“Angels can fly, but can they land as well?”

How investors can and should take a more holistic portfolio approach if they are invested as angel investors in seed and early stage start-ups

How many angel investments have you ever exited?

We ask the question “Is angel investing really a smart investment strategy for Family Offices, HNWIs or UHNWIs ?”

What about risks attached to those potential returns? How many Unicorns have you exited? In this edition of our blog we will explore the perceived risks and the real risks of angel investing. The question is if angel investing is really a smart approach for investors. How can investors with angel investing track records improve their overall portfolio strategy?

As always we only share our opinions and research on topics which we have or had significant of our own funds invested. Our experience comes from chairing and contributing to investment committees of a multitude of alternative asset classes such as angel investing, Venture Capital (VC), Private Equity, Real Estate and Private Credit.

Our guiding principle remains “We always have skin in the game” and we look forward to your remarks in the comment section below. All postings are our own opinions and please feel free to share them.

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Attractive (potential) returns… but are they real?

So it is no wonder, that angel investors typically ascribe the attraction of the asset class to the immense expected returns, which instil a certain level of excitement in the investor. For instance, consider the scenario of investing $100,000 in Spotify at its launch in 2000, and reaping a profit of $200 million just 15 years later, equating to roughly a 66% annual return on invested capital (IRR). Encouraged by such prospects, the angel investor proceeds to commit funds.

However, in assessing the potential returns as part of the investment process, angel investors often overlook the true probability that any single angel investment, or even a small portfolio of 5 or 10 investments, may ever yield any return greater than zero. One could argue that truly successful angel investors are even more elusive than the “Unicorns” they seek to invest in. As Tim Ferris, an exceptional entrepreneur and prolific angel investor, aptly points out, angel investing is not suited for individuals without the continuous insight track.

“After being in Silicon Valley for 17 years and having some pretty good luck with startups, my advice is , “Do not, under any circumstances, invest in startups .” Unless you’re living in the middle of the switchbox and you’re dedicating your time to that, do not do it.” (Tim Ferris, experienced Angel investor over 15+ years, 2023)

And which family office can really claim that they are living and breathing Silicon Valley or the Berlin start-up scene or the London Shoreditch scene and therefore has such a deep insight track?

So why angel investors do it anyway?

• Due Diligence: Thorough due diligence is essential before making any investment. Understanding the market, the team, the product, and the potential challenges is critical to making informed investment decisions. Per definition of a “disruptive start-up”, angel investing in such companies does not really provide for any real investment due diligence. The market is often small or non-existent at that point, the team is often young, naïve (in a good way), with little management experience and the product of course is non-existent or is constantly evolving (hopefully in adaptation to customer feedback).No comfort for angel investors here.

• Portfolio Diversification: Successful angel investors often have a diversified portfolio. By spreading investments across multiple start-ups, they attempt to mitigate the risk associated with any single company’s failure. But 90% of disruptive start-ups fail and 99.9% of unicorns fail, so a portfolio of 10 angel investments will not present an effective way to mitigate risk or invest smartly. 

  In our view, not 10 but more be like 50 or 100 angel investments would be required to effect any kind of meaningful diversification and then the portfolio returns will look very, very different. So no comfort for angel investors here either.

• Exit Strategy: Angel investor success often depends on the timing of the exit. However that point is never in the minority angel investor’s control as typically either the founder remains in control or the shareholder pool will change significantly over time towards institutional VC investors, as a start-up matures. A good example of the powerlessness of an angel investor has been shown when in 2006 Facebook received a serious offer from Yahoo valuing the company at $1bn, just 2 years after its foundation. All Facebook angel investors were screaming for an exit and they were shocked when Mark Zuckerberg (at the tender age of 21 years old) rejected the $1bn offer. Another aspect is that there may be start-ups that never exit and just continue to operate at low profitability for 20 years, never distributing any dividends and just continuously “re-investing” investor funds. So what’s an investment worth which never materialises?So no comfort for angel investors here either.

• Control: Angel investing is a very long term investment and often comes with non-control (as minority) and severe risks of dilution on the way. So even if the investment thesis holds and the company succeeds, angels face significant asymmetric risks due to the nature of their subordinated (submissive?) investor class. So constantly being on that end of the risk curve skews the entire investment portfolio of an angel investor, which again presents no comfort for angel investors.

• Patience: Angel investing requires extreme patience, as start-ups often take years to mature. Success may not be immediate and investors need to be prepared for a longer time horizon. The median exit time frame from VC investment to IPO in the US is 5-7 years. However, angel investors invest up to 3-5 years before VCs get involved, so they will be looking at 10-12 years exit horizon. In Europe that might even be much longer, Spotify e.g. took 17 years to IPO. Are you comfortable to lock up your capital without any return for 10 or 20 years? So no comfort for angel investors here either.

• Low (No)-correlation: Contrary to many believes, angel investing is not uncorrelated to public markets or other asset classes, at least not to equity asset classes. Economic conditions and market trends can significantly impact the success of angel investments. A favourable market environment can enhance the chances of success but it has been shown in most recent market cycles, that angel investing does not protect from downturns in other markets for the following reasons:

  • If public markets dry up, start-up valuations also drop
  • If interest rates rise, exit valuations based on discounted cashflows typically drop dramatically
  • If Limited Partners (investors) suffer (real or paper) losses through investments in other (public or private) markets they are often forced to re-allocate funding to other asset classes. As a consequence, VCs put on hold or reduce permanently their new and follow-up investment rounds. In tight funding situations, many VCs become selective which start-ups to support.
  • Markets have become highly connected in two main dimensions: firstly, the regional dependencies via exponentially growing speed of global dissemination of all content such as information, physical viruses (Covid), opinions, news, trade of goods and secondly, the industry dependencies via cross-industry supply chains. Even disruptive start-ups are not immune against these impact dynamics and they will suffer with disruption of their ecosystem by for example running out of customers (travel start-ups during Covid) or running out of resources like cash (e.g. during the recent US mid-market banking crisis).

  In our view, not 10 but more like 50 or 100 angel investments would be required to effect any kind of meaningful diversification and then the portfolio returns will look very, very different.

  How can investors find a good balance to angel investing in their portfolios?

  Our experience shows that especially for HNWI and family office portfolios stability and risk mitigation originate from asset classes withcontractual returnsspeculative returns

  In summary, the available risk mitigation strategies for angel investing are far removed if not unavailable from the typical actions to mitigate risks in other investments. Our experience shows that angel investing is much more risky than perceived by the angels because any risk mitigating factors are all stacked against the investor. We believe angel investing is highly speculative, risks are underestimated and cannot be managed through diversification. Overall, for HNWI/UHNWI and family offices with the goal to preserve capital and generate stable returns, angel investing an investment strategy with poor risk/return characteristics.

  Our experience shows that stability and risk mitigation come from asset classes with contractual returns rather than speculative returns.

  Stability in investment portfolios comes from investments with contractual return features such as:

  • defined legal payments,
  • asset security, pledged collateral,
  • protection against inflation and interest rate risk, and
  • protection mechanisms against market volatilities.

  We have published our research on the topics of contractual returns and lower risk exposure in asset classes such as Private Credit and their role in balancing investment risks against angel investing portfolios.

  What is your experience with angel investing? Please feel free to share your views in the section below or send us an e-mail: ggrueter@tropeaam.com.