Swimming Against the Tide (Angel Investing)

Christopher Mirabile, ACA Board member and Managing Director of Launchpad Venture Group, features a new post from his blog, ScratchPaper, that discusses angel investment decisions, and whether it is best to jump on the bandwagon or swim against the tide.  To read the original post, click here.

So the other day I’m chatting with a new angel about a very large round that had lots of momentum – it had been expanded and was still over-subscribed. Classic case, driven by the usual factors: little bit later stage with some traction, so risk is perceived as lower, great pitch by an appealing CEO, backed by a seemingly good team, momentum in the round building quickly, a product people can understand that is already built and in the stream of commerce, and, perhaps most importantly, a perception of scarcity as the round filled up.

That scarcity factor always gets people’s juices flowing. Whether you call it the bandwagon effect or not, people get themselves into a twist about it. And I would generally agree that it can be a problem. But for a different set of reasons. It’s the flip side of the coin I see as the real problem.

Here’s what I mean: the psychology of momentum plays a big roll in how well early stage rounds do. As an investors, it is easy to allow yourself to be caught up in that psychology. However, the risk of piling into a bad deal because tons of people are piling in is not the real threat. Sure, you definitely can get swept into mediocre stuff that way, but usually not catastrophes. That’s because these deals have some safety features built in: it is harder to pull the wool over the eyes of a large group of experienced investors than it is to fool just a few: with more eyes on a deal, important issues usually come to the surface. Plus those larger, broader-based deals have very strong foundations of support so if the company gets stuck, they often have sufficient financial and human capital at their disposal that they can get back on track.

So while there is surely some risk of positive bandwagoning, I think the risk of negative bandwagoning is the bigger risk to your portfolio. Here’s why: because most great ideas seem absolutely nuts early on. They just don’t seem like smart ideas. They are too crazy. They will never work.

And yet…

History teaches us that a lot of the best bests are these kinds of contrarian bets. Examples abound. Disruptive truth is inconvenient, it is ugly, it is threatening, it often sounds silly. So as an angel, one of the hardest and scariest things to do is to make a tough, non-consensus bet on a round that cannot seem to get momentum with investors. There are a lot of good reasons not to: the market is generally pretty efficient and many, even most, rounds that cannot get investor momentum ARE fatally flawed.

But not all of them. And that’s the rub.

Some of the best angel returns go to the smallest groups of people. There are great deals with relatively few early investors in them. When you are investing via a really good angel platform with lots of experienced, professional investors, it is relatively easy to collect promising-looking momentum deals as the basic building blocks of a healthy, diversified portfolio. And there is no harm in that – these big consensus rounds can be excellent, or made to become excellent with the help of their broad base of support. So they are pretty easy, and worth pursuing – up to a point.

What is very necessary, and very hard, is to find the genius amongst the deals that not everyone (or anyone) recognizes as genius. To swim against the tide. It’s hard because your experience tells you not to do it. When you are surrounded by a lot of extremely smart, extremely experienced investors, and you see them all turn up their noses at a deal, you know from experience that it is usually for very good reasons. Mass abandonment creates a pretty strong presumption that it is not a good deal.

But… it might be. Investors move quickly and they see a lot of deal flow. They are often looking for a reason to say no, simply as a way to help them process the volume of deals. So they get pretty good at finding the flaw and moving on. Problem is, occasionally the masses will have an off day and fail to grasp the potential hidden beneath the surface of something that seems at first glance to trigger a negative pattern recognition response. A group of smart people can pretty easily talk themselves rather casually out of something.

The challenge is to not allow yourself to be jaded and cynical and just be carried along by the currents around you. You have to keep your own counsel and be open to the possibility that every once in a while, there will be something that comes along that has huge potential that other people just don’t recognize.

What do you do in situations like that? How do you test your instincts that there is something being missed? You grab some other investors by the lapels and say “wait, I really think there is something here and we are making a big mistake. Come with me and let’s sit down with this CEO…” Of course, doing that is risky because you are spending social capital and putting your credibility on the line – no one wants to be the boy who cried wolf. But it is just a coffee, and no matter how unappealing the idea is, one almost never has a boring conversation with an entrepreneur about his or her passion. Plus, if your hunch isright, and people follow you into the deal, and the deal works out, your credibility is set for life, right along with the value of your portfolio.

But, you ask, what if they don’t follow you into the deal?

Now you have the hardest and loneliest choice of all: you can either go with the consensus and take a pass and see whether that company ends up on the “ones that got away” pile. Or you can have the courage of your convictions and put the money in and pray this one is the crazy one that turned out to be genius.