Angel Investing – Fools Rush In Where Family Offices Dare To Tread (1)
Note: This post originally appeared as an article on FOCAPNET.
Angel investing is hot… and not just because it’s so cool.
When for over a decade single-digit Venture Capital returns qualify as “top quartile”, seed stage investments have generated 27% ROI. (2) So it is only natural that family offices and high net worth individuals are eager to get exposure to this sector. The only problem is, they often don’t have the experience they need to do it right.
Here’s a typical family office startup story:
- A family office decides it wants to get into angel investing.
- One of the investment professionals goes to a few meetups and generally gets the word out that he is in the market for interesting startups.
- He starts getting pitched (directly, via LinkedIn, etc.) by a host of “investment advisors” representing “hot startups”.
- A few of these startups look pretty good so the family office invests.
- These investments fail miserably.
- The family office decides that startups are a “bad investment” and goes back to what it was investing in previously.
Hint: Step 3 is where things ran off the rails. I’ll get back to that in a moment.
Why family offices are ill-equipped for angel investing
The more sophisticated family offices employ investment professionals who have deep experience analyzing the strategies and returns of public equities, hedge funds, private equity funds, etc. These are all well defined instruments, within generally limited investment universes, for which substantial data is available. Even if you are considering seeding a hedge fund or committing to a newly minted PE/VC fund, you can still mine the principles’ track for a fair number of data points. Furthermore, there are well-established channels for learning about new opportunities (e.g., “capital introduction” dinners) in these spaces.
Now reverse every single one of the above characteristics and you get angel investing. Every halfway decent startup opportunity is unique, solving unmet needs in different industries – sometimes in industries that don’t even yet exist. There are no registries or directories of startups, no associations to join. And you can forget about data entirely with a pre-revenue company. At best the founders have one or two reasonably successful prior ventures under their belts. (If they had a real home run under their belts, they wouldn’t need investors at all.) Furthermore, the best way to find great startups to invest in is to know other great startups so if you aren’t already deep in that community, you’re already disadvantaged.
Unfortunately, most family offices don’t realize how fundamentally different early stage investing is from other alternative asset investments. So they don’t see anything amiss when investment adviser brings them startups to invest in. (I told you I’d get back to step 3.) They are used to meeting emerging hedge fund managers that way so why shouldn’t they find a great startup that way too? Because the best startups are never, ever represented by an investment advisor.
Think about it. VCs are the most networked people on the face of the earth. VC present at panels or judge pitch events practically every week. They meet dozens of entrepreneurs every week and know – and have often co-invested with – virtually every other VC in our area. If a startup founder can’t network his way into a warm introduction to a VC or angel, how is he going to find customers or key strategic partners? Is this advisor going to be holding his hand then too, after your check has cleared? Plus, the very fact that the founder thinks he can waive his hand and simply have someone else take something this crucial to his business for him is huge red flag in and of itself. So any startup that has an investment advisor fundraising for them is already automatically suspect. In practice, the deals the family offices are being shown by these advisors are the hairy, old, over-shopped deals that every VC and halfway serious angel have already turned down. It’s no wonder they fail miserably.
To be fair, to the untrained eye they don’t look that bad. Perhaps they have a cool piece of ad tech that you are convinced will take agencies by storm. You have to really know the industry to understand why agencies turned them down two years ago when they first tried shopping their solution around. That fantastic social media marketing tool? It’s so wonderful that five other companies are already doing it and they are all making better progress than the one you were pitched. But if you aren’t seeing dozens of startups each month, there’s no way you could be expected to be on top of all these trends.
So what’s a family office to do?
In theory, a family office could hire a seasoned angel investor to invest on their behalf. But good luck finding one. Many angels are running their own businesses and/or are entrepreneurs who had a large exit and have no interest in working for a family office. Also, angel investing is a numbers game. Most startups will fail, and many of the rest will be modest successes. You have to invest in many, many startups to have a reasonable chance of 1 or 2 of your investments being a home run. There’s a reason Dave McClure named his fund (now an accelerator as well) “500 Startups.”
Fortunately, there’s a better option: Startup Accelerators.
Accelerators(3) are the boot camps of the startup ecosystem. Companies accepted into top accelerators are the very best, earliest stage startups in the world. The top accelerators typically get hundreds of applicants for just 10-15 spots. Having just run the screening process for DreamIt NY’s summer 2014 program I can personally attest that this is no exaggeration. The odds of getting into Harvard are slightly better than getting accepted into DreamIt.
