How to Be an Angel Investor

[How to Be an Angel Investor]

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| March 2009(This essay is derived from a talk at AngelConf.)When we sold our startup in 1998 I thought one day I'd do some angel
investing. Seven years later I still hadn't started. I put it off
because it seemed mysterious and complicated. It turns out to be
easier than I expected, and also more interesting.The part I thought was hard, the mechanics of investing, really
isn't. You give a startup money and they give you stock. You'll
probably get either preferred stock, which means stock with extra
rights like getting your money back first in a sale, or convertible
debt, which means (on paper) you're lending the company money, and
the debt converts to stock at the next sufficiently big funding
round.
[1]There are sometimes minor tactical advantages to using one or the
other. The paperwork for convertible debt is simpler. But really
it doesn't matter much which you use. Don't spend much time worrying
about the details of deal terms, especially when you first start
angel investing. That's not how you win at this game. When you
hear people talking about a successful angel investor, they're not
saying "He got a 4x liquidation preference." They're saying "He
invested in Google."That's how you win: by investing in the right startups. That is
so much more important than anything else that I worry I'm misleading
you by even talking about other things.MechanicsAngel investors often syndicate deals, which means they join together
to invest on the same terms. In a syndicate there is usually a
"lead" investor who negotiates the terms with the startup. But not
always: sometimes the startup cobbles together a syndicate of
investors who approach them independently, and the startup's lawyer
supplies the paperwork.The easiest way to get started in angel investing is to find a
friend who already does it, and try to get included in his syndicates.
Then all you have to do is write checks.Don't feel like you have to join a syndicate, though. It's not that
hard to do it yourself. You can just use the standard
series AA
documents Wilson Sonsini and Y Combinator published online.
You should of course have your lawyer review everything. Both you
and the startup should have lawyers. But the lawyers don't have
to create the agreement from scratch.
[2]
When you negotiate terms with a startup, there are two numbers you
care about: how much money you're putting in, and the valuation of
the company. The valuation determines how much stock you get. If
you put $50,000 into a company at a pre-money valuation of $1
million, then the post-money valuation is $1.05 million, and you
get .05/1.05, or 4.76% of the company's stock.If the company raises more money later, the new investor will take
a chunk of the company away from all the existing shareholders just
as you did. If in the next round they sell 10% of the company to
a new investor, your 4.76% will be reduced to 4.28%.That's ok. Dilution is normal. What saves you from being mistreated
in future rounds, usually, is that you're in the same boat as the
founders. They can't dilute you without diluting themselves just
as much. And they won't dilute themselves unless they end up
net ahead. So in theory, each further
round of investment leaves you
with a smaller share of an even more valuable company, till after
several more rounds you end up with .5% of the company at the point
where it IPOs, and you are very happy because your $50,000 has
become $5 million.
[3]The agreement by which you invest should have provisions that
let you contribute to
future rounds to maintain your percentage. So it's your choice
whether you get diluted.
[4]
If the company does really well,
you eventually will, because eventually the valuations will get so
high it's not worth it for you.How much does an angel invest? That varies enormously, from $10,000
to hundreds of thousands or in rare cases even millions. The upper
bound is obviously the total amount the founders want to raise.
The lower bound is 5-10% of the total or $10,000, whichever
is greater. A typical angel round these days might be $150,000
raised from 5 people.Valuations don't vary as much. For angel rounds it's rare to see
a valuation lower than half a million or higher than 4 or 5 million.
4 million is starting to be VC territory.How do you decide what valuation to offer? If you're part of a
round led by someone else, that problem is solved for you. But
what if you're investing by yourself? There's no real answer.
There is no rational way to value an early stage startup. The
valuation reflects nothing more than the strength of the company's
bargaining position. If they really want you, either because they
desperately need money, or you're someone who can help them a lot,
they'll let you invest at a low valuation. If they don't need you,
it will be higher. So guess. The startup may not have any more
idea what the number should be than you do.
[5]Ultimately it doesn't matter much. When angels make a lot of money
from a deal, it's not because they invested at a valuation of $1.5
million instead of $3 million. It's because the company was really
successful.I can't emphasize that too much. Don't get hung up on mechanics
or deal terms. What you should spend your time thinking about is
whether the company is good.(Similarly, founders also should not get hung up on deal
terms, but should spend their time thinking about how to make the
company good.)There's a second less obvious component of an angel investment: how
much you're expected to help the startup. Like the amount you
invest, this can vary a lot. You don't have to do anything if you
don't want to; you could simply be a source of money. Or you can
become a de facto employee of the company. Just make sure that you
and the startup agree in advance about roughly how much you'll do
for them.Really hot companies sometimes have high standards for angels. The
ones everyone wants to invest in practically audition investors,
and only take money from people who are famous and/or will work
hard for them. But don't feel like you have to put in a lot of
time or you won't get to invest in any good startups. There is a
surprising lack of correlation between how hot a deal a startup is
and how well it ends up doing. Lots of hot startups will end up
failing, and lots of startups no one likes will end up succeeding.
And the latter are so desperate for money that they'll take it from
anyone at a low valuation.
[6]Picking WinnersIt would be nice to be able to pick those out, wouldn't it? The
part of angel investing that has most effect on your returns, picking
the right companies, is also the hardest. So you should practically
ignore (or more precisely, archive, in the Gmail sense) everything
I've told you so far. You may need to refer to it at some point,
but it is not the central issue.The central issue is picking the right startups. What "Make something
people want" is for startups, "Pick the right startups" is for
investors. Combined they yield "Pick the startups that will make
something people want."How do you do that? It's not as simple as picking startups that
are already making something wildly popular. By then it's
too late for angels. VCs will already be onto them. As an angel,
you have to pick startups before they've got a hit—either
because they've made something great but users don't realize it
yet, like Google early on, or because they're still an iteration
or two away from the big hit, like Paypal when they were making
software for transferring money between PDAs.To be a good angel investor, you have to be a good judge of potential.
That's what it comes down to. VCs can be fast followers. Most of
them don't try to predict what will win. They just try to notice
quickly when something already is winning. But angels have to be
able to predict.
[7]One interesting consequence of this fact is that there are a lot

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