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Have you ever noticed that sometimes people learn best when they hear how they should not do something? The hit television show What Not to Wear is very effective in demonstrating wardrobe mistakes to avoid.
With that in mind, here’s my list of the worst angel investing practices, with a tip of the hat to John Huston and the Ohio Tech Angels, who have used this teaching method for many years. Avoid these 10 mistakes or your angel investments could be losers right out of the gate:
- Put all of your angel money in one investment. Angel investing is risky – more than half the time startups fail. The U.S. is full of former angels who only made one or two angel investments and lost all of the money they set aside for angel investing.
- Accept a sky-high valuation from the entrepreneur. Some angels invest in deals with valuations they know are too high. Why? They either believe they will miss out on a really great company or don’t want to start out a relationship by being disagreeable. The problem is with an out of whack valuation, you end up owning a very small percentage of the company which reduces the odds of making money. Additionally, if the company attracts a next round of funding, it will likely be a “down round.”
- Calculate your potential returns only on going public (rather than through acquisition). It’s true that there have been some fabulous IPOs by angel-backed companies, however the overwhelming number of exits – close to 90 percent - are mergers and acquisitions. Rather than the 110X angel investors attained when
Green Dot Corp went public, M&A returns are often in the 3 to 10X realm. - Calculate your return with only one round of investment. Newer investors are often surprised to learn that successful companies usually need to raise several rounds of capital to become successful. Estimating and anticipating how much money will be needed in future rounds takes some work and learning, but it is a key driver of estimating potential returns.
- Invest in a company you don’t understand. A study on angel returns found investors were three times more likely to lose money when the company was in a field outside the investor’s experience. Investors can build their understanding of products, sectors or business models by learning from others and asking lots of questions.
- Disregard data on returns. These days, it is easier and easier to find data on VC-backed company exits, and even easier to get it for specific industries and regions. Unicorns happen, but historical data is a key indicator of potential returns, particularly when they are for the same industry and region.
- Make your decision solely on who else is investing. There is no denying that following smart and experienced investors is attractive – and in my opinion, should be part of a good angel strategy – but it doesn’t take away the need to review business and deal documents and ask questions to make sure the deal is right for you.
- Be silent after you invest. Companies that go out of business are the ones that didn’t get help and expertise from their more experienced investors. Be prepared to help solve product problems and to provide connections to potential large customers. A smart angel’s work is just beginning with the investment.
- Only participate in the first round of investment. Wading into follow-on capital rounds can require haggling over new deal terms and understanding nuances that may be new to you like “pay to play” or “pre-emptive rights.” However, you may need to make more investments to build the possibility of a return from your first investment in the company.
- Invest only to attract a tax break. Half of American states and many countries offer tax credits to invest in startups and small businesses, often offering credits of 25 to 50 percent of the angel’s total investment to their income taxes. Most of these program do reduce investors’ tax bills, but if the company or deal wasn’t good to begin with, that is the only positive the investor will get.
There are no guarantees in angel investing, even when best practices are followed, but those who follow two or more of the worst practices are almost guaranteed to lose their investment. Be smart. The next time you consider an angel investment, avoid these top 10 mistakes, and look here for good investing practices.
