While novice investors may agree to buy common stocks, experienced investors almost always request preferred stocks. There are exceptions, of course, as discussed in this short, three-part series.

Angels Used to Purchase Common Stocks

Before 2000, angel investing was relatively new, and established best practices were lacking. Hence, angels mostly purchased common stock. [1]

Image by: GDS Infographics

However, as angels learned from their mistakes and gained a sharper understanding of the industry after the dot-com bubble, they began to adopt best practices from the venture capital (VC) community and started doing preferred stock deals.

Since then, the angel world has split in the past decade, with experienced investors doing almost exclusively preferred stock deals, and “naive, friends and family angels” investing in common stocks and straight convertible notes. “Virtually no outside investors do common stock deals [nowadays],” says one angel.

Sidenote: Some seasoned angels are willing to do convertible debt deals as long as the notes come with a price cap. Convertible notes is a big topic on its own, and you can learn more about using convertible notes as a pre-Series A deal structure in a special report called “Startup Investing: What You Need to Know About Convertible Notes.” This brief focuses on common and preferred stocks.

Why Angels Want Preferred Stocks

Common shares are cleanly and simply structured. Founders, employees and friends and family investors typically hold this type of equity.

So unless they’re dying to get into a deal, sophisticated angels rarely purchase common stocks, as this type of equity offers investors little protection.

Unlike friends and family investors, professional angels don’t invest due to their warm, fuzzy feelings toward entrepreneurs; also, they invest hard cash as opposed to the founders’ and employees’ sweat equity. Thus, experienced investors want to protect themselves with rights that rank ahead of common shareholders.

This is where preferred shares come in. This type of equity includes a list of unique rights that protect investors’ downsides. Holders of preferred shares are entitled to preferential treatments over holders of common shares.

Among the special rights, the most important one, which differentiates between common and preferred shares, is called “liquidation preference,” a feature that entitles preferred shareholders to get paid in full first in a liquidity event (e.g., a sale, IPO, or shutdown); common shareholders receive the remaining proceeds. The payment to preferred shareholders is typically a multiple, for example, 1x or 2x, of what they originally paid for their stocks.

Outline

• Angel Deals: Quick Discussion on Common and Preferred Stocks
• Angel Investing: What Is a Preferred Stock?
• When Do Seasoned Angel Investors Invest in Common Stocks?

Image by: PhillipC

Talk with experienced angel investors, and you’ll realize that unless they have a trusted syndication partner across the border, proximity still matters.

True, tech advancement and the falling cost of communication might have enabled investors to invest farther from home, but the effect might not be as significant as we think.

After all, trust and face-to-face contacts are essential in angel investing.

Entrepreneurial angel Joshua Schachter, for example, doesn’t invest in companies that are out of his networks (Bay Area and New York). “I don’t like doing deals sight unseen,” Schachter avows.

Similarly, Canadian angel investor Boris Wertz, former COO of AbeBooks.com, which was sold to Amazon.com, told The Globe and Mail:

You need to be selective about it. Stick to an industry you really understand, and pick companies close to home – coaching over the phone is a tough one. You want to see them in person as often as possible.

In 2008, a team of academics from the University of Maryland drew a sample of 136 firms and examined proximity measures [PDF] based on the zip code of investors relative to the zip codes of the startups’ headquarters. They found that investors generally lived close to the companies they backed.

Sixty percent of angels lived within three hours of driving time from the firms in which they invested, and 18 percent were within the same zip code. The researchers also pointed out that pure angel-backed companies (i.e., those that haven’t raised money from venture capitalists) were most likely to be in the same zip code as the angels.

Yes, the sample size is small, but it does provide insights into investors’ preference in regards to proximity.

Why Angels Invest Close to Home

Angels invest for different reasons.

Some invest locally because they want to support local entrepreneurs as they’d been there themselves and want to “pay it forward” within their local community.

Others like Dharmesh Shah, an entrepreneurial angel and the founder of HubSpot, enjoys the welcoming advantages of helping out local entrepreneurs: “One of the side benefits of being an angel investor is that it builds credibility and good will within the local community,” Shan avouches.

For yet others, it’s due to the risky nature of angel investing. These investors invest close to home because it’s easier to monitor local investments and help resolve issues quickly at the first sign of trouble. They believe this helps improve company performance and reduce the risk of their investment.

