Does angel investing appeal to you? What is the difference between angel investing and venture capital? If you are considering an alternative form of investment, you may find my recent interview with David S. Rose, angel investor, entrepreneur, and founder of Gust, to be of particular interest. I spoke to Mr. Rose on the Goldstein On Gelt Show at the end of July.
Here is a transcript of the interview, which you can also listen to at GoldsteinOnGelt.com.
Douglas Goldstein: What is angel investing all about?
David S. Rose: Angel investing is when individual people take their own cash and use it to invest in the earliest stages of exciting startup companies that might be the next big Apple, Google, or Facebook.
Douglas Goldstein: What's the difference between angel investors and venture capitalists?
David S. Rose: Many people, particularly entrepreneurs, often refer to angels and VCs, or VCs and angels, as if there were no spaces between them and they were the same thing, but they are really quite different. A VC or venture capitalist is a professional money manager who goes out and raises a big pot of money in the hundreds of millions or more from institutions that have a lot of money - things like pension funds, insurance companies, or university endowments, as well as from super rich people who have billions of dollars. So the VCs take that big pot of money and they go and invest in companies that they think will have a high return. However, angels are individual people like us, who have to be a credit investor in the U.S., which means there are certain income requirements or asset requirements. We invest our own personal money out of our own personal pockets into companies that we think are high growth. The difference is that since we're typically investing a lot less money than big venture capital funds, we're investing in smaller companies at an earlier stage. So in the United States, angel investors invest more money than all VCs put together, something like $25 billion annually into something like 70,000 companies.
Douglas Goldstein: Is that through official angel investing channels, or would you, for example, call the parents of an inventor who give him $25,000 an angel investor also?
David S. Rose: No, that comes under the heading of friends and family. When I'm talking about angel investors, I'm talking about real arm's length angels, but the interesting thing is that parents, friends, and family account for an enormous amount more - something like $60 billion annually in the U.S. But angel investors, those who give $20-25 billion, these are arm's length investments by people who don't know you and they are investing for economic reasons in this high growth company.
Douglas Goldstein: Let's just go through the stages. The first stage of getting money is having no money and working out of your garage. The next stage is friends and family?
David S. Rose: No, the next stage is your own cash, because if you don't put your own cash, real hard cash, into your company, nobody else will. So you've got to have some cash - not a lot - but you have to show that it means something to you. Your savings, your credit cards, whatever, you've got to put your cash in first. Then comes friends and family because they are investing not on the company, they are not company experts or business or angel experts, they are investing in you. They are backing you because they love you, or they have faith in you, whatever. Only typically after you get to that stage are you then ready for angel financing.
Douglas Goldstein: Some people say on the street in the entrepreneurial world that once you start bringing on the angels, they're going to demand a huge percentage of the company because they're putting up huge amounts of risk capital. Is that true?
David S. Rose: The question is how you define "huge" and what the alternative is. If your business needs capital to do whatever is necessary to build the product or buy stuff, and you can't get it in any other way and you have no business without the investment, then it's a good deal. In reality, angel investors and VCs typically do not want to take control of the company. They don't want a majority because it's very important to them that you, the entrepreneur, are incentivized. Otherwise, they have nothing worth anything.
So typically, an entrepreneur should be prepared to give up roughly between 20 and 30% of the equity in the company at any given round, which should raise enough money to take them to the next level. Typically, in an angel round, you might be selling 20 or 30 percent of your company in exchange for the cash necessary to get off the ground and get going.
Douglas Goldstein: Do you think that a lot of times entrepreneurs believe they need money before they actually do?
David S. Rose: In the real world, you say, "How does this whole thing work?" Imagine that you're an entrepreneur and you have an idea for a company. What should you do? The first thing you should do is have a business plan, check out the market, and figure out how you get to your minimum viable product. But in reality, what happens is that somebody has an idea and they say, "Okay, I need venture capital." So that's not the way it works. These days, it is so inexpensive, particularly for IT-based companies, internet-based things, to go out and get your minimum viable products started that in many cases, you really don't need capital, and taking investment capital at an early stage is more of an intrusion and a distraction than anything else. So to the extent that a company can get started on its own by bootstrapping, I'm telling you as an investor, do not raise investment capital.
Douglas Goldstein: From the point of view of the investor, is angel investing a reasonable type of investment for regular people putting aside money to save for the long term?
David S. Rose: It has become a viable investment alternative. Until probably 15 or 20 years ago, it was some arcane bizarre backwater and somewhat unusual. Now technological development has advanced so fast that the world is changing. It's taking less money to start more companies. They can grow faster, have a bigger impact, and so it turns out that the average return for a well-mannered professional angel portfolio is 25% annually. You compare that to the 1% you might get in the bank, or maybe 5% in the stock market, or 10% for hedge fund if you're lucky.
