This is the fourth 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.
The first three skills I espoused were: access to the highest-quality deal-flow, domain knowledge of the topic area in which you’re investing and access to VCs to help fund the next stages of development.
As I’ve highlighted I believe we’re in a unique period similar to 2005-08 where the biggest tech firms of Silicon Valley (and some media companies) are scooping up small software companies as “talent acquisitions” versus accretive revenue / profit generators. Markets like these are very kind to angel investors because you get taken out early and see a nice pop on your investment.
But consider periods of time where the average time a company exists before acquisition or IPO is 7-10 years. This is actually the norm. I know some people think the whole market has been disrupted and startups and funding work differently these days. But then again I remember in the late 90′s when people were talking about the “new economy” and the “old economy” and how the old rules didn’t apply. How’d that work out? Easier to start companies, yes. Total disruption on the funding market? I doubt it.
I can tell you many angels I know – and really sharp ones with more than enough capital to put to work – are telling me, “I’m currently going to sit on the sidelines for a while. I have too many portfolio companies without exits and I want to see some returns before I put too much more money into this category.”
And these are people with deep pockets.
4. Deep pockets – In the previous posts I’ve compared tech startup investing with poker taking analogies of The Big Short & Delivering Happiness. I’ll continue with that analogy.
To win in poker you need to see enough hands until you’re dealt cards where the odds are stacked in your favor. If your two pre-flop cards are strong enough and if the opening bets are small enough you want to see your hand after the flop (3 more cards) before deciding whether to up the betting and put more money at risk. Ultimately if you stay in the hand you get to see the sixth care (the turn) and the seventh (the river). Each card reveals more information to calculate your odds of success.
When the cards align and your odds of winning increase you “lean” on your investment and take a more bullish stance. This is hard to do when you don’t have enough chips on the table. Imagine being at a poker game, seeing the hand of a lifetime – a straight flush – (call it Zynga or Facebook) and not having enough chips to protect this investment.
But often times your early hand isn’t strong enough and you fold before the pot becomes too expensive. That’s OK, too. You want to conserve cash to bet stronger on hands down the line where the odds are more in your favor. This is the same with angel investing. Protecting every investment – including bad hands – is a losing strategy in poker & in angel investing.
From an investment perspective you need to absorb three scenarios in angel investing that require deep pockets.
a. the diversity problem. You can back great teams and concepts but sometimes they simply don’t win. So just like in poker you can have two kings in the pocket pre flop and still come up empty. This is why you need to be able to do a large enough number of investments to create enough deal diversity. Angel investing has a high risk / reward profile so if you only make 5 angel investments your chances of success are greatly diminished.
b. leaning on your best deals – The second scenario is the one we’ve already discussed – the ability to “lean” on deals that are doing well. In the worst case you want to protect your prorata investment as much as possible (e.g. avoid being diluted). But the best investors are those that spot their best hands after the flop and find a way to increase their ownership before the turn or river.
“One of the biggest issues I have as a small venture fund is how to reserve for follow-on investments. While some have strategies of making extremely large numbers of small investments and following on in none or very few, IA Ventures’ strategy is a much more traditional “lean hard into winners” approach (albeit with extreme domain focus)
“When our capital and participation has helped de-risk a business to the point where it is appropriate to follow on and finance growth, we want to step up to do our pro rata and beyond.”
c. avoid being crushed – We all know what happens as company lifetimes elongate, which is the norm. Companies ultimately go through multiple rounds. If they raise in good times angels do fine. If the companies hit a rough patch – and let’s be clear that most companies DO hit a rough patch, even successful ones – then angels are vulnerable without deep pockets.
VCs will often put in punishing terms to those investors unwilling to dip their hands into their pockets. I’m not defending this behavior – sometimes it is appropriate, sometimes it is not. But it is. So know that going in.
And if you’re not busy being crushed (diluted) you might not notice that the people above you in the cap table (e.g. more senior to you) might be piling up liquidation preferences and tilting returns in their favor. Only deep pockets can protect this from happening. It’s why I’ve taken to calling angel investing “a mug’s game” unless you have deep enough pockets.
In summary …
A few great hands is all it takes to win big. But if you’re going to play make sure your table stakes are large enough to be sure you’re not taken advantage of with people who brought more chips to the party. If you’re the sucker at the table – others will smell it.
Final point worth noting …
While reading one of David Lerner’s comments on my last blog post it made me realize that sometimes it’s OK to play poker just for the sake of playing & enjoying and knowing that you might lose some money. And sometimes along the way to becoming a professional poker player you need to be able / willing to lose some money to learn the ropes. Pay to play. Either of these are obviously fine in angel deals. Just be clear on why you’re playing.
And I responded to David about my own angel investing this way:
“When people ask about my personal angel investing I often tell people have have non-traditional motives. Of course I’d like to make good returns. But I often also want to learn about a market, get to know other investors, help promising entrepreneurs get their first break as I once did, etc. I tell my wife to assume that money is lost.”
(Cross-posted @ Both Sides of the Table)