Understanding How Investors Make Money by ITEN EIR Jack Scatizzi

April 30, 2019 – In my meetings with ITEN entrepreneurs the most often asked question is how do I secure investments from professional investors—generally individual Angel Investors or Institutional Seed Funds. When I start asking additional questions, I realize that the entrepreneur’s knowledge of venture capital is limited to what they have read in TechCrunch or other stories about well-funded Silicon Valley startups. Thus, they don’t understand how professional investors make money and by extension whether or not their startup represents an attractive investment opportunity to professional investors.

In the three years that I was an analyst for a large Angel Investor organization in Southern California, our network received over 200 applications for funding each year, yet we  invested in less than 10 new companies per year. Which works out to approximately 4% of the companies that applied for funding, and the funding rate for institutional seed funds is even lower—some as low as 0.5%. This data clearly demonstrates that not every company is a fit for professional investors.

In support of that claim, data from the Kauffman Foundation’s State of Access to Capital for Entrepreneurs Report shows that venture capital is used by less than 0.5% of entrepreneurs.

Understanding whether or not your company will be an attractive investment opportunity to professional investors will allow you to better allocate your scarce resources to develop an appropriate growth strategy that matches your access to growth capital.

Before I get too far into this post, I would like to mention that just because your company may not be an attractive investment opportunity for a professional investor, it does not mean that it won’t be a successful business. Simply that you will need to identify alternative means of funding your company’s growth.

Portfolio Strategy

Investing in early-stage companies is very risky, which is why professional investors utilize a portfolio strategy where they can reduce that risk by investing in multiple companies. Think of it as buying multiple tickets verse a single ticket for a raffle or playing more than one bingo card at a time. Professional investors use a similar strategy building broad portfolios of early-stage investments to mitigate their risk and increase the chances of a profitable event. Research on early-stage investing suggests that an investor’s portfolio should include 10-25 companies to adequately reduce the risk. And of course, if an investor has enough capital, expanding the portfolio will improve the chance of it generating outsized returns. For the numbers nerds, analysts have run Monte Carlo simulations of Angel portfolios which have yielded some interesting insight into just how many companies in a portfolio it takes to ‘de-risk’ a portfolio.

Unfortunately, the raffle ticket and Bingo analogies are examples of binary outcomes- either you win or you don’t and there is generally only one winner. Investing in startups can yield multiple outcomes ranging from an investment returning less than the initial investment (<1x ROI), the investment generating a sizable return (>20x ROI), or something in-between.

Portfolio Dynamics

Now that we understand portfolio strategy lets dive into the dynamics of how a portfolio strategy hopefully allows investors to realize positive returns from their investments. The basic premise is that within a portfolio only one, maybe two investments will be responsible for the vast majority of the returns. Which means that the majority of the investments will fail to return even the initial investment (≤1x ROI).

Below is a fictitious example of the returns from two 20-company Angel Investors portfolio. Notice that in the first example, the entire $750k “profit” produced by the portfolio came from one investment- Company 10 and that the other 19 investments barely covered the initial $500k investment. And in the second example, the investment in Company 5 covered the initial $500k investment and that the other 19 investments which yielded smaller returns when aggregated totaled the $750k in profit for the portfolio. In both portfolios, the vast majority of investments failed to yield more than a return of the initial capital (≤1x ROI).

Example Investor Portfolio 1
Initial Return ROI
Company 1 $25,000 $0 0
Company 2 $25,000 $0 0
Company 3 $25,000 $5,000 0.2
Company 4 $25,000 $75,000 3
Company 5 $25,000 $200,000 8
Company 6 $25,000 $0 0
Company 7 $25,000 $0 0
Company 8 $25,000 $0 0
Company 9 $25,000 $0 0
Company 10 $25,000 $750,000 30
Company 11 $25,000 $50,000 2
Company 12 $25,000 $0 0
Company 13 $25,000 $100,000 4
Company 14 $25,000 $5,000 0.2
Company 15 $25,000 $15,000 0.6
Company 16 $25,000 $5,000 0.2
Company 17 $25,000 $0 0
Company 18 $25,000 $0 0
Company 19 $25,000 $0 0
Company 20 $25,000 $45,000 1.8
TOTAL $500K $1,250K 2.5

Example Investor Portfolio 2
Initial Return ROI
Company 1 $25,000 $0 0
Company 2 $25,000 $0 0
Company 3 $25,000 $0 0
Company 4 $25,000 $0 0
Company 5 $25,000 $500,000 20
Company 6 $25,000 $65,000 2.6
Company 7 $25,000 $0 0
Company 8 $25,000 $0 0
Company 9 $25,000 $15,000 0.6
Company 10 $25,000 $135,000 5.4
Company 11 $25,000 $175,000 7
Company 12 $25,000 $0 0
Company 13 $25,000 $0 0
Company 14 $25,000 $0 0
Company 15 $25,000 $90,000 3.6
Company 16 $25,000 $0 0
Company 17 $25,000 $125,000 5
Company 18 $25,000 $25,000 1
Company 19 $25,000 $25,000 1
Company 20 $25,000 $95,000 3.8
TOTAL $500K $1,250K 2.5

Typically, the return on a single investment is responsible for covering the initial investment for the entire portfolio or the majority of a portfolio’s profit. Therefore, early-stage investors must create portfolios of high growth companies capable of achieving outsized returns—generally over a 20x ROI.

Consequently, if an investor in your company does not have a realistic shot at turning a $25k investment into a $500k payout, you are probably not a fit for their portfolio.

To expand on this, a $25k investment in your company would have to result in the investor owning 0.01% of your company (accounting for dilution from subsequent rounds) at the point in time when your company is acquired for $50M in order for their initial investment to generate a $500k return for the investor. Data from The Angel Resource Institute shows that on average, Angel Investor portfolios generate approximately 2.5 times the invested capital, thus the example portfolios are relatively accurate reflections of an actual Angel Investor’s portfolio.

What Are Professional Investors Looking For?

The initial lens professional investors use when sourcing investment opportunities is your company’s growth potential. Even before they judge your management team, your solution, your barriers to entry, they will make sure that if executed properly your startup will be an attractive acquisition candidate, and will command a high enough price upon exit, that their equity in your company will generate a significant return (over 20x). Thus, investors tend to be interested in companies developing scalable solutions addressing large commercial markets.

If your company does not fit that description it does not mean that your business will fail. It simply means that your company may not be an attractive investment opportunity to traditional early-stage investors and that you will need to identify alternative methods to fund the growth of your company. Over the next few months, ITEN will be focusing on developing resources related to alternative funding strategies.

For those entrepreneurs focused on raising capital from professional investors, I highly recommend  you read at least one book on Angel Investing. Understanding the motivations of early-stage investors will be crucial to your ability to present your company as an attractive investment opportunity.

Additional Resources:

Jack Scatizzi

jscatizzi@itenstl.org

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