Chapter 22 - Seven Critical Lessons Learned in Angel Investing
To read:
Uncertainty is your friend: Risky things are predictable, quantifiable, and insurable. Uncertainty is none of these. Which is why startup founders should seek out uncertainty, argues investor Jerry Neumann.
Asymmetrical commercefare: So, you want to build a legendary company? Here are the most powerful asymmetrical weapons you’ll need, courtesy of venture investor Mike Maples Jr.
At last – European innovation: Europe’s slothlike embrace of entrpreneureal innovation is changing with such success stories as Early Venture Capital, active throughout Eastern Europe and led by Cem Sertoglu.
The Fourth Industrial Revolution: Ubiquitous, mobile supercomputing. Intelligent robots. Self-driving cars. Neuro-technological brain enhancements. Genetic editing. It’s here now, says Davos founder and CEO Klaus Schwab.
Chapter 22
Seven Critical Lessons Learned in Angel Investing
“Your job as an angel investor is to block out the haters, doubters, and small thinkers, because if you think small you’ll be small. I’d rather see my founders fail at a big goal than succeed at a small one.”
— Jason Calacanis, author, Angel: How to Invest in Technology Startups
As I transition into the Helping section of this book, I hope it’s been a short but effective overview of both my passion for the entrepreneurial life and of the reasons I encourage the intrepid, the daring, and the world-changing to roll up their sleeves and create the Next Big Thing. But beyond all that we’ve discussed, beyond the fear, beyond the mastery of network effects, beyond the ingredients of growing big and rich, there is something even larger than that Next Big Thing. This is The Next Big Frontier, the 21st-century economy itself, a sustainable economy of innovation, community, inclusion, and fairness.
This is a change on the scale of the Industrial Revolution itself. Venture-backed entrepreneurs will create this revolution. Angel investors, the foundation of this new venture ecosystem, will enable it. I realize that’s a bold statement, but I’m hardly alone.
“We are witnessing profound shifts across all industries, marked by the emergence of new business models, the disruption of incumbents, and the reshaping of production, consumption, transportation, and delivery systems,” wrote Klaus Schwab, founder of the World Economic Forum, in his 2016 book The Fourth Industrial Revolution. That book is one important window into our economic future.
My friend and fellow Austinite, polymath author, serial technology entrepreneur, and all-around genius Byron Reese sees the future in even bolder terms. Beyond just being a shift in economics, his 2018 book The Fourth Age - Smart Robots, Conscious Computers and the Future of Humanity, argues that we are at the frontier of societal transformation as profound as those wrought by the discoveries of fire, agriculture, and the written word. “A world without disease, poverty, hunger, or war is an old dream of humanity, one we are close to achieving,” Byron argues.
Now of course you’ll find more on both of these books on the Digital Companion, and I encourage you to read them. Ideally, before Byron’s next book, Stories, Dice, and Rocks That Think — How Humans Learned to See the Future and Shape It, comes out in August 2022. But both of these books build toward a third, just published as I was concluding my own. This is Sebastian Mallaby’s The Power Law — Venture Capital and the Making of the New Future, which I’ve referred to earlier. Of sweeping scope, The Power Law really explores how this new system of business finance has already changed the world and will transform it.
To summarize and combine Schwab’s new revolution, Byron’s new age, and Mallaby’s new future, the leitmotif running through all of their insightful studies of new modes of a capitalist organization is that the world generally, and the economy specifically, is increasingly built on intangibles. “In the past, most corporate investments were tangible: capital was used to purchase physical goods, machines, buildings, tools, and so forth,” Mallaby writes. “Now much corporate investment is intangible: capital goes into R&D, design, market research, business processes, and software.”
Now, for our purposes here we don’t need to go into how our farms will become high-rise laboratories, our universities' life-long learning modules, our transportation systems entirely robotic, and our medicine genetically engineered. But let me give the example of my current company, data.world. Founded in 2016, we’re on track to grow this year to more than 200 employees across 21 states. We’ve raised more than $132 million and we’re constantly branching into new markets for our primary data catalog products — the newest being our new product feature suite named Eureka. But what we produce are systems to manage something that you cannot see, cannot hold, and that intrinsically has no value until combined with other intangible assets. People say that data is the new oil but in this case, it truly is invisible in the sense that it’s virtual and it doesn’t stain your hands.
