By Dr. Jim Dahle, WCI FounderAngel investing is a challenging but potentially enjoyable method of investing for those who are already wealthy and love the process. It should not be viewed as a method to “get rich” or as a mandatory part of a portfolio.
Why Do People Look for Angel Investors?
When entrepreneurs run out of their own money but still don't have their business off the ground, they will usually turn to friends and family. However, since most people aren't very wealthy, that source of funds also doesn't last very long. They are left with two options:
- Take on debt
- Give away part of the company for cash
The problems with taking on debt are three-fold:
- Debt must be serviced, eating up valuable cash flow
- Debt takes time to qualify for and may not be available at all
- Debt does not provide any “extras,” such as expertise from an experienced entrepreneur.
Angel investing comes with none of these downsides, even if it costs a piece of the entrepreneur's beloved company.
What Is Angel Investing?
An “angel” investor comes down from above to save an entrepreneur and their fledgling company with both funds and (ideally) expertise that will help them “get the plane off the ground.” Angels are usually individuals, and they typically provide a relatively small amount of money to the company—generally $15,000-$250,000—in exchange for equity. In addition to the cash, they may also become part of an advisory board to the company. The typical progression of a successful company might look like this:
- Entrepreneur's own funds
- Friends and family money (loans, gifts, or investments)
- Angel investors
- Venture capital
- Private equity
- Initial Public Offering (IPO)
A venture capital firm or fund may provide amounts in the $1 million-$5 million range—less in early (seed) rounds and more in later rounds. The earlier the money is given, the more capital the entrepreneur must exchange to get the money. Sometimes it can be divided into multiple “rounds” such as:
- Seed: $50,000-$2 million
- Series A: $2 million-$5 million
- Series B: $5 million-$10 million
- Series C: $10 million-$50 million
- Series D: $50 million+
However, these dollar figures are highly variable and adapted to a given company. Private equity, often using borrowed money, may come in and purchase an established company (whether struggling or not) to try to fix it up, and then flip it a few years later to another buyer or take it public. However, angel investing comes before any venture capital or private equity. It's a far riskier time to invest, although the amounts required are typically small enough that it is generally individual money, not institutional money, despite the presence of “angel funds.”
More information here:
Entrepreneurship and Angel Investing
10 Reasons You Should Own a Business
What Kind of Returns Do You Get from Angel Investing?
The returns from angel investing are extremely variable, ranging from a total loss of capital (a frequent occurrence) to 100X+. Some data suggest that a diversified portfolio of intelligent angel investments can have quite a good return. A study at the University of New Hampshire suggested that ON AVERAGE an angel investor multiplies their capital by 3.5X. The most widely cited study, by Boeker, showed an equity multiple of 2.6X with an IRR of 27%. That study looked at 538 angels in 1,137 deals. Right Side Capital Management looked at multiple studies that showed returns ranging from 18%-37%.
The Need for Diversification
Perhaps the biggest issue with angel investing is the fact that most companies go bust. A majority of angel investments do not return any of their capital to investors at all. To borrow a sports analogy, this is not a game of “singles and doubles.” It's a game of not just home runs but World Series winning, walk-off, grand slam home runs. Three percent of companies provide 77% of the cash returned, and 10% of the companies provide 85%-90% of the cash returned. Basically, nine out of 10 deals are losers. So, you need to invest in enough of them that you get a few winners. You shouldn't invest in one or two and expect to make money. The most likely outcome of 1-2 angel deals is to lose all of your capital.
More information here:
The 6 Stages of Diversification — Where Are You At?
Due Diligence Matters in Angel Investing
One interesting finding from the return studies was that higher returns were correlated with additional due diligence time. Returns were better if you spent at least 20 hours of due diligence than if you spent less than 20 hours. Ideally, you're a bit like Warren Buffett in that you not only invest in companies but actually influence them for good. You're investing your money and your time.
You Better Enjoy Investing
Since you need wide diversification in this asset class, having 20-50 different investments seems like the minimum to have a reasonable disbursement of returns. And if you're going to spend at least 20 hours on each company and you presumably pass on at least as many as you invest in, we're talking about a serious time commitment here. That's 100 companies x 30 hours = 3,000 hours. That's like a year and a half of full-time work. Most physicians are going to be much better off spending that year and a half working and investing an extra $300,000 into a typical portfolio than chasing angel returns.
You Better Be Rich, Too
The other problem with having a diversified portfolio of angel investments is that it requires a lot of money. If your average investment is $50,000 and you have at least 20 of these, that's $1 million just in angel investments. If you're wise and limiting these to a maximum of 20% of your portfolio, that suggests a portfolio of at least $5 million. Kind of like private passive real estate, you need to already be rich before you invest in this asset class. It's not a method to get rich in the first place.
