Building an Angel Investment Portfolio

By David Hehman     1 comments     Add your comments

As an entrepreneur, it’s good to know how the minds of the angel investors work, and why they give you pressure on valuation. Here’s a talk given by Spartina Chairman David Hehman about the art of angel investing. It may help you understand their world a bit better.

The following talk was given at the 2009 Angel Expo in Palm Desert sponsored by Keiretsu Forum. The slides for the presentation can be found on Slide Share.

Why Build a Portfolio

Angel investing is a very personal endeavor. Everyone has individual likes and needs, much like making a second home purchase — some want a second home near water, others want the desert. Similarly, there are different motivations and different needs for each angel investor. Regardless of your motivation, building a portfolio is important if you want to achieve returns.

Angel investing is considered a high-risk alternative investment. As a result, the lack of diversification can cause a complete loss of your capital. A common mistake made by new angel investors is investing in only a few deals; for example, three or so. However, it has been statistically shown that the lowest number of deals for achieving success is 12. This is a “hits driven” investment business, and the chances are that you really don’t know which ones will hit.

While diversification is essential, how much to diversify, and how much to invest, is a very personal decision.

Sizing your Portfolio

One way to size your portfolio is to start with your overall asset allocation and determine how much you want to allocate to this class of investments. The easiest way to calculate the size of your portfolio is to create a percentage of your total asset allocation. If you have X dollars, you indicate that Y percentage will be for angel investing. Then, Stick to that!

To come up with the percentage, you might want to meet with your financial advisor, and discuss with him (and your spouse) how much you can you afford to lose. Angel investment money is often called mad money, as it is always high risk.

Be sure to include your spouse. Personal note: I always try to have my wife meet the entrepreneur. It is another chance for someone to see the individual whom I am investing in. (Remember angel investing is as much investing in the person with the idea as the idea, since ideas can change). If my spouse feels okay about the person, she will have a sense that it was worth the try anyway if the deal later fails. It can also be viewed as a scholarship to an entrepreneur pursuing their passion.

Time Period for Investments

With angel investing, you need to be indifferent to timing. Unlike stock, this is not a liquid investment, and you are likely to have to hold on to the investment for 3 to 7+ years. There will not be any cash flow during that time, and in fact, it is more likely you will need to add money to keep the new company afloat.

One way to mange your assets is to allocate the money by time and size of deal. For example, if you allocate $1 million for angel investing, and you want to diversify by having 20 investments, then each investment is about $50,000 (including any follow-on money needed.) If you assume you could find 4 deals a year, it would take you 5 years to make all the investments, and each one may take 3 to 7+ years to succeed/fail.

Another note about time is that when everyone is hibernating in bad time, this is a great time to invest. If you allocate a certain amount for each quarter or year, you can stay investing evenly through lean times. When the markets are bubbling or overheated, it is the time to be disciplined, and stick to your plan, not adding any more to your portfolio than you projected.

What to Expect in Returns

Our slides show some hypothetical returns for an investor. The main thing to notice is that the returns are highly skewed towards the winners. In the end, it is pretty black and white. You either score a home run, or not. The strikeouts typically occur earlier in the investment years. Others struggle on, more or less like the “walking wounded.” And the one that comes in, comes in big. That’s the scenario we hope for.

Analyzing a set of returns from a study about angel investment groups reveals that the average return was 2.6 times the investment after 3.5 years, or a 27% IRR. While 52% of all exits lost money, 7% of the exits returned more than 10 times the investment, bringing in 75% of the total returns.

How to Build a Portfolio

One of the key elements of building a portfolio is to find out about as many deals as possible, from reliable sources. We call this deal flow. Great sources of deals can be found in your own personal network: classmates, professionals you work with, lawyers, accountants, other entrepreneurs, and other angels and angel clubs. Networking is key. The greater the selection pool, the higher the potential for picking a good one.

Once an investment comes to your attention, you want to apply clear criteria in order to screen quickly. And the first rule of thumb is to be able to say “no” quickly. If it’s not a go, don’t waste time. Even with a no, try to add value with a suggestion or make an intro to someone who might help the entrepreneur.

However, if you feel there is potential, look at these areas:

  • The person: are they trustworthy? Do you like them? Are they committed?
  • The market opportunity – does it have a high (10x) exit potential?
  • The product – does it have a competitive advantage?
  • The business – low capital, high margin, recurring revenue?

Most of all, when screening opportunities, be sure that there is a fair valuation. Many portfolios are hurt more by overpaying for an investment than by its failure. You will also want to diversify your angel investments in the same way that you diversify any portfolio: across different industries, different risk levels, and different stages (concept, growth.)

Investment Styles

Another part of creating your portfolio is to know your own style. In addition to how much you want to invest, and the diversification you are looking for, it is also important to determine what kind of investor you are. Once you know your style, be consistent, and disciplined.

Some investors prefer to invest in fields they know well, and get actively involved. If you are active, and want to be on the board, building the business, be sure you can do that. At the same time, you need to diversify your portfolio so you are not on every board. Limit the number of investments that you will actively participate in so you are not spread too thin.

For more passive investors, the style might either be to go broad and invest in a stream of businesses, or, cherry-pick some projects as a learning experience. For the passive investments, pick the ones that will be supported by other investors in the deal, and cherry pick these. You will have little direct leverage so you want to choose these wisely. Some passive investors are more ‘lottery’ players, investing when they get excited by the presentation.

How much you invest in any one company is also a matter of personal style. The minimum amount is usually $25,000. Some people prefer to invest heavily in the first round, spreading themselves over a number of investments, while others will invest heavily in their favorites. In determining the size of the investment, keep in mind that you will often be asked to do a follow-on investment, which will mean holding back some amount initially.

Exit Strategies

Here are the essential steps in improving your exit performance:

1. Insure there is good front-end diligence. This means a good team has been created.

2. Get involved in budgets and forecasts. (We have a model which we will soon share with others, SBIFM, if you are investing in an Internet business. Also see the article about using Waterfall Forecasts

3. Set up metrics for success and measure them

4. Help the company build a strong Board of Directors

5. Mentor the CEO, sharing your skills. His success is your success. You are an investor, not an adversary.

6. Look for opportunities to buy others out as the company matures, if you feel it is a worthy investment.

Once the exit occurs, have a plan for what to do with the money. Most likely one third will go to taxes. Of the remaining, you might want to put a third back into your conservative savings, and add a third to your mad money angel investing pool.

The Bottom Line: Life is Short; Have Fun.

In the end this is a relationship game. You meet great people, and help others. You get to help an entrepreneur realize their dream. Sure, there are low times, but there are also highs. One big winner makes up for all the losses.

Go out and find a home run hitter.

About David Hehman and the North Bay Angels

David Hehman is the 2009 chair of the North Bay Angels The NBA was founded 11 years ago, and is located in Sonoma County, in Northern California. There are currently 66 active members.

David himself is a lifetime entrepreneur, who co-founded and successful sold five businesses. He has been an angel investor since 1997, spanning 25 deals, of which 10 are now active. He holds 6 Board of Director seats. He is also the publisher of Spartina.com, a resource for Internet entrepreneurs.

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1 comments

Early Exits

From: Marc Austin, 04/01/10

Great presentation, David. Alliance of Angels suggested I read "Early Exits" by Basil Peters. http://www.early-exits.com/ It looks like you may have referred to some of his data. A Spartina review of this book would be valuable.