Shorter Flights at Lower Heights: The Right Way To Angel Invest

By Dharmesh Shah on July 11, 2012

This is a guest post by Dave Balter.  Dave is the CEO of BzzAgent, founder of Smarterer, an active angel investor and a holder of proms. You can follow Dave on twitter @davebalter

Everywhere you turn these days, you find an angel investor. Aside from those who have always invested small amounts of cash in startups, more and more venture capitalists are making personal side deals, active entrepreneurs are investing in other entrepreneurs, seed funds are cropping up everywhere, and Angel List has emerged for the everyman.

But most Angels will fail to get back the capital they've invested (let alone make money), and it's not because they don't pick good companies or back great entrepreneurs — it's because they're completely mistaken about an Angel's role in the investing cycle.

I know this because my in my early days as an Angel investor I fell prey to behaviors that would practically guarantee that I'd lose money. And now that I've gotten to know the Angel community, it turns out I wasn't alone. The problem: most Angels attempt to act like sophisticated venture capitalists:angel investor onstartups

a) They seek 10x (or more!) homerun acquisitions and;

b) do follow-on investments (pro-rata or more) often through multiple rounds and;

c) invest in game-changing ideas that are incredibly risky;

d) wait for companies to eventually get sold to see a return.

A more effective model for Angel investing is long overdue. If Angels want to win — they want to lower their risk, create better returns, and help entrepreneurs more they'll do the following: fly lower heights (avoid trying to fund the next 5 Facebooks) and take shorter flights (avoid riding each investment out all the way to the end).

An Angel investor should:

a) aim for a 2-4x return;

b) get out of deals in 1-3 years, selling their shares to VCs at the Series A or B Venture Rounds (and not feel bad about it);

c) Remember that they're playing with their own money versus risking someone else's via a fund they've raised. Angel investing isn't about charity work; if they want to spend money to help others, they should just donate to good causes instead.

Ultimately, it's about following the rules of the investing ecosystem: Angels get things started, venture capitalists create mature, sustainable businesses, and investment bankers sell them. And if we all play by our roles, we're all going to win.

Here's what playing by the rules will do:

  • Reduce Risk. Losing money is rarely because the company goes out of business in the first few years. Rather, it's because the company matures and becomes more difficult to sustain through ups and downs. Getting out early will allow an Angel to get more out, more often.
  • Allow More Companies to Get Funded. The majority of Angels have the ability to invest in just a handful of deals, let's say 10 maximum. Their money is limited, and they don't want to overextend. Assuming some follow-ons, most just can't do much more than that. If an Angel exits from one or two in the short term, that 2-4x return will allow them to help start more companies, more often.
  • Avoid Dilution to Nothing. One of the major issues in Angel investing is that a successful company often goes through many rounds of funding at higher and higher valuations. Often at that stage, VCs don't provide early Angels the ability to invest, and even more often Angels can't invest due to the financial commitment. The result: an Angel is left diluted to a meaningless percentage.
  • Keep In-The-Know. In the successful company scenario, the outcome is even bleaker. The major investors no longer provide early investors with Information Rights (the right to receive financial or strategic facts about the company). So that leaves most Angels with a variety of deals that they're entirely clueless about.
  • Provide VCs with More Ownership. When a company begins to succeed, institutional investors want as much ownership as they can get. Without lowering valuation, this conflicts with founders who also wish to keep as much ownership as they can. One solution: Angels are expected to sell shares to the VCs as part of the round. The VCs get more ownership, an Angel makes money and the entrepreneur doesn't get diluted. Everyone wins.
  • Reduces VCs and Acquirers from Having to Deal with — well, Angels. This is an important one. VCs want clean capitalization tables (less people involved = less headaches) and acquirers don't want to have to deal with shareholder lawsuits or other risks of having a whole bunch of (relatively) unsophisticated investors involved. The less Angels involved later, the better.

Again, this is really just about Angel investors agreeing to be what they really are: small-time investors who want to use their own money to help companies grow. It's a great thing, and it shouldn't be confused with investors who are seeking to deliver returns for the Limited Partners in the funds they've raised.

For this to work, the whole ecosystem needs to behave accordingly. Entrepreneurs need to be supportive of an Angel who sells their shares; venture capitalists need to be willing to purchase shares from Angels during the A or B rounds; and Angels need to know their role.

To the Angels: Aim shorter. Aim lower. And for that, you'll get better returns and support more companies.

Which is the point after all, isn't it?

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The Startup Spouse: On Risks, Trade-Offs And Never Sleeping On The Floor

By Dharmesh Shah on July 9, 2012

The following is a guest post by Lisa Rosen, the startup spouse.  You can follow her on twitter @entreprenrswife.

"He who sleeps on the floor will not fall off the bed." ~Robert Gronock

"I quit my job today," announced my husband, Seth Rosen, as he casually dropped his briefcase and strolled through the front door of our apartment. As if it was no big deal. As if quitting one's job is a routine occurrence. To be fair, Seth had talked about leaving his day job to work full time with his best friend, Mike Salguero, on CustomMade.com, a website they had recently purchased. And, to be fair, Seth had asked me repeatedly how I felt about the move. I had assured him that, in no uncertain terms, he had my unequivocal support -- mostly because I didn't think he would actually do it. Yet, here I was, staring at my newly-minted entrepreneur, unsure of whether I should throw up my arms to hug him or strangle him. After all, lots of people talk about starting a company because they think they have a million dollar idea, but very few pull the proverbial trigger. There is a reason for that. Leaving a seemingly safe and reliable salary for the uncertainty and potential perils of a startup company is risky. More startups fail than succeed, especially if a business requires venture capital. A quick search on Wikipedia told me that there are around two million new businesses started in the United States every year, of which less than 800 receive venture financing or 0.04%. CustomMade was already doomed. To make matters worse, it was the summer of 2009 and the US economy was in a deep recession. Was he nuts?

sleep floor

Contrary to popular belief, Seth and Mike argued that the height of the Great Recession was an opportune time to start a company. In 2009, talented people were being laid off and investors were looking for better deals. Companies like Disney, Hewlett-Packard, and Microsoft provided ample precedent that great companies were born during hard economic times. Seth also convinced me that the timing was perfect for a young, well-educated couple with no children and decades of future earning potential to make the leap. Still, trading a plump six-figure salary (and health insurance, as my mother would rightly later point out) for an emaciated startup seemed irrational and incredibly risky to, well, everybody else.

"How could you let him jeopardize your financial security?" was the universal cry from friends, family and colleagues. Others probed deeper:

"When will Seth start to earn a salary?"

"How will you pay your rent?"

"Will you have to put off having a baby?"

"What does CustomMade do again?"

"What if you lose everything?"

"Wait, what do you mean you can't afford to come to my wedding?"

I was standing in front of a firing squad, dodging the bullets as best I could. Over time it became exhausting and my confidence in Seth and CustomMade began to erode.

One afternoon I called Seth at work and told him to be home for dinner, that I was going to cook. He agreed to leave work early only after I told him that chicken parmigiana was on the menu. This was code -- my notoriously limited culinary repertoire consists of any protein that can be breaded and pan fried, and microwave popcorn. If home-style chicken parmigiana is on the dinner menu, then something is up in the Rosen house.

The minute Seth stepped through the door my anxiety erupted. "Why are we starting a company now?" I asked. "It seems like too big of a risk."

"Well, it depends on how you define risk," Seth said without skipping a beat. He sat down at the kitchen table and poured himself a glass of wine. "How do you define risk?" His knowing look should have tipped me off that this question required more analysis than my first impression. But the answer seemed obvious. Without thinking I responded that "risk" is the chance that something bad will happen.

Seth shook his head. "Risk is not just about avoiding bad outcomes. It is the chance of an unexpected outcome good or bad."

"Risk is about evaluating trade-offs," he continued. "And evaluating trade-offs requires the consideration of opportunity costs: if I do this, then I can't do that. I could stay at my finance job, continue earning a salary, and insulate myself against the risk of CustomMade's failure. But what about the opportunity cost of my time?"

The implication was clear. If he continued as an investment banker, then he could not build CustomMade, attempt to change the way people consume retail goods, and reach for a successful exit. Every day he spent doing the "secure" job was a day he couldn't spend building a company.

"Although it seems counterintuitive at first, staying at my day job offers very limited upside financially and professionally. I think that's actually the riskier path."

I paused and slowly digested his words. He was right. From the beginning I had been viewing CustomMade through a much different lens. And so had many other people in our lives.

This is why the Robert Gronock quote above is so relevant for entrepreneurs and their families. Your interpretation reveals how you define risk. In the years before I married Seth, my life was predictable. As a child, my parents taught me to sit up straight, brush and floss my teeth twice a day, and to always color inside the lines. After high school I followed the safe path from college to law school to the conventional confines of a big Boston law firm that provided me with a reliable paycheck. In those days, after reading Gronock's quote, I would have thought, "Wicked smart!" and promptly traded my injury-prone four-poster bed for a mattress on the floor.

But a funny thing happened after I married an entrepreneur. Seth taught me to think differently about the world. The Gronock quote is not sage advice to avoid a bad outcome; it's about a trade-off. By sleeping on the floor you are eliminating a good outcome (a blissful night of sleep) in order to mitigate the chance of a bad outcome (falling off the bed and suffering an injury). Thinking about entrepreneurship in terms of trade-offs and opportunity costs is a better way to think about the associated risks.

Based on my discussions with Seth, this analytical framework is the same whether the decision is to start the company or a day-to-day operational matter. In either case, you need to consider your priorities, which are shaped, at least in part, by the opinions of your inner circle. Of course, multiple third-party opinions often complicate matters. This is especially true if you have a spouse like me that Monday morning quarterbacks your decisions. Let me give you an example.

Seth's company, CustomMade.com, runs an online marketplace for custom goods and services. They connect their network of makers with consumers who are looking for a durable good (like furniture, jewelry or clothing) to be made custom. In the beginning, I was adamant that the company should do capacity building like how-to-run-a-business workshops and other educational programs for their makers, who range from solo practitioners to large, multi-employee businesses. My thought was that adding extra programs would knit the CustomMade community together. It felt good to make the suggestion, like I was adding value to our company.

"Sure," Seth said. "It's a fine idea." I was thrilled.

But he never acted on it. Not even after I nagged him for the fifth time.

"Listen, it's a good idea. But I have a small team here, and everyone needs to be focused on building the product to make our engines run. If I focus my people on maker workshops, then that takes them away from our core priorities and I risk slowing down product development. See the trade-off?"

Oh, right. He was referring to the opportunity costs of his employees' time. I immediately shut up about capacity building, and since then I've tried to keep my backseat driver tendencies to a minimum. When I do provide feedback (solicited and otherwise), I try to frame it in terms of trade-offs. I've even applied the framework to our relationship, but with mixed results. Admittedly, it's hard to stop and consider trade-offs and opportunity costs when you are inherently impulsive, as I am. Unlike me, however, Seth always takes his time to carefully weigh all options before making a decision.

But perhaps I should take comfort from that fact. At least I know we'll never be sleeping on the floor.

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