Part 1 of How to Angel Invest: Strategy

Part 1 of a 4 part series on how to angel invest. In this first post, we explore Strategy, "How will I invest?" The next 3 parts of this series will explore Sourcing: "How will I find deals?", Evaluating: "How will I diligence deals?", and Picking: "Which deals will I invest in?".

We often hear the question “how do I get started in angel investing?”. This post is intended to show you how a small handful of successful investors have approached the angel investing game.

I've pulled together and summarized key lessons from some successful angel investors including Paul Graham (Founder at Y-Combinator), Naval Ravikant (Founder at AngelList), and Tim Ferriss (From 4 hour work week fame).

As I see it, there are four functions to angel investing, we’re going to break these functions into four “chapters”:

  1. Strategy: How will I invest?
  2. Sourcing: How will I find deals?
  3. Evaluating: How will I diligence deals?
  4. Picking: Which deals will I invest in?

First, we’ll explore strategy. 

How to Angel Invest Part 1 of 4: Strategy → How will I invest?

The first thing you learn at a VC fund, or as an angel, is that by investing in startups, you’re choosing to invest in one of the riskiest asset classes on earth. With this risk comes a unique set of rules, strategies, and consequences. 

In order to play this game you have to be prepared to lose every dollar you invest 🔥🔥🔥.

As Naval Ravikant likes to say, consider yourself

“a patron of innovation

Beyond the money, you’ll meet some very interesting people, sit at the front seat of innovation, and learn a lot from some very ambitious people.

Some of the smartest, most energized, and ambitious people i've met are via my VC & startup networks.

Step 1: Build a portfolio of bets

If you’re serious about angel investing, you need to build a portfolio of bets.

The reason? Because of The Power Law.

Put simply, The Power Law means that the majority of your returns are driven by a small fraction of your portfolio. The hope is that 1 or 2 of the companies you invest in will return more than the losses sustained on the rest of the portfolio. Startup investing is a game of home runs, not singles and doubles. 

Shape of Power Law (Grand Slam) Distributions compared to Normal (Get on base) Distributions. Adapted from Jerry Neumann’s Power Laws in Venture.

Here’s a good rule of thumb (checkout this sophisticated math)

  • 1/3rd of your portfolio will go to 0 (💰 = 🔥)
  • 1/3rd of your portfolio will break even (💰 = 💰)
  • 1/3rd of your portfolio will grow (💰 = 🦄)

The hope is that one of these companies reaches breakthrough velocity and makes up for all of the losses you’ve incurred. 

A good sized portfolio is 6 - 12 companies. 

The fewer investments you make, the more concentrated your portfolio, which means higher upside if you pick correctly. The challenge is that picking correctly is incredibly difficult. A more appropriate strategy might be a less concentrated portfolio to have more shots on goal. 

Step 2: Determine how much you want to invest.

Angel checks can range from $1,000 to $150,000. The most important thing is to stay true to a plan that works for you and your personal financial situation.

Nassim Taleb, the author of “Fooled by Randomness” and “The Black Swan,” advocates having a 10% ultra-risky portfolio, in other words, looking for a positive “black swan” - an opportunity for outsized returns. And the other 90% being balanced with ultra-safe investments. Many notable angels support this allocation.

For round numbers, let’s say you have $200,000 in liquid assets today. Based on this 10% rule, you can invest up to $20,000 into startups. A good rule of thumb is to spread this out over a few years to catch different “vintages” of startups -- yes, yes, this is a thing 🍷. 

$20,000 over 2 years is $10,000 per year. Distribute this across 5 companies a year and you can safely invest ~$2,000 per company. 

Here’s another example for someone with $1,000,000 in liquid assets. Your check size then would be $10,000 per company over 2 years, in a total of 10 companies (or $100,000 give or take). 

The rough formula here is: 

Step 3: Come up with investment principles

We won’t go too deep forming principles for now. We’ll focus heavily on this in our “how to evaluate a deal” newsletter in a few weeks. The important part is that you are aware of the process.

So what are investment principles? Think of them as guidelines you use to determine whether or not to invest in a company. When utilized correctly, they can be very powerful. 

Tim Ferris covers this well. As a quick intro, Tim Ferriss is the author of 4 Hour Workweek and the host of the Tim Ferriss Podcast. 

Tim was debating getting an MBA, but instead decided to invest into his “real world MBA”, where he would use the money he’d set aside for tuition to invest directly in startups. You can check out his story here & here.

In his words,

“I would aim to intelligently spend $120,000 over two years on angel investing in $10-20,000 chunks, so 6-12 companies in total. The goal of this “business school” would be to learn as much as possible about start-up finance, deal structuring, rapid product design, initiating acquisition conversations, etc. as possible.

The curriculum could be thought of as

“The Start-up Lifecycle from Birth to Acquisition/IPO or Death.” But curriculum was just part of business school; the other part was getting to know the “students,” preferably the most astute movers and shakers in the start-up investing world. Business school = curriculum + network.” 

On his first investment, Tim broke a rule and learned a valuable lesson. 

Tim invested $50,000 (far above the $10,000 - $20,000 per company he’d planned) into the first company he was excited by. A few years later, that company didn’t exist and his $50,000 burned along with it.

The lesson: As Tim would say

“Stick to your “Fu*king rules!”

Investment principles will steady your conviction in times of doubt. Some of the best investments are contrarian bets - the fact that it’s contrarian means that many people won’t agree with your investment strategy.

Mike Maples, a mentor to Tim and a well known VC at Floodgate says “Breaking your rules to co-invest with well-known investors is usually a bad idea, but following your rules when others reject a start-up can work out extremely well.”

Here are some examples of investment principles (This is not exhaustive. We explore this further later in the series):

  • Have a set amount of money you’re willing to invest per deal (e.g $10k per deal)
  • Only invest below a pre-determined valuation (e.g $10M valuation)
  • The company must have at least 6 months of steady revenue growth (e.g 15% growth month over month). 
  • The company is highly scalable (e.g Not a paddleboard rental company).
  • The company must have 2 founders for when times get hard. If there’s only 1 founder, it should be a technical founder (e.g Engineer not sales).
  • There must be one successful angel investor already involved with the company. 

Tims portfolio was immensely successful. 

The 15 companies he invested in included Twitter (Market Cap: $55B), Uber (Market Cap: $89B), Shopify (Market Cap: $198B). It's probably safe to say that Tims angel investments have generated more wealth for him than anything else he’s pursued. Potentially hundreds of millions of dollars. 

Tim had experienced guidance that gave him unique access to good companies. While you may not be best friends with a top-VC partner, you do have access to some top-tier investors via syndicates and rolling funds. We will cover that in-depth next week in our sourcing deep dive.Now that you understand the importance of strategy, take some time to model it out. How much should you be investing? What might be some of your investment principles?

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