9/10/2014 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.
Mechanics
Angel 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]
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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.
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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 Winners
It 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 hiteither 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 of
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people out there who have never even made an angel investment
and yet are already better angel investors than they realize.
Someone who doesn't know the first thing about the mechanics of
venture funding but knows what a successful startup founder
looks like is actually far ahead of someone who knows termsheets
inside out, but thinks "hacker" means someone who breaks into
computers. If you can recognize good startup founders by
empathizing with themif you both resonate at the same
frequencythen you may already be a better startup picker than
the median professional VC. [8]
Paul Buchheit, for example, started angel investing about a year
after me, and he was pretty much immediately as good as me at
picking startups. My extra year of experience was rounding error
compared to our ability to empathize with founders.
What makes a good founder? If there were a word that meant the
opposite of hapless, that would be the one. Bad founders seem
hapless. They may be smart, or not, but somehow events
overwhelm them and they get discouraged and give up. Good
founders make things happen the way they want. Which is not to
say they force things to happen in a predefined way. Good
founders have a healthy respect for reality. But they are
relentlessly resourceful. That's the closest I can get to the
opposite of hapless. You want to fund people who are relentlessly
resourceful.
Notice we started out talking about things, and now we're talking
about people. There is an ongoing debate between investors
which is more important, the people, or the ideaor more
precisely, the market. Some, like Ron Conway, say it's the people
that the idea will change, but the people are the foundation of
the company. Whereas Marc Andreessen says he'd back ok
founders in a hot market over great founders in a bad one. [9]
These two positions are not so far apart as they seem, because
good people find good markets. Bill Gates would probably have
ended up pretty rich even if IBM hadn't happened to drop the PC
standard in his lap.
I've thought a lot about the disagreement between the investors
who prefer to bet on people and those who prefer to bet on
markets. It's kind of surprising that it even exists. You'd expect
opinions to have converged more.
But I think I've figured out what's going on. The three most
prominent people I know who favor markets are Marc, Jawed
Karim, and Joe Kraus. And all three of them, in their own
startups, basically flew into a thermal: they hit a market growing
so fast that it was all they could do to keep up with it. That kind
of experience is hard to ignore. Plus I think they underestimate
themselves: they think back to how easy it felt to ride that huge
thermal upward, and they think "anyone could have done it." But
that isn't true; they are not ordinary people.
So as an angel investor I think you want to go with Ron Conway
and bet on people. Thermals happen, yes, but no one can predict
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themnot even the founders, and certainly not you as an
investor. And only good people can ride the thermals if they hit
them anyway.
Deal Flow
Of course the question of how to choose startups presumes you
have startups to choose between. How do you find them? This is
yet another problem that gets solved for you by syndicates. If
you tag along on a friend's investments, you don't have to find
startups.
The problem is not finding startups, exactly, but finding a stream
of reasonably high quality ones. The traditional way to do this is
through contacts. If you're friends with a lot of investors and
founders, they'll send deals your way. The Valley basically runs
on referrals. And once you start to become known as reliable,
useful investor, people will refer lots of deals to you. I certainly
will.
There's also a newer way to find startups, which is to come to
events like Y Combinator's Demo Day, where a batch of newly
created startups presents to investors all at once. We have two
Demo Days a year, one in March and one in August. These are
basically mass referrals.
But events like Demo Day only account for a fraction of matches
between startups and investors. The personal referral is still the
most common route. So if you want to hear about new startups,
the best way to do it is to get lots of referrals.
The best way to get lots of referrals is to invest in startups. No
matter how smart and nice you seem, insiders will be reluctant to
send you referrals until you've proven yourself by doing a couple
investments. Some smart, nice guys turn out to be flaky, high-
maintenance investors. But once you prove yourself as a good
investor, the deal flow, as they call it, will increase rapidly in both
quality and quantity. At the extreme, for someone like Ron
Conway, it is basically identical with the deal flow of the whole
Valley.
