Learning Curve of Angel Investing

Posted by Jeff Carter
on April 17th, 2012

I have been travelling all over the midwest recently. It’s been interesting meeting all kinds of people. I am learning a lot.

One of the things I am learning is that very few people understand angel investing. There is a very steep, and most of the time expensive learning curve to run down before you get good at it. Yesterday, at a lunch hosted by the Union League Club, Raman Chadha, Kevin Willer and I talked about different aspects of entrepreneurship. But there was one thing we didn’t focus on, but at least tried to get the point across. It’s risky business.

When you start to analyze companies, there are some tell tale signs to look for. Scalability can be illusionary for example. One thing that I am careful of in my role as an angel that promotes entrepreneurship is to be overly negative on business plans. It’s cool to push back. But, honesty is the best policy. Some people have terrific ideas that can be great lifestyle businesses. They will make a lot of money if they execute well. But, they won’t take over and change the world.

There is a lot of misinformation when it comes to seed stage investing. A lot. People lump seed stage investing with venture capital and private equity. However, all three are very different mindsets, and take some different skill sets.

Private equity is all about cash flow. Take a look at a business, build out the model. Make assumptions about growth and sales and look at how the cash flows through the business. Figure out how much you can lever up the business. This is where the PE guy takes risk. By levering up the business to grow the business they increase their risk, but also magnify their returns. But buying and accumulating businesses is a lot less risky than seed stage or venture capital.

Venture Capital is all about growth, but on a magnified scale. Generally, VC’s won’t look at a business unless it has a pre-money valuation of at least $7M, but most likely $10M. Of course, they do financial modeling too. The assumptions they use might be similar to PE, but many times they are dealing with disruptive technology so it’s very hard to know what the business will look like in the future. VC’s bet on horses, not jockeys. They keep a stable of management types around waiting for a new horse to ride. Angel investors like to say VC’s don’t take risk, but they do it in different ways. A good exit for an angel investor might be invest at a pre-money valuation of $2M and let it go at $15M. For VC’s, they need that business go grow to $90-$100M to make their IRR’s look good. Just like angel investing, everything a VC puts money into doesn’t always work. That makes them conservative.

Seed stage investing is similar to VC but very different. You are dealing with an entrepreneur that you cannot generally replace if things go south. You are betting on the jockey, not the horse. That heightens risk. Companies are pre-revenue. Very small. The market is validated, but it’s still generally an idea that may pivot several times before it hits the mark. Virtually every piece of analysis is very different. Once you analyze and validate an idea and market, then you have to build your confidence that the entrepreneur can actually execute. As an angel investor, you are going to mentor, but won’t be running the company.

The midwest is often criticized for not being risk takers. I disagree. The culture of the midwest was built on risk taking. No one takes more risk than a farmer. There are three exchanges in Chicago where thousands of independent traders assume more risk daily than any angel, VC or PE investor ever see.

As the midwest developed, it’s location made it advantageous for a lot of Fortune 500 companies to settle here. Instead of building a culture of Venture investing like they have on the coasts, we built an incredible culture of private equity. PE firms buy and build companies and flip them to Fortune 500 companies like nobody’s business here.

However, there is a pool of what I would term “uneducated” capital. Say the word private equity and the capital understands it. They get venture capital, but don’t really know how it works. Forget about seed stage capital. Few really understand how to make successful seed stage investments. Over time after being in the school of hard knocks, you learn. It’s an expensive education!

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.