Monday, November 24, 2008

Scott Shane’s new Book "Fool’s Gold" Dispels Many Myths around Angel Investing

I found the book Fool’s Gold insightful as it confirmed many of my assumptions about angel investing such as:

1. Most angel investing is done alone by individuals who are supporting a family or a friend and in such cases treats their investment more as a donation.
2. The majority of these investments don’t come with due diligence, terms, or other basic investment supports.
3. Most never see a return.
4. Most cannot help the company they invest in because they don’t know enough about the industry or the company.

As a director of any angel group I encourage people to join for education and deal flow. An angel can spend all day finding the deals but then must spend all night investigating those deals. I had the chance to speak with Scott Shane the author of Fool’s Gold.

In your chapter on why people do angel investing you list several factors such as to make money, to help the community, and more. Which factor do you think will be the driving force of angel investing in the coming years?

I think that it is to help the community. With a slow IPO market, a lot of acquirers slowing down their operations, and general economic malaise, I don't think the next couple of years will be the golden age for angel investments. I think the people who will do this and be happy with it in the next few years are the ones doing it to give back or to stay involved with startups.


I understand angel investing in total is just a little larger than VC investing. Within angel investing, family and friends money outweighs angel group funding by a factor of 13 to 1. What can angel groups do to support the "family/friends" money effort short of having them join the angel group?

I don't know that there is much angels can do to support the friends and family money. I think the best thing to do is to stop thinking in terms of this financing lifecycle model where the entrepreneur puts in money, gets money from F&F and then angels and then VCs. Very few of the businesses that get F&F money are appropriate for angels. So rather than supporting the F&F money effort, I think the issue is to figure out which F&F money is the end of the financing money and which is in companies that seek further rounds. You want to separate out those
for whom the F&F is a stage rather than an end.


You mention that only 5.9% of companies started each reach "gazelle" growth rates of 20% or more per year? Aside from industry is there any data that indicates which companies will grow that fast?

There is. Founder experience, IP protection, business strategy are a few. But none of this is for angels in specific. The study that needs to be done and that I have wanted to do for years because it would be so helpful is to look at all the deals that go into angels. The deals would be tracked and we could see what leads to higher performance. This approach is specific to angel deals and therefore
of great relevance to angels. Moreover, it can tell you if angels are picking winners or losers.


You write about the importance of "staging" funding for angel investments. What more can you tell us about that?

Angels generally think in terms of putting in money in one block and that's it. Staging, putting money in over time with milestones is a better way to monitor companies. So angels should think about how much time it will take to achieve a company's goal - say get the product on the market. Then they should create milestones to get there and give out money on achievement of the milestones. This is essentially the VC way and seems to be done by sophisticated angels,
but not all.


You indicate that angels receive 1.7x on their investment but that the data is hard to judge without time frames. If you separate out the family and friends money which is more a donation than an investment - what multiple would you expect to see?

I don't have the data to look at actual returns by typical angels. The book gives numbers on actual returns for angel group members, expected returns by typical angels, and actual returns by all informal investors. In general, I would say that we can infer that the typical angel neither has the return expectations nor the returns talked about by sophisticated angels in groups.


You indicate that financially successful angels look at the industry of a company to determine its potential value. You show a list of valuations for six-year old companies by industry and they range in valuations. Does this correlate to the maturity cycle of the industry? What other factors drive it?

That's a book in itself. Industry maturity, the nature of production, IP protection, firm size, and a host of other things drive the numbers. The purpose of the chart was to say industry matters and angels need to pay attention to that. They should investigate why industries are attractive or not.


You conclude that state tax policies aren't that helpful and the most practical support the government can provide is to foster the growth in the number of angel groups? Why?

Angel groups allow you to get people involved in investing in start-ups who have lower net worth. That enhances the pool of angel capital and gets the novices working with and learning from the experts. While everyone likes a subsidy, the state tax policies don't seem to actually move many non-investors into the investor categories because state tax rates aren't that high. So taxes aren't as effective. If the federal government created an angel tax credit that might be
different.


How would you encourage the investors to join an angel group?

I would suggest groups go out and look for accredited investors and try to bring them into the group. I would also encourage government programs to get these groups started. There is a bunch of effort that needs to happen in the beginning for which subsidies help and get paid off later.


How do you see the current economic climate impacting angel investing?

It's hurting. Angels invest their own money. They have to limit that to a portion of their net worth. If their net worth drops by one third, the amount of money for angel activity, on average, goes down a third. The only silver lining in this is that people might be allocating a greater portion of their wealth to angel investments. If they are going to lose a lot in relatively low risk low return activities like public equities, they might as well risk losing money for a big winner in a start up.


You list Austin as a good place for angel investing since the number of firms receiving external equity per million population actually puts Austin above San Jose? What should a city like Austin consider doing to improve its position here?

Focus efforts on building and maintaining angel groups. The system is working in Austin. So it is a matter of maintaining the top position. That means keeping the angel groups going. That's the thing under your control. You can't make new entrepreneurs emerge or new technologies be born. But you can make sure that the system stays there for financing them once they are born.


Best regards,
Hall T.

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