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| Opportunities & Exposures: Finance |
Flight Risks
Dan Rosen
11/01/2005
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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.
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