When people put the first outside capital in a start-up company, it’s usually called angel investing, and it’s yet another one of those activities that aren’t nearly as easy as they look.
Entrepreneurs who start investing in other people’s businesses seem to think they’ll be able to spot only the winners. The savviest of them know it shouldn’t be two or three deals but a little portfolio. So what’s the average number of companies that investors should own a piece of before they can expect a huge financial winner that makes the whole program make financial sense? Is it five? Ten?
Actually, it’s 19. Even with skill, patience and diligence, it’ll take 19 tries before you’ll find a company that will generate a huge multiple of the money you put in.
That was one of the key lessons entrepreneur Daren Cotter put into an essay he posted on the social networking site LinkedIn last week under the simple heading “What I’ve Learned in Three Years of Angel Investing.” It’s a must-read for anyone who wants to try their hand at this form of investing.
Angels like Cotter are just people, not institutions like a venture fund, and their investments are typically measured in thousands of dollars, not millions. As a group, though, they play an important role in getting high-potential companies off the ground. Cotter said encouraging more people to fund local entrepreneurs is one reason he put what he’s learned into an essay.
Cotter’s day job is CEO of InboxDollars, an online loyalty marketing company he launched in 2000 out of his dorm room at Minnesota State University, Mankato. His company is now based in Mendota Heights, and Cotter said last week it does about $25 million in annual revenue.
One thing Cotter soon found out as an investor is that it’s all but impossible to become expert at things like deal terms without hands-on experience, so just tiptoe into the water and expect to learn as you go. Another is to keep half of the capital handy to invest in subsequent financing rounds of the companies that are progressing well.
But the biggest thing he will teach somebody willing to learn is something he called simply “the basic math.”
His lesson starts with the observation that about seven out of 10 angel investments soon become worthless. That’s a pretty safe assumption based on studies he’s seen.
Maybe one out of four investments produce some return, along with getting the original capital back, and maybe one out of 20 is a home run, returning at least 10 times an investor’s money.
This is how the math works for an investor starting out with a small stack of $100 bills, 20 in all, to be invested equally in 20 different companies.
If 70 percent of the companies simply go out of business, then we know that 14 of those $100 bills are soon gone forever. Five of the $100 bills will come back along with maybe $100 more in investment return each.
So here are the investment results so far from 19 deals: a stack of $100 bills that’s about half as thick as the investor had at the beginning. In other words, it’s a stomach-churning, sleep-depriving loss of roughly 50 percent.
But then there is this one home run, an investment in a company that succeeded famously and was acquired. From this company the investor maybe got back 15 times his money. So now it’s a stack of 25 $100 bills, five more than our angel had at the start.
It’s up to the investor to decide if that was enough return to be worth the risk. But the point Cotter was making was that without that one home run, this typical investor would have done a lot of hard work only to lose a lot of money.
“Back to why I put this [essay] out there, when I started out I certainly didn’t have a plan to make 19 different angel investments,” Cotter said. “Conventional wisdom is, ‘Well, I’ll find one or two or three companies I’m really interested in. I’ll try it and see how it works.’ It’s clear that’s a really flawed strategy.”
It’s hard to argue with his math. The odds of hitting at least one home run clearly go up as the number of times at bat goes up. Cotter recommended that anybody serious about getting their money back with a return should make at least 30 investments.
It’s not simply a numbers game, either. Cotter isn’t proposing tossing 30 darts at a list of cool-sounding start-up companies, or using the same machine to spread investment capital around the Twin Cities that homeowners use to fertilize the front lawn.
His own approach is certainly anything but randomly picking companies. Among other things, he makes sure he only spends time considering a company that has managed to both develop a product and start selling it. He will pass on a business idea that sounds like pure genius, if it’s still just an idea.
His point is that deep thinking about a business opportunity, confirming that products work as advertised in conversations with real customers and a careful evaluation of the entrepreneur, still produces seven complete failures out of 10 tries.
“Some pushback I’ve gotten since I put that [essay] out there, is ‘Sure it’s a 70 percent failure rate, but I’m way better than the average investor,’ ” he said. “I would really challenge that. It’s a 70 percent failure rate for a reason. There are not a lot of stupid angel investors out there.”
Cotter called his investing on the side more of a hobby right now, and he still serves his company as CEO. He thinks he only has the time for perhaps six new investments each year. This summer his portfolio of investments, primarily in the technology space, numbered about 15.
None of them has been hit out of the ballpark yet. Of course, he’s got a few more deals to do before he should expect that to happen.