They’re called private equity investors for a reason.
In the world of angel investing, the sophisticated bunch are predominantly equity investors — investors who make money on exits. If they don’t see an exit, they don’t get in.
Legendary angel investor Ron Conway, for example, said he won’t invest if he can’t think of five potential acquirers for a company within 10 seconds.
“Equity investors can’t sustainably invest in startups without exits, because exits are how those investors get paid,” notes Thomas Thurston, president of Growth Science International.
They must be able to sell their equity (i.e. stock) at a higher value through a merger/acquisition or IPO. No exit, no returns. There must be a “liquidation event.” Startup funding is hooked on exits.
According to ACA [PDF], “the most sophisticated angels make at least 10 investments to make a return on their investment, counting on one or two to provide nearly all of their return.”
Case in point: Dave McClure, whose biggest exit to date is Mint.com, the financial website that Intuit Inc. bought for US $170 million in 2009, told WSJ that “he tends to make dozens of small start-up bets and can comfortably make money if just a few of the start-ups are bought by larger acquirers for less than $100 million.”
Brad Feld, managing director of Foundry Group, explains the concept of home runs:
Understand the difference between 0x and 100x: I’ve had two of my angel investments return over 100x each.
Since I had a strategy of investing the same amount in each company, all I needed was one 100x to allow me to have 99 companies completely flame out and return 0 and I’d still break even.
With two investments at over 100x, I now have a built in gain of significantly over 3x across all of my investments since I’m [sic] made about 75 of them and I’m now deliciously “playing with house money” on all of the rest.
As Scott Shane points out in his book, Fool’s Gold?: The Truth Behind Angel Investing in America, sophisticated angel investors know that many startups will fail so they use a portfolio approach to balance their risks. These angels make at least 10 investments and only invest in companies that have the potential to generate at least 10x their invested capital. This way, despite that many companies will fail, the handsome returns generated from the home runs will not only recoup investors’ losses but also fatten up their bank accounts.
Some critics argue that these angels are emulating VCs’ “ill-fated” investment model and question whether their approach would sustain.
“We have a whole different set of exit criteria [than those of VCs],” McClure stated matter-of-factly.
VCs require much bigger home runs to generate satisfactory returns for their limited partners; angels don’t.
Not everyone’s out searching for a home run though.
No doubt, home runs are still by far the most desirable outcome. But a number of angel investors are getting impatient with the expanding exit timeline and have opted for Basil Peters’ Early Exits approach.
In vast majority of the cases, angel investors, even super angels, make bets that are much smaller than traditional VCs. It’s easier and quicker to generate a good return on angel investors’ say, $50,000 to $500,000 investment, than on VCs’ $5 million to $50 million investment. Angel investors have a higher chance to exit earlier if their portfolio companies haven’t raised money from VCs.
Rather than hunting for “home run companies” that have the potential to generate exceptional returns, but likely require raising additional money from VCs to prove their business models, Peters’ strategy is to invest in pre-revenue, capital efficient companies that
Angels and VCs have different set of exit criteria, but without a doubt, all equity investors, be they angels or VCs, or whether they embrace the home run model or early exits approach, all depend on exits.
“To the extent that economic vitality depends on innovation, innovation depends on equity investment, and equity investment depends on exits… there is a problem. Exits are scarce,” Thurston laments.
Despite the improvement of the exit environment, some investors, having barely survived the depressing exit climate in the past years, are experimenting with a new model that doesn’t depend on exits, a model that’d help them get some returns even if the company isn’t a huge success in the traditional way.
Can you guess which investment model we’re talking about? Stay tuned. We’ll reveal our new series next week.
The entire series is now available:
* For series, references are published in the last installment of the series.