3. Are angels greedy to demand a massive 20X return on investment?
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Many of the entrepreneurs I advice are surprised that angel investors will not even look at a deal unless there is a clear path to making at least twenty times their money. They often ask “Why are angel investors so greedy?”
The reality is that Angel investors are, just looking to make even modest returns. It turns out that is easier said than done and the reason comes down to statistics.
The first thing to understand about angel investing is that it is an iterated game, not a one shot. Angels are making bets on many different companies, and they really are bets. This is not the stock market where a 10% swing is a big deal.
The harsh truth is that roughly half of angel deals return nothing. In other words, most of the time the angel will loose all the money they invested in a deal. Even when they survive, a significant fraction return less money than was initially invested, so the angel is still loosing money on the deal.
So how does an angel make money? It all comes down to statistics. If they invest in enough companies, they hope that one of them will be wildly successful. That one winner needs to make up for all the “losers.”
Investing in a company that can’t be a huge success does not make financial sense. Businesses that are likely to return just a few times the investment are just as likely to fail as the big payout opportunities, but there is no way for them to return enough to make up for the other lost bets.
Because of the high risk of failure in early stage companies, this is the only way it works financially for the investor.
Of course, a single unicorn result in a lifetime could erase all the losses from every other investment. However, unicorns are fabulously rare. I don’t even considered them in my calculations. It is very likely that I will never be lucky enough to invest in one.
Further, even this return is not a one year return. It often takes 5-10-15 years before a liquidity event can return anything to the investor. Until then, the investment is in a locked vault.
Even those few companies returning twenty times earnings after ten years only generate an annual return of 35%. While that might sound good, remember we are only talking about that rare success story. Average that in with some 0% and -100% returns and things start to look far more modest.
Angel investors are hoping to outperform the stock market over many investments and over a long time horizon. In exchange they are locking up their investments for years and taking on massive risk. There needs to be both a time value of money and risk premium to make this a rational investment choice.
You need to show the possibility of very high returns to get any traction with early stage angel investors. Understanding the mindset of your audience will go a long way to getting that second meeting.
Let me know in the comments what kind of expectations and reactions you have seen from investors.
Till next time … Ciao
