“The best early-stage venture capital investments appear obvious in retrospect; however, very few of them are actually obvious when you make them.” – David Sze

Early-Stage Investing: What You Need to Know About This Hot New Alternative to the Stock Market 

In the financial advisory business, angel investing is on fire. After years of watching college drop-outs become billionaires, many individual investors today are not happy with a long-term return of 10% on their stocks. They want more. And they believe they can have more with “early-stage” investing.

My clients that publish investment information are being dragged into this once esoteric corner of the market by customer demand. As a result, I’m seeing a stream of new information products and promotions generated by them.

I’ve done a lot of early-stage investing during my career. And I’ve learned a thing or two from the mistakes I’ve made. Despite those mistakes, I’ve done well over the years because a handful of these companies grew quite dramatically. There’s no doubt that early investing has contributed to the bulk of the success I’ve had.

But there is a difference between what I did and “angel” investing. I was always a founding member of the companies I put money into. I was, in other words, a first-stage investor.

Angel investing is second- or third-stage investing. As an angel, you are invited to put your money into a company after it has begun operations and, in most cases, is already making money. Which makes it, in my view, an entirely different kettle of fish than the kind of direct investing I did. Angel investing is riskier because (a) you don’t know the business or the industry very well, and (b) you have no control over its operations.

One thing I’ve done for many years that is similar to angel investing is putting money into limited partnerships that were developing real estate – apartment buildings, office buildings, single-family homes, and hotels. As a limited partner, I had limited knowledge of those real estate deals, and little influence on how the general partners ran them. By comparing what they did to what I knew about the direct investments I’d made, I was able to figure out some fundamental patterns that were typical of the businesses that flourished and those that failed.

The most important thing I’ve learned from this experiment is that, although it’s easy to identify business plans that make zero sense and/or feel flaky, it’s very difficult to be able to discern, among 5 to 10 good-looking business plans, the one that will become super-successful.

And so, I decided on this approach: (1) find someone I trusted to do the initial vetting for me, and then, (2) buy a dozen or more of his/her recommended companies, and (3) hope that one of them will be the breakthrough company that makes up for the rest and gives us the big results we need to make the whole effort pay off.

Recently, I’ve been reading the advice published by some of the investment advisory publications that have been touting angel investing. In the past week, for example, I’ve read 3 essays on how to do it. Two of them, I was disappointed to discover, provided advice that was not very helpful:

* Understand what you’re investing in.
* Know how much you want to invest before investing.
* Be patient.

The third essay was written by Roy Bahat, head of the Bloomberg Beta venture fund. I liked his advice because it sounded like it was based on experience A few examples:

* Expect (and embrace) the downside.

“Naïve angels worry about salvaging money from their losing investments,” says Bahat. “Experienced angels worry about keeping the upside by investing at a reasonable valuation so the winners make up for the losers.”

* Avoid deals that come with any mention of guaranteed returns.

“Extra control provisions, options in future iterations of the company, and milestone-based valuations are also no-nos,” he says.

* Take many bets.

Bahat recommends investing in a dozen companies to get your feet wet and to “get the hang” of the market. But, he says, a portfolio of 20 to two dozen companies will give you the best chance of success.

I’m sure there are far more secrets to be learned about angel investing, but those are a few that make very good sense to me. In future issues, I’ll update you on how my family’s basket of start-ups are doing and tell you what more we’ve learned about how to play this game smartly.