So if you want to invest seriously, the way to get started is to
bootstrap yourself off your existing connections, be a good
investor in the startups you meet that way, and eventually you'll
start a chain reaction. Good investors are rare, even in Silicon
Valley. There probably aren't more than a couple hundred serious
angels in the whole Valley, and yet they're probably the single
most important ingredient in making the Valley what it is. Angels
are the limiting reagent in startup formation.
If there are only a couple hundred serious angels in the Valley,
then by deciding to become one you could single-handedly make
the pipeline for startups in Silicon Valley significantly wider. That
is kind of mind-blowing.
Being Good
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How do you be a good angel investor? The first thing you need is
to be decisive. When we talk to founders about good and bad
investors, one of the ways we describe the good ones is to say
"he writes checks." That doesn't mean the investor says yes to
everyone. Far from it. It means he makes up his mind quickly,
and follows through. You may be thinking, how hard could that
be? You'll see when you try it. It follows from the nature of angel
investing that the decisions are hard. You have to guess early, at
the stage when the most promising ideas still seem
counterintuitive, because if they were obviously good, VCs would
already have funded them.
Suppose it's 1998. You come across a startup founded by a
couple grad students. They say they're going to work on Internet
search. There are already a bunch of big public companies doing
search. How can these grad students possibly compete with
them? And does search even matter anyway? All the search
engines are trying to get people to start calling them "portals"
instead. Why would you want to invest in a startup run by a
couple of nobodies who are trying to compete with large,
aggressive companies in an area they themselves have declared
passe? And yet the grad students seem pretty smart. What do
you do?
There's a hack for being decisive when you're inexperienced:
ratchet down the size of your investment till it's an amount you
wouldn't care too much about losing. For every rich person (you
probably shouldn't try angel investing unless you think of yourself
as rich) there's some amount that would be painless, though
annoying, to lose. Till you feel comfortable investing, don't invest
more than that per startup.
For example, if you have $5 million in investable assets, it would
probably be painless (though annoying) to lose $15,000. That's
less than .3% of your net worth. So start by making 3 or 4
$15,000 investments. Nothing will teach you about angel
investing like experience. Treat the first few as an educational
expense. $60,000 is less than a lot of graduate programs. Plus
you get equity.
What's really uncool is to be strategically indecisive: to string
founders along while trying to gather more information about the
startup's trajectory. [10] There's always a temptation to do that,
because you just have so little to go on, but you have to
consciously resist it. In the long term it's to your advantage to be
good.
The other component of being a good angel investor is simply to
be a good person. Angel investing is not a business where you
make money by screwing people over. Startups create wealth,
and creating wealth is not a zero sum game. No one has to lose
for you to win. In fact, if you mistreat the founders you invest in,
they'll just get demoralized and the company will do worse. Plus
your referrals will dry up. So I recommend being good.
The most successful angel investors I know are all basically good
people. Once they invest in a company, all they want to do is help
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it. And they'll help people they haven't invested in too. When they
do favors they don't seem to keep track of them. It's too much
overhead. They just try to help everyone, and assume good
things will flow back to them somehow. Empirically that seems to
work.
Notes
[1] Convertible debt can be either capped at a particular
valuation, or can be done at a discount to whatever the valuation
turns out to be when it converts. E.g. convertible debt at a
discount of 30% means when it converts you get stock as if you'd
invested at a 30% lower valuation. That can be useful in cases
where you can't or don't want to figure out what the valuation
should be. You leave it to the next investor. On the other hand, a
lot of investors want to know exactly what they're getting, so
they will only do convertible debt with a cap.
[2] The expensive part of creating an agreement from scratch is
not writing the agreement, but bickering at several hundred
dollars an hour over the details. That's why the series AA
paperwork aims at a middle ground. You can just start from the
compromise you'd have reached after lots of back and forth.
