1.3 Portfolio Targets The next major decision is how to spread your personal capital budget among investee companies. We know that most Angels make 90% of their returns from 10% of their companies. So investing in only one or two companies is almost certain to lose money. Risk management theory tells us that the more companies you invest in, the lower the variability in your returns. The most common advice here for good risk management is that you should seek to hold at least 20 companies in your portfolio or augment a smaller number of direct investments by investing in an Angel fund or Angel sidecar fund. A Real Options Approach to Angel Investing Unlike traditional investing, Angels should have a different approach to portfolio investing, because the distribution of returns is not a standard distribution, but one in which more than 50% of investments fail – producing zero returns. The idea is that Angels invest small amounts in a number of ventures, with the idea that some will fail fast, while others will show progress, at which stage additional funds will likely be required (often from the original Angels). This is called a Real Options approach and has three fundamental consequences: 1. Investments of smaller amounts are made, with early milestones agreed, which if reached trigger subsequent rounds of funding. 2. The Real Options approach encourages Angels to look for investments that can be rapidly validated and either fail fast or show rapid progress (however small). 3. The number of investments made is larger, because the Angel does not have to keep as much money in reserve for follow-on investing, as they will not have to invest subsequent funds in the companies that fail. — Dr. Andrew Maxwell , Chief Innovation Officer, Canadian Innovation Centre To further diversify risk, you could consider whether you want to diversify by sector, or focus your attention on certain industry sectors in which you have a personal interest or expertise, or that you think are hot. Most Angels focus on certain sectors but might co-invest outside that sector only with highly trusted partners. Diversifying the business development stage, geographic location and number of co-investors is another way to manage portfolio risk. The simplest way to enhance your diversification is to invest in an Angel fund or Angel sidecar fund (see section 1.6). Virtually all professional investors – not just Angels – will also tell us that, in addition to the initial round of funding, you should reserve up to an equal amount of money for any potential follow-on rounds of financing. This reserve is referred to as keeping your powder dry.
22 A Practical Guide to Angel Investing: How to Achieve Good Returns
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