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In Angel Investing as Asset Allocation Strategy (1): Brad Feld on Home Runs, 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 asses 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 3 to 7 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 you [sic] 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 3, 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.

Coming Up

Later in the asset allocation series we’ll talk about follow-on reserves, ideal number of investments, investment timeframe, typical deal size, multi-stage investments, net worth implications, and successful exits/returns allocation.

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Got ambitions for high-payoff potentials? Allocate a portion of your investable capital to angel investing, a form of alternative investments that offer high risk, high return opportunities.

William S. Podd, executive director of Landmark Angels, suggests, “Angel investing, with its historical high risk/high reward strategy, can provide an opportunity for significant returns for high net worth investors as part of an asset allocation strategy.”

Amazon, Facebook, Google, Mint, PayPal, and Yahoo are just some of the high-profile companies that have made their angel investors very happy.

High Risks/High Returns

A study by Scott Shane, author of “Fool’s Gold?: The Truth Behind Angel Investing in America,” reveals that accredited angel investors see a negative return in 40% of their angel investments, and 7% of investments account for 75% of all returns.

Roughly speaking, out of 10 angel investments, 3 to 4 will fail, 4 to 5 will be “walking dead” (survive but generate little or no return and not dead enough to be a write-off), 1 or 2 will be home runs that make up for the losses and generate a handsome return to angel investors.

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.

Financial Returns: Angel Investments vs. Other Asset Classes

Few years ago, the Ewing Marion Kauffman Foundation and the Angel Capital Education Foundation conducted the largest study on the financial returns of angel investors in North America and released a report in 2007, showing that angel investors participating in organized angel groups achieved an average 27% internal rate of return (IRR) on their angel investments.

Overall, this set of angel investors affiliated with angel groups experienced exits that generated 2.6 times their invested capital in 3.5 years from investment to exit. This return compares favorably to that of other private equity investments, including those of early-stage venture capital. Seven percent of exits generated returns above 10 times their initial investment.

New Series: Asset Allocation Strategies for Angel Investors

You see, angel investing is a high-risk, high-payoff activity. To help investors tap into the potential lucrative returns without risking more than what they can stomach, we’ve prepared a new series on asset allocation strategies, which studies what veteran angel investors recommend in respect to personal asset allocation and effective portfolio building.

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* Venture Hype will never sell or share your email address. And you can unsubscribe anytime.

According to exit strategist Basil Peters, selecting a great M&A advisor is crucial to the M&A process because advisors who can sell “ice to Eskimos” can increase the sale price 50% to 100%, which means investors and founders will make more money if the company is successfully sold.

Here, Maalouf picks up where we left off in Part 1 and talk about the roles lawyers play in the M&A process; why M&A deals fall apart and how to prevent it; how to select M&A advisors; and the purpose of Special Purpose Acquisition Corporations (SPAC).

* Edited interview

VH: From starting dialogue to closing, how long does it take to complete the M&A transaction?

JM: A typical M&A transaction can take anywhere from 2 to 5 months or longer. But it can vary widely depending on a number of different factors, such as

• the complexity of the deal;
• the amount of due diligence required; and
• how far apart the parties are with regard to price and other deal terms.

VH: Where do M&A lawyers come in? In what ways can attorneys help AppleSoft?

JM: Lawyers come in at the beginning of the M&A process to help AppleSoft move forward efficiently and maximize gains from the sale.

They can

• offer insight into selecting the right investment bank;
• help negotiate and structure the deal in the most profitable manner possible;
• help prevent unforeseen pitfalls, which can ruin an otherwise profitable M&A deal;
• draft all necessary agreements and documentation to protect AppleSoft’s rights and ensure it’ll receive all of the considerations agreed to; and
• advise on minimizing tax liability from the sale.

VH: Why do M&A deals fall apart? How to prevent it?

John J. Maalouf

JM: The due diligence phase is where a lot of M&A deals fall apart. If AppleSoft hasn’t involved an experienced finance lawyer in the drafting of Information Memorandum (IM) and Executive Summary (ES), then the documents may contain innocent misstatements and/or omissions, which can come back and haunt AppleSoft in the due diligence review process.

