How Angel Investors Boost Their Returns

Sophisticated angel investors don’t finance early stage companies because they love technology, want to help entrepreneurs, to benefit society or any of the other things that the term “angel” might imply. They do it to make money.

For their startup investments to be worthwhile, the returns angels generate have to exceed the returns the investors could earn from investing in other assets — bonds, public equities, commodities, real estate, and so on.

Financial Returns From Angel Investing

The financial returns from angel investing are driven by a combination of five numbers:

  1. The price of the company at the time the investor buys shares.
  2. The probability that the company can be sold or go public.
  3. The price of the company at the time the business is sold to someone else.
  4. The number of times the company will need to raise money.
  5. The time period between buying and selling.

The best way to make a lot of money investing in early stage companies is to buy a company with a high probability of being sold or going public, where the price at the time the company will be sold will be high, where the time period between buying and selling is short, and where the initial price paid is low.

Successful angels boost their financial returns from angel investing by getting these elements right.

1. They Invest at a Low Valuation

The higher the price the investor pays going in, the lower the multiple on the investment at a given sales price. An investor who put money into a company at a $1 million valuation will make 20 times her money on a company that sells for $20 million, while an investor who put money into the same company at a $4 million valuation will make only five times her money. Avoiding over valuation is key part of ensuring high returns.

2. They Invest in Companies That Have a High Probability of Exit

The greater the odds that a company can be sold or go public, the higher the chances that an investor makes a return greater than zero on the investment. Companies in some industries – like computer software and ecommerce — and companies with certain business models have a much higher probability of acquisition or IPO than companies in other industries or with other business models. Focusing on those industries and business models improves investor returns.

3. They Invest in Industries Where Companies are Acquired or Go Public at High Multiples

The higher the ratio of share prices to underlying metrics of business performance, like sales or earnings, the greater the price that investors will tend to get when the company gets sold. Again companies in certain industries and with certain business models have much higher multiples on price. Focusing on those types of businesses improves investor returns.

4. They Invest in Companies That Do Not Need to Raise a lot of Capital Before They Exit

When companies raise money after an investor has put money in, the initial investor’s stake in the company is often diluted down, which reduces their return. Some types of companies, like software as a service businesses, can get to positive cash flow without much investment, while other types of companies, like medical devices, cannot. Focusing on businesses that do not need to raise a lot of capital boosts investor returns.

5. They Invest in Companies That Have Quick Outcomes

The longer it takes to get to an exit of a given value, the lower the investor’s return. Some types of businesses, mobile phone apps for example, either take off quickly or disappear, while other companies, like biotechnology businesses, won’t have an outcome for a decade or more. As long as the size of the returns are equal, concentrating on businesses that have quicker outcomes enhances returns.

Investor Folder Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.