9 Proactive Steps You Must Do Before Investing in an Angel Fund
Discipline your method of investing by following a simple investing checklist
I’ve invested in several angel funds before, and I’m looking at some different angel funds right now, and there’s a ton of funds to look at.
There’s an entire industry of investor manager consultants (Frank Russell Company, Cambridge Associates, etc.) dedicated to the task. I’ve been on both sides of the fence on this one, having managed institutional fixed income for years and having been on the investment committees of a few large foundations that chose managers.
While many of the principles carry through to selecting a commingled seed fund, the number one tool of all limited partners, i.e., starting searches by reviewing “top quartile” managers based on past investment returns, simply is unavailable in early-stage managers.
Why? There is a lack of useful data, and it’s a relatively new field. So what to do? Well, here’s my checklist. Your mileage may vary.
1. Background of the Manager
Just as there are the big kahunas of traditional venture capital like Kleiner Perkins and the old pros starting feisty newer firms (Union Square Ventures, Andreessen Horowitz), there is a known pecking order in Angel World.
There are big kahunas (Ron Conway of SV Angels) and feisty upstarts (Dave McClure of 500 Startups) in angel land. While having a big rep makes it easy to attract money for your fund and deal flow, in my mind, that’s not the big thing. It’s experienced, whether that experience comes only from investing in the sector for a long time, or even better, investing combined with a successful career as a founder/entrepreneur yourself.
Just as focus, flexibility, drive, work ethic, and humility are essential in a founder, they are just as important in a manager. And that background goes a long way towards understanding how that manager will be able to source quality deal flow, which is the lifeblood for an early-stage manager.
2. Prior and Current Investments
There is no better indication of what types of investments someone will make going forward than by dissecting past investments. Study the portfolio: are these the types of investments you would want to have made yourself if you had had access to them?
Example: Felicis Ventures, Palo Alto, CA.
Who wouldn’t want to invest with someone who has found places in such hot companies as Groupon, LinkedIn, or Twitter?
These are overallocated, highly-sought companies that you can’t merely invest in by handing over a check; instead, you have to be hand-picked in advance. If, on the other hand, you see companies you don’t know, and worse, know and dislike, ask the manager why they invested in them, and see if you like their logic.
An interesting flip side is to ask about a manager’s “anti-portfolio,” i.e., the right companies that they passed on. There are plenty of good reasons to pass on a company, such as they don’t fit within your stated investment thesis or mandate, you didn’t buy the premise and didn’t see the pivot coming, etc. Fred Wilson of Union Square Ventures, perhaps the hottest VC firm today, wrote about why he passed on AirBnB; one of the longest-lived VC firms, Bessemer Ventures, talks about decades of greatest misses here.
To me, though, I’m less interested in why they missed — just that they were able to be in a big-time game and at least have a chance to see the winners. If the most significant success someone has had access to was some mere 4x small win, don’t linger — you can find better.
3. Focus: Sector, Geography, Stage
I’m not going to argue that anyone should be looking at, or limited to, any single sector. As an angel, I dabble in several: it’s my money, it’s my responsibility. But for outside managers, I want there to be a focus.
Most early-stage funds focus on some tech aspect for the same reasons most angels do — it’s capital efficient. But there is plenty of room for you, should you desire, think about hiring a manager to give you diversification on either a sector basis (e.g., healthtech), geography (critical if, like me, you’re living outside of major entrepreneurial regions), and stage (which is why large pension plans typically dedicate slices of their PE allocation to both growth funds and LBO funds, representing different market characteristics and risk.)
There has to be a hook that will allow the manager to specialize in something to know everything going on in that space. A micro-VC can have multiple foci, but only if they have various principles. As far as the stage goes — do they strive to be the first institutional money in, investing in lower valuations, managing relatively small amounts of money, and then handing it off to later stage investors?
Do they wait to invest in the A round, looking to invest $millions per company, through to B and beyond? (Most traditional significant VC funds.) Or do they try to do the whole gamut, including tiny investments to $50 million slugs (Andreesen Horowitz; Yuri Milner of DST). Again, not necessarily right away, but there are some wrong ways. See if you buy their approach and reasoning.