Jamie Rhodes, chairman of Central Texas Angel Network (CTAN) in Austin, Texas, says: “We invest in Texas-based companies because investors like to drop in on their investments.”

Most investors don’t actually monitor their investment like a hawk or visit their portfolio companies every day, but the ability to do so without having to travel a long distance does offer them a sense of security.

Because they feel more secured, investors who invest close to home are more likely to “rely on trust in lieu of more formal control mechanisms,” according to Venture Capital: Investment Strategies, Structures, and Policies. Those who invest aboard tend to use more formal (and costly) control mechanisms to protect their investments.

Not to Say Angels Don’t Invest Abroad

Having said that, investors are willing to commute to find good deals. As mentioned in the beginning, experienced investors are more willing to invest aboard if they have a trusted syndication partner across the border.

They’re also more willing to back companies located in a distant area that they’re very familiar with or frequently travel to.

Even so, convenience still plays a big role.

As Forbes’ Maureen Farrell writes, “most angels and VC can only go so many places so often so proximity to investors or at least proximity to an easily traveled route helps.”

Don’t Do This Just Because It’s Close to Home

Of course, don’t invest in a company operating in an industry you’re unfamiliar with just because it’s close to home. Without knowledge of the industry, you can’t properly evaluate the real risks and potential of investing in that company. And you won’t be able to leverage your expertise if the company needs help.

But if you must invest in a sector that’s new to you, either due to a strong urge or whatever reasons that captivate you, then check out “Angel Investing: Effective Ways to Invest in the Unknown” to learn how to go about it.

Doing that is valuable for 2 reasons.

First, it urges him to figure out whether the price of the item is decent enough that he would be able to sell it for a profit, or at least break even.

Second, it forces him to consider the market and identify a potential buyer.

Buyer Access is Half of the Equation

Without performing this little bit of precautionary measure, he might overpay or he might wind up stuck with an obscure item that nobody else wants to buy once he is finished with it.

Thinking his way past the point of sale also makes him consider the kinds of enhancements he needs to add in order to increase the item’s attractiveness to the next buyer.

For items that are time-sensitive, like depreciating options or cyclical commodities, he would set a deadline for sale.

For those that would likely gain value over time, like baseball cards, first-stage ventures, or retirement account, he would calculate the items’ potential appreciation.

That’s a smart approach, because buying before pondering the other end of the equation is never a good investment strategy.

Life Cycle Relationships

In the world of angel and venture investment, that comes down to finding follow-on investors and potential buyers.

If you want to be a successful angel investor, you ought to hunt for and cultivate potential buyers with the same degree of diligence and attention that you apply to uncovering promising deals or putting together effective management teams.

As a smart angel investor, you would also develop solid relationships with potential buyers, who can crown your portfolio companies with success.

Investing in start-ups is a business of life-cycle management – from sourcing and coaching, to funding through various stages and collaborating with others to make co-investment and exit decisions. All of those phases require resourceful, trustworthy relationships. If you have those relationships, you will succeed while others stumble or fall.

Birds of a feather flock also together, so if you cultivate relationships within both the entrepreneurial community and among potential buyers, you will find yourself surrounded by the kinds of resources that ensure success across every stage in the investment process.

With just a few days away from 2011, the new year is a great time to start seeding and cultivating relationships. Go make some new friends and have a happy and prosperous new year, dear angels!

Image by: L.Bö

* This is not legal advice. Consult with your lawyer.

Should angel investors care about Private Placement Memorandum (PPM)? Antoine Brand, a reader of Venture Hype, wondered.

Since it’s a question asked by many an entrepreneur, we decided to look at both sides of the table and examine the role PPM plays in an investment deal. We’ve used a fictitious company called Yo!Woo and its 2 angel investors, Annice (an accredited investor) and David (a non-accredited investor), to tell the story.

We first talked about Regulation D and defined what exactly a PPM is and whether it’s required in all investment deals. We then compared a PPM to a business plan as a fund-raising tool and looked into how Yo!Woo can get into trouble raising fund with a business plan. Please read previous articles to better understand the scenario below.

