Dan Rosen
11/01/2005
Entrepreneurs spin great stories. About eight years ago, I helped found the Northwest’s largest angel network, the Alliance of Angels. Soon after, a recent chemistry graduate from the University of Washington passionately claimed to have invented a novel way to make fuel cells that could ultimately replace lithium ion batteries. He had me dreaming of laptops running forever on replaceable cartridges, no power cords needed. I gathered some friends—some far more knowledgeable about fuel cells than I am—and they too were enamored of the chemist’s passion and knowledge. So we invested. We got lucky: The company is on the road to success.
Angel investors often get caught up with charismatic and passionate entrepreneurs. It’s the joy and the danger of angel investing. For angel investing to work, investors and entrepreneurs need that shared passion and vision. But angel investing is not for the faint of heart. Seed-stage investments tie up your money for a long time because you are investing early in the life of a company whose typical gestation period is six to eight years. No individual can do (nor does a relatively modest investment justify) the depth of analysis and due diligence that professional investors such as venture capitalists conduct; that often makes decisions difficult. And the likelihood that several additional rounds of financing will follow your initial investment and dilute your stake causes a large financial risk.
Even successful companies might not ultimately be good investments for the angels if later investors wash out or crush them in subsequent rounds of financing. This often happens if the company misses its milestones and must raise money at a valuation lower than the previous round. This happened to one of my early angel investments. The final investors in the deal recapitalized the company, reducing the value of each share of common stock by 580 to 1. My shares became almost worthless, despite the fact that the company went on to be modestly successful.
Many angels, especially those who were successful entrepreneurs themselves, struggle to give entrepreneur CEOs sufficient room to run their start-ups. For example, here in Seattle, many Microsofties retired early and became angel investors and board members. They wanted to roll up their sleeves and dig in. Clearly, start-up CEOs do not want or need a boss. Good angel investors are comfortable mentoring entrepreneurs and helping them make connections that will aid the business, rather than trying to run the business themselves. When angels meddle instead of advise, it weakens good companies.
Changeling Cherubs
Knowing this, many angel investors discover investing is just not enough. They bounce back and forth between starting companies and investing in them. For one of my friends, being an investor has been rewarding, but after a year or so, he always seems to find the next thing to build himself.
It helps significantly if the investor is experienced in the field of the entrepreneur. If all you have is financial expertise, due diligence is more challenging. For the angel willing to develop that subject-matter expertise, however, making an investment with a great entrepreneur is a wonderful way to stay ahead of the curve in emerging industries.
There are two strategies that help mitigate the high risk of angel investing: selecting the best deals and diversification. This is not terribly different from other investments, but it is more difficult given the very nature of early stage private equity. The average angel sees a limited number of deals each year. Generally, it is hard to investigate more than one deal at a time, so an active angel can do four deals per year at best. For diversification, one should have between eight and 12 active deals. Angel networks can be a good way for angels to increase their deal flow and to compare notes with other knowledgeable investors.
Angel investing in start-ups can be difficult and frustrating. But when they succeed, you not only make a great deal of money, you’re rewarded by one of the best feelings in business. My best advice to would-be angels: Know your strengths, weaknesses and desires. If they don’t match angel investing, don’t do it. If they do, have fun.
Dan Rosen, the founding general partner of Frazier Technology Ventures, is a technologist and investor in Seattle.