Example: IA Ventures, New York, NY
Roger Ehrenberg, Managing Partner IA Ventures, is an “Investor without Borders,” as likely to be looking for deals in Israel as he is in the U.S. But while he has no geographical bounds, his firm focuses like a laser on “Big Data”; he’s earned a reputation as one of the must-see guys for companies in that arena.
Just like it’s best to be on your own in a small market, it’s far better to be the big fish in a carefully selected small pool than to be roaming all over the tech market.
4. Philosophy: Size, Numbers, Due Diligence, Participation
At the core, you can divide angel funds, micro-VCs, and VCs in a graph with two axes: the first is the fund’s size, and the second is the number of investments.
Let’s start with numbers: the larger the fund, the more the pressure to hang on for home runs. That’s a function of VC math, and the reason why many proclaim the “VC model is broken”: the more money the VC draws in, the larger their 2% carry, and they can live fat off the land, eschewing singles and doubles and holding out for home runs.
I bought Basil Peters’ “Early Exits” strategy for most angel investments — there’s nothing wrong with a few doubles, and I probably would never consider a fund with more than $100mm dollars in it.
Small is good. However, being small doesn’t necessarily mean you can’t be swinging for the fences — Mike Maples Jr. of Floodgate bluntly states that Floodgate is going after “thunder lizards”, companies that will blast through their markets like Godzilla. Higher risk, higher return. Something for everyone, so know your manager.
While size generally is a good indicator of philosophy, most telling is “numbers” — how many investments does a fund anticipate making? With that information, you can figure out two essential ratios: average $s invested per company (which can tell you how many rounds are going to be invested along the way), and an average number of companies per partner, which means you how much attention each investment is going to receive.
The latter is the most prominent style item, as it goes to the heart of a manager’s philosophy. There is a strong case to be made for index-style investing, which in startup land is often derided as “spray and pray.”
While usually index investing is meant to give rock-bottom costs on efficient markets such as large-cap domestic equities where it is complicated to justify active management, in inefficient markets like startups, the argument is two-fold: when one is investing so early, especially when before the product-market fit is found, it’s a numbers game: it can be hard to judge between the top 20% of companies you see, and the hope of landing that 100x or even 1000x return the company can justify a portfolio with literally hundreds of companies.
Examples: SV Angel/Yuri Milner’s Start Fund; Dave McClure’s 500 Startups
While Ron Conway of SV Angel and Dave McClure of 500 Startups could not be more different, their investing styles are essentially alike: Invest broadly in areas you know, and then work your butt off for your companies, realizing that there is only so much of you to go around.
The Start Fund, which invests $150k in every Y-Combinator company at to-be-determined market rates, is the closest approximation right now we can find to a broad, high-quality index fund. The first batch was 40 companies at a time, and the next collection this summer is around 60. It’s provocative, but I think effectively investing across the board at an incubator as selective as Y-Combinator has many things going for it. SV Angels also have managed other funds, but I’m not yet familiar with them other than this video.
500 Startups focuses on data, design, and distribution in a quasi-accelerator fashion using terrific external mentors, as there is only so much McClure to spread around. When I asked him what his due diligence was, he glibly joked, “writing the check” — in other words, he makes swift decisions from the gut informed by his background at some seminal startups and the Facebook Fund manager.
Who’s best to do this type of investing? Someone with massive deal flow and a lot of experience. I am waiting for the day that Naval and Nivi bring out their “Best of AngelList” Fund. Since they spend time interacting and interviewing all of the people who get to post to AngelList, I imagine they know a thing or two about spotting winners, and their deal flow would be global and second to none.
On the other side of the coin, an investment manager’s hand-crafted style makes few bets but lavish portfolio companies with their time and attention. The idea here is that better coaching and selectivity leads to fewer write-offs leads to better ROIs. Jeff Bussgang’s terrific book “Mastering the VC Game” makes a good point — calculate the number of companies handled by each partner. How many boards can a person sit on effectively? Not many. But that’s the point — 500 Startups and SV Angel don’t want board seats — they want quality, but they want breadth.
