Angel Odds Versus Venture Fund Odds

When I first tried to raise a small fund back in 2006, I heard about venture fund odds on investments which was that for every 10 investments a fund made, about half would fail, 2-3 would return a little bit, and then there would be the 1 that would return everything that was lost on the failed startups and then some.
It seemed to make sense and also drove the original reason why I thought I should invest more often than not. If I put more bets out there, then theoretically I should have more chances to make my money back…right?
To date, I’ve made 16 investments and two exits. I invested more broadly than most angels, except for the super angels. But looking at the internet industry, the sad state of the economy, and the way early stage angel investing has progressed for me over the last 3 years, I have come to the conclusion that the one in ten odds for this biz doesn’t apply to us; for us angels, it’s more like one in 20, or 30, or even worse.
Why do I think this:
1. The economy sucks. Probability of exits is much much lower.
2. The economy sucks. Making money is harder. Paying consumers are harder to come by. Businesses are already slow in committing to pay for a service.
3. The internet is too crowded. Me-too products are all over the place, creating blur in consumers’ minds, and making it harder to attract customers.
4. The internet is too crowded. Truly unique products and services are super hard to find now, so gaining a competitive advantage is tougher.
5. Too many small business opportunities on the internet. The probability of starting a great small business is a lot more likely. But finding a suitor with a small business is tough because it may not generate enough revenue to be attractive enough to be acquired.
6. Angel investors typically invest in the earliest, most risky time for startups. Venture funds (except for the early stage funds) usually invest after the very earliest money in. Once startups get to a size that is attractive to a venture fund, a lot of risk is taken out already; we don’t have that luxury. We typically go in when there is just an idea, and maybe a prototype built, and occasionally a business up and running. We don’t know if the startup will fail in a few months or not; there is no history that we can look at. With that kind of risk profile for our typical investment, it would make sense that their would be more failures in our portfolio than for a venture fund portfolio.
7. Those that survive have a high probability of needing additional rounds of funding for growth. If we can follow on invest, that helps a lot. But most of us can’t do that. We may have enough capital to put one round of investment, but most likely can’t invest more money in a subsequent round. Thus, dilution will limit our investment unless we get lucky and find a startup that does not require further rounds. The more investment rounds after the initial round, the more we get diluted.
So all this means that it’s super hard to find that Google super-investment that makes back all that we lost and then some.
Ron Conway combats this by going super wide and doing more investments than we could ever hope to do. This increases the probability of finding a Google in his portfolio.
We could try to find more startups that are capital efficient, and that make money from beginning. Those that do not require a lot of cash to scale means they may not need another round. If they make money, then this also reduces the probability of needing more rounds of investment. Of course, companies like this are incredibly hard to find. Nor can we accurately predict what amount of money they will need later.
If we could follow on, this would help a lot. How about playing Lotto and winning a bucket of cash to play with?
Now, if more venture funds played in the early stage space, combining broad, early stage investment with follow on investments into the winners, this would seem to be a perfect combination. However, in thinking how many venture funds operate, it seems like there are problems with making this approach a success.
Any other possible solutions?

  • Great post. Its hard to imagine solutions for 1-6. However for 7, what if you established as part of the terms of your investment a right to sell a portion when/if they raise their next round. With Facebook and Zynga raising big rounds from DST and allowing their employees to take some equity off the table…Also Founders Fund customarily allows founders to take some equity off. This seems like a fair system. And it allows you to hit a double if you do not have the money to follow on. Thoughts?

  • While I don’t have anything to say that’s close to be called a “solution” 😉 … I do want to chime in with my 2c. But mostly and firstly I want to thank you for this post. Insights into the point-of-view of an angel investor are not too common a find in the open, and as an entrepreneur, I see great value in such insights. Thanks!
    Regarding 1 & 2 (“The economy sucks”). In such times, prudent startups would be more market-focused and know where exactly their customers are, and how to get there. They would know exactly how to create & convey a proven value proposition, and they would need to address the commitment issue that you mention, sometimes as an integral part of their product development…
    It can be argued, however, that many of the most innovative startups aren’t, or even can’t be, so prudent 🙁
    So I guess an investor’s selection criteria is adjusted during such times by his own assumptions, instincts and beliefs.
    Regarding 3 & 4 (“The internet is too crowded”)… Indeed there’s a low entry barrier for Internet startups nowadays – the skills & financial resources required for them are substantially lower than they used to be. So on one hand, that means any of the companies one invests in would face more competition, but on the other hand, one can expect them to do more with less… Is the answer indeed “go wide, go cheap”, then? After all, an angel investor has a limited amount of time, and handling existing investments does require time.
    Also, globally, more crowds are pouring into the internet. Even in markets with exceedingly high internet penetration, there’s still considerable growth in the average time spent online. So there’s still where to aim, we should just choose carefully 😉

  • The Y Combinator model seems pretty good, with some tweaking. The trick is to be able to spot talent very early on.
    Btw, Paul Graham thinks the 1 in 10 figure is a myth:

  • DShen

    Yes this is not a bad solution for hitting doubles or even 3 or 4x. However, it does not fully address the fact that a lot of early stage startups will just die and never even reach the ability to opportunity to return 2-4X. So unless you can get to a next round of financing *and* have the ability to exit out of some or all equity for a higher percentage of your portfolio, which unfortunately seems counter to the fact that a higher percentage of early stage startups are going to die outright…
    We can definitely say we can pick startups better, but if we could do that then this wouldn’t be an issue right?

  • DShen

    Thanks for the comments! Some thoughts:
    re: your 1 & 2 comments
    Yes I think we need to adjust and are adjusting our selection criteria. For example, I now tend to look at those startups which have more revenue focus from the get-go, to increase their survivability in these times. But often it’s the more innovative, uncertain revenue stream startups that explode big. The big question is how can we, as small angel investors, give these guys enough juice to survive long enough to grow big and also generate revenue.
    re: your 3 & 4 comments
    I think the issue is cutting through the clutter of our customers, who are constantly bombarded by new and exciting services, but are already to able to accomplish most of what they want/need/can do with what they have. How can we grab the already split attention of these new customers? Also, switching costs for services are very high; you invest a lot of time/effort/$$ and then we expect them to try something new simply because it’s better. It’s a hard proposition for the general populace.
    So if we are able to grab some people by getting their attention and inducing them to switch, then that slice is still very small, and growing very slowly – probably too slow before our bank account runs out! Or…the probability is high that we end up with a great small business, making decent money for all the founders and employees, but bad for us investors as our money is trapped in there, with no clear way to pull it out….

  • DShen

    Ycombinator is very good. But remember, they are not an angel investor. They are more like a venture fund in that they have investors and also have a much larger pool of cash to pull from. But also, regarding 1 in 10 – for them if you look through their cadre of “graduates”, many have died and they’ve had a few exits but many are still cranking away…I do not think they have hit on their “one” to make back all the money they’ve put out there….this is not a criticism on how they are performing, but it does seem to agree with the fact that if you play in early stage, the failure rate is extremely higher than for later stages, and that it is very, very hard to find that “one” when you begin your investment at early stage.