• Private Placement Memorandum: What Da Heck Is It?
• PPM vs. Business Plan: A Startup’s Fund-Raising Nightmare

How does David’s action affect Annice’s investment?

Picking up where we left off, Yo!Woo is unable to return David’s investment capital because it’s already spent a large chunk of the money toward achieving the milestone. David’s lawyer is happy to take Yo!Woo to court and take a bite out of its liquidated assets as a payment for legal fees.

For early-stage companies, this kind of hiccups is enough to have a major negative impact on employee morale. Yo!Woo is distracted. Management is stressed out and frustrated, and employees are scared of losing their jobs and ending up with worthless stock options. The entire atmosphere turns gloomy. Everyone’s focusing on the lawsuit rather than iterating products and acquiring customers. Annice’s investment is in jeopardy.

Yo!Woo will have to fight in court or return David’s investment – both require money that Yo!Woo doesn’t have.

What can Yo!Woo do?

It can -

• find a lawyer who’d take equity to represent the company in court;
• raise money to return David’s cash;
• raise money to fight in court; or
• declare bankruptcy and liquidate all available assets.

No matter which option the company chooses, they’re all extremely taxing on young companies like Yo!Woo. It’s all the more difficult to raise money from new investors in murky situations like this.

Most likely, Yo!Woo will go back to its other existing investor, Annice, who can either put more money in to bail the company out of its current situation and hope that it’ll pick things up quickly after the incident, or refuse to invest further and endure higher risk of Yo!Woo going bankrupt, thus losing her original investment.

A well-prepared PPM would have prevented this nightmare.

Had Yo!Woo used a PPM to document all the information that’s been communicated to investors, it would have avoided potential accusations or violations.

Had Annice made sure Yo!Woo was in compliance with the securities law before writing the check, she would have avoided the unpleasant investment experience caused by other investors.

As you can see, improper documentation exposes the company to severe penalties and possible criminal repercussions that not only irk the company but also other investors in the deal.

Preparing a PPM

The best way to go about preparing a PPM that’s in compliance with the securities law is of course to hire a qualified securities lawyer to guide the company through the process.

If cash is tight and Yo!Woo decides to purchase a PPM template and go the DIY route, it should, at the very least, have a qualified securities lawyer review the PPM draft to make sure it’s valid.

The game, appropriately named Angel’s Choice, allows the gamer to become a virtual angel investor for anything in the Apple App store inventory, according to VentureBeat.

As make-believe investor interest in a particular app grows, so does its value, so Angel’s Choice could be used as a tool to find new applications and then isolate those that have the most upside growth potential and overall industry buzz.

A Kind of Angel Search Engine

The reason that a toy might be taken seriously by an investor is that the volume of interesting apps making their debut each day is staggering, but nobody has time to analyze the market appeal of all of them.

The App Store carries more than a quarter of a million apps, for example, a number that is prohibitively large. But in the hands of a discriminating gamer, some people believe that Angel’s Choice can quickly delve into that Pandora’s Box and use realistic market forces to dynamically transform it into a treasure chest of pre-screened investment candidates.

A Virtual Marketplace

Whether or not Angel’s Choice succeeds beyond its premise as a pastime and rises to the level of a clever investment tool will depend on how well it can do a great job of recreating the marketplace (ostensibly for the purpose of recreation).

If it does offer users a reasonably accurate facsimile or shadow of the actual market for apps, then that could make it one of the most efficient resources for testing app popularity across a broad demographic of both consumers and would-be investors.

Of course there are problems with trying to use a game that is available as a free download to draw conclusions that can be transferred to the high-stakes arena of angel investment.

Players have nothing invested in the game or its outcome except some Monopoly money in the form of “Angel Dollars.” If they decide to artificially promote one app they can easily do so by enlisting friends to vote for the app and fuel its rise up the ladder of popularity and valuation.

In the real world that requires first stage investment. So unless Angel’s Choice players can figure out a way to discount that kind of misleading activity they might wind up buying a pig in a poke.

More than a Game

But there are some built-in protections. A user’s reputation is at stake each time they recommend an app, and the more successful a player is the more influence they gain. The Angel’s Choice system also holds app reviewers accountable.

If nothing else the game definitely promises to make it easier to filter through hundreds of thousands of apps – and that alone could make it valuable enough for investors to sign up and play along while they enjoy the fringe benefits.

