Last year, I became interested in angel investing as a potential hobby and business opportunity. It seemed like a pretty good fit for my professional experience: I’ve founded 2 profitable companies, raised venture funding, went through YC in W14, and have subsequently worked at Salesforce and Facebook. I’m not an expert in most things, but I have become an expert in building and shipping new technology products.
However, after reading 5 books and 24 articles on the subject, I have decided angel investing is not for me. I like building stuff, not talking to other people about building stuff. But that doesn’t mean it’s not for you! If you’ve ever wondered about the asset class and are considering making investments, but don’t have time to read 1,000+ pages on the topic, read on to get my take.
What Must Be True to Be a Successful Angel Investor?
If you meet the following 3 criteria, then I think angel investing can be an excellent way to have fun and generate a meaningful return on investment:
You intrinsically enjoy investing in companies. This means that absent any financial return, you’d want to do the work to invest in companies anyways. What sort of work am I referring to? Mostly taking meetings with entrepreneurs, reading about business models, and networking with other domain experts. Does that sound fun? If so, angel investing could be a really fun way to meet interesting people and make a few bucks along the way.
You have at least 10 hours/week for 3-4 years to do the work. All the authors I read advocate a portfolio approach to angel investing. This makes sense: even the smartest investors are only right a fraction of the time, so you need a bunch of bets to ensure you get enough winners to cover the losers. All of the available literature shows a positive correlation between return on investment and time spent conducting due diligence. Factoring in different assumptions about conversion rates (first meetings -> investments), I think you should budget at least 10 hrs/week spread over several years to build a suitably diversified portfolio. You can build your portfolio much faster, of course, this is just the lowest bound on time commitment that seems likely to result in market returns.
You have at least $3.3M in liquid assets in your portfolio. Angel investing is risky. Even if the average internal rate of return is ~20% (see the sources below), there is a very real possibility that the return on your specific portfolio will be negative. To be safe, then, you shouldn’t have much of your total portfolio allocated to angel investing. At the same time, if you have too few absolute dollars invested, even a 20% IRR becomes too small to make it worth your time. $3.3M seems to be the lower end of portfolio size required to have enough cash to create a diversified portfolio and have a shot at generating meaningful returns.
There are lots of other factors to consider when deciding whether or not to make angel investments: deal flow, connections, and industry knowledge to name just a few, but I think that as long as you meet all of the criteria above, you can reasonably expect angel investing to be both enjoyable and lucrative. In the following sections, I go deeper into each of the criteria above to explain how I came up with the guidelines so that you can evaluate my logic and make adjustments to my calculations based upon your own personal circumstances.
You Intrinsically Enjoy Investing in Companies
If you just really like investing in companies, that’s a big first step to becoming a successful angel investor. As I outline in further detail below, building a profitable portfolio takes a lot of time, focus, and attention. If you don’t enjoy the work, you’ll struggle to follow through and will likely not achieve the returns advertised by other prominent angels. The best way to know if you intrinsically enjoy investing in companies is to already be doing it. If you have already made an investment in a private company or if you spend considerable time investing in public companies, that’s a very strong signal that you would enjoy being an angel investor.
For people who aren’t already angel investing or actively managing a stock portfolio, it’s necessary to do a bit more introspection to determine whether you would enjoy angel investing. Here are some typical angel investor activities. I would recommend reading through the list and taking note of your immediate, instinctual reaction to each one. Do you feel excited to do the work? Do you recoil at the prospect of doing these activities? Does reading this list make you bored? Pay close attention to your gut reactions:
Reading launch announcements for new technology companies.
Reading fundraising announcements from companies.
Creating a big spreadsheet to analyze a company’s business model.
Networking digitally and in-person to meet entrepreneurs.
Attending incubator demo days and expositions to meet entrepreneurs.
Networking your way to industry experts to fact-check founder pitches.
Responding to founder inquiries for help with current business challenges.
Recruiting people from your network to fill current openings at your portfolio companies.
Discussing legal documents with your lawyer to make an investment.
Trying new technology products to understand them and their competitive landscape.
Finding and interviewing the customers of companies you may invest in.
If you are either already investing and enjoying it or you read through this list of activities and it sounds like a lot of fun, you probably have an intrinsic interest in investing and could make a really good angel investor.
If you are like me and think these activities sound kinda boring, you can probably stop reading now. Angel investing is neither a passive activity nor something you can outsource. There are other ways to passively invest your money that don’t require any of the above work and still make reasonable returns (index funds can reasonably return 6% per year with no effort, real estate crowdfunding sites like Fundrise are a bit more active, but return 10%+). You should look into those instead.