In addition to the creation of an economy based on intangibles, we’ve also inverted the conceptualization of risk. In the “old” capitalist economy that really emerged in Europe in the first half of the 19th century, commerce was all about avoiding long shots; investors were inherently conservative. Venture capital — which assumes that just 10 percent of investments will provide the bulk of returns — is by definition all about long shots and the power law of returns. And this is the prime accelerant of the innovation defining our new age.
We are part of the new means of economic value creation that traditional banking, financing, and even hedge funds are at best poorly designed for. Only a mere 60-odd years since its invention in Boston and migration to California, venture capitalism is the animator of this new world order. Interestingly, it’s a phenomenon that so far has all but bypassed Europe where the most rigid laws still punish failure and innovation is slow to appear — although that’s changing with such success stories as Early Venture Capital, active throughout Eastern Europe and led by Cem Sertoglu, an alum of the University of Texas at Austin. And venture capital — much of it originating in the Silicon Valley — is also a major driver of China’s rise to technological prowess, although China’s most recent moves at limiting their best entrepreneurs for political purposes could potentially kill their entrepreneurial golden goose. It may not be a system of production well understood by central banks or governmental regulators, but venture capitalism’s dramatically successful embrace by Israel is the main reason behind the 2020 Abraham Accords peace deal between Israel and a now-growing number of Arab states that need and desire the know-how. Clusters of VC activity are also emerging in Southeast Asia, India, and in 2021 there was a big first as three big venture investments in Latin America appeared on Forbes’ Midas list. And needless to say, this new order of business has long since broken out of the Silicon Valley to Austin, Miami, and even once-rusty industrial cities such as Cleveland, Detroit, and Pittsburgh.
I realize that’s a pretty long preamble to an explanation of why I now, in addition to being an entrepreneur, have become active as an angel investor as well. This is not just the logical progression of the successful entrepreneur, it is the emerging center of planetary transformation. If you acquire the means to do so, it makes sense to help in this way, as many have helped you before. You can both honor them and pay it forward. Angel investors are critical first because they are investing their own money, not as with conventional VC firms who raise a fund to invest the money of others. Secondly, the role of angels is expanding in importance as the broader VC system matures and most early-stage VC funds move upstream of Series A or “Seed” investment. Angels are now the “keystone species,” the organism that defines the entire ecosystem. This is the further role I first embraced in 2010, and now, 3,000 pitches later, my wife Debra and I are investors in more than 124 startups and 40 VC funds.
So without further delay, these are the seven lessons I’ve learned:
Lesson #1: New angels’ most common mistake is too much capital in too few startups.
I’ve limited our net worth in startup investing, cumulatively, to around five percent of our wealth. Very few angel investors I’ve met are that disciplined as greed can get the best of you. The beta risk is high as many startups go bankrupt and what you are looking for is the few that will generate a large enough return to make your efforts worthwhile. Others have made this observation, including author and book publisher Tucker Max of Austin. Mike Maples, Jr. of Floodgate, whom you met in the last Chapter 21, On Failure and Resistance, has written about the power-law dynamic in VC startup investing which is referenced on the Digital Companion. To put this in practice directly, if you have a million to invest, you are much better off putting $25,000 to $50,000 into each startup than $100,000 to $200,000. You need to stay in the game, where you will see, as Debra and I have, that this can be a profitable endeavor. A great resource on this is the work of Jason Calacanis. In addition to his podcasting on the subject, he’s the author of Angel: How to Invest in Technology Startups. Too many angel investors try it with just a few startups, don’t get good returns, and conclude that they are awful angel investors. The reality is that they didn’t give themselves a real opportunity to learn the craft. On the Digital Companion, there’s a blog on the topic by VC Jerry Neumann; it’s priceless.
Lesson #2: Invest in what you know.