During due diligence review, if the acquirer discovers information that’s inconsistent with that in the IM and ES, even if the inconsistencies are seemingly minor, the acquirer will likely view these as “red flags” and walk away.

VH: Any advice for AppleSoft as to how to choose M&A advisors?

JM: The United States Lawyer Rankings puts out an annual list of Top 10 Finance lawyers in the US. Any of whom will be able to provide AppleSoft with excellent legal and business advice.

If AppleSoft has a value of less than US$50 million, then it may want to choose one of the smaller firms on the list to make sure it’ll receive the senior level attention it deserves.

Experienced finance lawyers have relationships with all of the major investment banks, as well as most of the smaller ones. They can help AppleSoft decide which investment bank is right for the company.

VH: Anything else you’d like to add?

JM: We’ve seen a significant increase in M&A activity lately, due in large to the use of Special Purpose Acquisition Corporations (SPAC) to fund acquisitions.

A SPAC is a newly formed company organized for the sole purpose of going public and using the proceeds of the offering to acquire an existing business.

In general, a SPAC will raise between US$50 million and US$500 million in equity in order to fund an acquisition. Key features of SPACs:

• Have a limited life span of 24 months (with a 12-month extension). During which, the SPAC must identify 1 or more companies and conclude the acquisition(s).
• All acquisitions are subject to approval by the public shareholders of the SPAC.
• Pending an acquisition, a minimum of 99% of the IPO proceeds must be held in a trust account with a major money center bank.

SPACs have increased in popularity lately, as both the NYSE and NASDAQ have amended their rules to allow this type of offering.

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Sophisticated investors always think about exits before they invest. “Does the company have the potential to go public or become an attractive acquisition target?” If not, they’d take their money elsewhere.

Going public or IPO means the company raises money by offering stocks to the general public – you know, those stocks that anyone can buy at the public stock exchange. This allows private shareholders (e.g. founders and angel investors) to eventually cash out by selling their shares in the public market, explains Bill Payne, a veteran angel investor.

Mergers and acquisitions or M&A, on the other hand, means the company

• is sold to or merged with a larger private company in exchange for cash or for private, illiquid shares of the acquirer company; or
• is sold to or merged with a public company in exchange for cash or for publicly tradable shares of the acquirer.

In angel investing, IPOs are far and few between. A vast majority of angel investors exit their early-seed investments via M&As.

Ron Conway, the most influential angel investor in Silicon Valley, said he won’t invest if he can’t think of 5 potential acquirers for a company within 10 seconds.

Conway is of course legendary. But you get the idea: Think about exits before you invest. That’s how you make money.

M&As? “That’s Hot”

According to exit strategist Basil Peters, an increasing number of young tech startups (2 to 3 years old) are getting snapped up by big companies to increase competitive edge. Most of the M&A deals are done in the US$15 to US$40 million range, and the sweet spot is about US$30 million. Once the selling price exceeds that sweet spot, it’d become more difficult for the corporation’s M&A department to get approval for the acquisition.

With a record-breaking, all-time quarterly high of 111 startup M&A deals completed in the first quarter of 2010, M&A is the new black in the startup investment community. We did hear Paris Hilton say “That’s Hot.”

To learn more about the sell-side M&A process, we once again caught up with John J. Maalouf of Maalouf Ashford & Talbot to talk about small M&A transactions; specifically, M&A deals that are under US$50 million.

John J. Maalouf and Maalouf Ashford & Talbot

John J. Maalouf, known as the “Idea’s Man,” is a globally recognized attorney who’s been ranked by the United States Lawyer Rankings as one of the “Nation’s Top 10 International Trade & Finance Lawyers” 5 years in a row from 2006 to 2010.

Maalouf Ashford & Talbot regularly advises clients in the areas of M&As, IPOs, venture capital, private placements, and private equity investments, among others. They’ve recently opened their sixth office in Riyadh, Saudi Arabia. The firm also has offices in Boston, Hong Kong, London, New York City, and Shanghai.

