7 of the Most Frequent Mistakes Angel Investors Must Avoid
Angel investors are generally affluent individuals who provide funds for promising startups at their early stages in exchange for ownership in the business or convertible debt. Also known as seed/private investors, they usually finance newly-born startups when major venture capital (VC) firms are reluctant to support them. Angel investors come from various occupations, including business professionals, C-level company executives, successful business owners, and even ordinary people on fast-growing crowdfunding platforms. Now many people can become angel investors, but the truth is, investing in a startup is not just a fun pastime. It is a crucial decision and, better say, a lifestyle choice.
Although angel investing can greatly benefit immature startups, it might carry a certain degree of risk for your capital. Imagine yourself as an angel in an episode of Silicon Valley inside a glass-paned conference hall opposite the young founders of a prospective business. Everything in this setting brags about “innovation,” “breakthrough,” “revolution,” etc.; all seducing you to pull the trigger rapidly and make some basic angel investing mistakes. However, there are things you need to consider thoroughly before getting your feet wet. Here are some of the most prevalent mistakes you might make as an angel. Take them deeply into account before you decide to sign any papers.
Mistake 1: Investing in Startups That Are Desperate for Help
As you may agree, investment in a business is entirely distinct from making donations for benevolent causes. A forward-looking startup is different from a charity that strives for money to fulfill its altruistic intentions in education, medical rehabilitation, animal health, etc. As an angel investor, you are looking for a lucrative prospect, and investing your capital in a startup that urgently needs your contribution might turn out as a snare in the end.
As a matter of fact, top entrepreneurs are often highly resourceful in their business and do not require much external support from scratch. By turning to entrepreneurs that are desperate for your generous investment, you’re probably choosing the least resourceful ones. This is clearly correlated with how thriving their business is likely to be. Of course, even the best entrepreneurs need your support, but the help they ask for is normally defined in a really specific context. Entrepreneurs that require too much day-to-day help, particularly from angel investors, are those you’d better avoid. The story may be somewhat different for venture capitalists, who take on a more dynamic role. To prosper as an angel investor, you should keep financing only world-class entrepreneurs.
Mistake 2: Investing in Businesses Beyond Your Field of Competence
Investment in a startup is a game in which both entrepreneurs and investors adjust to one another’s behavior. Smart entrepreneurs are brilliant at storytelling, and many have learned how to impress generalist investors who lack relevant expertise in a certain vertical. Warren Buffet, the American business magnate, is a good example. He is renowned for his persistent adherence to what he labels as his Circle of Competence. He only invests in areas that he understands well, and this has greatly helped him turn into the most successful investor of his generation with a fortune over $103B (as of November 2021), just with an initial, negligible investment of $5,000.
The same strategy applies to angel investing. If you are eager to win significant ROI from your today’s investment, you’d better invest in an area where you and your co-investors are well-versed in. It doesn’t mean that you need to have extensive expertise in the area but understand how it works and flourishes over time. That’s why experts highly advise co-investing since it gathers people with diverse competencies together to accomplish a startup investment.
Mistake 3: Not Diversifying Your Investment Portfolio
Putting all your eggs in one basket can be the deadliest mistake you make as an angel investor. Focusing on your circle of competence doesn’t necessarily mean you should invest in only one startup. Imagine you have $60K burning a hole in your pocket. How would you spend that? Novice angels are generally excited to write out a large check for their first trial. That’s a dicey decision that can put all your capital in danger. As a rookie angel, the most helpful thing you can do is to create a diversified portfolio.
Variety is the spice of life. So, seek it when you are planning for your investment. The key to creating a diversified investment portfolio is to begin with small portions. As an angel investor, you should allocate a particular sum of money and invest across 10-12 different startups right from scratch. If you are incapable of extending investment over that number of startups, don’t fire up investing. Otherwise, you are likely to risk money with a lack of diversification. Thanks to the Internet, diversification is now much easier than ever. There are online platforms for investment like Propel(x) that help you invest in breakthrough science and tech startups, including those thriving in the Silicon Valley, regardless of where you live. They also facilitate diversification via investing through a syndicate. You can simply expand your capital across many different startups with a minimum requirement of $3,000.
Mistake 4: Not Figuring out Startup Valuations
Startup valuation is one of the main quantifiable, standard metrics used by most angel investors. Fresh angel investors are likely to over-obsess about valuation owing to a lack of knowledge of power-law dynamics. One mistake first-year angel investors may make is not realizing the market valuation for a given startup in a specified sector. For instance, a founder may request a $30M valuation, while the market value may equal $12M for their startup. In such a case, your reckless investment may reduce your ROI by 2.5X.
In contrast, some angel investors are over-obsessive about valuation. Imagine a company goes public for $20B, and you recall the day you were asked to invest at a $20M valuation (a 1,000X ROI) or even at a $30M valuation (a 666X return), but you refused. Declining a seed deal just for doubtful valuation is a terrible blunder. Many investors regret the day they passed on successful startups just because they reckoned a valuation was too high.
Mistake 5: Not Setting Aside Further Capital for Future Rounds
It’s evident that the early investment won’t suffice over time. Most startups will need to raise more funds from existing angels, external angels, or VCs. If you take part in the second round of funding, it’s much simpler for you to figure out the company valuation. By investing in the follow-on round, the founder can refer to the VCs and claim that it has already raised X in that round in return for Y% equity, which values the startup at Z. Otherwise, you basically lose the game in that round to the VC, allowing it to lay down the terms of the deal owing to its powerful position.
Mistake 6: Not Knowing When to Leave the Game
In the first place, you should accept that angel investing is a long-term dedication. Most startups’ business plans claim they anticipate to exit in 3-4 years, but in reality, it often takes much longer than that. Therefore, it’s crucial to invest capital that you can afford to live without for several years. Meanwhile, you should know when to walk out of the casino when things don’t go the way expected. Angel investors need to take the same approach as gamblers do when things don’t go well. Sometimes you have to take action in time and extract your investment from a malfunctioning business. Your lasting commitment to a flopping startup will undoubtedly deprive you of the golden opportunities that are bound to thrive. Of course, that’s not easy and needs non-stop business observation.
Mistake 7: Going with the Crowd
It is true that “two heads are better than one.” But that doesn’t always make sense when it comes to angel investment. Many investors tend to invest in groups since they can benefit from other investors’ proficiency, connections, etc. They think that their shared experience will lead to more secure investment. This is often the case, yet angel investors must be cautious enough not to put too much trust in other angels’ business acumen and to always conduct their own comprehensive research.
With all this said, it’s so helpful to join an angel network to find more prospective investment opportunities, create a portfolio, and benefit from other angels’ know-how with investing. It’s a golden chance to cleverly learn from their former mistakes.
Can You Think of Any Other Avoidable Angel Investing Mistakes?
These were some of the most prevalent mistakes angel investors make in their first-year participation. Have you ever made such ones? If so, how did they affect your ROI in the long run? What other rookie mistakes can you add to the list above? Share your thoughts and experiences with us, so other angels can gain better insights into how to earn massive potential returns from their initial investments.
