Sunday, May 23, 2010

Why don't angels invest in early stage or seed venture capital funds?

The vast majority of angel investors make investments on their own or follow other angels into deals. Few angel investors conduct due diligence on their own. Why? Because they don't have time and most don't have the needed expertise unless the investment opportunity is in the field of the angel's experience. Further, most angel investors don't have expertise in negotiating early stage investments. So, why do angels invest in early stage deals in such a haphazard way?

I'm not aware of any studies on why angels invest in this way, but I've represented many companies in their capital raising efforts at the early stage and have observed how angel investors typically behave. Most angel investors base their decisions to invest in early stage companies on the charisma of the founders, not on a thorough analysis of the products, markets and management skills of the founders. Yet. some early stage investments by angels pay off handsomely. How can this be? Frankly, I believe it is mostly luck.

I have a rule of thumb for seed stage investing - invest in 10 companies because 8 will fail (or you will lose all of your investment when later investors squeeze you out), one will make a 2-3 times return and, if you're lucky, one will make a 5 - 10 times return (maybe higher). Of course, the losses will occur in the first few years and the winners will take 5-7 years to achieve success for their investors. Most angels lose patience after five years.

In my experience, most angel investors do not invest in at least 10 early stage deals because they do not have sources for qualified deal flow. As a result, most angel investors get discouraged after investing in deals for three to four years and stop investing, almost assuring a loss on their investments.

If angel investors knew this pattern, why would they invest in a 3-4 deals expecting each one of them to be a 10X winner? In my experience, investors who are new to angel investing don't know about these odds or about the probability they will be wiped out by later investors when their companies have to have "down-rounds" with more sophisticated investors to stay alive.

I've blogged before about why angel invest (based on my experience). They invest for the "fun-of-it," not because they need to increase their net worth. Yet, they hate to lose money. If this is the motivation of most angel investors, it's understandable why they don't do due diligence, don't structure deals smartly and don't cultivate quality deal flow. It also explains why they don't invest in early stage or seed venture capital funds. A fund like this results in little or no contact by the investors with the investment opportunities and with other investors in the fund. In other words, the "fun" is taken out of the hunt for seed investment opportunities.

If angel investors wanted professionals to find the early stage investment opportunities, do thorough due diligence, negotiate favorable deals and offer guidance to each company after the investments are made, early stage/seed venture capital funds would spring up to meet the demand by angel investors to invest in these funds.

As an alternative, angels might band together to form angel investor groups hoping the group could engage a professional to do the due diligence and deal making for them with an approval process that would involve the angels in the decision making. These groups have been formed and some are purportedly successful in their investing missions, but my observation is that most angel groups fall apart after short periods of time due to the need for volunteers to do most of the work.

If angel investors were primarily motivated to invest in early stage companies based on potential returns, they should invest in early stage/seed venture capital funds. Commentators have recently been reporting that the smaller, early stage venture capital funds have provided greater returns to the investors. But, if an angel investor is primarily motivated to invest in early stage deals for the fun-of-it, that angel won't be interested in an early stage/seed venture capital fund because the fun is taken out of the equation and the investor will basically be a passive investor.

If a new, early stage/seed venture capital fund could offer some way to make it fun for angel investors to invest, that fund should succeed in raising capital from angels. Otherwise, a new, early stage fund will have to raise capital from institutional investors who are not into having fun, but into achieving the highest possible returns.