2008-04-24

20-40% Returns Sound Heavenly But...

An article in the April 28, 2008 issue of BusinessWeek reports, “The Center for Venture Research estimates that angels enjoyed a rate of return in 2007 between 20% and 40%”—and that another study of data from 1990 to 2007 “cites a rate of return of about 27%, on average, or 2.6 times the investment in 3.5 years.”

“Angels” here refer to folks who do angel investing. This is where you, typically as an individual (though perhaps simultaneously with other angels), put your money into a start-up business. Usually a high-risk, high-return venture—such as a technology company that intends to position itself ultimately for an acquisition or an IPO.

In my series on The 9 or so Paths to Getting Rich—and My Purported Analysis of Them, I described one path as “Opportunistic Luck” and (in Part 2 of the post) as sort of a “venture capital” strategy. I would consider angel investing as being along similar lines.

Is angel investing something that mere mortals can do—something that my family and I should consider doing to try to super-charge our more conservative strategies? Well, it’s not quite like venture capital—the price to admission is definitely lower. I know of one friend who has put money into a venture as an angel investor. He participates in an angel network. Start-ups present at meetings of the group to request funding, and each individual member can decide whether to participate. My understanding is that the minimum investment per person is $25,000.

That’s a lot of money. But it’s an imaginable amount of money. It’s an amount that some of us have and could invest. It’s around the price of many cars. It’s less than what some couples are contributing to their 401(k)s each year, if they are contributing near the max. It’s an amount that many people could readily access through borrowing, through equity lines or maybe even credit cards (not that either is being suggested here!). Maybe it’s an amount about which a friend or relative has approached in the past—for an investment or just for help.

So again, is this something that any of us should consider?

The study mentioned in BusinessWeek found that 7% of the angel investments yielded an overall return of 10 times (1000%)—and that 39% yielded return of less than 1 (that is, they lost money). It’s not clear from the article just how much was lost on those—or how the other 46% of investments did (presumably somewhere in between?). But my belief is that this strategy contemplates the need to hit some of those ten-times home runs to achieve the big overall returns.

If that’s correct, just playing averages, you would hit a home run with a 10-times multiplier only once in every 14 or so investments. So if you bet your luck or skill would lead to average results for an angel investor, you might need to make around 14 investments to hit at least one home run. If a minimum investment were around $25,000, that’s at least $350,000.

Whoa!

The article goes further on the overall risk profile:

Experienced angels recommend that investors create a diverse portfolio as a buttress against inevitable failures. After all, these are companies with little cash flow and no operating history… Only a small percentage of an angel's capital should be at risk—no more than 10% of investable wealth,...

So now take that $350,000 and make sure that it’s only 10% of your investable wealth. That implies you should be pursuing this only if your liquid net worth (excluding at a minimum any equity in your home) is $3,500,000 or higher. So this strategy—this “path to getting rich”—seems really to be a case of the rich getting richer.

Well, that puts angel investing—and to some degree invitations from Cousins Mo and Curly to put money into their “can’t miss” snake-oil venture—into perspective. Not an option for me and my family at least.


Related Posts:
The 9 or so Paths to Getting Rich—and My Purported Analysis of Them (Part 1)
The 9 or so Paths to Getting Rich—and My Purported Analysis of Them (Part 2)

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