Fool’s Gold?

Debunking the myths of angel investing.

Fools Gold

Amazon. Apple. Google. eBay. Just a few of the well-known companies funded by angel investors. With success stories like these, one might be tempted to think that angel investors typically do quite well for themselves. But contrary to the impression one might get from reading <i>Success</i> magazine, an angel rarely reaps outsized rewards. In fact, failure is the norm. 

In “Fool’s Gold: The Truth About Angel Investing in America” (Oxford University Press), Dr. Scott A. Shane, professor of entrepreneurial studies at Case Western Reserve University, dispenses a healthy dose of reality by defining the five W’s—who, what, where, when and why—of angel investing. In the process, Shane paints what might be described as a group portrait of angel investors, and answers the big question he posits at the beginning of the book: “Is angel investing gold for investors or worthless iron-pyrite?”

After reading “Fool’s Gold,” Failure magazine asked Shane a few questions of our own.

In the book you write: “Most people have gross misperceptions about what most business angels in America look like and do.” Why are they ill-informed?
It has to do with the way people think about entrepreneurship-related activity. People focus their attention on fabulously successful entrepreneurs, but don’t realize that these success stories are incredibly rare. Only a small number of entrepreneurs are really, really successful. The same thing is true for investing in these companies. The typical or average angel investor doesn’t do very well. 

The media contributes to this perception problem. It’s easy to tell the story about the angel who invested in Google or The Body Shop. But it’s very difficult to write an article about the average angel because it doesn’t grab attention. The typical person invests a small amount of money in a business and the outcome isn’t particularly good. How is that newsworthy? 

What is the definition of an angel investor? 
An angel investor is a person who provides capital—their own money—to a private business that is owned and operated by someone who is not a friend or family member. That distinction of not being a friend or family member is that if you add friends and family to angels you get this broader category of informal investors. Angels are one subset of informal investors. Friends and family are another.

Why is it important to define angel investors? 
If you don’t define them you can’t actually tell if they are the same or different than any other group of investors, and you run into problems when trying to compare information from one source to another. For example, some people say you can’t be an angel unless you are an accredited investor [as defined by federal securities law]. Others say there is such a thing as an unaccredited angel. You need to have everyone talking about apples if they are trying to describe an apple, and not have half the people talking about oranges. 

How well do angel investments typically perform?
Not very well. The typical angel investor doesn’t get any money back. Less than 0.2 percent of angel-backed companies end in an IPO [Initial Public Offering], and less than 1.5 percent end in an acquisition, so only a very small percentage end in one of the exits you want. 

Even if you consider accredited investors, who are on average, the better performing angel investors, and then look at the ones associated with groups—high net worth people investing as part of groups—you find that half of those investors never make any money. In fact, 40 percent of the investments return less money than the capital that goes in, and seven percent of the investments account for 75 percent of all returns. It’s the few phenomenal outcomes that make up for the losses of most. 

What do successful angels do differently from typical ones? 
One of the things they do is acknowledge distribution of performance. The successful ones realize that they can’t pick the winners with enough certainty, so they invest in 10 or 12 companies, as opposed to just one. 

The second thing is that they have incredibly high expectations for each of their investments. So even though most do poorly they make enough on the one that does well to get a decent return. That means having return expectations that are on the order of 30 times the invested capital. 

A third thing they do is to pay attention to industries that tend to attract professional investment. Venture capitalists invest in a relatively small number of industries that account for a disproportionate amount of the IPOs and acquisitions by public companies. Most successful angels understand this, so they only invest in those select industries. 

A fourth thing is that it can be tempting to make investments passive and not get very involved in companies. But the successful angels do more due diligence and more closely monitor their investments. 

Finally, successful angels are scrupulous about structuring deals. They are careful to not over-value companies and they have attorneys draft good contracts. 

What are angel groups? That’s a relatively new term, isn’t it? 
Angel groups are groups of people that get together to make angel investments collectively. Sometimes members do due diligence together then invest individually; sometimes members evaluate deals together and invest in the same companies. Some are very formal, where the group may be structured as a fund and people pool their money into the fund. Then the members of the group make an evaluation, and if it’s positive the fund puts money into the company. 

Angel groups haven’t been around that long. Most experts think the first group was the Band of Angels, which dates to the 1990s. The number of angel groups has been growing rapidly. But I suspect in 2008 there will be a decline in these groups—or at least the rate of growth of these groups—because of the economy. 

There are a couple things about angel groups that tend to make them better performing angel investors. First, because of disclosure reasons with the SEC [Securities and Exchange Commission] it’s very difficult to have an angel group that isn’t restricted to accredited investors. So the groups are made up of wealthier and more sophisticated investors. Another thing is that collectively people are more diversified because each person can put a little bit of money into multiple companies. They can also share expertise, and that collective action helps individuals to be better investors. 

What would you like entrepreneurs to take away from your book? 
First, you want to avoid believing the myths about the specialness of angels. There is a tendency to believe that angels are “smart money” and that friends and family are dumb money. The reality is that there is a lot of variance among angels. Some are smart money but many aren’t, and the typical one isn’t all that different than the typical friend and family investor. As a category, you don’t want to consider angels to be special. You just want to find a good angel. 

Second, you want to understand what angels really look like so you can find them and understand what they are looking for in companies. 

Lastly, realize that the decision making of angels is haphazard and involves human biases. It’s important that entrepreneurs remember that these are human beings making decisions for very human reasons and there can be all kinds of idiosyncratic behavior. 

What would you like potential angel investors to take away? 
One thing is to be realistic, to understand what people typically earn from investing in start-ups. If there’s one thing that the current financial crisis has shown people it’s the problem of unrealistic expectations. If you think the stock market is always going to go up 10 percent a year and it doesn’t, you are going to be very unhappy. If you think the typical angel investment is going to return an internal rate of return of 30 percent per year, you are going to be very disappointed unless you are really lucky. 

Another thing is to understand what motivates people to invest. Are they doing it because they care about making money, or because they want to work with entreprenuers or help their community? Understanding why people do this will help you recognize what kind of company you might want to invest in. If you think you are doing things for one reason and are actually doing them for another you could be very disappointed with the outcome. 

Finally, if your main motivation is to make money it’s important to know how the small number of people who make a lot of money at this activity tend to do it, so you’re doing it right.

Also by Scott Shane:
The Illusions of Entrepreneurship