Douglas Goldstein: Over what time frame are we talking?
David S. Rose: I'm talking annually.
Douglas Goldstein: I mean over the past 5 years, 10 years, 15 years?
David S. Rose: Several studies have been done in the last 3 or 4 years based on portfolios over the last 10 years or so. These are pretty standard numbers; however, the trick is that it's very risky. This is not like investing in the stock market. If you put your money in the stock market, you expect every company to either go up or at least stay the same. But if you're an angel investor, half the companies in which you invest are going to go bankrupt. So you need to have the psychological ability to understand that this is going to happen. On the other hand, if you invest in enough companies, and in the book I suggest at least 20 or 30 companies, then you began to hit the odds where the odds say that one out of those 20 or 30 is going to return many, many times the investment, And I mean 20 or 30 times the investment, and that ends up making the whole thing worthwhile. So the average person who calls him or herself an "angel investor" actually loses money because they do it lackadaisically or emotionally, or they only invest in one company, but if you do it with real discipline and you hold for a long term and you invest in a lot of companies, the odds are very much in your favor to actually make a quite decent return.
Douglas Goldstein: One of the catchphrases that people use today in portfolio design is they talk about including alternative investments. Sometimes, they'll talk about hedge funds or certain types of real estate. Do you consider angel investing an alternative investment?
David S. Rose: Absolutely, angel investment falls into that category. Basically you have stocks and bonds and everything else. So alternative investments include everything, from hedge funds to real estate, to private equity, to venture capital, and to angel investing, which is at the far end of the risk spectrum.
I've been investing in companies that have returned 60 times the original investment. You will never see that in the stock market, and on the other hand, I have a whole lot of companies that were very promising but now no longer exist.
Douglas Goldstein: I'm a financial advisor and I help people develop their long-term financial plans, and we do talk about alternative investments, but we're looking for things that are not necessarily correlated with the standard stock and bond investment portfolios. Do alternative investments fit that category?
David S. Rose: Alternatives in general is a very big category. Angel investments actually are not correlated because angel investments take so long to come to fruition. In the United States, the average hold for an angel investor is nine years of being completely illiquid before you have an exit because the company in rare cases goes public, or more frequently is acquired by a larger company. But if you're holding for nine years, you're really uncorrelated. It's illiquid over that period of time. The value does not go up or down. If anything, it follows a J-curve, where after you put your money into a company, it immediately loses value as the company spends it on trying to get its product going and then only after a while, after the company begins to make money does the J-curve take up. So angel investors are typically uncorrelated.
Douglas Goldstein: One of the things you mentioned before is that it's a good idea if you decide to be in angel investing to broadly diversify. You said 20-25 different companies. For a regular person, that might be impossible. Is there a technology solution? Do you have a platform that would help people?
David S. Rose: There are several that are coming out, and obviously you mentioned Gust, which is a company that I founded. Gust is the global infrastructure platform for early stage investing. So basically it's the internet tool and website that's used by virtually all of the angel investment groups in the world. Something like 70 or 80% of all the professional angel networks in the world, about 90% penetration in the United States, and angel investors use this to collaborate with each other and manage their dealflow. So probably the best way to get started as an individual first of all is to see if you are an accredited investor. In the United States, the regulations are that you have to have $1 million in assets, not including your primary residence, or you have to have at least $200,000 in income, or $300,000 without joining with your spouse, but if you meet that qualification then you're allowed to invest at will as an angel. The best thing you can do to get started is to join a group of angel investors because then you will be able to get your feet wet, a little toe at a time. You'll have people who have been there before who can mentor you. You'll have ready-made dealflow to see deals that might be interesting. That's a great way to get started.
That's why I wrote the book. The book that you referred to is called Angel Investing: The Gust Guide to Making Money and Having Fun in Investing and Startups, and it is a great and primer for anybody who is interested in this. It's available in e-book form and hard copy and even as audio book. It walks you through the entire process of finding deals, joining groups, analyzing, structuring them, and adding value to your portfolio.
Douglas Goldstein: How can people follow your work?
David S. Rose: You can follow me on Twitter and most social networks. My handle is @DavidSRose. If you happened to be on Quora, you can follow me on the site quora.com where I answer questions on the subject of angel investing startups, and of course if you're interested in looking at startups, come onto www.gust.com where you will see literally hundreds of thousands of amazingly cool startup companies.