* Edited interview

VH: What’s the typical sell-side M&A process? Let’s say the name of the selling company is called AppleSoft, whose valuation is under US$50 million.

JM:

1. Select M&A Advisors

AppleSoft needs to select experienced M&A advisors, such as an investment bank and a law firm. If AppleSoft selects a law firm first, the firm can help the company choose the right investment bank.

AppleSoft should look for advisors who specialize or have the expertise in representing companies of similar size. Otherwise, small transactions like this will be passed on to junior associates and won’t receive the senior level attention that it deserves.

2. Collect Documentation and Prepare Marketing Materials

This step involves

• collecting documentation, which will be required during the due diligence phase; and
• preparing marketing materials, which generally include an Information Memorandum as well as an Executive Summary.

3. Shop for Potential Buyers

Next, the investment bank will look for and contact potential buyers. These generally include: (i) direct competitors; (ii) companies that are in the same industry as AppleSoft but operate in a different geographic region; (iii) companies that are in a related industry and where potential synergies exist; and (iv) firms that exist mainly to buy companies, help them to grow, and then exit.

As an example to (i), one of our clients, which we’ve represented since the company was a startup 3 years ago, has just acquired a major competitor and is now worth over US$200 million.

Potential buyers are then vetted based on their interest level and financial ability. Shortlisted potential acquirers then submit a non-binding Letter of Intent, which spells out the proposed deal in broad terms.

AppleSoft compares the various offers and selects a single potential buyer.

4. Start Due Diligence

Enters due diligence, which is a lengthy and sometimes arduous process. It’s during this phase that many deals fall apart. Particular attention must be given to ensure that all documentation is in order and is in conformity with the information provided in the Information Memorandum.

5. Draft Contracts

The drafting phase is where actual contracts are negotiated and written. No 2 deals are exactly the same. It’s essential that the contracts are drafted by an experienced finance lawyer. Otherwise, AppleSoft may end up with significantly less than what they’ve bargained for.

6. Close the Deal

Once the contracts have been properly drafted, all that remains is the actual closing where the documents are signed and the consideration (either cash or stock) is delivered to AppleSoft.

Coming Up

Stay tuned next week as Maalouf talks about the roles lawyers play in the M&A process; how to prevent deals from falling apart; the purpose of Special Purpose Acquisition Corporations (SPAC); and more.

Thanks goes to Wall Street Journal‘s Russell Garland for taking us to the recent 2010 Angel Capital Association Summit in San Francisco and recounting how angels and VCs rivaled for the top spot. We all like a good scrum!

According to Garland, attendees listened intently to speeches about the need for angel and VC harmony, and about angel investors’ slow-but-sure rise to fame.

Garland further reports:

An informal electronic poll of attendees found that 48% sometimes look for investments that subsequently will require venture capital and 55% thought relations between the two groups are okay but have room for improvement.

Co-Invest with Angels Only

As exit strategist Basil Peters put it during a passionate speech at the conference, it’s angels’ time to rise above the VC “dinosaurs” and reign supreme when it comes to offering startups the proverbial booster they need to make it to the big time.

“VCs are essentially dinosaurs saddled with too-big funds at a time when entrepreneurs can create companies cheaply and quickly, sometimes over a weekend.” Peters asserted.

Peters has a point. Many startups need only a limited amount of outside capital which can be best provided by angel investors who know when to exit by “selling to corporations hungry for dynamic young companies whose revenue can scale from [US] $10 million to $100 million or more.”

Those who target small exits will find that their interests are better-aligned with those of angels than with most VCs, such as the case of venture firm Charter Life Sciences, which bets on relatively capital-efficient health care companies that can get to an exit on US$3 million to US$12 million.

Co-Invest with VCs

But angels sometimes need to connect with VCs too, said James Geshwiler, managing director of Boston’s Common Angels — even though it took him 5 to 6 years to learn how to syndicate well with venture firms.

