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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
In writing this book, we wanted you to benefit from our collective wisdom. With Joe’s extensive legal experience working with startup financings, and Pete’s experience as a startup founder and executive of successful and failed companies, and as an angel investor in Seattle, we believe our perspective will help you avoid the mistakes we’ve made along the way, and look forward to successes.
Keep in mind that when you start angel investing, it is all great. You invest in smart teams chasing big opportunities, and you are getting in early. But the sad fact is that most startups fail. It is only after a few years that you will start to see which of your portfolio companies are doing well and which are underperforming.
We have found that we learn more from the failures than the successes, so we’re passing along some of those painful lessons. By following the guidance in this book and doing your due diligence, you will hopefully decline to invest in a lot of companies with poor prospects, and get the most out of the investments you do make that succeed. Below are some of the keys we’ve found to unlock a great angel investing journey.
important We frequently see angel investors invest all of the funds they have set aside for angel investments too quickly, even within a year. If you are going to start angel investing, don’t get so excited you deploy all of your angel capital too quickly. It is only after you see a dozen or more pitches that you can start to get a feel for what is a really interesting opportunity. It usually takes years for your investments to start returning capital. So if you invest the allocable portion of your portfolio that you set aside for angel investments in the first couple of years of your investing, you might be out of the game for quite a while if you have to wait for a liquidity event to start investing again.
These are becoming more popular, and there are now two in Seattle. John Sechrest runs the Seattle Angel Conference, which educates twenty or so aspiring angel investors per class on how to do due diligence and evaluate opportunities. They screen something like forty companies who apply and over the course of the first two weeks they see all the pitches; over the next ten weeks, they break into due diligence teams, share information, and reduce the forty companies down to the four finalists who present at the Seattle Angel Conference event. Each investor commits $5K at the beginning of the class, and the winning company takes home a $100K investment in the form of a convertible note.
As a participating investor, you get lectures, you get to see forty companies, you get to see diligence performed on twenty companies and to participate in the process yourself. Pete was part of the first class of Seattle Angel Conference, and the company that won is still alive and growing today. There are many other formats, including angel investment funds where members participate in due diligence and make small investments across many companies. SeaChange Fund in the Pacific Northwest is one example.
important We refer to your “portfolio” of angel investments throughout this book, and let’s be very clear about why: You don’t want to rely on just one startup panning out, but build a portfolio, or collection, of many companies to maximize the likelihood that you’ll see a return! Rather than putting $100K into each of two investments, put $25K into eight companies. You don’t want all of your eggs in one or two baskets. Ideally, you have enough capital to build a portfolio of ten investments or more. All you need is one big win out of that portfolio to make money overall.
Another way to extend your portfolio of investments cheaply is to invest in a fund that allows you to participate in a large number of angel investments. For example, the Alliance of Angels has a “sidecar” fund that co-invests along with individual angels when more than three members invest in a single deal. By participating in the fund, one can invest in all of the popular deals that come through the group. The angels who invested directly in those deals did the due diligence, so if you have confidence in your fellow angels it is an easy way to diversify your portfolio.
important Similar to the lesson about having a large, diverse portfolio of investments, do not invest too much in any one company. This can be hard, especially when you are highly confident you have found a winner. Know this: it is very hard to predict winners when you are making early-stage company investments.
examplePete’s first investment was into a company that looked like it couldn’t lose. Through personal relationships of the founders, the company had locked up an exclusive distribution deal in the telecom space that looked like it would just print money. The founder was a real salesman, and Pete put in $75K as his first formal angel investment. Two very frustrating years later that company was bankrupt. If he had put $25K into each of three different investments, he would have learned more, had more fun, and had three times the chance of a positive outcome.
Most startups fail, but they don’t all fail quickly. Companies that are struggling will often need to raise money again without having hit the success milestones they pitched in their last round. You will see requests for bridge financing, which is when a company asks for more money to get them to a near-term milestone (like a product launch or big customer signing) that they believe will allow them to raise more money on better terms not far down the road. They know that their best bet for raising money in a challenging situation is from existing investors who already have skin in the game. They often offer incentives to participate, like warrants or a big discount to the next round if it will be a convertible note financing.
Pete has seen two of these requests from companies he invested in. In both cases, many investors participated, but Pete declined. (Not because Pete is such a smart investor, but because he is a nervous investor, and looks for reasons not to invest!) Both companies eventually failed.