You Have At Least 10 Hours Per Week to Do the Work
Angel investing is a lot more time consuming than it may appear. Because most of the returns in a portfolio are earned by the top 5-10% of deals, you must spread your risk over a large number of companies to realize anything close to 20% IRR over the long term.
Finding and investing in a large number of companies, however, takes time. How much time? Let’s do some quick estimates to get a ballpark:
Since the average and median for this dataset are the same, let’s use 20 as the minimum size of a functional portfolio.
Time Required for Sourcing and Due Diligence
So now we know how many companies we need to invest in to achieve industry norms for return on investment. But how long does it take to find and close a deal? The data here is sparse and a bit disjointed, but let’s review what’s available.
In his book, Angel, Jason Calacanis writes that he can typically perform the necessary sourcing and due diligence for a deal in about 3 hours.
By contrast, in one of the most famous oft-quoted studies in the industry, Robert Wiltbank of Willamette University reports that when operating in groups, angel investor returns are significantly better when the groups devote more time to due diligence [source]. He cites 20-40 hours as the threshold for realizing better returns.
Taken together, what we know from available literature is that the amount of time required to perform due diligence on a company ranges from 3-40 hours, but seems more likely to be in the 10-30 hour range. If we take the average, we get 20 hours of time required to perform due diligence on deals that you close.
This makes intuitive sense. It takes time to find a company, arrange to speak with the CEO, research their pitch, speak with industry experts to learn more about areas you may not have domain expertise in, examine any documents or financials, model expectations around valuation and dilution, negotiate valuable (if you can), make a decision, and communicate it to the team.
But of course you aren’t going to invest in every company you research. In fact, you’re likely to invest in only a tiny fraction of the deals you hear about. There is no available data for how long it takes an average or even highly skilled angel investor to disqualify deals, but it’s safe to say it’s much less than the time spent getting all the way to an offer for the deals they do close.
Because there isn’t any available data to use, I propose using a fairly simple rule of thumb that it takes about 5 hours on average to vet a deal. This allows us to incorporate a few very long due diligence processes where you spend more than 20 hours learning about a company only to not invest/not be able to get into the round as well as a large number of very shit deals that you are able to quickly reject.
What % of Deals Should You Expect to Close?
Ultimately, this boils down to your personal decision making. You could choose to invest in every company that pitches you. You could choose to only invest in companies that have already achieved product/market fit, are scaling, and have taken money from Andreessen Horowitz. In the former case, you would expect to achieve far less than 20% returns (most companies fail) and in the latter case, you would expect to never actually have your money accepted because you will be a new angel investor with no reputation fighting to get into deals that already have very little risk and seasoned investors.
In my reading, I only came across two authors that disclosed their conversion rates. Jason Calacanis invests in 4% of deals he identifies, and David Rose invests in 2.5%. I think it’s probably safe to use the higher number, especially when you are starting out and deal flow will be a challenge.
Time Required to Build a Portfolio
Let’s say you invest in 1 company every year for 20 years. By the end, you will have invested in the requisite 20 companies, but you are very unlikely to achieve anywhere close to 20% returns. Why? Your portfolio performs better the larger it is for a sustained period of time. If you only invest in 1 company/year, the size of your portfolio as measured at any point during the 20 year period is likely to be quite small. This creates two problems:
Timing effects. If you have allocated $500k for angel investments, but you happen to pick poorly on your 5-10 tries (which should be expected), you might not have enough capital left to do follow-on investments or invest in new opportunities. Both of these will limit your returns.
Lack of social/human capital. When building dealflow, it helps to have experienced success. If you invest very slowly, you will have less access to high quality deals for a larger portion of your portfolio building years.
All of the authors I read accept the industry norm of building your portfolio (20 companies) over the course of 1-5 years. Calacanis is on the extreme short end (recommending would-be angels to quickly get to scale in year 1) with Rose being on the opposite extreme, suggesting that new investors shoot to make 20 investments in 5 years. I think Rose is more realistic and will suggest 4 years as a compromise.
Putting it All Together
We now have all the necessary variables to calculate the total amount of time you can expect to spend building a suitably diversified angel portfolio. To review:
We can figure out how many hours/week it will take you to build a minimum viable angel portfolio with the following equation:
((Time Required for Due Diligence / Deal Conversion Rate) x Necessary Portfolio Size) / Time to build Portfolio in Weeks
Plugging in values, we get:
((5 hrs / .04) x 20) / (4*52)
(125 x 20) / 208
2500 / 208
12 hours/week
First, I want to point out, that’s a lot of time required to build your portfolio! 2,500 hours is a little more than a year’s worth of full time work in the US. The proposal here is to spread about 1.25 years worth of full time work spread over 4 years to get the portfolio up and running.