Geshwiler later comments:

I think the best answer [to whether or not to syndicate with VCs] is “it depends.”

As our panel highlighted, the decision depends first and foremost on the best financial strategy for the company to optimize value; and second, on aligning the incentives and capacities among the investors.

Neither angel investors nor VCs are one size fits all. Entrepreneurs and both parts of the capital markets need to understand the various trade offs in much greater detail and have much more open discussions these days given the state of the capital markets and of exits.

What’s that saying about keeping your friends close and your enemies in your pocket?

Just kiddin’.

Quick Notes

• Venture capital investing is up 41% in the 1st quarter this year vs. a year ago
• Number of startup acquisitions is at an all time high
• Quantity and quality of acquisitions are good
• 14 to 15 IPOs in 1st quarter, compared to 18 IPOs in the last 2 years
• Quality of IPOs – some good; some aren’t
• Briefly discussed corporate VCs

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A reader, Taliba M., recently told us she wants to invest in a SaaS startup but lacks expertise in this area. We suggested co-investing with an investor friend who has experience in this field, and learning the fundamentals of SaaS companies to make herself easy to teach.

Read Effective Ways to Invest in the Unknown for our complete response and the purpose of this series. (It isn’t investment advice and it’s by no means a comprehensive guide to SaaS.)

Since we’re a gigantic fan of our fans, we decided to write a series to cover the basics of SaaS ventures and learn alongside Taliba (and those who are interested in SaaS).

Investing in SaaS Ventures (Part 1): The Basics covers what is SaaS, why SaaS companies rock, and why they require significant amount of capital. Here, we’ll look at Enterprise vs. Consumer SaaS and their respective capital requirements.

Enterprise  vs. Consumer SaaS

There are 2 major categories of SaaS ventures: Enterprise and Consumer.

Enterprise SaaS companies offer business solutions, such as expense management and customer relations management (CRM). Examples of Enterprise SaaS companies are: Concur Technologies, NetSuite, and Saleforce.com.

Consumer SaaS companies offer services to the general public, such as online personal finance, photo storage and sharing, and file backups and synchronization. Examples of Consumer SaaS companies include: Mint, Flickr, and Dropbox.

SaaS Capital Requirements

Don Dodge, developer advocate at Google, quotes Michael Skok of North Bridge Venture Partners (NBVP) — a VC firm that actively invests in both enterprise and consumer SaaS companies:

• SaaS companies need an average of [US]$35M in VC capital, versus $20M for a similar perpetual license company
• It takes 6 to 7 years to get to a liquidity event (IPO or acquisition)

Moreover, “it takes 70% to 100% more capital to fund [an Enterprise] SaaS company to a liquidity event than a traditional perpetual license company,” Dodge continues. “It also takes 2 to 3 times longer to get there.”

Consumer SaaS companies, on the other hand, requires less capital and can “get to market faster,” adds Dodge. “The feature requirements, integration and customization requirements are also usually less demanding for consumer applications.”

According to Bessemer Venture Partners, “it took [US]$126m [for] NetSuite to go public, $66m for DemandTec, $61m for Salesforce and $45m for SuccessFactors.” These are all Enterprise SaaS companies.

Bessemer notes that although “the best of the second generation SaaS businesses may be more efficient than [their] predecessors [e.g., NetSuite and Salesforce], in almost all cases, significant capital will be required to build a dominant SaaS business.”

Mint, a Consumer SaaS venture, however, “only” raised US$32 million over 3 venture rounds before getting acquired by Intuit for a happy US$170 million.

If you’re like us, you already know what we’re thinking. We prefer companies that require less capital to get to liquidity. So in the context of SaaS, we think most Enterprise SaaS companies are best left to venture capitalists and powerful syndicates.

Next, we’ll look at different categories of SaaS monetization models.

The reader writes -

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

We’ve covered dilution in an up round in Part 1 and examined dilution in a down round in Part 2. Here, we’ll go over some of measures you can take to lessen the impact and/or likelihood of getting burned by dilution. If this topic is new to you, you may want to read the basics in Part 1 and Part 2 before proceeding.

