Should You Become an Angel Investor?

Two years ago I wrote about how I was “winding down”, whatever that means, after selling Consumerism Commentary, in the sense that I was looking to involve myself in new projects. I was considering, among other things, investing a portion of my assets in start-up companies. In fact, I signed up for a service called AngelList that pairs potential investors with visionaries looking for capital.

I never took the next step. Although I continue think it’s a good idea to diversify my portfolio across a variety of investing possibilities, I’ve maintained a mix almost exclusively of stock and bond index funds. Several potential investment opportunities came to me from friends, but in the end, each opportunity didn’t progress to the final stage. I’m not so sure investing with friends is such a good idea anyway.

But what about with strangers? Can you pick a company from a list and be comfortable investing in it? Can you receive a pitch from a colleague, research the company’s potential, and feel confident enough to hand away your cash?

It’s risky. And it’s a risk I’m not willing to take. Despite the self-help industry’s promises for hopeful entrepreneurs, most new businesses fail. Forbes claims that the percentage of failed new businesses is eight out of ten. Entrepreneurs don’t mind; those that risk their investors’ money more their own simply try again, and keep trying (and losing their investors’ money) until they succeed. There may be many entrepreneurs who risk their own money, and certainly no entrepreneur wants to waste time with a business that has no path to success, but the investors suffer the financial losses.

As a result of this record of failure for new businesses, advisers recommend that investors wishing to add start-up companies to their portfolio diversify their total pool of cash set aside — which should be just a small portion of someone’s overall assets — into twenty or more companies. The one or two that succeed will partially offset the other failures. This, of course, gets lost in the headlines.

If you follow start-up investing news, you might hear about a successful start-up investor who made $5 million from an initial investment of $100,000, but if this investor had twenty different $100,000 investments, all of which failed except for the one, it really took an total investment of $2 million to return the $3 million profit. That’s not bad, but not as good as the headline implies. And a good number of people have $50,000 to invest; a significantly smaller number have $2 million.

On the HBO program Silicon Valley, an eccentric venture capitalist is investing in the lead characters’ start-up company. The tech entrepreneur is surprised when he discovers that not only is the investor placing his bets on a dozen competing companies, but he didn’t even consider this entrepreneur’s achievements thus far impressive. The way to succeed with angel investing is to hedge your bets, and for someone without a fortune to invest across so many companies, the risk is too great.

The first investment opportunity of the two I mentioned above involved a company that a friend and I were planning to establish. The idea was something we both believe could have a big future, and we would be entering as partners. It would have been a full-time job for the both of us, but it was in an exciting field, at a time where the market was (and probably still is) perfect for this type of business.

But my friend and potential partner in this endeavor also already runs his own business. I think he was growing a little frustrated with the lack of growth opportunities in that business and was looking for something else to start. His primary business began picking up, from what I can tell, and our discussions regarding this new business stopped.

The second opportunity was incidentally with the same friend. It involved the expansion of his existing business into a new area, one he felt offered significant potential. I was skeptical in the beginning but allowed his team to pitch me. In the end, I didn’t invest — the money I had set aside in cash was used for something else, and it didn’t seem like it would be a good choice to sell stocks and bonds to risk a portion of my invested assets. They ended up getting a loan from a bank rather than giving away equity to an investor. That was probably a better decision for them in the first place.

While I would have been given equity in the new company created out of that second opportunity, we would need to go through the process of agreeing on a valuation for nothing more than a hypothetical business based on assumptions about what this company might be able to achieve. Comparing the two opportunities, the first is better, because I would be directly involved in the day-to-day management. It’s more of a commitment, but in return for more control of how the company — and my investment of money and time — performs.

But that’s not angel investing. Now that more people can become angel investors, potential investors are lining up to accept risk in the hopes of being a part of the next Instagram. I think this is a sign of a bubble in the tech industry, but that doesn’t mean there aren’t some great opportunities out there. But as usual, the opportunities are better the more money you have. Even if you pool your resources with other investors, you will generally be on the losing side of an investment negotiation.

So stop and think before you invest in start-up companies.

Do you really have enough assets to invest in risky companies? You need to be an accredited investor to invest in certain circumstances. That requires investable assets of $1 million (not including primary home) or an income of at least $200,000 each of the past two years. You do not need to be accredited to create a private investment arrangement; accreditation is only for companies that are raising capital publicly.

But just because you’re accredited does not mean you should be investing in start-up companies. Let’s say you do have an investable net worth of $1 million. If you’re, say, 40 years old, you may want that nest egg to keep growing so you can afford to retire. You’ll still want to keep that invested mostly in a stock market index fund. When it comes to adding some risk by investing in unproven companies, you may want to risk only 5 percent of your net worth.

That leaves you with $50,000 to invest as a would-be venture capitalist. Spread that across twenty companies to properly diversify your investment, so you have a much higher chance on winning with at least one investment, and you’re left investing $2,500 in each company. That doesn’t buy you much leverage.

Do you really know the industry in which you’ll be investing? I recently wrote about a war between consumers and creators. Creators are the salespeople who turn a profit by manipulating — whether with friendly or malicious intent — the consumers. It’s not much different with investors and entrepreneurs. Entrepreneurs want capital from investors, and they want to give as little of their company away for as much capital they can get. Investors are on the other side of the negotiation, looking for as much control over the company for as little investment as possible.

That’s a gross oversimplification of the situation, but it’s the general, implicit concept behind negotiations. If you, as an investor, are less familiar with the industry than the entrepreneur, the entrepreneur will use that void to his or her advantage. You must research the company, the industry, and the market before making any deal.

This is a far cry from buying shares of stock on a stock exchange because these companies have, in theory, been properly vetted. Your investment is relatively liquid so you can sell at almost any time if things aren’t going the way you planned. Investment bankers and the company have already determined the valuation of the company. As an investor in a private start-up, the typical financial industry assurances around your investment don’t exist.

Given these drawbacks and hurdles to angel investing, I’m confident that it’s not for me at this time. What about you? Would you invest a portion of your assets in a start-up company? How big of a net worth is necessary for angel investing to make sense?

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