Angel Investing is for Suckers

From VENTURE CAPITAL BRAZIL

At least, that was the original theme of this post.

Lately, however, I have seen how angel investing might make more sense than I originally thought. Let's look at both sides (I have been angel/seed investing for almost ten years and don't feel strongly about proving one side of the argument or another.)

First, the case AGAINST angel investing. It can be summed up fairly simply — dilution. Because the angel does not have enough money to keep his pro rata ownership in subsequent rounds and, even if he did, the VCs may not let him participate, he is likely to be diluted down to a small percentage of the company by the time there is a liquidity event.

In addition, his shares will likely be in common stock, while subsequent VCs will have preferred shares; this means, among other things, that the VCs will have a "liquidation preference" that ensures that they will get their money out first. Finally, the angel will not have a board seat or any other form of control over the company.

Let's analyze three scenarios for an angel investment: a home run investment, a return of investors' money investment and a loss. VCs generally expect their portfolio companies to fall into each of these categories in equal proportion.

1. The Home Run Scenario,

Angel Investment $100,000
Pre-money Valuation $400,000
Post-money Valuation $500,000
Post-money Angel Ownership 20%

Year Two
Pre-money Valuation $3,000,000
Series A Investment $2,000,000
Post-money Valuation $5,000,000
Post-money Angel Ownership 12%

Year Four
Pre-money Valuation $10,000,000
Series B Investment $4,000,000
Post-money Valuation $14,000,000
Post-money Angel Ownership 9%

Year Five
Exit $50,000,000

Gross Return to Angel 43x
Angel IRR 112%

In the Home Run scenario, everyone is happy — the VCs come in at the Series A and Series B at ever higher valuations and, in year 5, there is a exit that at a value that obviates the liquidation preferences of the VCs. In other words, it doesn't help the VCs' return to exercise the liquidation preference so everyone shares in the proceeds of the exit proportionately. There is a back-slapping closing dinner at Fogo de Chao on Park Avenue.

2. The VCs Barely Get Their Money Back

Angel Investment $100,000
Pre-money Valuation $400,000
Post-money Valuation $500,000
Angel Ownership 20%

Year Two
Pre-money Valuation $3,000,000
Series A Investment $2,000,000
Post-money Valuation $5,000,000
Angel Ownership 12%

Year Four
Pre-money Valuation $10,000,000
Series B Investment $4,000,000
Post-money Valuation $14,000,000
Angel Ownership 9%

Year Five
Exit $8,000,000

VC Liquidation Preference $6,000,000

Remaining for all Investors $2,000,000

Gross Return to Angels $171,429
Gross Return Multiple 1.7x
Angel IRR 11%

Now, we have some problems. In this scenario, the portfolio company stumbles and exits at an $8,000,000 valuation. In theory, this should be okay for the angels, more than okay, since they own 9% at exit. The problem is that they own common shares and the VCs own preferred shares, which have a liquidation preference. As I mentioned, the liquidation preference means the VCs get their money out first, so instead of all investors splitting up a pie worth $8,000,000, the VCs take out their $6mm of invested capital, leaving $2,000,000 for all investors (including the VCs) to split pro rata. The result is an 11% IRR for the angels, which is meager considering the massive risk profile of the investment.

By the way, this scenario assumes a 1x liquidation preference; a 2x liquidation preference, not uncommon, would mean that the VCs get twice the amount their invested capital back before the common stockholders get a share of the proceeds. A 2x liquidation preference in this example would result in a complete loss to common shareholders.

3. Complete Loss

We don't need a model to show what happens to the roughly 1/3 of VC investments that go under. Suffice it to say, in this example, if the exit results in less than $8mm in proceeds, the return to angels quickly drops to $0.

So we see how high the odds are stacked against angels. David Rose of the New York Angels has said that he needs to believe an angel investment will return 20x before he will invest. You can see why: angels are entering at the riskiest point of the company's life and, generally, face years of dilution before seeing their portfolio company exit. An angel investment needs to be a huge home run to provide an ample risk-adjusted return.

It's worth noting two other variables that control how an angel investment will perform. One of the largest determinants is valuation at the point of angel investment. I listed a pre-money of $400,000 in the above examples. This is possible if you are dealing with a first-time entrepreneur at the very inception of the company. If you are dealing with a proven entrepreneur (i.e., the kind you want to actually invest in), the valuation is likely to be much, much higher. Two of the seed rounds I took part part in with successful, "repeat" entrepreneurs, both had $10mm pre-money valuations. So if an angel invested $100,000 they started out owning less than 1% of the company. With numbers like that, the possibility of a worthwhile return for the angel becomes infinitely smaller.

Another major factor involves the capital requirements of the business. In the two examples above, the company takes in only $6mm total in the Series A and B rounds. If you are investing in a web-based software company or a consumer-facing internet play, this is possible. If you are investing in a device-based business, however, forget it. A company that needs to build a product: a medical device, a music player or a even just a metal widget, will require a lot more capital, which means more dilution for the angel (unless the valuations go up astronomically at each round). So, IMHO, angels should stay away from "product" businesses completely. Pharma and the massive amount capital required there is not even worth mentioning in the same breath as angel investing.

We'll review the case FOR angel investing in the next post.