I had dinner with my good friend and Bazaarvoice co-founder, Brant Barton, on Tuesday at the new Sway in West Lake Hills (yummy) and we talked about lessons learned in angel investing. It was on my mind as I’m doing an AMA (Ask Me Anything) webinar with my good friend and often investing colleague, Josh Baer, on Tuesday, Feb. 5 from 4-5pm CT (you can sign up here). During my conversation with Brant, I distilled down to seven lessons learned (in the spirit of Lucky7, of course). Brant is reading Jason Calacanis’s book on angel investing and told me that many of these are in there (maybe all of these, I haven’t read the book), so you may want to turn to that to really dig in as I’m going to do my best to keep this post short. My hope in sharing these with you is that it ignites more angel investing in Austin - it is vital to our startup ecosystem here. We are doing better on that front in Austin than ever before, but I believe we are only scratching the surface here. And I hope these lessons have an impact beyond Austin angels and startups as well.
These seven lessons are distilled from angel investing since 2010. We are in 62 startups and 19 VC funds now (our portfolio), and I have some good data at this point on how profitable our endeavors have been, so I feel pretty qualified to share these lessons with you. Outside of the scope of this post is what is on my mind when I actually meet with an entrepreneur to assess their startup - and I’ve looked at over 1,300 startups since 2010. I’ve written about that in my free ebook on entrepreneurship, The Entrepreneur’s Essentials - read lesson three on the five critical ingredients to build a big company if you want more on that. Ok, without further delay, here are the seven lessons learned:
The number one mistake I’ve seen new angel investors make is that they invest in too few startups with too much capital in each. I’ve limited our net worth in startup investing to around 5% of our wealth. Very few angel investors I’ve met are that disciplined as greed can get the best of you. The beta risk is high as many startups go bankrupt and what you are looking for is the few that will generate a large enough return to make your efforts worthwhile. Others have made this observation, including Tucker Max in Austin (you can read his thoughts in this post). Mike Maples, Jr. of Floodgate has written about the power-law dynamic in VC startup investing, and I would encourage you to become educated on it. To put this in practice directly, if you have a million to invest, you are much better off putting $25,000 to $50,000 in each startup than $100,000 to $200,000. Austin needs you to stay in the game and learn it well enough where you can see, like Jason Calacanis has or Debra and I have, that it can be a very profitable endeavor. Too many angel investors try it with just a few startups, don’t get good returns, and conclude that they are “awful angel investors”. The reality is that they didn’t give themselves a real opportunity to learn the craft. I’m a big fan of Jerry Neumann’s posts and here is a great read on this lesson.
You are better off investing in what you know. For me, this is Software as a Service (SaaS). Half of our startups are SaaS. You’ll be able to help these companies better as a mentor. It doesn’t mean you won’t be able to help other companies, and we are in many B2C startups, for example. Often your mentoring will be focused on topics like how to raise money (and making connections for the startup CEO), how to recruit, how to manage your Board and investor relationships, how to sell, etc. Those are applicable to all sectors of startups. But you’ll have better pattern recognition (and therefore likely better outcomes) in the sector you know best. Mark Cuban has made this point, I’ve heard (and read in an article awhile back), but it should be obvious to you overall.
On average, we have generated far better returns from serial entrepreneurs than first-time entrepreneurs. Michael Dell, Mark Zuckerberg, and Bill Gates were first-time entrepreneurs, I guess (I say I guess because I know Michael was very entrepreneurial even prior to Dell), so you may question this logic by thinking, “I’ll miss out on the best if I don’t take that risk on that first-time entrepreneur kid genius.” Maybe that is right, but there are many, many more examples of successful entrepreneurs that are repeat (e.g., Reid Hoffman and LinkedIn, Reed Hastings and Netflix, Aneel Bhusri and Workday, John Mackey and Whole Foods, and I could go on and on and on). It is true that some young entrepreneurs have otherworldly wisdom but most of us, including myself, build that entrepreneurial wisdom over time. I’m on my sixth startup at data.world. With my fifth startup, Bazaarvoice, our initial investors generated a 70-110x return! Imagine that - if they invested $100,000 they generated up to $11,000,000 if they held on to the peak of our stock price. Some of our most exciting angel investments in Austin are led by serial entrepreneurs and include startups like AlertMedia, Dosh, Dropoff, ClearBlade, Infinite IO, Convey, Rollick, Smarter Sorting, Pingboard, Zen Business, RocketDollar, and others - this is certainly not meant to be a comprehensive list for us and excludes some in our portfolio founded first-time entrepreneurs that are really exciting, such as Julia Taylor Cheek’s EverlyWell.