Note: Not all of the measures below can be taken simultaneously. Sometimes it’s either A or B, but not both. Talk with a lawyer who’s very experienced with startups and angel financing to gain a better understanding of the terms and deal structures.

Aligned Interest. Align your interests and objectives with the founders’. Paul Graham of Y Combinator writes:

Dilution is normal. What saves you from being mistreated in future rounds, usually, is that you’re in the same boat as the founders. They can’t dilute you without diluting themselves just as much. And they won’t dilute themselves unless they end up net ahead.

One way to do this is to offer entrepreneur-friendly terms, such as opting for common shares instead of preferred shares. The tradeoff is that common shares offer you very little protection.

Another way is to agree on an exit strategy early on. Basil Peters — an angel investor, prolific speaker, and author of “Early Exits” — believes that “angels, and entrepreneurs, would have fewer dilution surprises if companies had good alignment on an exit strategy before the first investment went in.”

Angel-Only. Focus on angel-only deals to prevent follow-on financing from VCs (which can be very dilutive), notes Peters. The companies should require only US$0.5 million to US$3 million to prove its business model.

Early Exit. Big corps like Google are increasingly buying pre-revenue ventures as their growth strategy, says Peters. Help the company exit early (e.g. look for an attractive acquirer before it becomes sustainable or profitable) once it’s proven its business model. Exiting early allows you to cash out and helps avoid raising dilutive rounds.

Anti-Dilution Provision. Include anti-dilution provision in the term sheet, which allows you to re-price your stock if subsequent funding rounds are down rounds. In general, this comes in 2 forms, full ratchet and weighted average ratchet. More on anti-dilution protection in a future post.

Even if you’re protected by this provision, later investors can force you to waive or remove it. It’s really a matter of bargaining power. If the company needs the cash to survive, but potential investors refuse to invest if you don’t waive your right, then the company could die.

Board. “Negotiate for permanent board status or at least observer status,” advises Jeffrey Leavitt, partner of DLA Piper. This way, you can “learn of pending company activity that could affect [your] interests.”

But don’t take this as you-should-stick-your-nose-into-every-little-detail. Y Combinator, for example, interferes as little as possible. The seed firm realizes that independence is one of the reasons startups succeed. “Investors who try to control the companies they fund often end up destroying them.”

Though we should mention, the amount Y Combinator invests is relatively small — usually around US$11,000 + US$3,000 per founder. Which means US$17,000 for 2 founders, US$20,000 for 3, and etc.

Capital Efficient. Invest in companies that don’t need a lot of capital to reach breakeven or profitability. These companies have better odds to become self-sustainable; they’re less likely to be desperate for cash or funding from outside investors.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” stated James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Deal Structure. Avoid unnecessary dilution by acquiring preferred shares or convertible debt, which converts to shares at a later date when the venture is properly valued by professional investors, Leavitt further suggests. Download Investing in Tech Startups: What You Need to Know About Convertible Notes to learn more about this structure.

Follow-On. Reserve funds for follow-on investment. 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.”

Milestones. Before you invest, make sure the company has set, and will likely hit, milestones that will increase its valuation before raising the next round. Increasing valuation in the next round means there’ll be no down round. As mentioned in Part 2, down round can be very dilutive and can decrease the value of your holdings significantly.

Significant milestones include “licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc.,” notes Payne.

Valuation. Value the company reasonably from the start. New angels frequently pay too much at the early stage, placing too high a value on the startup. Over valuation is more prone to down round if the company needs to raise more money from outside investors in order to get the business going. Again, down rounds can significantly dilute the value and size of your holdings.

Final Words

Dilution is inevitable in both good times and bad. When it comes down to it, you ought to be confident that the company’s valuation will exceed the impact of dilution before opening your checkbook; otherwise you may want to pass on the opportunity and look for one that has such potential.

In a down economy, valuations drop and some companies see it as an opportunity to snap up smaller competitors or to bargain-hunt for startups that are strategically valuable to the acquiring company. Which means you can cash out via an M&A exit.

