save a failing investment.
Points 1 and 2 are related. If you know about an industry from experience you will be aware of proven business models, market dynamics, obvious pitfalls and what innovations are likely – which is what due diligence seeks to learn.
Requirements to be an angel
When considering whether or not to make angel investments you need to note the above strategies. I have also listed below my own more detailed list of requirements to become a successful angel.
1. Accept the risks
You must have cash available that can be locked into highly illiquid investments and which you can afford to lose.
2. Spread the risks
You should spread risk and increase the chance of successful investments by planning to make at least ten investments. This important point is discussed in the next section.
3. Invest systematically
You should stick to an investment amount consistent with points 1 and 2.
4. Take advantage of available tax reliefs
Recent changes to tax legislation have increasingly encouraged investment via the EIS. Not only have the tax reliefs been enhanced, but the amount an individual can invest in a SIPP has been severely restricted.
As a result of these changes some people who have not previously invested in private companies are being encouraged to do so. This may lead to the development of a new wave of angels.
5. Invest mostly in things you understand
Most investment opportunities need a group of angels who invest, say, £500,000 in total. Ideally you should have some experience of the venture’s sector but if not you can take comfort from the presence of those who have.
6. Do some due diligence
Intelligent questioning and verification of claims made goes a long way. If one member of an investment syndicate has deep knowledge of the venture’s industrial context he can add value to the due diligence process for the benefit of all.
7. Only invest when you like and respect the management
This crucial issue is discussed in Chapter 4.
8. Plan to offer your experience when and where it may be of value to a venture but don’t impose it
An angel can provide huge added value to a young company. An early stage venture may need help with sales contacts, recruiting, pricing strategies, financial management and more. If mistakes that are obvious to the experienced angel can be avoided that saves time, money and maybe even failure.
9. Avoid investing good money after bad when things don’t go to plan
This is discussed below under ‘How big should a portfolio be?’
10. Enjoy being an angel
Whatever their backgrounds and reasons for investing, all angels need to be sceptical and have their eyes open as angel investing can be dangerous. Angel investing is full of stress and disappointment as well as having high points. Only a sense of humour can keep you sane as you ride this roller coaster.
So you must find it fun or you should not do it. The high points are not just making a lot of money from an investment, nice as that is, but they include the satisfaction of helping others to succeed in their plans.
In the final analysis if you cannot feel comfortable with most of the list of attributes described above, angel investing may not be a wise choice for you. There are, though, other approaches you might consider if you wish to invest in small unquoted companies without the same level of risk and involvement. These are discussed later in the chapter.
Portfolio considerations
Before you make unquoted investments you should give serious thought to the importance of spreading your risk through a portfolio rather than making one or two isolated investments in an unstructured way.
Modern portfolio theory
Modern portfolio theory (MPT) is one of the most influential economic theories about investment returns. It was first published in 1952 and has been widely used ever since. It addresses the concept of spreading risk through several investments and was developed for investors in quoted stocks who invest in large markets with many investment opportunities.
The theory says that it is not enough to look at the expected risk and return of one particular stock. The risk with each individual investment is that the return will be lower than expected. The risk in a portfolio of diverse individual stocks will be less than the risk in holding any one of the individual stocks.
MPT quantifies these benefits mathematically but put simply the theory argues for not putting all of your eggs in one basket, which brings us to the angel investor.
The relevance of the theory to the angel investor
Earlier in the chapter, I drew attention to angel investment returns reported in an academic research study. That data, together with my own simple analysis of the enhancement to investment returns from use of EIS tax reliefs, showed that angel investing can make attractive returns.
However, 56% of investments in that study failed to return the amount invested and most of those lost it all. At the other extreme, around 10% of investments returned more than ten times the amount invested. This means that 80% of the total cash flow from the investments came from less than 10% of them. If the angels in the research sample had known which investments would return more than ten times their money they would not have made the others.
These results starkly illustrate just how hard it is to pick winners and that money needs to be spread across a number of ventures to have a decent chance of enjoying an attractive overall return.
It is clear then that you must spread risk by investing in a portfolio of opportunities if you want to make an attractive overall return with a minimised risk of losing all your money, which is exactly what MPT says you should do.
How big should a portfolio be?
How many investments?
The range of possible returns on a single investment is from zero to ten or more times the money invested, with perhaps only 10% of investments achieving the highest returns. So a sensible strategy is to invest in at least ten ventures and to invest roughly equal amounts in each.
How much to invest in each?
Alongside the decision to diversify your risks, you need to give thought to how much you are prepared to invest in your portfolio. As part of this thinking you should consider the difference between the amount you invest and the net cost of that investment after tax reliefs, as it may well influence the decision on the amount you invest.
For example, you might decide you are prepared to invest a total of £250,000 before tax reliefs. That will cost you £175,000 after upfront EIS income tax relief of 30%.
However, if you had paid capital gains tax at 28% in the preceding three years or are expecting to do so in the next 12 months, you can claim capital gains tax rollover relief as well. That might reduce the upfront net cost of the investments by a further