Angel investors love software companies.
Since 2002, when the Center for Venture Research at the University of New Hampshire first reported the results of its annual survey of angel investment activity, software has been the number one industry sector for angel investments in every year.
And our friends in the Granite State aren’t the only ones showing angels’ affection for software companies. The 2015 Halo Report — a joint publication of the Angel Resource Institute at Willamette University and Pitchbook — shows that more angel investment dollars went to software start-ups last year than went to start-ups in any other industry.
Why do angels like to invest in software companies so much?
First, software companies are capital efficient. Because angels are using their own money to finance businesses, they can only make so many investments of so much money per company per year. Therefore, they prefer to invest in companies that can achieve meaningful outcomes with small amounts of money. That financial structure allows them to participate in the financing of startups in ways not possible with companies that need so much capital that simply cannot raise money in $25,000 increments.
Second, software companies can pivot easily. Most startups will have to iterate to get the right product market fit. Angels prefer companies that can undertake that iteration cheaply and quickly. If a company has to build a supply chain or a factory, or get regulatory approval before they can figure out if they have the right product for the market, then pivoting isn’t as easy.
Third, software companies scale well. Angels like businesses that can become large rapidly because that opportunity offers the potential for high financial returns. Software companies can add volume relatively cheaply because they do not have to build expensive production facilities or distribution outlets to grow larger. In addition, their margins often improve dramatically as the companies grow.
Fourth, software companies often attract later stage financing. Venture capitalists concentrate their investments in the software sector. By focusing on a sector that venture capitalists favor angels can increase the odds that later investors will follow on their investments at a higher price.
Fifth, software companies are simpler to build than many organizations. They have relatively straight forward supply chains and distribution arrangements. Angels, who cannot provide as much assistance to their portfolio companies as venture capitalists prefer those simpler-to-build businesses.
Sixth, software companies are understandable. Diligence is doable on most software businesses because the core ideas behind them can be understood by most investors. That contrasts with many biomedical or advanced manufacturing businesses, which are tough to grasp without specialized industry knowledge.
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“software companies are capital efficient” – that depends on what software are they developing. Most startups are some kind of app or web applications. They all start as a free service but only portion of them manage to start making money out of this app. Twitter still have problems in making a profit. Quick profits is not something one should expect from most of startups.
Great post!!! I would also add that savvy entrepreneurs and angels use the lean startup methodology, which is very easy to implement and follow in software startups. LSM reduces risk, time and money spent in projects and increases the probabilities of success of startups.