Three Keys to Generating Angel Profits

Three Keys to Generating Angel Profits

Investing in early-stage private companies has similarities and differences with stock investments in publicly traded companies.  Investors are generally called Angel Investors, because many are motivated not only by a desire for profit but enthusiasm for helping young companies grow and succeed. Public companies have well-established markets and performance patterns that can be analyzed according to massive research on things like key financial performance data, the business cycle, industry structure and so forth.  Great knowledge about many such factors is available from newsletters and public databases.  Many firms specialize in generating company specific analyses and serious investors spend substantial amounts on gaining such information.Early-stage companies, by contrast, have no established markets and no data. They have creativity, adaptability, a key business idea, some patented intellectual property of potentially great value and a vision of what could be.  They do need capital to advance their technology to the stage that customers want products or services in which it is embedded.  In short, they need to develop a product or service and a business to serve customers in that market rather than capital to expand markets (say) globally.   It follows that the information investors need to make good decisions cannot be gained in traditional ways.  It takes a great deal of direct, hands-on investigation.  This investigation is called Due Diligence because serious work is required to make a real investment in young, hopeful companies.Secondly, since early-stage companies do not have the stable continuity of large, public corporations, successful investment must go beyond merely building a reasonable portfolio of investments; although this is all that is possible for publicly traded corporations. That is, investors in the early-stage scene cannot be passive in the way they would be in the stock market.   Investors need to "follow-up" with their early-stage companies and keep an eye out for danger as well as opportunities to help the company develop.Research and opinion in early stage investment has generated convincing argument and data on the relative success of different degrees of due diligence and follow-up.   This article briefly summarizes one particularly key research study by two Professors (Wiltbank at Willamette University and Boeker at U. Washington) on angel investors' payoffs compared to investing in major stock markets and compared to what have historically called Venture Capitalists (VC's).  This research (for simplicity, referred to henceforth as the Wiltbank* research) shows that angel investors do generate superior returns to these other approaches: 27% internal rate of return over 6 years.

Table 1 Comparative Returns for Different Investments

Note: Both venture capital (which uses pension fund money to invest) and Angel investors (using their own money) outperformed traditional investments handsomely. Angel investing is worth the effort and the risk. So the big issue is where is the effort best applied.

Can Angels do more than “make a bet” on an early stage company?Investing is NOT gambling. One may take risks but in investing but one does so because it is required when seeking higher than "normal" returns. The practical question then is, "What are the critical things that separates highly successful angels from the rest?" The Wiltbank* research gives a definitive answer to that question.  Wiltbank* documents two factors that are tightly linked with returns on investors capital, time and talents.  These factors are:

• Due Diligence

Due diligence is means reading 'the fine print' and more. Entrepreneurs must make their 'best case' when they are seeking capital. The burden of seeing beyond the capital sales pitch false on the investor. The importance of the intellectual property and non-substitutability by other technologies is obvious.  How and balanced between business and technology is the top team? Is the business model and business plan realistic and doable with projected capacities?

• Follow-up

Follow-up is a much less technical term than Due Diligence. Subsequent research, cases and experiences show that follow-up includes, consistent monitoring and contact with investees, helpful coaching, advice giving, door opening and facilitative support from time to time, engagement in more active forms of involvement (e.g., serving on Boards) and much more.Due Diligence Effects on Investment ReturnsWiltbank's* research on due diligence emphasizes two causal factors: Time spent in DD and Industry expertise applied to the data gathering and analysis task.

1. Table 2 below shows the pattern results for High vs. Low time investment in due diligence. "High" means a median of 20 hours invested in interviewing, verifying facts, reviewing legal records, and exploring many business, industry and technical factors.

Table 2: Time Spent in Due Diligence Effect on Returns on Investment*

Note:  

• 20% of High DD investors did over 40 hours of due diligence
• The dramatic results show most clearly at the extremes:
  • Low due diligence took losses at nearly twice the rate of high due diligence investors.
  • Big wins,10 times or more return on investment, go to high due diligence investors and the very big wins (over 30 times) only to high due diligence.
  • Overall, "High" made 5 times on their capital in 4 years while "Low" did little more than get their money back in roughly the same period.