This suggests 12 hours/week average, so let's say a minimum of 10 hours/week for our guideline.
But Don’t Take My Word For It
The reason I wanted to go into such detail in this section is to provide you with the underlying research and variables I used in coming to my conclusion. You may, however, have different data sets that lead you to use different underlying variables and therefore alter the resulting time required. If your day job is already investing, for instance, you may have the skills necessary to evaluate companies much faster. Feel free to adapt the formula above to your life circumstances and arrive at your own conclusions for how long it will take to build your portfolio per week.
Tweak the Formula with My Calculator
You Have At Least $3.3M in Liquid Assets in Your Portfolio
Investing in startups is risky. Here’s how most venture capitalists expect a portfolio of 10 companies to work out after 10 years (this data is an amalgam from the books I read):
5 companies die and return 0x
2 return the investment and no more, for a return of 1x
2 return 3x
1 returns 22x
Internal rate of return is tricky to calculate, and I’ve made some assumptions about the timing effect of these returns in the linked spreadsheet, but this roughly lines up with the 20% IRR that the authors I read suggest is average for the asset class.
The important thing to understand here is that diversification is the key to hitting the 20% IRR target. If you invested in 10 companies as described above, but miss the one that returns 22x and another that returns 3x, your return will be a paltry 8% IRR - you would have been better off just parking your money in Vanguard and calling it day. Some angel investors lose 100% of their principal. It’s just a cost of doing business.
Apart from building a portfolio of companies, how else do angel investors protect themselves from the volatility of the asset class? They only invest a small portion of their overall portfolio.
How Much of Your Portfolio Should You Invest?
Everyone will have a different risk threshold, but the consensus among authors I read seems to be 10%. They differ, however, in how they define a portfolio. On the extreme end, Jason Calacanis recommends up to 20% of your entire portfolio (including illiquid asset classes like real estate and 401ks) whereas John Huston, the founder of Ohio Tech Angels, recommends no more than 10% of your family’s cash flow, in other words, the money you set aside for savings on a yearly basis.
I prefer to take a compromise between those two extremes and suggest that would-be angel investors allocate no more than 15% of their liquid invested assets in startups. What do I mean by “liquid assets?” I mean cash, stocks, and bonds that are not held in a retirement vehicle like a 401k, Roth IRA, or in an asset class that penalizes early withdrawal (CDs for instance).
To take a concrete example, let’s say your total net worth is $5M, but $500,000 is locked up in home equity, $300,000 is tied up in investment properties, and another $200,000 is in your 401k. I would say you have a liquid portfolio of $5,000,000 - $500,000 - $300,000 - $200,000 = $4M.
Why exclude all those otherwise normal assets? Because they are costly to access and those costs can dramatically erode your upside potential. Many 401k plans, for instance, require the owners to take a 10% penalty if funds are withdrawn early. That means that to make a 20% IRR return on capital withdrawn early from a 401k, you would need to earn substantially more to adjust for the early withdrawal penalty. Although such returns are possible, they are unusual for the asset class.
How Much Should You Invest in Each Company?
The only step remaining to calculate a minimum viable liquid portfolio size is to determine how much you want to invest in each company.
This isn’t as straight-forward as it sounds, however. You will need to calculate not just how much you want to invest, but also how much you want to hold in reserve for follow on rounds. Some investors only do seed round investments and don’t participate in follow-on rounds, but the literature suggests that doing so substantially limits portfolio returns since you aren’t able to double-down on the successes.
According to several surveys by the Angel Capital Association and Angel Resources Institute, the average investment per angel per company is $25k, which includes participation in follow-on rounds. This suggests that initial investments made by most angels fall in the $15-20k range.
Venture funds and Lord and Mirabile recommend holding at 100% of the initially invested capital in reserve for every investment. Putting this together, let’s say you go with a $15k initial investment and hold $15k in reserve in case the company does well. That means you need $30k per investment. And we know from the first section that you should be trying to build a portfolio of at least 20 companies. $30,000 x 20 = $600,000. This is probably a bit high of course, because most companies (~50%) die outright, and of the remaining companies, only a fraction will have appealing deal terms or space on their cap table. It’s not precise, but I round down by $100,000 to take into account the large number of companies that don’t need follow-on funds.
This leaves us with a lower bound of $500,000 required to build a minimum viable angel portfolio. Using the guidance that you should only invest ~15% of your portfolio in startups, that implies a minimum liquid portfolio size of $3,300,000.
What is Your Time Worth?
Another way to think about the minimum size of your liquid portfolio is to calculate the expected hourly wage. Savvy investors will have a good sense what their time is worth per hour.