Rob Delman (aka "Golden Dude")

Another brilliant guest post by Rob Delman, a professional angel investor and the managing director at Golden Seeds in New York. He’s proud to be nicknamed the “Golden Dude” by his female forum mates.

I have noticed a disturbing trend lately when listening to entrepreneur pitches at various angel investor forums. The investor has a “burning question” that cannot wait until the Q&A portion of the presentation (at least it shows they are listening) and interrupts the entrepreneur.

C’mon people, let the entrepreneurs finish their pitch. There will be plenty of time to ask questions afterwards. Write it down so you don’t forget! We have told them that they only have x minutes to present and they have most likely spent considerable time honing and refining their pitch to meet these guidelines. With interruptions, they will most likely never finish their presentation and then we will penalize them for not being focused and getting to all their slides. On the flip side, I guess this is also a good reason for them not to have a lot of slides. If you are interrupting to “test” the entrepreneur’s ability to perform in a stressful situation, the initial presentation is not the time.

It is our responsibility to be respectful of their pitch and effort. What else can we do (and not do) during and after the pitch?

• Make them feel welcome and comfortable while still maintaining professionalism.
• Praise them when appropriate and give criticism when warranted – honesty is crucial for everyone’s benefit.
• Be accurate in the number of investors in the room so the entrepreneur can bring the correct number of deck printouts.
• If you advertise the forum as an investor event, make sure there are actually investors in the room as opposed to all sponsors and service providers looking for clients.
• Temperature in the room should be comfortable.
• Block out ambient noise from the hallway and adjacent rooms.
• Provide a glass and pitcher of water.
• Make sure tech is set up with remote. Nothing is worse than having a tech glitch at the beginning of the presentation. Discourage the use of “live” content from the internet.
• Put e-devices away – only exception should be computers if you are genuinely using them to view their website or do quick research during the pitch. However, even this will divert your attention from the presentation.
• Have a timekeeper and give them 5 minute, then 2 minute warning. As timekeeper it is your job to start and end on time.

The entrepreneur is already feeling a lot of stress. Let’s not make it worse!

Interested in submitting an article to Venture Hype? Just follow these guidelines to get your article featured.

• Angel Investing as Asset Allocation Strategy (1): Risks, Returns, Homeruns explains why you may want to allocate a portion of your investable assets to angel investing; discusses risks and returns of angel investing; and covers the concept of home runs.
• Asset Allocation Strategies (2): Easiest Way to Determine How Much to Allocate to Angel Investing talks about how long it typically takes to exit an investment and shows you the easiest way to determine how much to allocate to angel investments.
• Asset Allocation Strategies (3): Angel Portfolio Strategy of Brad Feld, Will Herman, Sim Simeonov, Et Al. goes over some of the reasons why you should reserve funds for follow-on investments and takes a quick look at the portfolio strategy of some well-known angel investors. The article also highlights the minimum number of angel investments you should make to reduce risks and increase potential payoffs.
• Asset Allocation Strategies (4): Create a Solid Angel Investment Plan to Capitalize on Portfolio Effects shows you a way to determine how much to invest in each deal; talks about typical deal size we’ve been seeing; and discusses how sticking to your angel investment plan can help you leverage the market climate.

Here, you’ll learn about allocating assets based on the company’s stage of development and your investment style; calculating the net worth requirement based on your investment criteria; and allocating your investment returns for future investments.

Angel Investing: Diversify via Multi-Stage Investments

Seed-stage is the cheapest (requires the smallest check size) to get into and generates the highest payoffs but it’s also the riskiest. David Hehman, former chair of North Bay Angels, points out that you may “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.)”

Even so, you may want to avoid investing in industries you don’t understand just for the sake of diversification.

Will Herman, TechStars mentor and Boston angel investor, stresses:

Invest in stuff you understand – bright shining objects attract attention (“we have the basis for a cure for cancer”), but the more you know, the less shiny things often look. If you can’t judge the team, market and product relatively thoroughly, it’s probably not a wise investment.

Having said that, we understand that investors sometimes just have to get their hands on an unknown sector that they’ve developed an interest in. If this is the case, check out Angel Investing: Effective Ways to Invest in the Unknown to learn how to go about this.