Those opportunities can work out for investors, but you should be very cautious. Your opportunity cost for spending $25K bridging a struggling company is investing in the next really exciting opportunity you see. There is a great McKinsey & Company article about how software and services companies grow fast or die slowly. You don’t want to be funding that slow death.
“You are obviously super smart and have awesome experience; we would love to have you on our advisory board if you invest. You’d be vesting another 0.1% of the company essentially for free!”
Pete’s embarrassed to admit he was swayed by flattery like this to make an investment he was only marginally excited about. That company is still alive, but they are on a slow growth trajectory and the CEO has changed twice. The advisory board met a couple of times in the first year.
Flattery can be tremendously appealing, and an advisory role means you likely have more insight into the company’s progress and you can help them succeed. In reality, there is very little in most cases that a single advisor can do to sway the outcome of a company. If you think you can materially contribute, you should do that out of your interests as an investor anyway, and only after you have fully vetted the company before investing.
If possible, stay within your area of expertise, as we discussed in Finding Opportunities. For example, Pete has no idea how to evaluate medical device companies. He doesn’t understand the steps in the FDA approval process or the distribution channels or pricing for that market. He doesn’t go near medical device investments!
danger Negotiating deal terms too aggressively can have major downsides for the company down the road, and set a bad precedent for future deals. A classic example: you negotiate for a multiple liquidation preference and participating preferred. This might be great for you, but when the next round comes in and those investors put more money in and get the same multiple and participation you got, you might not be too happy.
Additionally, once you have invested, you are all on the same side. You don’t want to poison the relationship with the entrepreneurs by being too aggressive. (We debated titling this section “Don’t be a dick,” but didn’t want to offend our sensitive readers. But it’s a good rule.)
caution Do not accept a board seat unless you are willing to take the risk. Make sure that the company can afford directors and officers liability insurance; make sure the company has good indemnity provisions in its documents (have your lawyer review); and make sure the company gives you an indemnification agreement. Even if all of the above are in place, seriously consider whether you have the time and want the responsibility.
It can be a challenge for some angels who have backgrounds as successful CEOs or operating executives to be in a position of being an observer and not a decision maker. There may be a temptation to jump in and help to fix a problem or close a key deal. You’ve found the right marketing executive for them, why won’t they just hire her!?
It’s important to remember that you have invested in the entrepreneur’s company. It is not your company, and you are not the CEO. You can advise, and make introductions to prospective customers and key hires, and help in lots of ways. But you bet on this horse and you have to let it run the race. Or if you are not into gambling on innocent animals… you invested because you had confidence in the CEO and the team. Now cheer them on.
I have enjoyed every conversation I have had with an entrepreneur, whether I thought their idea was brilliance or lunacy. If you are a curious person and like to learn about new industries and technologies, and how intelligent, motivated, energetic people are trying to solve big problems, angel investing is incredibly satisfying. If you are fascinated by the entrepreneurial journey because you have lived it yourself (or aspired to), it is fun and fascinating to follow your portfolio companies’ successes… and challenges, along with many other companies that you can follow through your angel investor colleagues. Angel investors tend to be smart, successful people who share the same excitement and passion for startups. It has been a great way to meet people and make new friends. Don’t do it just for the payout. As much as the destination of a big payout appeals, it’s the journey that makes becoming an angel investor really worth it.Pete Baltaxe
Remember, this book is meant to be a helpful reference guide, not an encyclopedia. Don’t be afraid to reach out for help. Rely on your mentors, your friends, your colleagues, get a good lawyer, and come back here when you need a reference. Always remember that angel investing is optional. Keep your objectivity. Don’t get emotional, don’t. Getting too excited over a deal can keep you from properly performing due diligence. Move slowly. Don’t think negatively, but think neutrally. There’s no opportunity so great that it’s worth writing a $25K check without knowing what’s going on or how it’s going to affect you down the road. At the same time, don’t get so caught up in the minutiae of the deal terms that it becomes a source of angst or stress. All of the rules, advice, and admonitions found in this book or anywhere else only have value in the right situations, and following these rules too closely can breed arrogance and even ignorance. You don’t want to be so strung up on following ‘rules’ that you’re gummed up on taking any action and miss out on a great deal. Remember that the best return I ever saw went to an angel who wasn’t too stuffy to take a common stock deal—even though you wouldn’t normally be advised to buy common stock! Angel investing is all about situational awareness. Don’t lose your perspective, don’t lose sleep, and don’t invest money you can’t afford to lose.Joe Wallin