A Concise Guide to Angel Investing. Part 1.

I have been making small investments in tech companies for almost 20 years. Some successes, lots of failures, and a few lessons along the way. I thought I would share some brief thoughts, focused on those who are new to the angel investing game.

We'll cover the following:

• Getting Started
• Deal Flow
• Investment Terms
• Lifecycle

I will break the topic up into a couple of posts for easy data snacking. That still leaves a lot of important stuff. For example, what makes a good deal? We'll get to that eventually as well.

I will reference some numbers carelessly and without attribution. That is because I am too lazy to dig back and find the original articles, but I will try to give you a clue as to where I heard the numbers. Over time, I will update the post with references. In some cases, I will just pull "facts" out of my ass based on my own anecdotal data.

Angel investing has become hip. It was not always thus. People used to look at me funny when I told them I plowed my life savings into companies that hemorrhage cash. Now, everyone is tripping over themselves to invest in startups. I view this as being actually destructive to innovation, because too many startups dilute the talent pool and make it harder for good ideas to break through the noise.

I question whether there is really a functioning business model for angel investing in the current environment. Valuations at the seed stage are high, but success rates are low. Statistically, returns are in the 20-30% range depending on whose data you look at (eg. ACA, NVCA), but there is a significant bias, I believe, to this data, as many less active and less successful angels do not contribute their data. You seem the same thing in the hedge fund indices. Hedge funds that go out of business or have a lousy year don't bother reporting, so you have a positive bias to the index which makes the asset class look more attractive than it really is.

Angel investing is, in many ways, like owning a vineyard for people who prefer tech to dirt. It is a romantic notion to help startups, and it is, in fact, good fun. But that leads to people doing it for love rather than money, and that perverts the original intent. Do you know what is cooler than bragging about all the startups you are invested in? Doing it on the deck of the yacht that angel investing paid for.

First of all, can you afford to be an angel? The typical minimum investment level in the Bay Area is $25k. You can reduce that on some deals and if you participate in an angel syndicate. To build an adequate portfolio means at least 10 deals. Chances are you will lose every penny.....allocate accordingly. Basically, you should have more than $2.5m and ideally more than $5m in net worth to be a sensible angel investor.

There is a core of angel investors, the "super angels", who are really just small venture capital funds. They spend OPM and earn management fees for doing so, which changes the investment philosophy to be more aggressive. Around this core is a cadre of active and experienced angels who have access to the best entrepreneurs, and therefore the hottest deals.

Chances are, you are not one these angels with premier access to deals. Deal flow is key to the angel model, but all is not lost if you are not one of the cool kids--it does not mean that you have to be the greater fool.

How do you get a look at a lot of deals? You can just join AngelList and tap on to a firehose of deals. Ideally, you join a local angel group so you have collaborators and can take advantage of the existing deal flow and experience. AngelList is a great resource for deal flow, but it lacks the face to face interaction that is important for accelerating your angel nous. Get a sense of the investment landscape--valuations, terms, sectors that are in or out of favor.

There are a number of angel groups in the Bay Area, some with a sector focus (eg. Life Science Angels). Personally, I am a member of the Sand Hill Angels, North Bay Angels and Berkeley Angel Network. The Angel Capital Association is a good place to start looking for a local group.

You want to look at a few deals before you pull a trigger with dollars attached. In an active angel group you can see 20 deals in 6 months. By look at, I mean actually have a meaningful discussion with the entrepreneur, not just read the plan. Don't just look at the Excel model.

I have yet to see Excel play out accurately in the real world, though it is useful for understanding unit economics. Ideally, invest in an industry where you have significant operational experience. It is more fun for you if you can be helpful, and it is also more fun when you dramatically improve your chances of making a successful investment.

In the next post, we will talk about the deal and what happens afterwards.