When you fund a startup, both your lawyers should be specialists
in startups. Do not use ordinary corporate lawyers for this. Their
inexperience makes them overbuild: they'll create huge,
overcomplicated agreements, and spend hours arguing over
irrelevant things.
In the Valley, the top startup law firms are Wilson Sonsini, Orrick,
Fenwick & West, Gunderson Dettmer, and Cooley Godward. In
Boston the best are Goodwin Procter, Wilmer Hale, and Foley
Hoag.
[3] Your mileage may vary.
[4] These anti-dilution provisions also protect you against tricks
like a later investor trying to steal the company by doing another
round that values the company at $1. If you have a competent
startup lawyer handle the deal for you, you should be protected
against such tricks initially. But it could become a problem later.
If a big VC firm wants to invest in the startup after you, they may
try to make you take out your anti-dilution protections. And if
they do the startup will be pressuring you to agree. They'll tell
you that if you don't, you're going to kill their deal with the VC. I
recommend you solve this problem by having a gentlemen's
agreement with the founders: agree with them in advance that
you're not going to give up your anti-dilution protections. Then
it's up to them to tell VCs early on.
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The reason you don't want to give them up is the following
scenario. The VCs recapitalize the company, meaning they give it
additional funding at a pre-money valuation of zero. This wipes
out the existing shareholders, including both you and the
founders. They then grant the founders lots of options, because
they need them to stay around, but you get nothing.
Obviously this is not a nice thing to do. It doesn't happen often.
Brand-name VCs wouldn't recapitalize a company just to steal a
few percent from an angel. But there's a continuum here. A less
upstanding, lower-tier VC might be tempted to do it to steal a big
chunk of stock.
I'm not saying you should always absolutely refuse to give up
your anti-dilution protections. Everything is a negotiation. If
you're part of a powerful syndicate, you might be able to give up
legal protections and rely on social ones. If you invest in a deal
led by a big angel like Ron Conway, for example, you're pretty
well protected against being mistreated, because any VC would
think twice before crossing him. This kind of protection is one of
the reasons angels like to invest in syndicates.
[5] Don't invest so much, or at such a low valuation, that you end
up with an excessively large share of a startup, unless you're sure
your money will be the last they ever need. Later stage investors
won't invest in a company if the founders don't have enough
equity left to motivate them. I talked to a VC recently who said
he'd met with a company he really liked, but he turned them
down because investors already owned more than half of it.
Those investors probably thought they'd been pretty clever by
getting such a large chunk of this desirable company, but in fact
they were shooting themselves in the foot.
[6] At any given time I know of at least 3 or 4 YC alumni who I
believe will be big successes but who are running on vapor,
financially, because investors don't yet get what they're doing.
(And no, unfortunately, I can't tell you who they are. I can't refer
a startup to an investor I don't know.)
[7] There are some VCs who can predict instead of reacting. Not
surprisingly, these are the most successful ones.
[8] It's somewhat sneaky of me to put it this way, because the
median VC loses money. That's one of the most surprising things
I've learned about VC while working on Y Combinator. Only a
fraction of VCs even have positive returns. The rest exist to
satisfy demand among fund managers for venture capital as an
asset class. Learning this explained a lot about some of the VCs I
encountered when we were working on Viaweb.
[9] VCs also generally say they prefer great markets to great
people. But what they're really saying is they want both. They're
so selective that they only even consider great people. So when
they say they care above all about big markets, they mean that's
how they choose between great people.
[10] Founders rightly dislike the sort of investor who says he's
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interested in investing but doesn't want to lead. There are
circumstances where this is an acceptable excuse, but more often
than not what it means is "No, but if you turn out to be a hot
deal, I want to be able to claim retroactively I said yes."
If you like a startup enough to invest in it, then invest in it. Just
use the standard series AA terms and write them a check.
Thanks to Sam Altman, Paul Buchheit, Jessica Livingston, Robert
Morris, and Fred Wilson for reading drafts of this.
Comment on this essay.