This is the third article in a series on what it takes to be a great angel investor (and why this should matter to entrepreneurs). Part 1 – Access to Great Deal Flow – is here. Part 2 discussed the need for domain knowledge since merely “joining the right club deal” will in no way determine success.
Not everybody agreed. Paul Kedrosky made the case for “naive optimism” being an important part of startup success. Chris Dixon made the point that he thinks investors should look for the founders to have the domain knowledge rather than them having domain knowledge themselves. Me? I’d rather be Roger Ehrenberg with a thesis around data-centric companies and base my investment decisions on my background. And if I were an entrepreneur I’d rather find investors who understood “my space” so that in tough times they felt comfortable about “doubling down.”
I should say that I agree that naive optimism in entrepreneurs can produce higher beta (upside or flops) and that’s good from an investment standpoint if you’re looking for big returns. I have often argued that case and paralleled it to America itself – we often don’t know what “can’t be done” so we just plow on and do it. But I prefer a certain naive optimism in founders but I can’t see that this extends to angel investors. I think being knowledgeable about your sector can be important. One of the biggest problems is when “you don’t know what you don’t know.”
For that reason I don’t even look at deals in the biotech or clean tech fields. I could see a Phd from Stanford and still not know whether there was a foundation of whether what they were proposing would be possible or laughable.
To some extent Keith Rabois agreed with me about domain knowledge and argued that most of his investments are in the consumer Internet space as a result. That’s what he knows best. And he argues that you need to have some “comparative advantage” as an investor. Obviously I agree.
But knowing the right people and knowing a market only works well for angel investors in bullish tech markets in which IPO’s happen quickly (97-99) or where larger companies are actively scooping up little tiny companies at sub $50 million valuations to drive innovation (05-08, 10-?). If we head for a period of no to slow growth (Japanese “lost decade”) or even worse, a double-dip recession, I fear these days will end quickly.
Either scenario requires angel deals to be funded further. This is where VC comes in and why it’s needed in the industry no matter how much populist sentiment exists agains the industry. I know that in late 2010 it’s not as popular to say this because we’re in the era of “super angels” and feel good startups. But I promise you I’ve been here before and know that this is temporary. So what else matters when one considers history?
3. Relationships with VCs who “protect your investments” – In poker you can win a few hands and feel like you have the magic touch. But really we’re all dealt some good cards from time-to-time. You can’t mistake that for being the one who wins the poker tournament or even comes home with more money than you brought to the game.
The lucky cards some angels are dealt with mostly have to do with the timing of their investments. Let’s call these cards 1996-99 and 2005-08. In the first instance many angels made beaucoup bucks by getting in on deals that IPO’d quickly. In the latter case many companies (Flickr, Delicious, Blogger, Writely, etc.) got picked up early without raising a lot of VC. We’re back in the “feel good angel” phase.
In both of these scenarios angels made great returns precisely because they didn’t need to dip their hands into their pockets a second or third time, their companies didn’t go bankrupt and they didn’t get buried in the cap tables by large VCs who put in “pay to play” provisions in tough times.
So where are we now? It’s hard to say. If 2011 & 2012 look like 2010 then the current crop of angel investors will look great. There has been a preponderance of early-stage deals that have seen quick exits. My thesis on why this is happening is that large tech companies didn’t invest enough in R&D between 2008-2010 (Google even went through layoffs!!!) and now they’re all buying their way into innovation and talent. This is cheaper for them than waiting for big competitors and buying companies at big prices.
But if 2011 & 2012 look more like 2008-2009 than 2010 or 2005-2007 then one of the most important skills of angel investors will be whether they can get their companies financed (or ramen profitable, but this is harder to sustain over a long period of time). That is why I find it curious when angels start shouting that VC’s are dinosaurs, evil, money-grubbing and non-value-add. This is easy to say in times where VC’s aren’t needed but will be regretted in times where longer runways are needed.
Yes, the VC industry was over funded and too many non value-add people entered the industry. But VC is also a very important part of the technology ecosystem – like it or not. And the best early-stage investors know this.
First Round Capital & True Ventures seem to spend as much time cultivated relationships with “second round capital” as they do entrepreneurs. Keith Rabois (mentioned in my previous posts on angel investors) is on record on GigaOm as saying how important VC backed deals are to him. Why? Because he doesn’t look to invest in quick flips. He believes that returns are derived by industry-changing companies and as an investor in LinkedIn, Yelp & YouTube (to name a few) I guess he’s got the credibility to say that.
And in my interview with Howard Morgan on This Week in VC he said (paraphrasing), “First Round Capital views our original investment as ‘babysitting’ but we spend a lot of time working with later-stage investors who can ultimately ‘take ownership of the day-to-day oversight’ of the companies once they are looking to scale. That’s our model.” New entrants to the angel space should take notice.
Do you have solid VC relationships? The kind where the VCs are likely to want to invest precisely BECAUSE you provide social proof that this is a worthy investment? In the long-run it is a critical skill to being a successful angel investor.
It’s one thing to exit early in good times and early M&A markets. It’s another to make money in times where exits are more elongated. There a strategic differentiator is the ability to find VC followers. If you’re an angel – I suggest that a portion of your time go into cultivating these relationships. And resist the temptation to extend thy middle finger. As tempting and as deserving as it might be 
(Cross-posted @ Both Sides of the Table)
