Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
We’re all aware of the importance of diversifying one’s investment portfolio. You may have even received this advice with respect to angel investments. The most appropriate time to determine how you’ll conduct your angel activities is just as you’re first getting started. Do you want to invest in a broad range of companies in order to maintain a diverse portfolio or are you more interested in making larger investments in fewer companies? There are pros and cons to each investing philosophy and you should give them each some thought prior to making a choice. Thinking about this now can help to shape your investment criteria and overall strategy.
As an angel investing beginner, it’s wise to review the industry’s collective wisdom. Reinventing the wheel and repeating mistakes that others have made is both unwise and a waste of money. The internet has made it easier to share these cautionary tales; the more you can learn from them, the better you’ll be able to craft your investment strategies. Sure, you’ll still hit some bumps in the road, but you’ll hopefully avoid any hidden sinkholes.
Diversification: The “Spray and Pray” Strategy
There is a great deal of positive information to be found about diversification. This is at least partially due to the fact that many angel investors have borrowed the technique directly from traditional investors. However, that fact’s clearly related corollary is that much of the data supporting diversification as a wise investment strategy isn’t based on angel investing activities. Therefore, it’s unwise to draw definitive conclusions on how well diversification might translate to angel investing.
In a November 2007 paper entitled “Returns to Angel Investors in Groups,” Robert Wiltbank and Warren Boeker concluded that diversification served to increase the likelihood of a positive return on investment. This is thought to be due to the disproportionately high risk of failure faced by startups. Wiltbank and Boeker reviewed 1,000+ exits by over 500 angels. They found that 52% of those investments resulted in a loss of investor capital and that ~7% resulted in an ROI of at least 10X the original investment. The fact that angel investors are statistically more likely to lose money than to make money appears to support the idea that investing in multiple startups can increase one’s odds of a successful exit.
Although this appears to be a logical conclusion, the funding levels required to invest in multiple startups – plus the investment of time spent in due diligence and other investment activities – can be difficult to manage for some angel investors. For those who desire more hands-on involvement with a startup team, diversification can place an undue burden on an investor’s available time. Additionally, the concept of simply spreading one’s investments and hoping that a couple pay off has received something of a bad rap thanks to its nickname, the “spray and pray” method.
It’s important to note that diversification doesn’t happen all at once; it takes time to build a portfolio. Investing in one to two companies per year is an excellent means of slowly assembling a diversified portfolio. So long as you don’t exhaust your angel funds all at once, you should be able to diversify slowly and strategically as you identify companies of interest.
Fewer Investments, More Time
Investing in multiple companies isn’t for everyone. It can be challenging to track the progress of each team and monitoring parallel due diligence processes can prove burdensome. For those more interested in working directly with entrepreneurs and helping companies to shape their futures, investing in fewer companies is likely to be a more satisfying strategy.
Active investors who engage with their entrepreneurs and offer mentorship tend to experience a higher rate of return as compared with more passive investors. However, if you’ve invested in more than a relatively small number of companies, providing this sort of mentorship involvement might prove to be difficult. Particularly if you’re investing in your industry of expertise, you may want to engage more with your companies and help them to navigate the challenges of running a business. One of the findings in Wiltbank and Boeker’s report shows that those who invest more time with their teams tend to net higher returns.
Those who caution against investing in only one or two companies point to the large failure rate for new businesses, as well as the length of time required to realize returns, as reasons to diversify and stagger investments.
As angel strategies, both diversification and investment in one or two companies each have their pros and cons. Available research speaks for both methods and it’s clear that further study is needed to positively determine whether one is objectively superior to the other. Absent that additional research, choice of the most appropriate investment strategy is a matter for each investor’s subjective discretion.
Prior to making an investment, an investor should thoroughly assess his goals and availability and only then commit to an overall strategy. The level of that commitment may itself provide the best indication of future success. Those leaning toward diversification would do well to focus on due diligence and to invest primarily in their area of expertise. Those who’d prefer to limit the number of companies in which they invest should allocate time to mentor their entrepreneurs and should also consider focusing on their area of expertise.
While crafting your strategy, it’s important to keep in mind that investing intelligently is a long game. You shouldn’t expect to see a return next year. Rather, you’ll hopefully see a return in 5-10 years. It takes time to grow a business. Many will fail and oftentimes you’ll only recover your initial investment, if that. Occasionally, one of your investments may generate an unusually large return, though it will almost certainly take a significant amount of time.
No one can determine the right strategy for you, though being aware of the risks associated with various investment strategies can help you to determine for yourself the strategy that will best fulfill your requirements.
Report: Returns to Angel Investors in Groups http://www.baylor.edu/business/finance/doc.php/229628.pdf
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.