Should Doctors Be Angel Investing?

By Dr. Jim Dahle, WCI Founder

Angel investing is a challenging but potentially enjoyable method of investing for those who are already wealthy and love the process. It should not be viewed as a method to “get rich” or as a mandatory part of a portfolio.

Why Do People Look for Angel Investors?

When entrepreneurs run out of their own money but still don't have their business off the ground, they will usually turn to friends and family. However, since most people aren't very wealthy, that source of funds also doesn't last very long. They are left with two options:

1. Take on debt
2. Give away part of the company for cash

The problems with taking on debt are three-fold:

1. Debt must be serviced, eating up valuable cash flow
2. Debt takes time to qualify for and may not be available at all
3. Debt does not provide any “extras,” such as expertise from an experienced entrepreneur.

Angel investing comes with none of these downsides, even if it costs a piece of the entrepreneur's beloved company.

What Is Angel Investing?

An “angel” investor comes down from above to save an entrepreneur and their fledgling company with both funds and (ideally) expertise that will help them “get the plane off the ground.” Angels are usually individuals, and they typically provide a relatively small amount of money to the company—generally $15,000-$250,000—in exchange for equity. In addition to the cash, they may also become part of an advisory board to the company. The typical progression of a successful company might look like this:

1. Entrepreneur's own funds
2. Friends and family money (loans, gifts, or investments)
3. Angel investors
4. Venture capital
5. Private equity
6. Initial Public Offering (IPO)

A venture capital firm or fund may provide amounts in the $1 million-$5 million range—less in early (seed) rounds and more in later rounds. The earlier the money is given, the more capital the entrepreneur must exchange to get the money. Sometimes it can be divided into multiple “rounds” such as:

• Seed: $50,000-$2 million
• Series A: $2 million-$5 million
• Series B: $5 million-$10 million
• Series C: $10 million-$50 million
• Series D: $50 million+

However, these dollar figures are highly variable and adapted to a given company. Private equity, often using borrowed money, may come in and purchase an established company (whether struggling or not) to try to fix it up, and then flip it a few years later to another buyer or take it public. However, angel investing comes before any venture capital or private equity. It's a far riskier time to invest, although the amounts required are typically small enough that it is generally individual money, not institutional money, despite the presence of “angel funds.”

More information here:

Entrepreneurship and Angel Investing

10 Reasons You Should Own a Business

What Kind of Returns Do You Get from Angel Investing?

The returns from angel investing are extremely variable, ranging from a total loss of capital (a frequent occurrence) to 100X+. Some data suggest that a diversified portfolio of intelligent angel investments can have quite a good return. A study at the University of New Hampshire suggested that ON AVERAGE an angel investor multiplies their capital by 3.5X. The most widely cited study, by Boeker, showed an equity multiple of 2.6X with an IRR of 27%. That study looked at 538 angels in 1,137 deals. Right Side Capital Management looked at multiple studies that showed returns ranging from 18%-37%.

The Need for Diversification

Perhaps the biggest issue with angel investing is the fact that most companies go bust. A majority of angel investments do not return any of their capital to investors at all. To borrow a sports analogy, this is not a game of “singles and doubles.” It's a game of not just home runs but World Series winning, walk-off, grand slam home runs. Three percent of companies provide 77% of the cash returned, and 10% of the companies provide 85%-90% of the cash returned. Basically, nine out of 10 deals are losers. So, you need to invest in enough of them that you get a few winners. You shouldn't invest in one or two and expect to make money. The most likely outcome of 1-2 angel deals is to lose all of your capital.

More information here:

The 6 Stages of Diversification — Where Are You At?

Due Diligence Matters in Angel Investing

One interesting finding from the return studies was that higher returns were correlated with additional due diligence time. Returns were better if you spent at least 20 hours of due diligence than if you spent less than 20 hours. Ideally, you're a bit like Warren Buffett in that you not only invest in companies but actually influence them for good. You're investing your money and your time.

You Better Enjoy Investing

Since you need wide diversification in this asset class, having 20-50 different investments seems like the minimum to have a reasonable disbursement of returns. And if you're going to spend at least 20 hours on each company and you presumably pass on at least as many as you invest in, we're talking about a serious time commitment here. That's 100 companies x 30 hours = 3,000 hours. That's like a year and a half of full-time work. Most physicians are going to be much better off spending that year and a half working and investing an extra $300,000 into a typical portfolio than chasing angel returns.

You Better Be Rich, Too

The other problem with having a diversified portfolio of angel investments is that it requires a lot of money. If your average investment is $50,000 and you have at least 20 of these, that's $1 million just in angel investments. If you're wise and limiting these to a maximum of 20% of your portfolio, that suggests a portfolio of at least $5 million. Kind of like private passive real estate, you need to already be rich before you invest in this asset class. It's not a method to get rich in the first place.

At a minimum, you would need to be a legal accredited investor, i.e., have an income of at least $200,000 each of the last two years or investable assets of at least $1 million. However, my definition of an accredited investor is two-fold:

1. Be able to evaluate the merits of an investment on your own without the assistance of an attorney, accountant, or advisor and
2. Be able to lose your entire investment without it affecting your financial life.

In my estimation, the latter requires you to possess BOTH of the legal accredited investor definitions and then double them. i.e., an income of $400,000+ AND investable assets of $2 million+ to invest in anything that requires accredited investor status. And angel investing is probably one step beyond that.

Clubs and Funds

Since angel investors seem to mostly do this for fun (psychic returns), they often do it with other people. They join clubs of angel investors or invest via funds to be a little more diversified. I suspect they imagine themselves like the stars of Shark Tank with entrepreneurs coming to them to beg for their money and expertise. While a fund seems like a great idea, be aware that it doesn't always pan out. One professional investor said this about his funds:

“I have invested in 51 companies directly. I am a general partner directing investments in two funds (one a small VC fund, the other an angel fund), and I am a limited partner (i.e., a passive investor) in four low fee/low carry angel funds. The four funds I am a limited partner in are diversification plays (two vertical-specific and two geographical). Five of the six funds will each yield me some ownership in about 35-45 companies (so approximately 200 companies across those five funds), and the little angel fund has done about a dozen. None of the funds has experienced any big positive exits so far—just a couple small exits and a dividend or two . . .”

There is clearly a lot of hope involved in investing in this asset class. Bear in mind that most funds are really just groups of people pooling their money and due diligence. It's not really a passive experience. For example, the Golden Seeds Annual Fund has a once-a-year capital call, and then members vote on which companies to invest in throughout the year.

More information here:

A Moderate-Income Physician’s Approach to Alternative Investments

Is It Just ‘Too Hard?’ Know Your Circle of Competence

Do I Invest in Angel Investments?

No, I do not. I believe in investing my time actively and my money passively. I don't get a lot of joy out of investing. It's mostly a chore I try to spend as little time as possible doing. That approach is not really compatible with this asset class.

What do you think? Are you an angel investor? How rich were you when you started? How many deals have you done? What kind of returns have you seen? Any tips for success? 

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