At a minimum, you would need to be a legal accredited investor, i.e., have an income of at least $200,000 each of the last two years or investable assets of at least $1 million. However, my definition of an accredited investor is two-fold:
- Be able to evaluate the merits of an investment on your own without the assistance of an attorney, accountant, or advisor and
- Be able to lose your entire investment without it affecting your financial life.
In my estimation, the latter requires you to possess BOTH of the legal accredited investor definitions and then double them. i.e., an income of $400,000+ AND investable assets of $2 million+ to invest in anything that requires accredited investor status. And angel investing is probably one step beyond that.
Clubs and Funds
Since angel investors seem to mostly do this for fun (psychic returns), they often do it with other people. They join clubs of angel investors or invest via funds to be a little more diversified. I suspect they imagine themselves like the stars of Shark Tank with entrepreneurs coming to them to beg for their money and expertise. While a fund seems like a great idea, be aware that it doesn't always pan out. One professional investor said this about his funds:
“I have invested in 51 companies directly. I am a general partner directing investments in two funds (one a small VC fund, the other an angel fund), and I am a limited partner (i.e., a passive investor) in four low fee/low carry angel funds. The four funds I am a limited partner in are diversification plays (two vertical-specific and two geographical). Five of the six funds will each yield me some ownership in about 35-45 companies (so approximately 200 companies across those five funds), and the little angel fund has done about a dozen. None of the funds has experienced any big positive exits so far—just a couple small exits and a dividend or two . . .”
There is clearly a lot of hope involved in investing in this asset class. Bear in mind that most funds are really just groups of people pooling their money and due diligence. It's not really a passive experience. For example, the Golden Seeds Annual Fund has a once-a-year capital call, and then members vote on which companies to invest in throughout the year.
More information here:
A Moderate-Income Physician’s Approach to Alternative Investments
Is It Just ‘Too Hard?’ Know Your Circle of Competence
Do I Invest in Angel Investments?
No, I do not. I believe in investing my time actively and my money passively. I don't get a lot of joy out of investing. It's mostly a chore I try to spend as little time as possible doing. That approach is not really compatible with this asset class.
What do you think? Are you an angel investor? How rich were you when you started? How many deals have you done? What kind of returns have you seen? Any tips for success?
I don’t recommend it to most doctors. We tend to be too busy and too trusting to do well. My mind sees a simple pattern and projects wild success going forward without considering the vast number of scenarios that fail.
Having said that, I do invest in small local businesses with capable leaders and good business models. My state provides a 20% business investment credit that helps. I’ve had a few successes and a couple that went to zero. This provided diversification but didn’t move the needle much on my overall portfolio.
Jim if this is true “ . I don’t get a lot of joy out of investing. It’s mostly a chore I try to spend as little time as possible doing. ” why do you have real estate investments? I’ve read about your multi state tax returns needed with real estate funds. Why not just dump real estate (except maybe VNQ) and go all index funds?
I figured when reading the title that angel investments were going to be your next hobby path. You are financially beyond most doctors, so perhaps you need a separate website, the 8 figure investor, that talks about real estate, angel investments, and netjets. 🙂
This one has talked plenty about real estate, a little about NetJets (https://www.whitecoatinvestor.com/when-should-you-fly-first-class/), and now about angel investing so I don’t see much need for another one. While most of our audience doesn’t have 8 figures, there are plenty of people in it who do.
The main reasons we invest in real estate are low correlation with our stocks and bonds and high returns. More info here:
https://www.whitecoatinvestor.com/private-real-estate/
We are definitely always looking for ways to simplify our portfolio though. I wrote a post about it recently but I don’t think it’s been published yet. But it involves getting fewer accounts and investments. For example, I think I’m about done with I bonds. I don’t have any problem with them, but we just can’t buy enough of them to move the needle and it’s three extra accounts with the world’s worst account provider (Treasury Direct).
i recommend a bit of caution. i am immersed in tech innovation, it is the world I live, but the problem is there is so much hype and BS that you really need to know the fundamentals of the core idea to understand if the product makes sense. angel investing really helps push projects over the top for the founders, but it may not help you as the investor if you do not understand to core fundamentals. The success percentages you have seen are probably a bit optimistic so take care. i love this stuff, it is what i do, but i suggest a bit more due diligence that you might not think necessary.
I love articles like this that really break down what “success” in this investment niche would actually look like, and where the numbers sit in that regard. I have started to think in this framework myself, from reading so many WCI articles. “20 funds at 50K a piece means 1 million that I’ve gotta be willing to part with to make this worth my time, etc.” Will I ever be at the point that I can toss away a million bucks and not bat an eye? Probably not. If I had 5 million and could stop “playing the game” would I feel much desire to do the angel investing game? All this for returns that are a little above the stock market. And then when you add in how much money we can make just working shifts for that same length of time?