What Are the Motives Behind M&As?

Exit strategist Basil Peters sums it up nicely –

The only reason any company buys another company is because they believe

-    they can increase the value of the company being acquired, and/or
-    the acquired company will increase the value of their company.

For example:

• eBay acquired payment platform PayPal to increase efficiency
• Yahoo bought Flickr to acquire its tagging technology and the Flickr team
• Twitter bought Summize to build out its search capabilities
• Consumers Union acquired Consumerist to reach a younger audience
• Facebook bought FriendFeed to enter the real-time space and get its hands on the team of seasoned ex-Googlers behind FriendFeed

In many cases, the common motive is to acquire innovation. Big companies are better off buying smaller companies outright than to waste time and resources on internal R&D. Growing by acquisitions allow them to begin adding value and/or generating revenue pronto — assuming they’ve made the right purchases, of course.

Focus on Smaller Transactions

According to Peters, you should focus on smaller M&A transactions if you want to exit and make several million dollar capital gains within a few years after the startup’s launched. Big companies typically purchase tech companies that are under US$30 million.

Once the selling price exceeds that sweet spot, it becomes more difficult for the corporation’s M&A department to get approval for the acquisition. For early exits, don’t wait till the startup has grown so big that it’s become an unattractive acquisition target.

Instead of waiting to get noticed, you may want to help the startup exit and seek help and advice from M&A professionals. Below, I’ve summarized 2 of Peters’ posts on this topic:

In other words, companies under US$30 million should look for individual practitioners and boutique firms. And for these smaller transactions, be sure to look for an M&A advisor who’s close to home – the farther away the company is from the M&A advisor, the higher the transaction failure rate.

What ensue are high-flying antics and much bloodletting–which in the parlance of multinationals is called “mergers and acquisitions.” If you have never seen the movie, or don’t remember the scene, it’s worth revisiting for its twisted take on hostile buyouts and takeovers–obviously, what else would you expect from Python.

Now you on the other hand, as an angel investor, might find the scene hilarious in a surreal sense. But when it comes to reality, your ideal depiction of the buyout would be a little less violent, much more joyous event. Try a wedding, with flowers and good food, a toast with brut, and you the bride’s father, handing her off to her suitor, who then promptly hands you a sack of cash.

Doesn’t Matter How, Just Get Out

That’s the symbolic happily-ever-after you’re looking for–the bride of course being the startup or entrepreneur who you’ve helped grow to become a successful enterprise, the suitor being a larger competitor in the same industry, the sack of cash your heady returns on investment.

That’s not to say a buyout is the only way for you to realize returns on investment. But it is perhaps one of the more common ways, and perhaps one of the soundest ways to ensure your returns. And a buyout doesn’t necessarily have to happen with a competitor. The possible suitor could also be a private-equity group, venture capital firm, or some other investment vehicle. The other primary way to collect on your investment, or exit strategy, is for the startup to go public, thereby loading up on equity from a market.

No matter how you do it, get out. There is some disagreement over how soon angel investors should plan their exit strategies. But the general rule of thumb for you should be exiting in three to seven years.

Evidence backs this up. A study [1] recently put out looked at nearly 100 U.S. angel investor groups and more than 500 single investors, and it found that, when investors exited their investment in 3.5 years, they scored returns of 2.6 times. And they didn’t even need a pirate ship!

But get this other finding from the study: when angel investors didn’t get out–and instead “double-downed” (or re-invested) in the startup–they lost more money the majority of the time. About 70 percent of the time to be exact.

Homework And More Homework

The way to succeed then is to ensure your startup gets bought out relatively soon after you help launch it. But how? One of the best ways is to do your homework–your due diligence–before ever handing over any capital to the entrepreneur.

Of course, there are more to the art of exit strategies than what I’ve mentioned in this post. So do additional homework by networking with other angel investors, tapping into the collective wisdom of such online communities as Venture Hype.

Note:

1. Angel Investors in Groups Achieve Investment Returns In Line with Other Types of Equity Deals