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Reprinted from OnStartups. Original article here.
By Dave Balter. Dave is the CEO of BzzAgent, founder of Smarterer, an active angel investor and a holder of proms. You can follow Dave on twitter @davebalter
Everywhere you turn these days, you find an angel investor. Aside from those who have always invested small amounts of cash in startups, more and more venture capitalists are making personal side deals, active entrepreneurs are investing in other entrepreneurs, seed funds are cropping up everywhere, and Angel List has emerged for the everyman.
But most Angels will fail to get back the capital they’ve invested (let alone make money), and it’s not because they don’t pick good companies or back great entrepreneurs — it’s because they’re completely mistaken about an Angel’s role in the investing cycle.
I know this because my in my early days as an Angel investor I fell prey to behaviors that would practically guarantee that I’d lose money. And now that I’ve gotten to know the Angel community, it turns out I wasn’t alone. The problem: most Angels attempt to act like sophisticated venture capitalists:
a) They seek 10x (or more!) homerun acquisitions and;
b) do follow-on investments (pro-rata or more) often through multiple rounds and;
c) invest in game-changing ideas that are incredibly risky;
d) wait for companies to eventually get sold to see a return.
A more effective model for Angel investing is long overdue. If Angels want to win — they want to lower their risk, create better returns, and help entrepreneurs more they’ll do the following: fly lower heights (avoid trying to fund the next 5 Facebooks) and take shorter flights (avoid riding each investment out all the way to the end).
An Angel investor should:
a) aim for a 2-4x return;
b) get out of deals in 1-3 years, selling their shares to VCs at the Series A or B Venture Rounds (and not feel bad about it);
c) Remember that they’re playing with their own money versus risking someone else’s via a fund they’ve raised. Angel investing isn’t about charity work; if they want to spend money to help others, they should just donate to good causes instead.
Ultimately, it’s about following the rules of the investing ecosystem: Angels get things started, venture capitalists create mature, sustainable businesses, and investment bankers sell them. And if we all play by our roles, we’re all going to win.
Here’s what playing by the rules will do:
Reduce Risk. Losing money is rarely because the company goes out of business in the first few years. Rather, it’s because the company matures and becomes more difficult to sustain through ups and downs. Getting out early will allow an Angel to get more out, more often.
Allow More Companies to Get Funded. The majority of Angels have the ability to invest in just a handful of deals, let’s say 10 maximum. Their money is limited, and they don’t want to overextend. Assuming some follow-ons, most just can’t do much more than that. If an Angel exits from one or two in the short term, that 2-4x return will allow them to help start more companies, more often.
Avoid Dilution to Nothing. One of the major issues in Angel investing is that a successful company often goes through many rounds of funding at higher and higher valuations. Often at that stage, VCs don’t provide early Angels the ability to invest, and even more often Angels can’t invest due to the financial commitment. The result: an Angel is left diluted to a meaningless percentage.
Keep In-The-Know. In the successful company scenario, the outcome is even bleaker. The major investors no longer provide early investors with Information Rights (the right to receive financial or strategic facts about the company). So that leaves most Angels with a variety of deals that they’re entirely clueless about.
Provide VCs with More Ownership. When a company begins to succeed, institutional investors want as much ownership as they can get. Without lowering valuation, this conflicts with founders who also wish to keep as much ownership as they can. One solution: Angels are expected to sell shares to the VCs as part of the round. The VCs get more ownership, an Angel makes money and the entrepreneur doesn’t get diluted. Everyone wins.
Reduces VCs and Acquirers from Having to Deal with — well, Angels. This is an important one. VCs want clean capitalization tables (less people involved = less headaches) and acquirers don’t want to have to deal with shareholder lawsuits or other risks of having a whole bunch of (relatively) unsophisticated investors involved. The less Angels involved later, the better.
Again, this is really just about Angel investors agreeing to be what they really are: small-time investors who want to use their own money to help companies grow. It’s a great thing, and it shouldn’t be confused with investors who are seeking to deliver returns for the Limited Partners in the funds they’ve raised.
For this to work, the whole ecosystem needs to behave accordingly. Entrepreneurs need to be supportive of an Angel who sells their shares; venture capitalists need to be willing to purchase shares from Angels during the A or B rounds; and Angels need to know their role.
To the Angels: Aim shorter. Aim lower. And for that, you’ll get better returns and support more companies.
Which is the point after all, isn’t it?
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