For me, this is Software as a Service (SaaS). Half of our startups are SaaS. You’ll be able to help these companies better as a mentor. It doesn’t mean you won’t be able to help other companies, and we are in many B2C startups, for example. Often your mentoring will be focused on topics like how to raise money (and make connections for the startup CEO), how to recruit, how to manage your Board and investor relationships, how to sell, etc. Those apply to all sectors of startups. But you’ll have better pattern recognition (and therefore likely better outcomes) in the sector you know best. Billionaire investor Mark Cuban is among the many who has made this point repeatedly, but it should be obvious to you overall.
Lesson #3: Serial entrepreneurs, on average, generate better returns than first-timers.
Michael Dell, Mark Zuckerberg, and Bill Gates were first-time entrepreneurs. Or close to it, if we don’t count Michael’s early entrepreneurialism before Dell, or Gates’ first business in high school. So you may question this logic by thinking, “I’ll miss out on the best if I don’t take that risk on that first-time entrepreneur kid genius.” Maybe that is right in rare circumstances, but there are many, many more examples of successful serial entrepreneurs. Among them are Reid Hoffman at LinkedIn, Reed Hastings at Netflix, Aneel Bhusri with Workday, and John Mackey who launched and leads Whole Foods here in Austin. I could go on and on and on. Some very rare, young entrepreneurs indeed have otherworldly wisdom but most of us, including myself, build that entrepreneurial wisdom over time. I’m on my sixth startup at data.world. With my fifth startup, Bazaarvoice, our initial investors generated a 70—110x return! Imagine that — if they invested $100,000 they generated up to $11 million if they held onto the peak of Bazaarvoice’s stock price. Some of our most exciting angel investments in Austin are led by serial entrepreneurs and include startups like AlertMedia, Dosh, Dropoff, ClearBlade, Convey, Rollick, Pingboard, ZenBusiness, Rocket Dollar, and others. In 2021, both AlertMedia and Convey had very exciting exits, which generated a large investment return for us (and much more for them, in a very well-deserved way as they are the ones in the arena). This is certainly not a comprehensive list. And it’s not a hard and fast rule, either. We've indeed helped some first-time entrepreneurs that are really exciting. One great example of the exception making the rule is Julia Taylor Cheek who we backed when she founded the digital health services company EverlyWell in 2015. As of this writing, her company has a valuation of $2.9 billion and we haven’t sold a share.
Lesson #4: If an investment is performing well, make sure you join in the next round.
Momentum begets momentum. So you should be ready to join the next round, at least at your pro-rata amount. VC funds always reserve 30—50 percent of their fund’s capital for follow-on rounds. In general, we invest in seed, Series A, and sometimes Series B rounds — and sometimes in all three for a single company when things are going well. Investing early means taking on more of what VCs call “beta risk,” meaning relatively high volatility. On the other hand, if the investment really hits, there is much more so-called “alpha” benefit, meaning returns higher than standard markets or benchmarks. You’ll find a good tutorial on this on the Digital Companion.
Lesson #5: Invest in proven VC funds when it serves to diversify your portfolio.
We are investors in the VC funds of CAVU Venture Partners, which focuses on startups producing healthy foods and sustainable food systems. In part, this is because we believe in what they are doing, very much in sync with the transformation I described above. But it’s also a way to diversify our startup portfolio beyond our areas of expertise and with the safe hands of proven experts. We are not experts in consumer packaged goods (CPG), but were fortunate enough to become angel investors in Austin’s Deep Eddy Vodka.
Deep Eddy was headed by our good friend Clayton Christopher, who per Lesson #3 above was a serial investor and had founded Sweet Leaf Tea. And when Clayton sold Deep Eddy Vodka and started a venture fund, we knew we had to be investors. We already believed in the macro trends of niche brands, and retail differentiation (and disruption) in the age of eCommerce. Consumer tastes and diets shift faster than big CPG companies can keep up, so it’s a sector ripe for the new age of capitalism. In all things being equal — capital being capital — we thought that entrepreneurs would want to work with CAVU to get experienced guides for their journey — proven CPG experts, who understood shelf placement, branding, and market research. Likewise, we invested in Multicoin Capital’s first fund because we personally don’t specialize in cryptocurrency and blockchain. And we invested in Forerunner Ventures because they understand B2C and serve a different geography. We’ve invested in many other funds as well. In general, this means we are primarily in SaaS and in Austin startups as direct investors and leave expert VCs for the rest, including diverse industries and geographies. As of this writing, around 57 percent of the capital we’ve invested in startups is directly invested and around 43 percent is through VC funds.
