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Is Angel Investment Broken?

The ROI for 39% of US angel investors is negative.1

While 39% is not a majority, it represents something bigger than a trend or coincidence of all angel investing. The bottom-line, from a pure financial perspective, is that more than one third of all angel investors are wasting their money.

That’s less than a 1x return on capital. That’s a losing proposition. And it’s down-right puzzling. After all, angel investors are all accredited investors having achieved some substantial success. Come to think of it, I have never met an angel investor who did it to get by! 

There are many contributing factors to this problem, whether you consider modern angel investing practices or the current climate of early stage investing. One factor stands out to us.

WHERE IS THE MONEY?

I spent a year exchanging emails with angel investors across the world in my role as Community Manager at Angelsoft.net, the collaboration platform used by most angel investor groups. Once, a manager of a California angel group relayed his disappointment when meeting promising entrepreneurs. Even if the entrepreneur presented a strong deal to the group, many willing and interested angel investors in his group could not invest because their available capital was in ventures still far from exits.

When the recession hit, everyone was affected. My own startup raised $200k in the weeks before Lehmen Brothers fell. Our business model relied on the availability of bank financing for real estate projects. When that financial infrastructure came screeching to a halt, we closed our doors and returned the funds we raised. Thankfully, nobody got hurt and we parted on good terms.

For those angel-funded startups that survived with cash on hand, the path to a liquidity event has become a longer one. Only years later are we seeing a surge in technology IPO activity.

The recession has reduced the number of angel funded startups still in business and increased the “gestation period” for pre-recession angel investments. This is all aside from the bigger issue of how many angels lost liquidity in the recession from other investments.

RELOAD THE ARTILLERY

Angel investors risk their own cash. And when it is gone, it is gone. Unlike venture capitalists, angel investors will not raise another round to maintain their investment habit. They have to wait until a portfolio investment turns into cash to continue investing.

According to Kauffman’s eVenturing guide, “While the average time to exit was four years, the home runs took an average of 8.6 years to harvest. Lemons sour quickly but plums take longer to ripen.”2

It’s a liquidity problem, of course. It is to be expected when investing directly in an early stage company in exchange for equity in the venture. The benefit, of course, is the potential upside of the venture if it is extremely successful.

For some angel-funded or VC-funded ventures, there is an opportunity to hold on to that upside potential while returning the principal investment so that it can be reinvested in the next big thing.

ROYALTY AND EQUITY, LIKE PEANUT BUTTER AND JELLY

Revenue Trades is pioneering the process of combining equity and royalty investments. For ventures with the right margins and growth potential, royalty with equity provides benefits to entrepreneurs and investors.

A royalty investment is a promise to pay out to the investor a percentage of future revenue for capital given today.

Investors can plan on a return of their principal and even interest from the revenue of the company. And an uncapped royalty can tie the upside potential to steady liquidity. Entrepreneurs can give up less equity. After all, they expect to stay in the venture until the end! 

A simplified royalty agreement consisting of a set percentage over a set period of time would not work for many typical startups. What about including a delayed period where revenue is 100% retained for a couple years? How about a variable royalty percentage tied to other growth metrics?

Getting principal back sooner from a healthy investment can be the difference between saying yes or no to that next new entrepreneur—while maintaining that portfolio of long term investments with fantastic upside potential.

Will this solve the problem of negative ROI for 39% of angel investors? Probably not. But we must all do our part to solve that problem. After all, we want to be angel investors too.

References
1 Page 4 of the Kauffman report, “Returns of Angel Investors in Groups”. About the study or download the full report.

2 Page 9 of the Kauffman-sponsored eVenturing guide. Download the guide.

Entry by: Israel Vicars

Filed under angel investing royalty royalty based finance

  1. revenuetrades posted this