If you have a company performing really well, make sure you invest in their next round, at least at your pro-rata amount. Momentum begets momentum! VC funds always reserve 30-50% of their fund’s capital for follow-on rounds. In general, we invest in seed, Series A, and sometimes Series B rounds - and sometimes in all three for a single company when things are going very well. Although investing early means taking more beta risk, you also have a much higher alpha upside if it really hits.
We invest in VC funds when it serves to diversify our startup portfolio in the hands of proven experts. This is why we are investors in both CAVU Funds. We are not CPG experts but we were fortunate enough to be angel investors in Deep Eddy Vodka, led by our good friend Clayton Christopher (who, by the way, was a serial entrepreneur, having led Sweet Leaf Tea before - see lesson 3 above). When Clayton decided to start a Fund after his incredible sale of Deep Eddy Vodka, we knew we had to be investors. We already believed in the macro trends of niche brands, retail differentiation (and disruption) in the age of eCommerce, The Long Tail, and consumer tastes and diets shifting faster than big CPG companies could keep up. In all things being equal - capital being capital - we thought that entrepreneurs would want to work with CAVU to get experienced guides for their journey - proven CPG experts, who understood shelf placement, branding, market research, etc. Likewise, we invested in Multicoin Capital because we personally don’t specialize in cryptocurrency and blockchain. And we invested in Forerunner Ventures because they understand B2C and serve a different geography, and others. In general, this means we are primarily in SaaS and in Austin startups as direct investors and leave expert VCs for the rest (diverse industries and geos).
If you can really help the company, offer to serve on their Advisory Board for common equity in addition to your preferred equity investment. This has worked out very well for us and allows us to help the company even more directly. For the hit companies in your portfolio, you’ll make money on both the preferred and common equity this way. The entrepreneurs are very interested in protecting their common and maximizing the value of it, so you are aligned with them as an Advisory Board member on maximizing its value. If the company is early enough in its history and the stock value is very low (such as it is at a company’s founding, before it raises any money), then you should see if the founders are doing an 83(b) Election and whether or not you can participate as well as an Advisory Board member. Note that you have an advantage as compared to venture capitalists in that they cannot earn equity in this way - it is unique to the angel model (VCs don’t get additional equity for serving on your Board of Directors or being an advisor to your company as it is expected from their LPs and they need to share in the standard 80/20 model). As an entrepreneur, I practice what I preach here — look at all of the amazing Advisory Board members we have at data.world. Also note that if the company becomes a fight for preferred over common, in almost all cases no one is going to make a lot of money and it is not a great outcome overall (for anyone). Entrepreneurs have to do well for investors to do well, generally speaking (and as it should be - they are doing the real work every day). This is why I almost never invest in a company that is early stage and already has a big Board of Directors of angel investors that already control the majority of the equity (with little to no VC involvement) - that is a clear sign of the entrepreneur being micro-managed and not very incentivized (and it is usually a sign that those investors are playing for a conservative base hit instead of swinging for a home-run outcome).
Don’t just trust your own instincts, make introductions. Building a network is a very valuable activity for you as both an entrepreneur and investor. When I meet a new entrepreneur that I really like, I make a lot of introductions to potential investors and advisors. This is not just easy to do, it is really valuable for the entrepreneur as well as us as the potential investors. I get market intelligence from people that I know can really help, and they get to see the deals that I’m looking at. Plus it incentivizes them to do the same - show me their deals. This activity also bonds you to the entrepreneur - they genuinely appreciate it and know the value of a warm vs. cold introduction. When you are just beginning as an angel investor, go out there and start selflessly serving the community. Karma will inevitably kick in. Become a mentor at Capital Factory, TechStars, SKU, and other places that are known for helping entrepreneurs. This will ultimately help you build a network rapidly.
Note that if you hold your stock in a startup for at least five years before selling, you could have a very favorable capital gains exemption. I encourage you to get familiar with Section 1202 of the Internal Revenue Code.
I hope all of these lessons help you become a first-time angel investor, or a more successful one if you are already doing it. We feel truly fortunate to work with the entrepreneurs that we do. It keeps us young, and it is one of the inputs that led to me starting my sixth business in data.world (i.e., being genuinely inspired by them). I would love to hear your own lessons learned in the comments! I’m certainly under no illusion that this is a “complete” list, and I’m always learning.