This is really one of the strengths of this website and the whole WCI movement. You do this same thing in many other articles, for instance when you compare returns of stocks versus real estate, and that same reductionist logic has dissuaded me from going down that avenue as well (just like you’ve done here with Angel Investing). Just like (for me) the idea of starting a small business. I had a few good ideas, but the idea of a second job just doesn’t ever seem worth it.
While I would love to do ALL these different types of investing (I’d love to be the Shark Tank guy! or a real estate tycoon!), when you run the numbers and include time and skill required to gain some alpha, it just almost never, ever shakes out to do anything better than working more ER shifts and just sinking that into index funds (I’m a 3 fund guy with a little REIT tilt).
There is a kind of comfort in that.
To knowing it’s reasonable to not have to try so hard.
To knowing there really ISN’T much sense (for me) in learning a whole ton about real estate or angel investing or value stock picking or starting a small business or derivatives or whatever. To have the “myth debunked” (the myth being that I will get guaranteed richer if I just do this or this or this…): it is liberating.
I have now read hundreds of your articles and almost every book recommended on this site and listened to many of your podcasts and at the end of all of that I think I have come to realize that a simple portfolio of boring (fixed asset allocation) index funds, a 20% savings rate, and just “doing my time” in the ER really IS the simplest and best (for me), most guaranteed path to financial success.
It is nice to feel like I really don’t have to worry about or learn about that much more.
Now I can go back to reading sci-fi novels and playing video games on my free time and not have to feel guilty about it.
We just try to tell it like it is without the hype. Obviously, some people will look at the same data with angel investing or real estate investing and make a different choice than you.The nice thing about docs and other high income professionals is they can retire as multimillionaires without doing anything special. Working shifts, carving out 20%, index funds. Yes, it works. Maybe you can speed it up a little by doing some other stuff, but you certainly don’t have to.
By the way, a 3 fund portfolio plus REITs is a 4 fund portfolio! I think Rick Ferri even stuck a name on that one. Core 4 maybe.
Nah, it’s called the “FloridaEDDoc 3-Fund plus REITs portfolio” now 🙂
I’ll stay anonymous for this one, please.
I live in the Bay Area and my own accounting business has put my eyes right into the personal and business books of a lot of high net worth individuals. I see them doing very well as Angel Investors. I see them getting maybe 300% back over a 5 to 10 year span. I also agree with every word and statistic that Dr Dahle has in this post. How can these mutually exclusive views both be true?
As each Angel fund batches up a new group of founders and puts them into a portfolio that is proposed to individual Angel investors, there are people involved whose job is to do serious due diligence. These are seasoned professionals who look at one start up after another, and when they see what they consider to be a ‘good one’ in the pool, they seem to somehow let their friends know.
As an outsider investor, you have the choices in this post – wide diversification or heavy hours doing your own due diligence. As a friend-of-an-insider, you also get tips. Of course, not all the tips are going to pan out. I do see funds go to zero in my clients books. But enough tips seem to pan out to make higher returns than average.
Have I ever used my ringside seat to invest on the tips my clients receive? No. It would be unethical for me to use my clients info. But it seems to be a light grey area for the employees and consultants of Angel Funds to let their own friends know that one portfolio might just be better than another. I mean, it’s their whole job to hype up all the portfolios, one after another.
“It’s a big club, and you ain’t in it!”
Did they do a study similar to this for investing in public markets? I bet extra time doesn’t improve results, maybe even worsening from overtrading.
“One interesting finding from the return studies was that higher returns were correlated with additional due diligence time. Returns were better if you spent at least 20 hours of due diligence than if you spent less than 20 hours. Ideally, you’re a bit like Warren Buffett in that you not only invest in companies but actually influence them for good. You’re investing your money and your time.”
I think public and private markets differ in this respect.
I guess sets up a strategy where it makes sense to passively index in something low fee and tax efficient for public markets. And to put in “sweat equity” for seeking out angel investments. Of course the second one is easier said than done.
I’ve founded 2 healthcare startups and raised from angel investors and VCs. I’ve also angel invested in about 10 companies.
Take it from me, having learned the hard way on both sides of the trade – If you’re reading this, you should probably not be angel investing.
If you really can’t stop yourself from taking on some risk, you can take plenty of risk in the public markets. Why take on the extra risk of the earliest stages of company formation and the illiquidity?
The only time it may make sense to write an angel check is if you personally know the founder very, very well and you truly don’t care if it goes to zero.