Should You start Angel Investing? Numbers say You should, but…

Some people have asked me for advice on whether they should become angel investors.

Now, I’m still a freshman in this stuff; I struck my first deal at the beginning of 2021 and at the moment have only 10 companies in my portfolio.

That’s why I can’t tell you for certain if you should, but there’s one way to decide.

But first, a little background story.

When I started angel investing, being an engineer, I wanted to understand the math behind it.

I started researching it – reading books and articles, asking for advice from my fellow investors. I went as far as participating in the OnDeck Angels 5 (ODA5) fellowship program.

Well, jokes on me because I quickly realized that most angels rely on a gut feel and don’t really have any technical system behind their investment decisions.

You see, at the pre-seed investing stage where angels usually come in, the only given you can count on is the founders, and everything else will most likely change quite a lot along the way. So it’s almost like math isn’t even on the table.

But being an engineer, life finds a way.

Buckle up because it’s about to get technical

A general consensus is that angel investing is a high-risk initiative, so you should only put money where you’re ready to lose. Generally, that should be no more than 10-15% of your Net worth.

Now, here are two important metrics to keep in mind.

First, your angel investing portfolio success is usually measured by something called TVPI – Total Value to Paid In. This is the ratio between the amount of money you got back to the amount of money you put in as an investor.

TVPI can be fully measured only when all the companies from your portfolio either exited or went belly-up. And since the exit time for a company can vary anywhere from a couple of years to decades, this isn’t exactly the easiest metric to calculate.

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Second, IRR – Internal Rate of Return. It has a complex calculation formula, but it basically represents what your ROI needs to be in order for it to be on the same level as the amount of money your Portfolio is currently returning per annum.

The IRR of 20% at the end of year 3 of your investment means that you’re making as much money as you would if you invested in a stock that returned 20% a year. This way you can compare it to other asset classes one to one.

When it comes to benchmarks, a good one to keep handy is AngelList AccessFund, which is sort of an index fund for investing in startups.

They invest into a wide portfolio, that way helping you mitigate risks and save time on choosing the right companies to invest in.

Their stats display TVPI (Return Multiple) and IRR from the last few years for different funds:

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Keep in mind that this chart includes an unrealized upside; not all the companies from these funds exited yet, and since the older, the more mature they are, the chances of them failing are much smaller (see the concept of J-Curve).

Here’s what the AngelList TVPI distribution over time looks like (source):

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During the ODA5 program, we had a workshop on the topic and were told that a highly successful angel investor should have a TVPI from 3 to 6 and an IRR of 30%.

If we consider the returns at the end of year 5 after the investment, we’re talking about 2.5X.

Chances of success

All the research suggests that the startup success rate follows the Power Law distribution.

This basically means that a very small percentage of companies has a chance to become 100X for you, a couple will become relative successes with let’s say 10X and the rest are going to fail or just return what you invested.

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Parameters of the Power Law are, of course, different depending on what data you rely on. The rule of thumb, however, is that Unicorns, Decacorns, and other Corns happen about 1% of the time.

This, in turn, means that in order to have any chance of succeeding, you need to work hard to get this one 100X company in your portfolio.

Your portfolio size

Look at the chart below. It shows Return vs Probability for portfolios of different sizes.

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It’s clear that the more companies you invest in, the more chances you have for a decent return. Most global funds base their portfolio on at least 30 companies.

Putting it all together

Now, let’s assume that you’re going to be a very good investor and will achieve your 2.5x return.

To have an over 50% chance of achieving this return, you’d need to invest in around 30 companies. (Preferably many more, though.)

This will require you to review around 300 companies and talk to, let’s say, 150, plus spend time and effort generating this deal flow.

The back of the napkin calculation shows that it’ll take you at least a year if you’re going to spend 1+ hours every day on this. Let’s say around 300 hours. This is an optimistic scenario.

As you can see, all this has a significant opportunity cost, especially if talking to founders and digging through heaps of “subprime” projects isn’t exactly something you enjoy.

If, however, you’re lucky with all of the above, your 5-year TVPI is 2.5X, and you initially invest 10% of your Net worth, you’ll now have 15% more of your Net worth.

That result is great from the investment return perspective, but not amazing from the Net worth growth standpoint – it does not really make much difference.

Two ways

Hopefully, the calculations gave you some pros and cons to think about and decide if becoming an angel investor is something you want to pursue.

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If you want to get into angel investing, you have multiple options to do that.

One, you can pick and choose individual companies to invest in yourself.

As described above, even if you’re successful from the get-go, you probably won’t generate life-changing returns. To me, this only makes sense if you:

  • enjoy collaborating with founders and can commit to doing this for a few years or even your whole career
  • enjoy the process and want to improve the quality of your decision-making.

(That’s a whole separate topic for discussion, but practicing decision-making without skin in the game doesn’t really teach you anything.)

If the above doesn’t work for you, there’s the second option, and that’s investing in early-stage companies via Rolling Funds or by being LP in the Pre-seed funds. This allows you to invest in dozens or hundreds of companies at once.

Final thoughts

Finally, here’s what you came here for:

  1. If you play by the rules (i.e. put low % of Net worth for Angel investing and stop) – you probably won’t generate life-changing returns.
  2. To make the whole thing worth it (have reasonable chances of positive returns) you need a wide portfolio (30+ companies), which requires significant time if you pick them one by one. Thus, you should go on a one-by-one Angel investing journey if you enjoy it and see your future there.
  3. You can go with Rolling Funds or as an LP in early-stage funds. In this case, I’d argue, angel investing becomes significantly less risky and you can potentially devote more of your Net worth to this activity. Data shows that good rolling funds tend to over-perform the public markets (see the IRR data above).
  4. If your motivation to become an angel investor is purely financial, I’d just put money in a Rolling fund and spend this time and effort on your own business, health, and well-being, which may have a higher ROI.