This part gets a little complicated because internal rate of return isn’t super easy to calculate. It involves the present value of cash, inflation, and uneven returns over time. Luckily for you, I’ve done the math in my calculator!
My findings suggest that most investors that follow my guidance above will earn a healthy $720/hr for their time, which is probably a fairly good rate of return for most people in this wealth and income class. You can tweak the calculator below:
Tweak the Formula with My Calculator
But What About Prestige and Connections?
Based upon my research above, I think that if you like investing in companies, have at least 10 hours/week, and have a liquid portfolio of at least $3.3M, angel investing can be fun and lucrative.
Before I wrap up, however, I wanted to take a moment to call attention to the elephant in the room: not all angel investors are in it to make a buck. Some are altruistic, preferring to give money to companies as a way to support people like themselves or to further advancements in a particular area of research and development. Other angels are drawn to the prestige of networking with the rich and powerful.
Having done my research, I have to conclude that neither reason is bad, provided you relax the assumption that you will earn market returns on your investments. For the person who just wants to look good at parties (no judgement here, being an early investor in successful, innovative companies is pretty fascinating), it doesn’t matter whether you earn 20% IRR on your invested capital, it just matters that you get what you came for.
So, if you have read this far and say “you know what, I actually just want to help out entrepreneurs because I relate with their struggles, and it’s not a financial problem for me to do it” then who cares about any of the above? Go and invest in some companies.
Similarly, if you do a little introspection and decide that your primary motivation is to meet interesting people or have a shot at witnessing the meteoric rise of a cool new technology, who cares what your rate of return ends up being? You, too, can disregard my advice.
Finally -- and I saved this to last because it’s such an extreme edge case -- if you are already rich or famous, it seems likely that none of this blog post applies to you. If you are Tim Ferriss, for instance, you won’t have to work to generate deal flow, it will come to you. And through your network of highly knowledgeable friends and acquaintances, you can more easily vet deals, check out business model assumptions, and get intros where needed.
Conclusion
The picture that I’ve painted above about a successful angel investor may not sound super appealing to a lot of people. In practice, starting out as an angel, even one with great connections in a major tech hub like Silicon Valley or New York, is a humbling experience. You won’t get access to the best deals, you’ll try to give companies your money and get rejected, you’ll have to negotiate against absurd valuations, and if you’re lucky, you’ll earn 20% IRR for your efforts. If you have a liquid portfolio of $3.3M, that amounts to a healthy $720/hr, but it’s certainly not free or passive income.
As I mentioned in the opening paragraph, I failed the “intrinsic motivation” part of the equation, so I never even got to the point where I was comparing my desired vs realized hourly wage. But for anyone interested, it’s a sobering realization that even experienced angel investors are only a few mistakes away from earning less than a passive index funds.
#Thanks a ton to Nick Winter, Steve Saines, and Eric Xiao for suggestions and edits.
Sources
Articles
After 20 years: Updating the Berkus Method of valuation - Dave Berkus
How I Invest - Mark Suster
How to Become an Angel Investor - Upstate Business Journal, 2016
Guide, Don’t Control - FeldThoughts
Staging Capital: Angel Follow-on Theory - Christopher Mirabile (Seraph blog)
Approximations, Assumptions and Aspirations: Methods For Valuing Startups [Part I] - Christopher Mirabile (Seraph blog)
Approximations, Assumptions and Aspirations: Methods For Valuing Startups [Part II] -
Christopher Mirabile (Seraph blog)
Startups Are Risk Bundles - Coding VC
For a fraction of the price, angel investors can pay huge dividends - The Globe and Mail
New Data on Angel Investor and Angel Fund Returns - AngelBlog
Stop the Merry-Go-Round, I Want to Get Off: An Introduction to Angels and Exits - Seraph Blog
Angel Investors Do Make Money, Data Shows 2.5x Returns Overall - TechCrunch
In-Depth Angel Investor Survey Sheds Light On Angel Success - Forbes
Prediction and control under uncertainty: Outcomes in angel investing - Robert Wiltbank
How to join an Angel Investor Group - Investopedia
Top 3 ways to Getting started with Angel investing in less than 30 minutes
The Mechanics of AngelList Syndicates - Hackernoon
An angel investor's ultimate guide to AngelList Syndicates - VentureBeat
My Angel Investor Checklist - TechCrunch
How To Invest In Startups - Sam Altman
How to be An Angel Investor - Paul Graham
Books
Angel: How to Invest in Technology Startups--Timeless Advice from an Angel Investor by Jason Calacanis (288 pages)
Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups by David Rose (304 pages)
Fool's Gold?: The Truth Behind Angel Investing in America by Scott Shane (288 pages)
Fundamentals of Angel Investing by Hambleton Lord and Christopher Mirabile (192 pages)