Long-term angel investing: Understanding capital requirements and how to find quality investments

Why angel invest? There are three primary benefits to angel investing if you work in the technology industry: financial, educational and professional. Which benefits are most important to you will dramatically shape your approach as an investor.

Everyone dreams of being a seed investor in companies like Google or Facebook, but the reality is that these companies are few and far between. Still, angel investing does offer the potential for returns that can greatly exceed public markets. Over the last 11 years, I have invested in 120 private companies, mostly at seed stage. Financially, the results have been far above expectations. My first “fund,” the 23 companies that I invested in from 2012 to 2014, had a value of 21.2x total cash invested, and an IRR of 48.6% as of May 31, 2022.

However, it is important to go into angel investing with realistic expectations for financial results. Most professional venture capitalists are considered top quartile if they have returns that exceed a return of 3x invested capital over 10 years, and a 5x return would put you in the top 10%. It takes significant hubris to assume that you, as a new investor, would match those returns given the advantages professional investors have.

Financial returns are not the only benefits of angel investing. Being an investor can also offer educational opportunities not available through any other means. First, angel investing gives you a front-row seat to not only company formation but also the legal and financial process around private markets. For many operators who have only held technical positions, taking on the role of an investor can be an eye-opening experience.

Second, most people stick to products and businesses that they understand well for the professional roles, but this can be very limiting. As an angel investor, you get access to seeing the execution of strategies, products and businesses that you might personally be unqualified to lead directly.

Third, there can be significant career benefits to angel investing, particularly if you work within the technology industry. As an angel investor, you have the opportunity to build new relationships, not only with the founders, but also with the other investors and employees of the company. Every investment is a chance to build a new network, and networks of weak connections often open up surprisingly valuable new opportunities. These benefits compound over time, as one investment often leads to others, and these new networks begin to overlap and strengthen each other.

More importantly, as an operator, seeing how other founders and teams represent their vision and execute against it can help you improve your own capabilities. Most of us have limited experience from the roles and companies we have worked for directly. As an angel investor, you can increase that exposure by 10x to 100x.

How much can you afford to invest?

Unfortunately, the root cause of failure for most aspiring angel investors is not thinking clearly about how much money it will take to be successful in the long term. More often than not, the fundamental issue people fail to take into account is the lack of liquidity in private market investments.

Most see the incredible results from anecdotes about amazing angel investments and assume that angel investing is always massively better than more common asset classes like public equities, bonds and real estate. But the truth is that, on average, the risk-adjusted returns for angel investing can often be worse than traditional investments.

The fundamental problem with angel investing isn’t the capital required, although with accredited investor laws, that isn’t insignificant. The larger problem is that angel investments are illiquid. You can’t just sell private stock if you need cash the way you can sell publicly traded stocks on Robinhood. On average, it takes seven to 10 years from seed stage for successful companies to reach liquidity. Even worse, the companies that fail tend to fail more quickly than the ones that succeed.

As a result, even if you are a great angel investor, you can only really afford to invest money that you may not have access to for up to a decade.

Here’s a simple system you can use to think through how much money you will need to be a successful angel investor:

1. Figure out how much money, per year, you can afford to lock away in angel investments. If you are angel investing out of income, this will be a number that reflects what you can invest per year. If you are angel investing out of your portfolio, this means deciding what percentage of your portfolio you are comfortable allocating to angel investments. Take that amount and then divide it by 10 to get the amount you can invest per year.
2. Figure out how many investments you want to make per year. Research indicates that you need between 15 to 20 companies in your portfolio to effectively lower the “per company” risk of each investment, and suitably increase your odds of finding at least one big winner. Venture investing is dominated by “power law” distributions, where a very small number of winners end up paying for the vast majority that will not return the money invested.

With these two numbers, you’ll have a clear idea of how much you can afford to invest per deal. Most professional venture capital investors will only make one or two investments per year, but angel investors tend to make more. When I started angel investing, I decided I wanted to invest in about 15 to 20 companies over the first three years, which worked out to be about six investments per year.

The math here can be daunting. If you have a portfolio of $1 million, and you want to allocate 10% of your investments to angel, that gives you $100,000. Divided by 10 years, that is $10,000 per year. If you want to make four investments per year, that means you can afford to invest $2,500 per investment.

This is made even more difficult because most founders aren’t interested in adding people to their cap tables with small amounts, largely due to legal and procedural issues, plus the limits on the number of investors in a private company. So if you assume that most founders will set the minimum investment at $10,000, then suddenly you either have to have four times as much money, or you need to limit your angel investing to just one deal per year.

