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Being an Angel for Fun and Profit: Three Ways to put “Profit” back in the Equation

October 22, 2012

Who wouldn’t want to be an angel?  Apart from the ridiculously loaded word, investing in startups offers a direct line to many of the comforts of the human soul.  If you’re an angel, you get to share your hard earned wisdom, give back to the community, hang out with exciting, smart young people who would otherwise never invite you to their parties, be seen as wise, rich, and magnanimous.  And in addition to all that, there’s the thrill of high-stakes gambling.  Buried, way down in the list, is the idea of making money.  For me, at least, it took a while for that motivation to rise to the surface.

Here’s how angel’s typically work:   Instead of going to the track, they go to demo days.  A handful of startups catch their eye and they think “I like the way this entrepreneur paws the ground, and I’ve been looking for a horse of this color to add to my stable…”  Then they do some due diligence and filter out startups that, on a closer look, appear to be losers (the market’s too small, the people don’t know the domain or aren’t competent to build the product).  Then they decide to own a piece of some fine-looking horse.

Once that’s done, they do three things to help the startup succeed: mentor, provide connections, and, sometimes, provide more investment.  None of which are particularly effective.

Providing more money doesn’t seem to work – angels who double down appear to do worse, on the whole, than others (at least according to this study).  Unless you’re a big enough shot that all your acquaintances are either scared of you or owe you big time, providing connections isn’t very productive. (Try this thought experiment:  Imagine all the people on your linkedin list.  If you were to reach out to every one of them and ask if they’d talk to a young entrepreneur of your acquaintance, how many would?  Now of those, how many would be likely to go into business with, or buy from, your entrepreneur? Just because you decided to bet on a long shot doesn’t mean they’ll like the same horse.)

Mentoring does, on the whole, appear to increase payouts, but there’s huge variation in what the word means, and most of what’s called “mentoring” has little economic value, especially for the mentors themselves.

Instead, if you want to be an angel, and also want to make money, try focusing on these three things:

1)       Systematically help your portfolio companies de-risk their businesses.  Don’t think of mentoring as making yourself available to offer wisdom and connections. Instead, help portfolio companies do the structured work they need to do in customer discovery and in building a valid business model, in order to de-risk.  There’s a fair amount of knowledge now about how startups should operate to minimize stupid, expensive failure.  So don’t helicopter in with miscellaneous advice; support the process.

2)       Focus on raising the value of equity over the length of the runway.  If “lean” means anything, it means that startups need to maximize every unit of value created per dollar invested.  This idea often gets lost in talk about iterating and pivoting and embracing failure, because all that stuff often smells like inefficient, unproductive exploration. It isn’t.  Startups simply cannot maximize value by charging ahead.  The less risky ones iterate and pivot and fail while their burn rates are low, in order to avoid flailing around when burn rates and stakes are high.  That is efficient use of capital. That’s the most important thing an angel can do to make money, because in a few short months, when the startup needs more money, the angel and the entrepreneur will be sitting on the same side of the table.

3)      Design for scale.  Take a lesson from electronics manufacturers.  When these guys come up with new devices, they build and test prototypes at an astronomical per-unit cost.  But once they’re ready to scale, they focus on DfM, or Design for Manufacturing.  Maybe three twenty-cent components will do the work of a single one-dollar component, maybe you can save on a software license by adding another chip, maybe a different layout will reduce the failure rate of populated boards by 10%.  Design for Manufacturing frequently reduces the per-unit cost of electronics by 20%, even over good original designs, a metric that doesn’t matter before ramp-up,  but makes all the difference  for overall success.

Similarly, designing for scale can make the difference between a startup that moves sideways, always just barely justifying more investment, while the earlier investors get diluted to hell, and the startup with a sharp enough upward trajectory to retain value for seed investors.  There’s no simple rule for when a company should shift to more scalable systems. Managing this issue has gotten easier, with cloud and just-in-time scaling solutions (see Eric Ries’s somewhat optimistic take here).  The point for angels is that intervening with your wisdom and experience to help entrepreneurs manage the scaling trade-offs, is one of the best things you can do to maximize your investment

So, what else?  If you’re an angel, what are your motivations?  What interventions have maximized value for you?  If you’re a at an angel-funded company, what have your investors done to make themselves, and you, rich?

— Matt

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