Table 3 below shows equally detailed and compelling results for Investors who applied "High Industry Expertise" (vs. "Low") during the DD process. Such expertise might be heavily technical (e.g., programming in related types of businesses).  It can also mean business, client, marketing, and finance expertise in the industry or similar industries. The pattern of results is almost as dramatic as that shown for Table 2 for time spent in due diligence. This makes sense since the critical questions cannot be answered by simple fact checking. It also implies that networks and contacts matter in making judgments as well as subsequent follow-up.

Table 3: Angel Investor Industry Expertise Effect on Returns on Investment*

Note:

The zero or less returns for "Low" expertise angels is actually more dramatic than for the time factor. Sheer time does not compensate fully for lack of expertise.Also consider the fact that Wiltbank* takes care to acknowledge that "High" expertise angels apply that expertise throughout the entire investment period. Angel investors who have no talents to bring to the party cannot expect time spent to yield equally good outcomes.Follow-up effects on Investment ReturnsThe discussion above shows that, even at the DD stage, it takes relevant talents as well as time and effort to make good investment decisions. The importance of talents and connections is undoubtedly even more value in Follow-up.This brings us to the third research result, the one focusing entirely on 'investee' follow-up.

Table 4: High vs. Low Investor Follow-up Effects on Investment Returns

Note:High follow-up Angels (1 to 2 interactions per month) show the same pattern of investment returns as seen in the earlier charts.  However, it appears that high follow-up has less impact on the underperforming cases (can fix what was a lost cause in the first place). Importantly, high follow-up has substantial advantages in the 5 to 10 times investment return category and is overwhelmingly important in 10 to 30 times investment return cases.The obvious conclusion from Table 4 is that even high follow-up angels need to have multiple investments (portfolio diversification) because the ability to predict success is so difficult in early-stage companies. The importance of getting some 'big wins' in a portfolio is emphasized because some losses are inevitable and the big wins must make up for those. ConclusionSeveral conclusions flow from the Wiltbank* research, reported in this article. The most global conclusion is that Angel investing in a few companies or the passive investing style of a typical investor in the stock market.  Successful angel investing requires a lot of work and work by people with relevant skills, experience, knowledge and connections.

1. Due Diligence is the first activity that needs substantial time and effort. 20 person hours of rigorous data gathering and study are needed to get good payoffs.
2. The skills, industry experience, technical competencies of the people doing the activity matter as much or more than 'doing the DD work'.
3. Following-up with investees in a meaningful way so that one can help in a variety of ways during the twists and turns of company development are equally important to due diligence efforts. 'Helping' is a vague term it can mean:
   1. Giving advice when it is asked for. This implies the investee CEO and BoD respect the talents and opinions of the 'helper' sufficiently to take them seriously.
   2. Alerting the CEO about issues that seem off in either top-level decision-making or some aspect of running the business. This might even rise to the level of criticism and certainly rises to the level of asking challenging questions and raising uncomfortable issues from time to time. The CEO must respect and have computability with the 'helper' for this to get off the ground.
   3. Confronting the CEO or "blowing the whistle" if things get too far off track and the business is on the verge getting into serious trouble. Having the freedom to alert other shareholders, despite already having a CEO trust relationship may be a necessary part of this facet of the helper's role.
   4. Providing and supporting follow on capital raising as the company develops and expands scale, scope, and competitive advantages.

4. All in all, follow-up activity is far less definable than is due diligence and far more dependent on access, respect and relevant talents to deal with key challenges and opportunities of the investee company.  And it takes a lot of conscious attention and effort.

---------------* Research source: Robert Wiltbank and Warren Boeker, Returns to Angel Investors in Groups, November 2007. [sites.kauffman.org/pdf/angel_groups_111207.pdf]