How to Set Up New Angel Investors for Success

Angel investing is risky, and it’s hard. You review hundreds of deals and invest in only a few. Of those investments, most will lose money. If you manage to do well, you’ll have a couple of winners in your portfolio that drive your overall return. While success can seem like a matter of chance, there are a few things you can do to tilt the odds in your favor.

Portfolio Construction

By investing in a large enough group of startups, you’re more likely to invest in one of the winners. Using data from a 2007 Wiltbank study and a Monte Carlo analysis, we can look at the probable outcomes for various portfolio sizes. The difference is stark: a portfolio with only 6 investments has a 50% probability of not losing money (but not making any either). Increase the portfolio to 24 investments, and there’s a 90% probability of a 2.6x return. That’s a significant difference, based on nothing more than increasing your number of investments.

But why is diverse portfolio construction so important? It’s nearly impossible to know which companies will be winners. Some startups have great traction at an early stage, then run into issues scaling. Others fail because a competitor pushed them out of the market. Some fail due to the larger macroeconomic situation, not necessarily through any fault of their own.

The risks and rewards at the angel stage are asymmetric. You can only lose the amount you’ve invested, but on the upside you can potentially see a 20x, 30x, or 100x return. The majority of companies, 67%, will return less than $1 for every $1 invested, but roughly 7% will have a 10x or greater return. Those large returns on a relatively small number of investments are what drive overall portfolio success.

Key takeaway: You’re better off writing more checks, and smaller checks, at the angel stage. Diversification is one of the best ways to protect your overall portfolio.

Due Diligence

This is a term that gets thrown around a lot, but what exactly does it mean? Due diligence is the comprehensive appraisal of a business undertaken by a prospective or current investor to establish a company’s assets and liabilities, as well as to evaluate its commercial potential. The process helps investors thoroughly understand the business they are considering, including its market potential, financial status, operational aspects, and legal standing.

The importance of due diligence in angel investing can’t be overstated. It gives investors the confidence to make well-informed decisions, reducing the likelihood of falling into pitfalls or getting involved in bad deals. Proper due diligence not only uncovers potential risks and challenges but also identifies opportunities and areas for growth. It also sets the stage for ongoing engagement between investors and entrepreneurs, fostering a stronger relationship and a shared understanding of expectations.

When you go through the diligence process, particularly as an angel, you’re looking for deal killers and obvious mistakes. You want to spend time with the management team, educate yourself on their market, and ask common-sense questions. You have to identify the key risks, build your investment thesis, and then decide what you need to believe in order to invest.

Key takeaway: Once your comprehensive due diligence appraisal has wrapped, you can piece together your thesis. At this stage you should be focused on three questions:

• The team: Are they an A team or a B team?
• The market: Is the market big enough?
• The product: Is it a nice-to-have or a need-to-have?

You’ll never totally eliminate all risk from angel investing, but with disciplined portfolio construction and thorough due diligence, you can meaningfully reduce it.