Archive for May, 2014

Angel Investing is growing in Seattle, and in many ways it’s a good thing. More capital to test more ideas is what will build our economy in the long term. My concern lies with the model of investing that is becoming encoded and passed on to new investors. It’s very much driven by the economics of technology companies: lots of front-loaded investment leading to a payoff or a total loss. The risk of the total loss is pretty high, so for the model to work at a portfolio level the potential payoff also needs to be high. It’s pretty straightforward math: if your investments have a 1 in 10 chance of getting to payoff, then the one that pays off needs to pay 10x or you don’t even break even! It’s not realistic to believe you can guess which ones will payoff, so you need a portfolio approach. When I took the “Power of Angel Investing” class around 2007 they suggested you needed at least 10 companies in your portfolio. In David Rose’s book on Angel Investing that just came out he’s now saying 20. Fundamentally, this is a kind of gambling.
For some angels, it kindof works, but it only works if you stick to the formula: your companies need to have the possibility of paying back 10x. Now maybe one will, and not all will go bust, some will return 1-2.5x and that’s how it makes money. The problem is that possibility of paying back 10x – it only makes sense for high margin businesses like software or healthcare technology (and why margins are so high in healthcare is another interesting systems discussion we could have about why we have all the hottest innovations in the US and broad lack of access or affordability and is that really what we want?). Further, once a business pursues this fundraising path, it’s now under pressure to “swing for the fences” and continue to make high-risk choices as it learns from the marketplace and pivots its business model. A more conservative path that would mean slower growth is no longer acceptable. I believe it becomes self-fulfilling prophecy – that by taking high-risk investor money, the business is driven to become a high-risk business, and may forgo opportunities that would be less lucrative but more likely to generate stable employment or a reliable long-term service to customers. This extends down into business schools and incubators – we are all coached to focus on rapid scale. The primary thing I see driving that is the pressure of the capital providers, and it saddens me to watch angel groups form to reproduce this capital market view unexamined for its larger effects.
Exits often destroy value – acquiring companies are often not thoughtful about who and what they acquire, they instead have money to burn, or are acquiring the people. Larger companies might have higher return goals than a group of small investors might be satisfied with, and they’ll meet those goals by “streamlining operations” – laying off the local accountant, the local support people, discontinuing the local rent and relocating people into their offices.
For many kinds of businesses this kind of high-risk/high reward front-loaded investment with an eventual payoff is not the economics of the business. What then? They need equity too. For me the pinnacle of angel groups over-driving the Capital conversation was when a local farm made the rounds. We need to have much more creative conversations about how to fund business. Hopefully the Element 8 event about Investing Without Exits was a start. We need to think about loans, about patient returns, about lowering risk for ourselves as investors AND for the entrepreneurs, and seeking more reasonable returns. We also need to think hard about what we’re taking risk for and how much we can take– and then apply that budget consciously to buy the kinds of communities we want to live in. You can’t eat software, and I hope it will be many more years before my date nights are the waiting room at Drs office.

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