Taking Your Pro Rata as Angel Investing Strategy

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In thinking about my angel investing strategy going forward, I started thinking about how venture funds always talk about taking their pro rata allocations in their winning companies, or even raising their share of the companies. They do this to keep "leaning on the winners" meaning that the will increase their investment "bet" on these companies which are doing well (and stop investing in those that aren't doing so well). This then increases the return they get, while also minimizing the risk somewhat.

I thought that this may be a good angel investing strategy as well. In the world of the so-called lean startup and capital efficiency, everyone talks about finding a startup that only requires one round of financing, then gets to breakeven and profitability without requiring more rounds of financing. They get big and then an exit happens making everyone happy with the return because there is no dilution.

However, in practice, this is very hard to find. The twists and turns a startup can take invariably means that more money needs to be spent before they get to breakeven/profitability. Also, in today's competitive world, getting huge quickly can give you a leg up on the competition and doing so may mean that you need some more funding to build your team quicker and to scale the business faster; without that funding, your organic earnings can't give you that velocity of growth. The probability of needing another round or more than one extra round is definitely higher than the probability of getting lucky and dropping into a business that needs only one financing round.

As more financing rounds happen, then previous shareholders get diluted as someone new wants a piece of the company. We can either let ourselves be diluted, or, if we invest further, we can maintain at least our percentage ownership. Then when an exit happens, we maximize the return we get instead of watching our percentage ownership dwindle and get screwed for us helping the startup so early.

Here I started thinking that this may be a good way to invest even as an angel investor.

If you invest only in the first round as an angel investing strategy, then you must try for the lowest pre-valuation and hope for capital efficiency so that an exit can happen without further rounds of funding. But waiting for the perfect funding opportunity may mean you will pass on or miss some of the best opportunities even if the pre-valuation is not the best. Or the probability of a startup being truly capital efficient enough to get to be huge, or just to a decent exit, without further rounds of funding is very low.

Also, you must put in a large amount of money in the beginning, thus commiting capital at the most riskiest moment of a startup's life: the beginning.

Then I started thinking that perhaps assuming I would not invest only in the first round, but also in subsequent rounds, then I could gain some advantages.

If I assume that dilution will happen, or assume that further rounds of financing will be required which is probably a more likely case, then I could commit lesser funds in the beginning, take my pro rata on each subsequent round, and still maintain my percentage ownership into the future. At some point in the future, I would have been diluted to this percentage ownership in any case. I would be, in effect, dollar cost averaging into the investment. Over a period of time, I could place relatively small bets into the winners of my portfolio, with each amount being within the range of my single investment amount.

I could also invest capital only when risk was reduced, meaning that if a company were successful and growing and could raise another round to grow further, then I would commit more capital rather than committing it all at the first round, when the chance for losing it all was greatest.

Now the problems with this are...

Getting my pro rata investment ability can be really tough in later rounds. A lot of venture terms exclude small investors in later rounds from being able to take their pro rata. If I don't have specific pro rata rights, I would have to fight for my ability to invest further by having a great relationship with the founders and/or CEO. I may not be able to take my pro rata and maintain my percentage ownership.

At some point, the amount I would have to invest in a given round will inevitably grow to be beyond my ability to invest. My hope would then be maintain percentage ownership as long as possible before I couldn't invest any more because that amount exceeded my ability to invest out there at any one time. So I might still get diluted if further investment rounds happen.

A lot of early investment rounds are in notes with caps, and those notes have no terms defined yet. It is quite possible that if I invest in an opportunity like that, that I will have no pro rata rights at all when the round finally converts into an equity round. Thus, I take a lot of risk when I invest in those companies with respect to employing this strategy.

When I talk to VCs, they always tell me that "leaning on the winners" meaning investing in futher rounds, taking their pro rata or even increasing their percentage ownership in the companies of their portfolio which are doing great, results in the greatest returns. So shouldn't I do the same, even as an angel investor?

I would love to hear from more experienced angel investors and see if they have ever tried to employ this strategy in investing.

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This page contains a single entry by DShen published on October 21, 2010 6:48 PM.

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