product. Many people have their mom’s recipe for a killer hot sauce. They could build the product in a commercial kitchen or through a co-packer. But, the real risk is in their ability to successfully market and sell the product since there is so much competition with similar products.
Small business software is an example of both high technical risk and high market risk. It requires the team to successfully build business grade software with a strong value proposition and a reasonable price. In the meantime, the team also has to be able to sell the software to small businesses through affordable distribution channels. Small business software is one of the toughest nuts to crack in business.
As part of the market risk evaluation, it is also critical to analyze the TAM (total addressable market) and the growth potential of the product. If a team can build and sell a niche product successfully, but the ultimate market size is not very large, it is important to think about what kind of return this investment can generate in the long run based on the valuation.
Understanding Founder-Market-Product Fit
Once a product’s market and technical risk is well understood, the next step is to evaluate the founder-market-product risk. In my opinion, the most important question to evaluate an angel investment is “Is the founding team made of the right people to build and sell this particular product?” Of course at the very early stage, the team might not have all of the talent to be able to do both building and selling well. I typically grill them about how they are going to implement their overall plan, the sequencing, and what it takes to be successful. Good founders should be able to communicate well and be strategic about their plan. I think it is important that the founding team and I agree on their strategic direction and have alignment on goals. If we believe in different things, it is hard to fathom that things will go the way I envisioned. After all, I am not investing in a business that is up and running and generating profits. I am investing in a vision and the most important thing is that the founding team believes in the same vision and I can trust them to execute on that vision.
One thing I would like to point out is that I typically shy away from first time founders. Entrepreneurship is something people do not understand unless they have experienced it. It is very similar to parenthood. Only people who have cared for a newborn understand how hard it is. There are a lot of capable people out there who are not suitable for entrepreneurship. A simple filter for me is to focus on serial founders. If they have endured the pain of founding a company and have decided to do it all over again, that is a strong positive signal.
Returns and Investment Horizons
I want to end this section discussing returns and investment horizons. Angel investments are illiquid and take a long time to realize. In fact, I just had the first IPO announcement from my portfolio after 9 years. Matterport is actually my very first angel investment. It is going to return about 40X but I had to wait for 9 years with a lot of ups and downs in between. AirBnB raised their angel round in 2008 but did not IPO until 2020. That is the timeline people have to be comfortable with when angel investing.
As for returns, people have to realize 80% of their angel portfolio are not going to work so well. By that, I mean they either go to zero or barely break even. Your overall return will be driven by the top 20% of your investments. My target has been to return an average 20X of mt top 20% and overall break even for the remaining 80%, which will give 4.8X of overall invested capital. From what I have observed, the actual return is highly variable based on the current stock market climate and overall startup valuation at the time of investments. In general, there is not a lot of data available to the public about angel returns so most angel investors more or less are flying blind a bit. The top dominated nature of angel returns also brings another important point: you need to build a portfolio of at least 20 investments to have a good probability to hit a home run. This can be time consuming compared to investing in stocks. In addition to all of the research to complete a transaction, you will have to speak to the founding team multiple times, review/sign a lot of paperwork, and wire the money instead of just clicking on a website a few times to purchase a stock.
Despite all of the differences, there are still a lot of similarities between angel investing and growth stock investing. These are fundamental investing principles I would summarize as follows:
- Invest in Growth and What You Know. I am a big believer of Peter Lynch’s investment philosophy. Invest in what you know and invest in an industry that is on the upward trend. No matter what industry you are in, be it enterprise software, real estate, health care, or consumer brands, use your industry knowledge to pick high growth opportunities to invest. Do not invest in a dying industry. You might be thinking you are buying something cheap for a good P/E ratio and dividends. But, imagine buying JCPenney or Blockbuster when they were *cheap*. They are only going to get cheaper and eventually disappear.
- Invest in Great People. Warren Buffett had a famous quote on qualities he looks for in great people: integrity, energy, and intelligence. This applies to both angel investments and stocks. You want to make sure the management team has the integrity so they do not cheat investors, has the energy to adapt to the ever changing world, and has the intelligence to strategize for better outcomes. For public companies, you would assess this based on the corporate actions, customer feedback, quarterly results, and investor communication. For angel investments, you should be able to assess after spending time with the founding team. Helping companies in your angel portfolio is to be expected and it is very common for people to start with investing a small amount and then increase the amount as investors build more trust toward the team.
- Patience. A lot of investors would buy a stock and sell it after it rises 20% of 30%. But, as we have observed in the past two decades, the best investment strategy is to buy a high growth, wide moat, well run company, hold onto it, and ignore the volatility. It is pretty much the Warren Buffett philosophy. Once you find a good investment, stick with it and let it snowball. Do not try to trade. 99.9% of day traders do not beat the market. Since the investments are illiquid, angel investments actually help investors manage their impulse of wanting to sell whenever there is a profit. But, overall, investors need to be patient. Please do not call your founders and ask them when you can realize your investment. Big exits take a long time. Patience is a virtue.
If the idea of angel investing excites you, I would like to end this article offering two pieces of advice when talking to founders and I hope you enjoy the process of finding the next unicorns.
- Be Respectful. The product might look half-baked, the sales might be non-existent, and the founder might sound delusional. But, please be respectful. The entrepreneurs pour their blood, sweat, tears, and life savings into their startups. It takes courage. Do not be disparaging no matter what you see. You also do not know if they will become a billionaire tomorrow and that does happen in silicon valley.
- Be Helpful. Startups are usually very resource-constrained and they can use your help. Your help decreases their burn rate, accelerates their execution, and improves your odds of success. Helping them is a win-win situation. If they are in a different industry from yours, it also expands your horizon. By all means, be helpful to your founders!
The content here is for informational purposes only, and should not be taken as investment advice. All views contained herein are my own and do not represent the views of any other organization.