Entrepreneurship is getting hotter. With the job market decline, people are starting to look inward for ideas to make money. Stock market returns stink too. Many people with money are looking to increase their return by investing in start ups. However, you need a game plan.
It’s risky to be an angel investor. Fortunately for investors, academics are studying and publishing data. The Kaufman Foundation is a well respected source for entrepreneurship, and they published a study that identified some best practices for angel investors.
Strategies to Enhance Performance
The historical picture of angel group investor outcomes offers lessons in the practice of angel investing. These include:
Due diligence time – Investors experienced better returns in the deals where they exercised more due diligence. Sixty-five percent of the exits with below-average time spent on due diligence reported a return that was less than their original investment. Losses occurred in only 45 percent of the deals where investors did above-average due diligence.
Industry expertise – Analysis indicated that expertise has a material impact on angel investors’ returns. Returns were nearly double for investments in ventures where the investor had related industry expertise.
Participation – After an angel makes an investment, his or her participation in the venture – through mentoring, coaching, and financial monitoring – is significantly related to that venture’s returns, according to the study.
Follow-on investing – Deals where the angel investor made follow-on investments generated significantly lower returns. In ventures where follow-on investments were made, nearly 70 percent of the exits occurred at a loss. The study recommended additional research to determine the impact of other factors in these results.
These are interesting points. Due diligence is the things you do to research the company. The problem with doing extended due diligence is it takes time. The longer you take, the longer the entrepreneur waits for their money. If they have some sales, and are generating some sort of cash flow, it makes the wait less painful. However, if they need it to live, it makes it tough.
Industry expertise and participation are key parts of successful investing. Mentorship and helping small companies navigate the twist and turns in the road are critical to success. No small start up succeeds without some sort of mentorship. If you have industry knowledge, it really helps. Angel accelerators try and mentor companies over 90 days, but sometimes that knowledge can’t be transferred. You need it when you need it, and no one knows when that time is. Utilizing your network to help the firm is also important. An investor can create customers, or be a customer. That’s why these little companies exist, to service customers.
Follow on investing is an interesting data point. It does need more study. Why do a follow on? In many cases, it’s an angel’s confirmation bias. You think the company is great even though it’s not doing well. Or, you sunk quite a bit of money in, and you can’t bear to see the company go out of business. Instead of seeing it go down and chalking up the first investment as a sunk cost, you sink more funds in the firm.
However, we just did a follow on investment with a company you should be using. Ycharts.com is a cool stock research company. Amazing entrepreneurs. The second round featured some of the initial investors, and a big firm, Morningstar, jumped in. I made an initial investment, and another one. It remains to be seen if Ycharts is successful or not, but I am using the PRO version of their charts in a presentation I have to make today.
Data sometimes is messy, so I wonder what the parameters of the Kaufman study were? From personal experience, I know that follow on investments in some of my firms didn’t work out so well. Most of the time, it’s because I didn’t do a deep enough dive on due diligence.
One thing is for certain. I don’t know if the probability of success of any start up is better than the probability for success of any other start up. Even when you bet on previously successful entrepreneurs, the odds of a successful exit don’t go down dramatically. A past home run does give an investor comfort-but usually it results in a higher valuation for the entrepreneur. Their “price” goes up, mitigating the decline in risk.
What are your strategies when making start up investments?