Tips for aspiring angel investors

Due diligence should be done to reduce the risk of bad investments

It sounds like a surefire way to get good returns on your money: Invest small amounts across a dozen or more young companies; reap outsize rewards on one or two; repeat.

This is the simplified version of angel investing, the euphemistic term given to early-stage investments in companies that are long on ideas and short on capital.

At a time when conventional returns are low, lawyers and financial advisers say clients who would not have thought of angel investing a few years ago are looking at it now. But too often, investors are not doing their due diligence. The idea of angel investing has become too alluring. Think of those early investors who backed Pinterest or Twitter.


ST ILLUSTRATION: ADAM LEE

'EASY' MONEY

The current environment we're in, with ample liquidity and low interest rates, has spawned a rush of people with half-hearted business plans who have been able to raise money from unsuspecting investors.

MR RICK MARCATOS, senior vice-president at UBS Wealth Management Americas

"Smart people are doing it because they don't know what they don't know," said Mr Daniel L. Gottfried, a partner at the law firm Hinckley Allen. "When these doctors and lawyers are doing it, they're investing with the hope that they're going to make lots and lots of money. It's roulette.

"But unlike roulette," he said, "there are things they can do to stack the deck in their own favour."

Mr Gottfried, who has advised angel investors and companies seeking angel investments, said he had become sceptical of the culture of angel investing.

"What bugs me is this whole start-up scene is a lifestyle, and there are these investors who think it's sexy and want to be part of that lifestyle," he said.

That is why otherwise successful professionals are succumbing to the siren song of mega-returns and blocking out the pitfalls, which are often discussed openly by people who are members of angel-investing groups and who have had success with these investments. Considering the pitfalls is one way of minimising them.

Said Mr Rick Marcatos, senior vice-president at UBS Wealth Management Americas: "The current environment we're in, with ample liquidity and low interest rates, has spawned a rush of people with half-hearted business plans who have been able to raise money from unsuspecting investors."

If you're a sophisticated venture capitalist, you're out looking at hundreds of potential opportunities before making a decision. If you're a professional with a day job, it's not realistic to think you have the time to do that. Picking from just a few may be convenient, but it is not rational.

Another option is to find investments where you can use your knowledge as well as your capital.

Mr Brin McCagg, an entrepreneur on his fourth company, has received financing from friends and family, venture capitalists and angel investors.

He sought out angel investors with industry knowledge for his current company, RecruitiFi, which brings together companies looking to hire people with executive recruiters who have expertise in finding the right people.

"I'm going to people with a great idea and they happen to know the industry," Mr McCagg said. "They say, 'I think you can execute and I think I can add value. Can I invest?'. That's very different than making a half-dozen angel investments."

At RecruitiFi, Mr McCagg brought on the former chief executive of one of the big four recruiting firms to advise the company on the art of recruiting as well as to invest.

And Mr McCagg, despite asking for angel investments, advises people to wait and make sure they have enough money before they make an angel investment.

"You should build a diversified portfolio of stocks and bonds and make money, and sooner or later someone is going to come along with a business opportunity in an industry you know," he said.

Just because some entrepreneurs ask you to invest in their company doesn't mean you should. Flattery, after all, clouds judgment.

Who is managing the company is as important, if not more important, than the idea itself.

"Usually, it turns out that the greatest idea in the world is not the only greatest idea in the world," said Mr Craig Mullett, founder and president of the Branison Group, a corporate finance firm, and an angel investor himself.

He said he liked to see managers who were careful about how they spent money. He also avoided managers enmeshed in complicated family dynamics that could disrupt the running of the company and managers who had grown comfortable with their salary and lost the drive to grow the company so it would benefit investors.

Mr Mullet said he also looked at the expertise of the board members and how they functioned together. One risk is that the company has to bring in a strategic investor who gets a board seat and then essentially takes over the company, often reducing, if not wiping out, early investors.

The company's prospects are also helped, he said, if there are some barriers to competition, either in terms of the technology or the relationships the company has built with crucial vendors.

Aspiring angel investors should also try to gauge the time it will take for the company to bring the idea to fruition. When subsequent rounds of financing are needed, the original angel investor will need to put up more money or risk having the investment diluted.

Mr Alan Mendelson, who ran the venture capital firm Axiom Ventures and is also an angel investor, said he looked for angel investments that did not need more than one or two rounds of financing.

Then there is the question of how the investment gets made and what provisions are in the investment documents.

Mr Mullet said he had often made angel investments in the form of convertible debt, not equity. Doing that gives him some of the protection of debt and some of the upside of equity - if the company doesn't collapse.

But more important, he said, he makes sure there is a limit on how much his investment can be diluted. An investment today that is worth 25 per cent of the company, for example, could be diluted to 1 per cent or less of the company if a larger investor comes in later and there is no cap in place.

Even going through all these checks doesn't guarantee that the investment will pay off.

Mr Gottfried has been on the other side of his advice. He invested in a company that found security holes in networks and automatically patched them. The technology, he said, came from the Israeli military, and the company had been operating for 18 months.

Everything checked out, so he invested. Two years later, the company folded.

But hearing those tales of failures may be the hardest part for amateur investors.

NEW YORK TIMES

A version of this article appeared in the print edition of The Sunday Times on October 18, 2015, with the headline 'Tips for aspiring angel investors'. Print Edition | Subscribe