Investment Styles: Active/Passive

If you want to take an active role in the company and plan to allocate a large portion to a particular startup, make sure your intention is clearly communicated with the entrepreneurs. Some founders might welcome your involvement while others might prefer to be left alone. Don’t assume anything. Make sure your interests are aligned with those of the entrepreneurs before cutting that fat check.

On the other hand, if you’re a passive angel investor who’s new to the angel investing game, you may want to start with a smaller amount and co-invest with experienced lead investors, who’ll handle everything from herding investment cats to closing the deal.

Angel Investing Net Worth Requirements and Implications

As an alternative to creating an allocation pie discussed in Easiest Way to Determine How Much to Allocate to Angel Investing, some angel investors are interested in working the numbers backwards to bring forth the net worth requirement.

Let’s say John Doe wants to

• invest $25,000 per company;
• double down on each investment (reserve 100% follow-on funds; total = $50,000 per company);
• diversify risks by investing in 20 companies; and
• allocate 10% of his net worth to angel investments.

To satisfy his criteria, he’d have to possess a net worth of:

• $50,000 per company x 20 investments = $1,000,000
• If $1,000,000 is 10% of his net worth then he must hold a net worth of $10,000,000

Just run the numbers until you’ve arrived at the figures you’re comfortable with.

Note: Seasoned angel investors suggest allocating no more than 10% of your net worth to angel investing.

Successful Exits/Returns Allocation

Congratulations, you’ve got exits!

Consider Hehman’s suggestion on allocating your returns:

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.

Now, have fun and allocate away!

• Angel Investing as Asset Allocation Strategy (1): Risks, Returns, Homeruns explains why you may want to allocate a portion of your investable assets to angel investing; discusses risks and returns of angel investing; and covers the concept of home runs.
• Asset Allocation Strategies (2): Easiest Way to Determine How Much to Allocate to Angel Investing talks about how long it typically takes to exit an investment and shows you the easiest way to determine how much to allocate to angel investments.
• Asset Allocation Strategies (3): Angel Portfolio Strategy of Brad Feld, Will Herman, Sim Simeonov, Et Al. goes over some of the reasons why you should reserve funds for follow-on investments and takes a quick look at the portfolio strategy of some noted angel investors. The article also highlights the minimum number of angel investments you should make to reduce risks and increase potential payoffs.

Here, we’ll show you a way to determine how much to invest in each deal; talk about typical deal size we’ve been seeing; and discuss how sticking to your angel investment plan can help you leverage the market climate.

Angel Investment: How Much to Invest in Each Deal

After reading and completing the steps outlined in the articles above, you may then determine how much to allocate to each deal and decide on an investment timeframe.

Example:

• You’ve allocated $1 million to angel investing.
• You want to invest in 25 companies.
• You decide to allocate ($1,000,000/25 companies) = $40,000 per company (follow-on reserves included), assuming you plan to invest an equal dollar amount in each company.
• You want to invest in 5 companies per year.
• It’ll take you (25 companies/5 companies per year) = 5 years to make all the angel investments.

David Hehman, former chair of North Bay Angels, notes that each company “may take 3 to 7+ years to succeed/fail.” Those that succeed will provide additional funds for future angel investments.

Typical Angel Investment Deal Size

In the example above, we calculate that you may invest $20,000 (plus $20,000 follow-on reserves, which comes to a total of $40,000) in each company. But how much to allocate to each deal/company is really up to you.

Let’s look at the deal sizes we’ve been seeing as a point of reference:

• In 2008, Angel Capital Association found that an independent angel invested between US$10,000 and US$200,000 in a single company.
• In his book, Fool’s Gold?: The Truth Behind Angel Investing in America, Scott Shane finds that the typical (median) angel investment is US$10,000, whereas the average investment is US$77,000.
• Though we don’t have research to back this up, it does appear that noted angel investors are investing at a minimum of US$25,000 (plus follow-on reserves) per company.

You might write the same check size for all companies, or you might allocate more money to your favorites. No matter how you go about it, remember to also allocate a portion for follow-on investments.

Stick to Your Angel Investment Plan and Timeframe

Hehman then points out how sticking to your plan can help you leverage the market climate:

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 Hehman is saying is that if you’ve decided to invest in 5 companies every year, don’t invest more than planned when there’s the investment climate it too “hot,” and stick to your angel investment plan even during bad times. Fact is, many greats companies like Apple, Hewlett-Packard, and Microsoft were started during the recession.

