Creating a Portfolio of Angel Investments
By David Smith
The general risks of unquoted investing
Each of the Dow Schofield Watts Angels investment circulars states that you are significantly more likely to lose your money than to make money.
This is more than just boilerplate. We do want investors to take it to heart and invest in a way that helps mitigate their personal risk exposure.
The individual vulnerability of each early stage investment can be partially mitigated by spreading your investments. You might therefore choose to make a smaller investment in several (or all) of the Dow Schofield Watts Angels propositions, rather than stock-picking a few much larger individual investments.
This raises the question of how many investments you might need to back in order to get a balanced portfolio.
It depends, of course – for example whether you’re a start-up or a late stage investor. In any case you can’t rely on experiencing the market average results in any particular portfolio; chance plays a large part.
What is a typical range of returns on a spread of VC investments?
OK, so that’s the wealth-warnings out of the way, and let’s now look at what, historically, the outcomes have been like for early stage investments.
There are various rules of thumb, such as the rule of thirds:
- 1/3 of companies return zero or a (typically) small proportion of cost;
- 1/3 of companies return capital plus a bit;
- 1/3 of companies do well.
A more statistical analysis suggests that the position might actually be more skewed than this rule of thumb. The following graph[i] reflects a deep study from the US market over a ten year period, and suggests that about 2/3rds of investments actually lose money:
This shows heavily left-skewed volumes and right-skewed values – in other words you get your return from just a small proportion of your individual investments.
Let’s reverse-engineer these numbers, by ranking each investment in order of return, and work out how many you need to have made before you’re in profit:
Only at (about) the 95th percentile is a US tech VC fund in profit. On average, in a portfolio of twenty, the least successful nineteen investments return enough to pay back the portfolio’s cost of investment. It’s only when the most successful investment is realised that the investors are in profit – a profit of very roughly 2-fold overall by this simplified analysis[ii]. This pattern is reflected in European VC data[iii] also: just four per cent of exits deliver 50% of overall returns.
So how should you spread your investments – and what else can the investment manager do – to mitigate risk
Your takeaway might be – “I need to have at least 20 investments – or more!” However, this doesn’t really take account of the nature of the funds in the analyses which include funds focused on deep tech, biosciences, or big bets on finding the next Google or Tesla. These can be long-odds investments, needing big cheques, competing to out-spend other VC-backed companies or taking-on massive incumbents, or needing venture-funding over a very long period. So – a huge chance of failure, but potentially huge paydays.
Our investment strategy is somewhat different: we try to target less competitive niches, smaller investments, businesses with revenues that can get into profit quickly, and which have got lower burn rates (we just won’t back companies with high founder salaries or heavy general overheads). Maybe this gives us less chance of world domination but, equally, we are planning for a much lower failure rate without sacrificing the overall portfolio return.
Additionally – and crucially – our approach to investment management is intended to mitigate the failure rate – very close portfolio management by our team, appointing industry experienced management as active non-executives, early intervention by us as managers when the business veers off course, and a very close continuing attention to the burn-rate.
So, in summary, we operate in an investment market which makes money from only a small fraction of its investments. We aim to significantly improve these odds – by the way we select and then manage our own venture investments for the Dow Schofield Watts Angels network. But, in the final analysis, this is still a risk business.
It DOES pay to spread your bets.
David joined Dow Schofield Watts as a director in June 2016. He heads up the tech sector corporate finance operations for the group as well as leading the Dow Schofield Watts Angels investment arm.
[ii] This is consistent with the 10.28% IRR for US VC funds over the ten years to 2014 analysed at https://www.cambridgeassociates.com/wp-content/uploads/2015/05/Public-USVC-Benchmark-2014-Q4.pdf and with the average hold period of approximately seven years http://www.angelblog.net/Venture_Capital_Exit_Times.html