Given the daunting amount of capital required, most angel investors get started by ignoring this basic math. Instead, they make a large number of investments, all at once, using up all the capital they had allocated to angel investing in a year or two. In bull markets, this makes sense, because for tech employees it can feel like the next liquidity event is just a few years away or that their own stock will keep going higher. Some angel investors just invest out of income, allocating 10% of their compensation (or similar) to making angel investments.

Unfortunately, when the business cycle inevitably reasserts itself, these angels quickly deplete their pool of capital and become unwilling to invest more when the markets are down. In many cases, this means they over-invested when prices were high and competition is higher, and then under-invested when prices are lower and competition is lower. It’s the worst of both worlds.

How do you find high-quality companies to invest in?

Access to capital is no guarantee of success: In the end, all of the benefits from angel investing only accrue if you find great founders building successful companies.

But why would they want your money?

This sounds ridiculous on the surface. Startups have a hard time raising capital. We read about them burning through hundreds of millions of dollars. Of course they would want your money! Isn’t it green?

Unfortunately, in most cases, companies that will take money from an unknown angel are rarely the companies that succeed.

If you follow venture capitalists on Twitter, this may sound counterfactual, but in my experience, getting access to great investments requires a degree of humility:

1. Why would a founder take money from me?
2. Why would another investor refer a founder to me?
3. Why would a founder or investor think of me when a round is being raised?

Here are five proven ways angels get access to high-quality opportunities:

1. Build your reputation. What is your expertise? Is it brand building? Building out a sales funnel? Product-led growth? Design? Whatever it is, spending time publishing content can be immensely valuable. First, it builds an audience of people who think highly of your capabilities and may refer you to founders, and second, it provides a library of material for founders to evaluate you when they get your name as a reference.
2. Current and former colleagues. People who have worked directly with you are often the first and best source of referrals. Assuming that your colleagues think highly of your work, these people can turn into either market intelligence (which startups are they joining?), founder references or even founders themselves. I’m a seed investor in Figma because it is an amazing product and company, but the reason CEO Dylan Field came to talk to me back in 2013 is because he was an intern at LinkedIn while I was VP of Product.
3. Founders. One of the biggest improvements in the startup ecosystem in the past 10 years has been the deepening resources and networks available to founders. Founders know other founders, and they reference each other when considering investors. One of the most effective things you can do for your reputation is to make sure that the founders you work with consider your help valuable. This doesn’t just mean investments, by the way. It includes meeting people at events, taking meetings for advice and helping fellow investors with their companies.
4. Seed funds and other angels. This sounds obvious, but it’s surprising how many would-be angel investors do a poor job of telling people that they are angel investors. Seed funds often try to woo founders with access to high-quality angels, so they are well incentivized to refer you. But they have to know about you first. Remember, everyone needs an elevator pitch, so you want to make sure that other investors know how to quickly describe you to founders. This includes what type of companies you invest in, and the more specific you are, the easier it is to remember and reference.
5. AngelList (or similar platforms). Getting access to high-quality investment opportunities is extremely difficult when you start, and platforms like AngelList offer an amazing opportunity that didn’t exist previously. More established angels will effectively share the access they’ve gained with you in exchange for a share, usually 20%, of the profits (“carry,” short for “carried interest”). While this is expensive, following a number of established syndicates on AngelList can give you access to incredible opportunities. For example, I was late to figuring out what a tremendous business Marqeta had, but Auren Hoffman wasn’t. Even though it cost me 20% of the profits, the ability to invest in Marqeta in 2017 at a $400 million valuation was a 10x+ opportunity over just four years.

In the end, your reputation as an angel investor compounds over time, based mainly on the founders and companies you have had the opportunity to work with. This is why long-term operators have an advantage in the beginning — every company you worked for becomes a potential reference point. (For example, I doubt the founders of Good Dog would have been interested in my involvement if I didn’t have direct experience at eBay.)

Angel investing in 2022

After the frothy markets of 2020 and 2021, it might seem counterintuitive to begin angel investing now. However, aspiring investors can take heart in the fact that many of the largest success stories of today were founded during tough times.

Angel investing, and the culture around it, has been one of the formative and unique aspects of startup culture in Silicon Valley. In most places, convincing successful operators to become advisers is difficult and expensive. With angel investors, founders get access to experience and advice, and instead of paying them, they invest their own capital into the company.

Becoming an angel investor is a great and worthy tradition in technology. Just make sure you are prepared to invest successfully for the long term.