Angel investing portfolio construction

Portfolio construction is often an overlooked part of angel investing but I think its critical to maximize returns. While venture capital has a lot more intricacies and the following is geared towards angel investing. 

While inevitably your first or second investment may be driven by excitement for a new idea, its important to have a structured approach in planning the cadence and amplitude of future investments. 

1. How much will you deploy?

Step 1 of portfolio construction is determining your total pool of capital. In the venture capital landscape this is your fund size. For angels this is the total amount of capital you want to deploy towards your angel investments.

Personally, this is 15% of my net worth at this point. It's crucial to have this number in mind or you risk deploying your entire pool in the first three investments. For the purposes of this newsletter, let's say you will invest $1,000,000 over the course of your investing journey. 

2. How many investments will you make?

Before we talk about your number of investments, we have to talk about the power law. Returns in startup investing do not follow a normal distribution, instead a small minority of your investments will drive a large majority of your returns. This is a game of hitting grand slams and your batting average is irrelevant.

Generally, if you are "good" at this game you can expect 10% of your startups to fail, 80% to return 1-2x and 10% to return 5x+. From a venture perspective, generally the target is certain percent ownership (usually between 1-10%) till exit.

To maintain this ownership, you have to invest more money in future rounds of financing. 

Another method would be to not worry about maintaining this ownership and factoring in a 20% dilution per round x 4 rounds before exit. I will skip the math here, but this results in maintaining 40% of your initial ownership stake at exit. Say you invested 100k at a 1 million valuation, you own 10% of the startup.

If the startup doesn't raise another penny and gets acquired for $100 million, you get $10 million (from your 100K initially invested).

Generally the startup will raise more rounds and your equity will get diluted 20% per round. If the startup raises 4 rounds before exit, your 10% will be diluted to about 4% (10 - 8 - 6.4 - 5.12 - 4.096) and your initial investment will return $4 million. 

Now if you maintained your "pro-rata" or 10% ownership stake you would still return $10 million, but you would have to invest more capital to do so. Let's say the valuation at the next 4 rounds was $4M, $10M, $20M and 40M.  

To maintain your ownership you would have to invest 4M (300K, 600k + 1M + 2M). Now you've invested 4M to return 10M. In this specific scenario, you might say it doesn't make sense to invest in the following round, or perhaps you just want to invest in the 2nd round and then forego your prorata. As you can see this can get complex fairly quickly. 

Most angels chose to simply invest early on and do not follow on. Going back to our proposed $1 million investment, a simple straightforward approach could be to invest 50K in 20 startups at a median valuation of 5 million targeting a 1% initial ownership and recognizing that ownership at exit will likely be 0.4%.

If 2 of those startups exit at a $500 million valuation, you've returned $4 million, 4x your initial investment (likely over 10 years) given all the remaining startups return nothing. For comparison if you invested this $1 million in the S&P 500 you would return about $2.1M.

Now the above scenario is contingent on being "good" at deal flow, diligence and value add post investment. It's impossible to predict early on which startups will fall in the 10% as external events/ tailwinds will drive a considerable amount of success. 

Final thoughts

Figuring out how many investments at what target ownership is an important part of startup investing and you should ideally model out a few scenarios to see which one appeals most to you. I am a proponent of investing alongside your risk tolerance and following a detailed analysis at times picking the strategy you're most excited about is preferred. 

I hope the above provides some clarity and gives you a strong base to launch your angel investing journey.

Thank you for reading,
Rishad