Accelerators give the startups they accept a little cash ($20k-$40K on average), co-working space for the duration of the program (typically 3-4 months), and extensive mentoring, coaching, and introductions. Finally, on “Demo Day” the startups graduate by pitching their business to an audience of hundreds of active angel investors hand-picked by their accelerator. In exchange for all this, the accelerator gets equity in the startup (usually 6-8%) and the right to co-invest in the startup’s seed round.
From the perspective of the family office, accelerators can be the capital introduction dinners for startups. Unlike the shady investment advisors discussed above, accelerators are personally invested in the startups they accept. Accelerators do not get commissions on the fund they help their startups raise; they only profit when their portfolio companies have an exit so their incentives are aligned with the other angel investors.
But they are more than just a trusted recommendation from a fellow angel investor. Accelerators like 500 Startups, DreamIt, TechStars, and Y Combinator invest in dozens of startups each year and can bring a structure and rigor to the investment process that few angel investors have. Established accelerators bring unparalleled networks and reputation to the table enabling them to source the very best new companies out there.
Many accelerators are structured much like VC funds. But there is one crucial difference: co-investment. Even the most co-investment friendly VCs only make their portfolio investments available to LPs if they are unable or unwilling to invest their full pro rata. If it’s a great portfolio company, the VC will continue to invest until it runs out of powder or starts bumping up against position caps. And if the VC is able to but does not want to exercise its full pro rata, do you really want a bigger stake in that company? In both cases, the VC eats first and the LPs get leftovers.
Accelerators on the other hand, rarely invest in more than a small fraction of the portfolio company’s seed round. As I mentioned above, early stage investing is a numbers game so they reserve most of their investment capacity for new startups. As a result, 75% or more of the round goes to new investors.
Think about that for a moment. Here’s an entity that filters out 98% of the startups they see, takes the top 2% and gives them all the help a young company could ask for, and then willingly steps aside and lets any other angel or VC swoop in and invest in those elite new ventures. No commissions, no membership fees. Wow.
If all a family office did was go to the Demo Days of the top 4 or 5 accelerators and invest in the presenting startups, the filtering effect alone would give them a high quality portfolio of early stage investments, no additional effort required.
For the family offices who want to build their own experience base and startup network, there is an even better option: invest directly in the accelerator. Accelerators typically give their LPs early access to their new class so LPs can track a startup’s progress over a longer period of time before deciding to invest and/or can invest before Demo Day and avoid the risk of missing out on the hottest prospects. Furthermore, most accelerators will gladly explain their selection process, describe how they are assisting the startups, and introduce LPs to other members of the startup community. This practical education is not something you can buy anywhere but you can get it for free simply by investing in something you already want to invest in.
Investing directly in a top accelerator also makes sense from an efficiency perspective. Even investing the bare minimum $25K per startup (and some startups insist on $50K or $100K minimums), creating a portfolio of 100-200 startups would cost a family office $2.5M-$5M. But this leaves no money for follow on investments. As a rule of thumb, you want to set aside $1 for follow on investments for every $1 initially invested so getting that 100-200 startup portfolio actually means committing $5M-$10M to early stage investing. In contrast, you could invest $1M (4) into the accelerator’s fund for the same portfolio of 100-200 startups, including follow on investments. That comes out to just $5K-$10K per portfolio company.
So let’s re-write the family office story:
- A family office decides it wants to get into angel investing.
- It researches the accelerators in its area and invests in 1 or 2 of them.
- It spends the first few accelerator cycles learning the ropes and making connections.
- As it gains confidence, the family office invests directly in a few of the accelerated startups, effectively doubling-down on a few, high conviction plays.
- The diversified portfolio does well
- The family office makes disciplined, intelligent, efficient angel investing a formal part of its allocation strategy
Now how’s that for a happy ending?
(1) Just in case you were wondering, “For fools rush in where angels fear to tread” was first written by Alexander Pope in his poem An Essay on Criticism.
(2) Right Side Capital analysis of eight large studies of historical angel investing returns in the US & UK (http://rightsidecapital.com/assets/documents/HistoricalAngelReturn.pdf)
(3) Sometimes called incubators, although incubators are more often shared co-working spaces with some additional services that are of value to startups. Unlike accelerators who rigorously screen their applicants, incubators are generally open to all, space permitting, as long as they can pay the rent.
(4) Many accelerators will allow family offices to invest as “individuals” rather than “institutions” enabling them to qualify for minimum investments of $500K or even as low as $250K, which comes out to as little as $1,250 per startup(!)