An engaging reader recently shot us an email and suggested the following topic:
Flying under the radar. Investing in companies that will never get really big, but have the potential to make a few people financially very happy.
Before I offer my take, let’s narrow down the type of angel investors I’ll be referring to throughout this post.
According to Dr. Scott Shane, the author of Fool’s Gold?: The Truth Behind Angel Investing in America, some of the top reasons people become an angel include:
The topic suggests “financially very happy,” so I’ll focus on the type of angels that are in it for the money. Please keep that in mind.
In an ideal world, you’d just invest in one company that will be a sure win. It mightn’t get very big but it’ll certainly make you “financially very happy.”
In reality, an average of 55% of startups fail within five years. No matter how experienced an investor is, she doesn’t know at the outset which venture will score and which will fail.
According to Shane, even accredited angels and those who invest with an organized angel group see a negative return in 40 percent of their investments. And only 7 percent of investments account for 75 percent of all returns. In other words, it’s the few home runs that make up for the losses.
Savvy investors know they aren’t psychics and aren’t living in an idealized world. They know that many startups will fail so they use a portfolio approach to balance their risks.
They invest in a number of companies rather than just one and only look for those that have a potential payoff of at least 10x to as much as 30x their invested capital in three to five years.
This way, the startups that succeed would generate a return handsome enough to not only recoup their losses but also fatten up their bank accounts.
So, it depends on how you define “big.” According to Angel Capital Association, in 2008, angel groups invested an average of US$281,000 in a single company whereas an independent angel invested between US $10,000 and US $200,000.
How much capital in total does the startup need? Does the startup offer that growth potential and 10x to 30x expected payoff within five years?
If not, financially-focused angels won’t invest in this startup and the founder may have a better chance securing funding from friends and family or non-financially focused angels.
They invest in a number of companies rather than just one and only look for those that have a potential payoff of at least 10x to as much as 30x their invested capital in 3 to 5 years.
* For series, references are published in the last installment of the series.