Lesson #6: If you can really help, consider serving on an investment’s Advisory Board.
If you have insight or expertise to offer a startup in which you are investing, consider serving on the Advisory Board in exchange for common equity above and beyond your preferred equity investment. Entrepreneurs are very interested in protecting their common equity and maximizing its value, which you can help them accomplish when aligned as an Advisory Board member.
This has worked out very well for us and allows us to help the company even more directly. For the hit companies in your portfolio, you’ll make money on both the preferred and common equity this way. If the company is early enough in its history and the stock value is very low (such as it is at a company’s founding, before it raises any money), then you should see if the founders are doing what’s known as an “83(b) election” and whether you can participate as an Advisory Board member. This IRS rule can allow you to pay taxes on the value of the grant when it is made, rather than on the value at the time of stock vesting, and the difference can be substantial. Note that you have an advantage as compared to venture capitalists in that they cannot earn equity in this way — it is unique to the angel model (i.e., VCs don’t get additional equity for serving on your Board of Directors or being an advisor to your company as it is expected from their limited partners and they need to share in the standard 80/20 model). As an entrepreneur, I practice what I preach here — we have over 65 Advisory Board members at data.world.
If the company becomes a fight for preferred over common, in almost all cases no one is going to make a lot of money and it is not a great outcome overall for anyone. Entrepreneurs have to do well for investors to do well, generally speaking. This is as it should be — they are doing the real work every day. This is why I seldom invest in a company that is early-stage and already has a big Board of Directors of angel investors that already control the majority of the equity (with little to no VC involvement) — that is a clear sign of an entrepreneur being micro-managed and not very incentivized. This is also usually a sign that those investors are playing for a conservative base hit instead of swinging for a home-run outcome. Again, to make a lot of money — for both entrepreneurs and investors — the power law return has to be a possibility. A bad setup kills your power-law potential.
Lesson #7: Don’t just trust your own instincts, make introductions.
Building a network is a very valuable activity for you as both an entrepreneur and investor. When I meet a new entrepreneur I like, I make a lot of introductions to potential investors and advisors. This is not just easy to do, it is really valuable for the entrepreneur as well as us as the potential investors. I get market intelligence from people I know can help, and they get to see the deals that I’m looking at. Plus it incentivizes them to do the same — show me their deals. This activity also bonds you to the entrepreneur — they genuinely appreciate it and know the value of a warm vs. cold introduction. When you are just beginning as an angel investor, go out there and start selflessly serving the community. Karma will inevitably kick in. Becoming a mentor is a great way to build your global brand and expand your expertise. In Austin, Capital Factory, TechStars, and SKU are just some of the places known for helping entrepreneurs who could use your shoulder to their wheel. In the Bay Area, these opportunities abound at places like Y Combinator. Business schools are often looking for mentors and I’ve served numerous times as Entrepreneur-in-Residence at the McCombs School of Business at the University of Texas at Austin and my MBA alma mater, the Wharton School. This will ultimately help you build a network rapidly.
So in conclusion, these are my main lessons learned from angel investing, to cap my broad thoughts on the future of the economy, society, and innovation. As we’ve explored, it is entrepreneurs who are leading the world on this journey. It is a journey of risk and reward, of innovation, of public benefit corporations, of Conscious Capitalism, of exhilarating highs and subterranean lows, and of restorative commerce in a fast-changing world in desperate need of leaders who can keep up. Let me leave you with the thought of one of the most profound thinkers of challenging times. Roll up your sleeves, and let’s get to work.
‘There has never been a better day in the whole history of the world to invent something. There has never been a better time with more opportunities, more opening, lower barriers, higher benefit/risk ratios, better returns, greater upside than now. Right now, this minute. This is the moment that folks in the future will look back at and say, ‘Oh, to have been alive and well back then!’’’
— Kevin Kelly, author and founding editor of Wired