If you're serious about angel investing, it's critical to understand the underlying economics. This article is also important for founders to help understand how angels think about their investments to speak their language.

The most common advice to new angels is to make at least 20 investments.

But why?

It comes down to statistics.

This article is part of a series on Angel Investing 101. Check out the rest of the topics HERE.

You can also get this, and all the rest of the Feel the Boot content, as a podcast.

Studies of typical angel investor portfolios show that 60% of investments will be complete losers. They'll return between zero and a few cents on the dollar. About 30% return a few times your investment. Around 10% are successful, yielding 20 to 100 times your money. Those are the big winners. They're what you're going for.

That math drives the advice to make at least twenty investments. Your returns are dominated by results that happen 10% of the time. If you make ten investments, there's a 50% chance that none of your startups generate a significant return. In that case, your angel investment portfolio will look pretty bad.

With 20 investments, you've got a good chance of making one, two, or maybe even three high-returning investments.

You might think you can identify the likely winners, but if there were a simple way of doing it, some people would be incredibly successful as angel investors. But so far, no one's ever shown an ability to beat the odds systematically.

Startup success is incredibly precarious. There are so many ways in which things can go well or disastrously. Timing, market conditions, strife within the founding team, and many other events can completely alter the company's trajectory. The only way to ensure reliable returns is by getting a statistically significant number of investments to ensure you hit those big winners.

Making many investments also allows for sector diversification. Right now, AI-based companies are red hot. They're springing up everywhere and getting a tremendous amount of attention.

Last year everyone was talking about blockchain and crypto companies, but that sector has cooled off a lot, and their valuations have crashed.

If you'd put all your investments into that one sector, it probably would have turned out very bad. We don't know how AI will turn out, but it's probably a bubble too. There will be a few fantastic companies, and a majority will get washed away as the sector matures.

If you invest in many different sectors, you will participate in the upside if any of them does exceptionally well. And if one of those sectors tanks, that's a couple of the losers in your portfolio, but it doesn't take the whole portfolio down.

Angel Investment Portfolio Size vs. Returns

Let's look at how an angel's returns vary depending on the size of their portfolio. Angelist created a fantastic report called "How Portfolio Size Affects Early-Stage Venture Returns."

The average return on investment for five company portfolios was zero. Most of those investors lost money.

Portfolios with ten investments had an average 6% annual return, but about a third of the investors still lost money.

With 20 companies, the average annual return was 7%, and only about one in six portfolios ended up in the red.

By the time you reach 50 investments, the average annual return is 10%, and only one in ten portfolios lost money.

Things don't get much better beyond fifty companies, and with anything more than 20, the statistics are firmly in your favor.

One of the things that drives down the annualized return is the duration of the investments. You hope that you will see a return in five to seven years. But most of your big winners come in after about ten years, so your total return gets divided by ten for annualized returns. Even with a good return on the portfolio, you might not be outperforming the stock market.

Three Angel Portfolio Scenarios

Let's analyze the results from a typical portfolio of 20 investments. Out of that twenty, one will deliver 20x, and one will return 10x. Six have mid-range success producing 2-3x. The remaining twelve investments all lost money. For this example, I assume an average return of $0.20 on the dollar for the losers.

The portfolio returned 130% overall, primarily driven by the two big winners. Assuming ten years to exit gives you a 13% return per year. That typically beats the market and would be considered a successful outcome.

But let's look at what happens if you fail to catch the whale.

Although it's not likely, suppose you didn't get any big returns. The 20x became a 3x, and the 10x became a 2x. Now the entire picture looks very different. You have a 7% return on the whole portfolio, meaning you make less than 1% annually! And there's a reasonable chance you might have lost money.

With these kinds of returns, you should have been putting money in the bank.

But the investment game is really about trying to find unicorns. That's why so many angels look at the maximum upside a company can produce. We're not investing in any company without the potential to return at least 20x-50x, and we are hunting for those with the potential for 100x or 1000x.

So let's consider a case where one out of the 20 companies returns 100x, and the other 19 are all losers. That portfolio delivers a 419% return over ten years which is 42% per year which is phenomenal! That's why everyone is so focused on unicorns.

Angel investing tends to have a binary outcome. Because the returns on the big wins are so gigantic, finding the unicorn makes everything worthwhile and eclipses results from even dozens of moderate successes. A single or a double that a founder might think was a good outcome is not attractive to startup investors.

Your Angel Investment Budget

To ensure you will reach that magic number of twenty investments, put together a budget before you write your first check, or right away if you have already started.

Typically, angels make investments over a five to 15-year period. You might continue much longer, but this makes it likely you will fill your portfolio before you stop.

Let's assume you are planning to invest for ten years. To hit 20 investments, you must invest in two companies a year.

You shouldn't put more than 10% of your total investments in startups because even when making many investments, there's still a chance this will be a total bust. And you don't want to do that with your retirement savings.

That tells you how much money you have to play with, and I encourage you to put that in its own account. That will help you resist the impulse to invest once that runs dry, no matter how tempting. That is a slippery slope to disaster.

But, not all that money is available for new investments because you should hold back about half for follow-on investments. When you've got a winner in your portfolio that's starting to take off, you would like to maintain your pro-rata ownership. As the company grows, the risk generally goes down, so continuing to invest in your winners typically produces the best returns.

Since you plan to invest in 20 startups, your budget per investment is one 20th of that pot. So now you know the average size of the investment you can make.

That also determines how you make those investments. Most startups don't want to take pre-seed investments of less than $25,000 to avoid cluttering their cap table. If your budget allows for investing $25k or more in each company, you can do conventional angel investing.

But if the calculations show your typical check size will be more like $1k-$5k, then you need to look at using either crowdfunding or syndicates.

With a syndicate, a lead investor picks the company, and you can choose to invest or not. You don't invest directly but in a special-purpose vehicle (SPV). Everyone puts their small investments into that, and it makes a single bigger investment into the company.

Many crowdfunding platforms allow you to invest as little as a few hundred dollars. You can still follow this portfolio model even if you only have a small investment pool.

Angel University by LAUNCH created a useful spreadsheet to help you calculate all this. Find that HERE.

Of course, economics is not all there is to angel investing. If you are just getting started, I suggest checking out this article next.

Until next time. Ciao.