by Kamal Hassan
I was sitting yesterday with someone who wants to become an angel investor. This young man asked me for my advice on angel investing (although I normally blog for entrepreneurs, I have also been an angel investor for ten years). Here’s the wise advice of the older, experienced angel investor:
The first thing you need to do is make two strategic choices:
- what size cheques will you write?
- will you be a ‘passive’ or ‘active’ angel investor?
Cheque size: is a simple calculation, once you know the two rules:
Rule #1: always keep 1-2x more money in reserve to ‘protect’ your investment
In other words, if you’re investing $10,000, keep another $10-20,000 in reserve. Why? Because entrepreneurs virtually always run out of money and want more money. Sometimes the company is growing well, people are throwing money at the company, and the valuation is going up. In that case you want to buy more of a likely winner (make sure the shareholder’s agreement has some sort of ‘right of first refusal’ for existing investors). More importantly … and more frequently … many companies run out of money at some point. When it does, they can get desperate, and the next round of financing will be at pennies on the dollar. Only the angel investors wise enough to have some money in reserve will benefit from buying what may still be a good company at a discount.
Rule #2: you need 15-20+ investments to be suitably diversified
Many people dabble in angel investing, make two or three investments, watch them fail (or worse, succeed while the angel gets screwed – a topic for another post), and decide ‘angel investing is a waste of money, I’m going to stick with public markets’. That’s a huge mistake. You can’t judge angel investing as a class from your first three investments (either way): you should expect to have to make 15+ investments!! So if you are going to make, e.g., 5 investments per year over three years (that’s a three year commitment to the asset class!!), divide your total money available to invest per year by 10 (see rule #1), and that’s your cheque size.
In other words, you need $100,000 a year over three years to build a proper angel portfolio, where your average cheque size is $10,000 per company (note: most entrepreneurs won’t take less than a $5,000 cheque because it isn’t worth the trouble to them). This is a sizable commitment!! Of course, with the upcoming legalization of crowdfunding, things will change: cheque sizes will get smaller, and diversification will require less capital to achieve!
Passive vs. Active Investing:
For me, it was very straightforward. I decided that I would be writing $5,000 to $10,000 cheques. If you want to be an ‘active’ angel investor, you need to be able to dedicate 20-50 hours per year to each investment. If my time is worth $50-100/hour, then I would be giving $1,000-5,000 worth of free labor per year to support a $5,000 investment: not worth it to me. So I decided to become a ‘passive’ angel investor. This basically means that I sit back, receive information [promotional note: there’s this great platform called IncMind which makes it easy to do that], and provide help – like an introduction or opinion or two – when asked.
I’m not going to get actively involved in the company, and I’m not ready to step in to help run things if the investment is going bad: active angel investors do that. I’m going to rely on management, and will succeed or fail with them.
I’m also going to spend a limited time on due diligence, and I’m going to focus the bulk of my diligence on the key factor, the people I’m investing in – which I will post more about later. I also have 15 years of running businesses and was a management consultant before, so I can evaluate companies very quickly – especially if they are set up on [warning: promotion ahead] IncMind. If I were an active investor, I would do much deeper diligence on the company, product and market … again, the subject for another post.
So you want to be an angel investor? Figure out your cheque size per the above, and decide if you’ll be an active or passive investor … and you’re ready for our next blog post!!