A Smarter Approach to Angel Investing
After working with hundreds of top silicon valley angel investors there several non-obvious insights can save most new angels time, money, and sanity.
New angels typically dive straight into mental models and frameworks for evaluating opportunities. I believe this approach is wrong. Instead, new angels should take a step back and think about the bigger picture before jumping into the nitty-gritty. Venture capital is a distinctive form of investing - a game if you will - that operates by a set of non-obvious and at times counterintuitive rules.
The Game of Venture Capital
“Never bring a knife to a gunfight”
In the venture capital game proximity is power. Alpha tends to come not from picking, but rather from superior access. Improving your access to high quality founders is the key to improving your odds for success.
One of my favorite analogies is that venture capital is like a game of hot potato. Angel investors discover and finance companies in their nascent stages, and then ‘pass them’ up the chain (pre-seed, seed, series A, etc) to the next investor willing to invest at a premium. Ultimately many of these companies will falter, or be modest successes, while a handful of “outlier” companies will return multiples of 100 - 1000x.
The challenge is that at the earliest stages it’s nearly impossible to know what companies. The math behind venture capital is a key concept for new angels to understand. The asset class is alluring because the downside is capped, while the upside is unlimited, but the catch is the power law. Each year it’s only about 100 companies total that will provide the majority of the returns.
Luck also plays a considerable role in which companies become the massive winners. Although angels can’t control luck, they can better stack the odds in their favor through diversification. Angels need to invest in a portfolio of opportunities to maximize their chances of finding outliers. In addition to diversification, developing a consistent process and creating ‘advantaged’ access are the primary ways to increase your chances for success.
Certain angels start their investing journeys with unfair advantages when it comes to access:
- Operator angels with deep networks and startup experience
- Angels in major tech hubs like the Bay Area and NYC
- Angels connected to ecosystems producing high potential founders
- Angels with pre-existing brands and audiences
Knowing where you stand in terms of access will help inform what allocation strategy you should pursue as you get started.
Jobs To Be Done (JTBD) for Angel Investors
Angel investors play a specific role in the startup ecosystem: they help founders build momentum.
Unlike professional venture capitalists, angels exclusively invest their own money and have no fiduciary responsibility creating a form of independence. This independence has two key ramifications. First, angels invest for a multitude of reasons outside of simply financial returns and motivations matter. Second, independence allows angels to occupy a unique, more friendly role with founders. This makes sense as angels often may have a pre-existing relationship with the founder. They are also the earliest supporters, providing belief capital and betting more on the individual than the idea. Angels’ independence allows founders to view them as “trusted advisors” in a way they typically can not with institutional investors.
Understand Your Angel Investing Persona
Depending on an angel’s underlying motivations, there are different approaches to allocation strategy when starting out. As an example, not all angels aspire to start a fund, or to work closely with founders. While I like to invest directly and actively help out my portfolio companies, I do so because a more hands-on style gives me energy.
Depending on factors such as access quality, future goals, and time commitment capacity newer angels might opt to start by co-investing using SPVs. Platforms like AngelList allow angels to bypass the need for direct deal flow and larger minimum investments by instead piggy-backing off ‘high signal’ co-investors. Another route is for more risk averse investors to allocate to venture funds to mitigate risk through portfolio diversification.
If you plan on investing directly from the start, the questions below can help give you a sense of where you stand in terms of access quality:
- Do I have a network (friends, colleagues, etc) who have gone on to raise venture capital from top VCs?
- Have I had the opportunity to invest in a company that became an outlier?
- Are many of my friends and/or colleagues already active angel investors?
If you answer “no” to most of the questions above, you’re likely better served by starting your investing journey with SPVs or funds. Another alternative is to mitigate risk starting out by investing very small checks ($1- $3k) across a larger number of bets.
A Foundation for Angel Success
Angels need three things to be successful:
- Access (i.e., sourcing)
- Judgment (i.e., picking)
Capital - Angels must meet the definition for accredited investor status (though new ways to qualify for accreditation are emerging). While I’m a proponent for democratizing access to venture and know plenty of people who are ‘sophisticated’ without being wealthy – there is good reason to want to wait to start angel investing until you have ‘enough’ capital: diversification. New angels should be thinking in terms of building a portfolio from the start and generally building a portfolio takes capital.
Access (sourcing) - Access creates alpha. An angel’s proximity to high-potential founders – especially founders who specifically want to work with them – is what separates the good from the great. Angels need to work hard to level-up by building a reputation as someone founders want on their cap tables. Over time as reputation compounds, so too will access, and ultimately returns.
Judgment (picking) - Angels need to develop instincts for picking great opportunities. Judgment takes practice and patience. Elite angels might only invest in 1 in 25+ deals. A common trap for new angels is that most deals look good at first. It’s only by building your evaluation muscle (i.e., putting in the reps and honing your mental models) that your instincts will improve. Go slow and consider the secretary problem. A good heuristic is to evaluate 30+ companies before making your first commitment.
Bonus! Allocation (winning) - The best angels are also able to get into hot deals and secure the allocation sizes they want. The ability to win competitive allocations takes time and comes from developing your reputation and competitive advantage.
New Angel Checklist
Congrats! If you’ve reflected on all the points above and still think you’re ready, go write your first check.
To further help “check the boxes” on your first couple deals, I’ve also created a basic deal checklist. As you start out, it can be helpful to bias toward proven success patterns such as technical teams and software dominant businesses.
Building A Track Record & Leveling-Up
Once bitten by the bug, it’s natural to want to level-up and focus on building a track record. Angel investing is addictive!
Angel investing is a craft and the pursuit of mastery in the craft is an incredibly rewarding journey. Angels hold incredible power. Saying ‘yes’ to a founder can change their life. I’ve also heard people say that each check you write is like casting a vote for the future you want to see.
As you continue to level-up, it’s good to have goals. Three of the most common goals I see angels aspire toward are:
- Consistent Outperformance (repeatability)
- Moving from push to pull (i.e., being ‘sought after’ by founders)
- Raising an SPV, or starting a fund (adding leverage)
At On Deck I taught a cohort based course focused on the craft of angel investing (and helping people hit the three goals above). I’m thinking about re-launching it soon and if you’d be interested in joining the next one, please let me know!
→ To learn more about these topics, also checkout my appearance on the Wannabe Angels podcast: