Want to get funded? Understand angel investment returns - 09/16/2008

Recently I have been studying overall returns in the private equity market, including angel investing. An understanding of angel investment returns can be very useful to entrepreneurs who seek angel financing, as the founders must be able to put together a compelling story that will convince the investors they have a shot to achieve the returns needed and expected. And for angels, as with any investment, it is always useful to compare your own performance to that of the market overall.

One surprising fact is that overall returns for angel investors largely track those of the broader private equity market, including venture capital. Returns for private equity/venture investments are often talked about in terms of their return or exit multiple, such as 2X or 3X. If an investment returns 2X that means it returns double the money of the initial investment. Half of the returned capital compensates for the initial investment (the principal), the second half represents the profit or gain. Talking about the multiple alone unfortunately ignores how much time it takes to get the return, so a more complicated measure called Internal Rate of Return (IRR) is also used.

Some highlights from the research:

  • 39% of angels lose money on their investment portfolio
  • 52% of individual angel investments lose money (return less than 1X)
  • Only 7% of individual angel investments return 10X or more back to the investor
  • The average angel investment is held 3.5 years
  • Angel investors can increase their odds by doing significant due diligence, retaining close ties with the company post investment, and investing in industries in which they are knowledgeable.

These key data points come from an excellent report on angel returns produced with support from the Kauffman Foundation. This is the most extensive study done to date on overall angel investing returns. This data is based exclusively on angels who participate in angel groups. This report is well worth reading in its entirety (fortunately it is only 16 pages).

The following chart, from the report, graphs the return multiple of deals covered in the report and highlights average investment holding period for each group.

From Returns to Angel Investors in Groups, November 2007

From Returns to Angel Investors in Groups, November 2007

A key finding in the research is that the top 10% of investments returned 75% of the total capital back to the investor. So 1 deal in 10 pays back all the money lost on the others and generates most of the profits too. From an investor’s perspective then, the only way to make any real money is to have one or more investments in the top 10% of all investments. One strategy to help do this is to make sure the investment portfolio is diversified, with 6, 8, or even 10 or more companies. But beyond that, the investor must try to pick winners. Each new, potential investment will be weighed with the criteria “does this venture have the potential to be in the top 10%?”

Understanding this is critical for an entrepreneur when they have an opportunity to approach or present to an angel group. If they cannot convince the investors that there is strong potential to be in that top 10% of investments that will return 8X, 10X, or even 30X, then it will be very difficult to achieve funding - at least on an investment return basis. The fact is that some angels will invest in certain projects for reasons more complex than just investment return - personal interest, community building, or they may have a soft spot for the mission of the proposed business. But these are the exceptions and should not be the basis of a business plan.

I remember the first angel presentation I ever listened to sitting on the investor side of the table. The company was a web commerce business. The company was seeking $200,000 in seed capital to ramp up the business, do marketing, and establish a modest physical presence in addition to on-line. In 6 years, the company anticipated increasing yearly sales from $50,000 to $800,000, generating approximately $80,000 in net income in year 6.

Looking at the potential return on this deal, let’s assume for a moment the investors would take a generous 50% of the company for their $200,000 investment. They would then hope the team executes to plan with no more funding, wait 6 years, and after all that the best case is that the business might be worth a million dollars or maybe a little more to the right strategic buyer - but more likely closer to 600-800k based on a 7-10X multiple of profits as typically calculated by a financial buyer. This would be a 2.0-2.5X return to the investors after holding the investment for 6 years. Clearly this company would not get funded. It might make a nice family or hobby business if it could be bootstrapped.

The Internal Rate of Return (IRR) calculation is more useful than the multiple, when we want to take into account the holding period of the investment. IRR comes from a method to compare investments originally used inside companies, and it can get complicated when applied to venture and private equity funds. However, in looking at an angel investment, basically the IRR is the equivalent yearly investment return you would need to get on a traditional type of investment (mutual fund, money market, etc) to result in the same amount of capital being returned to the investor at the end of the period. In a traditional investment, you get returns each year and re-invest them along the way, ending up with a certain balance at the end of the investment period. In the example of angel investment, the all the returned capital comes in a lump sum at the end. The angel investment would need to have been earning a certain “internal” rate of return throughout the whole investment period, to return the same amount of capital as the non-angel investment at the end. This whole calculation gets more complex with venture funds which draw down capital over a period of time, and do actually return capital along the way, but we won’t cover that here.

On average, angel investing delivers an IRR of 27% - not too bad. The eCommerce business above would have provided about a 12% IRR, if it succeeded. This might not sound bad, but remember 50% of the investments will fail. The deals that will positively contribute to the 27% overall average IRR must have a much higher individual deal return to compensate for the failures. Any investment must have the real potential to generate an IRR of 50% or more to have a hope of being funded. Your job as an entrepreneur is to convince the investors, supported by data, that your company is one that has the realistic potential to be a top performer - returning 10X or more - to be what is called a “home run” for the investor. These are the deals the investor needs to find if they want to make any money, therefore these deals will draw the investment dollars.

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