This post comes from a local Seattle angel investor Keith Laepple, who's active investing is usually in collaboration with other investors in groups such as Seattle Angel Fund, Alliance of Angels, and Seattle Angel Conference.
What basic strategies should guide angel investors’ selection of various startup opportunities coming their way?
It’s an on-going and often confusing question for angels of every experience level. And Seattle Angel Fund manager Susan Preston’s presentation at Seattle Angel’s recent “Portfolio Approach to Angel Investing” kick-off workshop drove head-on into some of the fundamental principles – and math -- angels should know as they build a portfolio that in the long haul will make the difference between lackluster (or worse, negative) returns, vs. the 20-30% IRR known possible with favorable deal flow and due diligence. As Susan showed, the very skewed averages of eventual startup exits – e.g. only 7% of deals bring 75% of returns – implies that by the numbers, every pure equity deal (i.e. no revenue-based returns) in a typical angel portfolio needs 10-20X return potential on paper, independent of the competence of the entrepreneur team, innovation of the product, size of the market, and so on.
That may sound daunting on the surface, particularly for new angels and entrepreneurs, but Susan (thankfully) went on to show that estimating ROI is actually straightforward, even refreshingly objective, once you know the basic formula and data to use. It’s also made easier by working together with the founders, who as equity stakeholders themselves want as clear a view on exit ROI as their prospective investors.
While examining a startup’s financials before diving into the typically more fun team, strategy, and technology vetting, does take discipline, it also usually produces some of the most useful insights for founders. Importantly, it can prevent a waste of everyone’s time on further due diligence if key numbers– revenue growth, valuation, industry multiples, exit timeframe, subsequent funding rounds, etc. – can’t show high potential return. By walking through even speculative “pro forma financials” together with investors, entrepreneurs will test and improve their grasp of their market, industry, and business model. And beyond just number-crunching, this exercise surfaces relevant assumptions and open questions for product roadmap, customer definition, and marketing strategy, which then give investors clear focal points for the rest of their business due diligence.
Of course, a lot more than just ROI math factors into the portfolio strategies and preferences of experienced angel investors, and this was explored in part 2 of the session in a panel conversation with angels Geoff Harris and Eric Doebele, who invest independently and as part of groups including Seattle Angel Fund, Alliance of Angels, and Oregon Angel Fund. Looking for “something extraordinary,” Geoff said, like the hydroponic lettuce company in his portfolio, often leads him towards individual startups, since he enjoys the intellectual curiosity and stimulation of angel investing. Eric Doebele highlighted that in his portfolio, diversification isn’t so much about a mix of industry/product category, but rather investing in startups at different stages of growth and valuation. And for both, seeing opportunities to utilize their career experience and network to help founders build their businesses is an important consideration.
Attendees, a mix of both active and aspiring entrepreneurs and angel investors, engaged Geoff and Eric with questions about their portfolio approaches, from a variety of angles: How do you narrow your deal flow, before devoting time with specific startups? Do you look only for opportunities for on-going involvement as an advisor or board member, or do you also make passive investments? What traits do you look for in entrepreneurs? What signs of revenue, or revenue potential? How do you defend against dilution from future funding rounds? How much do founder salaries and personal skin-in-the-game matter to you? How does crowd-funding affect portfolio diversification?
As every angel investor comes to figure out through sessions like this plus their own experiences, there are no uniquely correct answers to any of these questions. But some common patterns and principles do emerge, first and foremost that, as this Seattle Angel session thoroughly underscored, angel investing truly requires a portfolio approach in order to produce great returns in the face of startups’ high-risk odds and skewed exit returns. Moreover, there as many successful portfolio strategies and “investment theses” as there are successful angels, built around the various aspects of investors’ experience, personalities, talents, and values. For this reason, participating in a local angel group fund and network is probably the easiest and most fun way to develop and refine a personal strategy, learn what types of startups fit your interests, and build a portfolio faster and with less overall risk through collaborative due diligence and fund pooling.
Watch this spot for additional Seattle Angel blog posts and education session announcements that will further explore angel portfolio topics!