Example: Manu Kumar’s K9 Ventures, Palo Alto, CA K9 only invests in local companies where they can add value. How hands-on? He funds companies at the concept stage — for those of you who remember CardMunch, Manu was so integrally involved that he’s a co-founder of the company. That’s the furthest thing from “spray and pray” — more like “invest in and dig in.” In that way, he’s more like a typical VC.
There are more early-stage funds around than I can count. How can a firm differentiate themselves not to their LPs, although that’s important, to the startup companies they need to court? Reputation is essential, as is the focus, but what can give it an edge?
Example: Borealis Ventures, Hanover NH
Borealis is a small shop out in the boonies. While its three partners have the classic background I mentioned earlier (including stints as early employees at Yahoo, SoftDesk, etc.), Borealis’s unique edge is its intimate connection with Dartmouth College. From involvement with the Dartmouth Entrepreneurial Network of alums to faculty/founders and the Tech Transfer Office, those ties got it into megahits like life science companies Adimab and Glycofi.
While there are hundreds of VCs circling Stanford, Borealis is the only game in town in Hanover, and that townhouses Dartmouth College, its Business School, its Med School, its Engineering School, and a surprising amount of entrepreneurial mojo.
If “a man is known by a company he keeps,” it also holds for VC firms of any stage. The best sign of respect for someone’s judgment is co-investing alongside. That’s the basis of Chris Farmer’s work on “Investor Rank,” which is akin to Google Page Rank. It’s a simple matter to cross-reference deals on CrunchBase to see who else is finding and valuing the same startups as the fund on which you’re doing your due diligence and who’s in how early.
7. Decision Process
I’ve been noticeably absent from talking about sidecar funds of angel groups. Why? Lots of reasons, but a major one is that angel groups act so slowly, and therefore second-time entrepreneurs often pass them by in favor of their existing connections. How slow? Well, it might take a few months to get from a selection meeting onto the next opening in a monthly meeting, and then again another two months to get due diligence together and execute.
Who would you instead call on, someone who can give you a quick answer or someone who takes four months from start to finish? There are reasons beyond financial to invest in some angel groups’ funds — see my last post on that. But if more than one person is needed to pull the trigger (which generally I prefer), I want to know how the decision is made.
This goes without saying — you don’t want to entrust your funds to people who are cavalier about paperwork, reporting, etc. You should get examples of the fund’s communications back to the LPs. Should you wish to back a new firm that otherwise passes the above tests with flying colors from their past lives, makes sure they have this in place.
Some entities entrust their back-office matters to Village Ventures, which oversees the activities of many venture funds. That’s fine as well — but find out in advance how you’re going to receive tax accounting, statements, etc., from all of your big winnings. Remember, these are long term commitments — avoid long term headaches.
I’m not talking about the personal rapport between you and someone within the Fund’s management. I have no idea who manages my small-cap index fund at Vanguard, for example. But I’m talking about the rapport between the partners and between the partners and their companies. Again, this will be a long-term arrangement between you and the firm, and you don’t want the partners of that firm to be undergoing a company divorce.
Example: The Foundry Group, Boulder, CO
Consider what Brad Feld of the Foundry Group said in his post about Deeply Held Beliefs: We will never add anyone to the team. I have three partners (Seth Levine, Jason Mendelson, and Ryan McIntyre). We’ve worked together for a decade. We’ve committed to each other to work together as partners “until we are done investing as VCs.” We work extraordinarily well together and have no interest in ever introducing someone new into the mix.
I believe the best funds are those where everyone works together in the same office, and everyone is on the same page on any investment. Those of you who have used it in a distributed workplace where there are clashes of personalities with geographical lines know what I mean.
I especially like those teams who have worked together before in good times and bad and who are equal partners. Suppose you can visit the fund in person and see the interaction of people, all the better. My time at Year One Labs in Montreal is one reason why I hope to be involved in backing their next vintage fund.
As for checking up on the relationships between the fund and their portfolio companies, that’s easy to do nowadays. Peruse their list of companies, figure out a connection to one of them via LinkedIn, and make a few calls. Maybe peruse The Funded, although I wouldn’t take any single comment as truth. But it doesn’t take long to get a sense of the general drift.