How I Develop My First Angel Investment Strategy
A framework to find the right startups to invest in.
In my last post, I introduced Ante Up and talked about why I started investing in startups. However, before I get started, I need first to develop an investment strategy. Given the opaqueness and riskiness of startups investing by nature, I want to create my initial plan with some structure and focus approach instead of "spray and pray."
Goals
Before I create a plan, I spent some time studying and talking to several seasoned angel investors. Based on those insights, I decided that my short-term goals should focus on learning and building a solid process for due diligence and decision-making instead of thinking solely about building an investment track record. Much like planting a brand-new grapevine, startup investing is a long game, where it takes many years before you can see any concrete result.
In addition, I learned that many established angel investors have built a strong reputation of being well-connected and very helpful. The degree of "value-add" depends on their experience as operators/founders in the industry. The significance of having a solid reputation, especially in Silicon Valley, has yielded them constant deal flows. Given this, establishing my reputation as a value-added investor is another important goal besides honing my investor skillsets.
Valuable Data to Set Expectation
Fred Wilson, a well-known venture capitalist from USV, once said, "you lose more than you win. And when you win, you need to win big." In another relevant post, Andy Rachleff (Wealthfront & Benchmark Capital) shared his skeptical perspective on angel investing.
To get a better sense of these sentiments, I found the most recent and comprehensive research in the 2016 Tracking Angel Returns report. Here are some relevant statistics:
Internal Rate of Return (IRR), a measure of investment return, was approximately 22% compared to 13% of annualized return if you invested in the stock market (S&P 500) during that period (based on my estimate).
Another measure of investment return - cash on cash multiple - was around 2.5x.
Failure rate (defined as exits less than 1x return of capital) was around 70%.
10% of all exits generated 85% of all cash.
The average holding period was around 4.5 years.
Important key takeaways that support the points made by the two posts referenced above are:
Investing in startups is long-term, illiquid, and risky.
But, on the other hand, there are potentially huge returns from a few investments that could compensate for the many losses. Startup investing follows the Power Law curve, a fundamentally important concept that I will explore in-depth.
Starting from Zero
My biggest challenge is to find a way to see as many deals as possible to start my learning process. At the same time, I'm self-funded, which means I have limited capital that I can deploy. Given these factors, it made sense to limit my focus on early-stage startups and limit my total startup investment between 5-10% of my total investment assets per Andy's advice.
While I have some existing networks in the startup ecosystem from my professional experience as a founder, engineer, and product manager, I need to expand my network significantly to build deal flows. However, as a former founder, where I had to establish my startup's business development and sales efforts from scratch, I have at least some relevant experience and skillsets to lean on.
The biggest hurdle is time. As a solo angel investor, it takes time to run proper due diligence and process. Therefore, it seems reasonable for me to narrow my deal focus, as shown below.
Initial Investment Strategy
To illustrate my first startup investment strategy, I borrowed from my favorite philosophy - Ikigai - activities that give your life meaning and purpose. The chart above shows four significant buckets that will guide me as I find and filter startup investment opportunities.
Knowledge
As a long-time stock market investor, I resonate well with the philosophy Buy What You Know from the legendary fund manager Peter Lynch. He advised all investors to invest in industries they understand well.
While I have a wide breadth of experience across products, engineering, strategy, and finance, I plan to lean on my sector expertise developed from direct experience of starting and working in companies, side projects, and actively researching and investing in public companies.
As mentioned earlier, I have a small tech network with relevant and significant experience in several sectors. So it makes sense to start with those sectors and gradually find and build a close tribe of fellow angel investors, operators, and ultimately founders and venture capitalists.
The goal is to leverage those networks to learn about companies and sectors at deeper levels to collaborate and have frank and objective discussions. Hopefully, the product of these collaborations will produce solid due diligence and a decision-making process, which is one of my goals above.
My initial sector focus includes e-commerce, fintech, SaaS, deep tech, and AI/ML. It makes sense that I have a strong interest and passion in these areas since I have shown a strong willingness to invest my own time, energy, and capital to accumulate knowledge/experience and a network of experts. The trade-off is I will limit myself in learning new industries, but I plan to expand my focus as I gain more experience and network.
Value
One of the crucial questions for myself is how do I differentiate myself as an investor. The best startups in Silicon Valley have leverage over which investors they want on the cap table. Simply offering large sums of money might not guarantee a seat on the table in some cases.
Ultimately, the best way to answer that question is to figure out where to bring value to the table, which is another goal stated above. If money is a commodity, my understanding is founders look for other attributes from investors. This value could be in the form of mission alignment, relevant network connections, value-added services like sales leads to marketing over social media, and specific expertise in the industry.
As I figure out which companies to invest in, the constant question is whether there is an opportunity to bring additional value to the table. Do I either have the strategic contacts that will be valuable for founders or have the ability to procure them? Is there a collaboration opportunity to work with founders in the near term as well as other investors? Having opportunities to bring value to founders certainly aligns with my goal to build my reputation as a value-added investor.
Impact
I was inspired by Marc Andressen's It's Time to Build post, which is essentially a call to arms for founders to tackle some of today's biggest problems. So naturally, it makes sense for me to think about some of the significant issues that resonate with me, such as climate change.
As I conduct my investment process, I will try to visualize the founders' presented ideas and figure out how they fit with those issues or how the founders' visions will benefit humankind in order to find alignment.
Finding early alignment is vital given the ups and downs of startup grind, where investors should provide proper support and help to founders as needed. It's also helpful to visualize how important it is for the startup's success and its potential impact on the world. Tesla's mission to accelerate the world's transition to sustainable energy is a perfect example of how many investors support the company during the long struggles in the early days.
Market
Many experienced investors advocate funding startups aiming for large markets, specifically Total Addressable Market, to find outsized returns. This advice is consistent with my approach and experience of investing in public markets, where I tend to gravitate towards companies operating in large markets instead of niche ones. This is a subject worth exploring in-depth with some actual live deal examples.
Sweet Spot
My sweet spot for investing would be finding startups that can check off all the four buckets highlighted above - Knowledge, Value, Impact, and Market. I aspire to find those startups where I would like to contribute in the form of money, time, and energy.
Using this guideline to invest directly in startups is not the only option. In the next post, I will go through all the other options to start angel investing.
Thanks for reading. Until next time,
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