Sim Simeonov, an angel investor and a former VC, also stressed that financially-focused angel investors must invest “thoughtfully and consistently over a period of years to take advantage of portfolio effects.” Angel investing “isn’t something to casually engage with.”

Simeonov concluded:

Angels should start by asking themselves the following question: “How much can I consistently invest in startup companies for at least five years, regardless of what the public markets do?” Then, they should take this amount and look for ways to invest in 5 or more companies per year.

Coming Up

Next, we’ll look at multi-stage investments, investment styles, net worth implications, and successful exits/returns allocation.

• Angel Investing as Asset Allocation Strategy (1): Risks, Returns, Homeruns explains why you may want to allocate a portion of your investable assets to angel investing, discusses risks and returns of angel investing, and covers the concept of home runs.
• Asset Allocation Strategies (2): Easiest Way to Determine How Much to Allocate to Angel Investing talks about how long it typically takes to exit an investment and shows you the easiest way to determine how much to allocate to angel investments.

Here, we’ll go over some of the reasons why you should reserve funds for follow-on investments; check out the angel portfolio strategy of several noted investors; and determine the number of angel investments you should make to reduce risks and increase potential payoffs.

Reserve Money for Follow-On Investments

Out of the funds you’ve allocated to angel investing, you’d also want to reserve a portion for follow-on investments. This will help keep your portfolio companies afloat, mitigate risks, and protect your position from getting significantly diluted, especially in a down round.

Brad Feld of Foundry Group states: “I always assumed I’d double down on each investment before the company either raised a VC round or was acquired (so – when I put $25k in, I was really allocating $50k to the company.)”

Will Herman, TechStars mentor and Boston angel investor, reasons:

Keep some powder dry for subsequent rounds – while the best return in a successful investment comes from investing earlier, holding some cash back to see how the company does and to play alongside any institutional money that comes into the company mitigates some risk and ensures you’re playing on the same terms as the rest of the investors.

John Huston of Ohio Tech Angels Fund said: “The angels’ best protection against a ‘down round’ is to have adequate dry powder to preclude the need to seek new outside investors.”

Don’t throw good money after bad, though. Like Mark Suster of GRP Partners suggests, “[if] the management team fails to deliver against even a modest set of expectations, doesn’t ship product, has internal conflict, demonstrates a lack of maturity” or if there are any other indications that the venture isn’t performing or isn’t hitting milestones, then you’d obviously steer clear from doubling down.

So, use your best judgment to decide whether the company worth your additional investment. While some startups might die despite the extra time and money, others might just work their magic and become world-class enterprises!

Angel Portfolio Strategy to Increase Expected Returns

In Angel Investing as Asset Allocation Strategy (1): Risks, Returns, Homeruns, we found that almost 5 out of every 10 companies fail. If you invest in only 5 or fewer companies, there’s a high chance that most, if not all, of them will fail. You’ll need to invest in more companies to improve the chance of success.

Sim Simeonov (angel investor, entrepreneurial computer scientist, and former venture capitalist) and Jeff Miller (angel investor and hedge funds advisor in the quantitative/automated trading space) each created computer simulations to calculate the hypothetical returns of angel investing.

Simeonov found that median returns increased substantially with portfolio size – the more companies you invest in, the better you do:

• The median expected return increases by more than
  * 50% when a portfolio grows from 5 to 10 companies;
  * 100% when a portfolio grows from 5 to 20 companies.
• The probability of making an over 2x returns on invested capital goes up by more than 50% when a portfolio grows from 5 to 20 companies.

Miller’s takeaway from his experiment: “Angel investors can expect favorable payoffs with only 10 deals, but it takes at least 20 investments to truly be safe.”

Simeonov offered a note of caution, though (emphasis added):

My advice to angel investors is to look beyond the portfolio effect. It is necessary but most likely not sufficient. It is not a panacea, especially in a world where there are more and more sources of seed-stage capital. Good deal flow and the ability to win deals will matter more and more in the coming years. Developing real differentiation above and beyond being able to write a quick check is the key.

Angel Portfolio Strategy Tip: If you’re unable to allocate money to invest in 10 companies, you may want to consider investing in an angel or private equity fund for better diversification.

Ready to create a solid, proven angel investment plan? Good. Let’s go!

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In Angel Investing as Asset Allocation Strategy: Risks, Returns, Homeruns, we reviewed why angel investing isn’t for the faint of hearts. The risks involved can be quite overwhelming.

For the ambitious bunch, though, it’s difficult to resist the attractive payoffs offered by angel investing. If we want to tap into the lucrative potentials and make sure our bottoms are covered, we need to understand the importance of personal asset allocation decisions and strategies.

This installment deals with the typical time required to exit an investment and the easiest way to determine how much to allocate to angel investments.

Liquidity Timeline

Angel investments are illiquid assets; you can’t just sell your positions like those in the public stock market. Angel investors primarily make money through liquidity events (e.g. M&A or IPO), which can take years to occur.

Lisa Lambert, Vice President at Intel Capital, said:

It just takes a long time to go from startup idea to a liquidity event. [...] During the boom days, it was like 2.6 years to get liquidity. And today, the latest average from NVCA, the National Venture Capital Association is 8.7 years.

Some suggest you should angel invest the money you don’t need for another three to seven years or longer. But the safest bet is to invest the money you can afford to lose forever. That is, only play with the money you can lose without affecting your lifestyle.

Even if you have a sharp eye for picking promising entrepreneurs, there’s no guarantee as to when a liquidity event will occur, or if it’ll even occur. There are too many factors that’d affect the evolution and progression of a startup.

Joshua Schachter, an entrepreneur-turned angel investor, states, “I’ve been investing since 2006, in 38 deals so far, and I’ve seen exactly one exit so far.”

Thealzel Lee of VANTEC notes, “One angel investor lamented that some of his investments are in their second decade and he has no way of liquidating his initial investments.”

Having said that, there are great exits that have put a huge smile on angel investors’ face too. Otherwise, no one in their right mind would angel invest!

Mint, a consumer SaaS startup, had raised a total of US$32 million over 3 venture rounds before getting acquired by Intuit for a handsome US$170 million. At a mere age of 3 at the time of acquisition, Mint went on to become “The 2009 Poster Child of Early Exits” for angel investors.

Problem is, even the most sophisticated investor can’t say for sure how long it’ll take to get to an exit. Thus, having an asset allocation plan helps you stay on course and understand how much you’re putting at risks.

Asset Allocation Pie

David Hehman, former chair of North Bay Angels, says that the easiest way to determine how much you want to allocate to angel investments is to create a percentage of your total asset allocation:

If you have X dollars [in investable capital], 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 afford to lose. Angel investment money is often called mad money, as it is always high risk.

Let’s say John Doe Jr., Jane Doe, and John Doe Sr. each has $2,000,000 to invest.

John Doe Jr., who’s risk-adoring, allocates his capital this way:

Asset Class: % Allocation ($ Amount)

Public Equities: 20% ($400,000)
Bonds: 0% ($0)
Alternative Investments (Angel Investing): 80% ($1,600,000)

Jane Doe, who’s less risk-tolerant but not exactly conservative, allocates her capital this way:

Public Equities: 40% ($800,000)
Bonds: 20% ($400,000)
Alternative Investments (Angel Investing): 40% ($800,000)

John Doe Sr., who’s the most conservative among the three, allocates his capital this way:

Public Equities: 0% ($0)
Bonds: 100% ($2,000,000)
Alternative Investments (Angel Investing): 0% ($0)

Your asset allocation pie will likely look different. How much you allocate to each asset class would depend on your risk tolerance.

But as you can see, asset allocation isn’t rocket science. You may come up with a percentage yourself to keep things simple, or discuss with your financial advisor if you have a more complex portfolio.

Having an asset allocation plan helps you understand how much money you’re allocating to high, modest, and low risk investments.

Now, let’s hop over to Angel Portfolio Strategy of Brad Feld, Will Herman, Sim Simeonov, Et Al. This article goes over some of the reasons why you should reserve funds for follow-on investments; takes a quick look at the portfolio strategy of these noted angel investors; and discusses the minimum number of angel investments you should make to reduce risks and increase potential payoffs.