Math of Being an Angel Investor

Aug 2022

(Based on conversations at a MAP launch)



“Success is often achieved by those who don’t know that failure is inevitable.”

– Coco Chanel, Founder of Chanel


 “Anyone can cook… but only the fearless can be great.”

Chef Auguste Gusteau, Ratatouille


I get asked a lot why I don’t do more angel investing. Especially considering I write and talk a lot about technology companies. The short answer is because I don’t have enough liquidity to do so yet. The medium length answer is that I don’t have the right risk to return profile to be an angel investor yet to absorb sustained losses to find the profit generating companies, if I find them at all, at this stage of my life. Being 29 and recently married and starting a home and family.

Then the long answer is going to be this essay.

Some Numbers To Make Sense of it All

2 axioms are true in the startup and venture capital (VC) investing world. Building a meaningful unicorn company is exceptionally rare. But also almost all of the returns come from investing in these unicorn companies because the venture world follows a power law distribution. A “unicorn” is a term coined by Aileen Lee to describe startups whose valuations have risen to $1 billion or more. A power law distribution means that the top performers make more than everyone else combined.

From this article, Quartz’s June 2015 study on the biggest “unicorn makers” in the VC world listed the top 14 VCs who hunted down 93 unicorns which collectively represented just 2.6% of their deals. Aileen Lee herself estimated that only 0.07% or 1 in 1,538 tech startups reach unicorn status. Currently the average time it takes to build a unicorn company is 7 years. This produces an aggregate range of say between 1 years and 14 years from founding to becoming a unicorn.

Interestingly, comparing the rates, a startup funded by one of the top VCs is 40 times more likely to be a unicorn than a random startup. This is implicitly why people like to invest in startups already funded by the top VCs. The distribution of outcomes is much more likely because it provides that signaling, even within a field of unlikeliness. This is because world famous professional investors just have much better dealflow.

Also because there’s a lot of due diligence involved. You have to remember these aren’t just any old business, these are businesses in open ended markets with new products designed for high growth that have the potential to grow into unicorn success stories. This means their DNA is different and it takes diligence to filter and understand if one is looking at for example a coffee shop vs software for all coffee shops. One can become a unicorn, the other can’t.

Inverting a lot of these numbers, even the best investors in the world are losing money on 97.4% of their investments and make all their money on 2.6% of deals. These are full time active investors who do a lot of due diligence and have some of the best networks in the world, something not easily replicated by people who are not living in concentrated technology hubs like Silicon Valley or working on it full time.

If you only make money on 2.6% of your investments, it means you need a portfolio of at least 38 companies to statistically achieve at least 1 unicorn in the portfolio. I’d probably double the portfolio size to 76 companies to near guarantee to get the 2 unicorns or at least 1 unicorn in a portfolio rate that you would need to make this a sustainable business model because you might just get unlucky the first time and not have one.

This happens a lot to angel investors. I know a few angel investors who were once very prominent who had made over 100 startup investments and not hit a single unicorn. They had 100 shots, did the whole portfolio thing right and missed every swing they took. It wasn’t that unicorns weren’t started around them, they just didn’t invest in any of them. They invested in companies that failed instead. That happens very often. It is the most common scenario in fact as most angel investors do not make any money.

The numbers are terrible. It is part of why I deeply deeply admire angel investors. Because they are essentially pricing a fixed amount of capital into loss making with an unpredictable upside. The most probable outcome is to lose everything while allowing idealistic entrepreneurs to try to change the world with their money. They play a vitally important role because their money gives birth to new businesses who are too early for traditional capital sources such as venture capital firms or banks. Many of those businesses wouldn’t have been able to exist without the angel to help get it off the ground.

In almost every founder success story somewhere in it is an angel that helped them and an angel investment that allowed them to quit their jobs and work on the new company full time. It is an incredibly altruistic model. But one they have to go into eyes wide open. That they probably will lose all their invested money. It is why, first you have to get to that amount of liquid disposable capital. This means they already have to be rich. Not just paper rich, cash rich. They have to know that they can lose this amount of money and it have basically no effect on their lives.

How Rich Do You Need to Be?

The benchmark minimum level of security a rich person would likely need to have before commencing an endeavour to lose lots of money is to make sure they’re taken care of for life. This would likely mean they have all their income for spending money taken care of and their home owned outright with no debt on it so they always have a roof over their head for them and their family.

Let’s assume the income side is going to be an income of $50k per year to satisfy a middle class frugal lifestyle. As most of these angels are still working, they probably still have income sources but let’s assume they have it all upfront. As these people are likely at least 30 years old, that means a working life of a maximum of another 30 more years to 60 years old, so they would need to have future earnings or already have $1.5 million dollars that they would need to service their lifestyle.

In Australia we have an unfortunate thing to have happened where we have very expensive median housing prices. The median house price in Australia is $1.2 million dollars. Contrast that to the US where the median house price is just shy of $400k thousand dollars. So Australian house prices are almost triple that of American house prices. But our angel investor is likely living in an expensive area so their homes will be more expensive.

So our angel investor in the US would need around $1.7 million dollars liquid while our Australian angel investor would need close to $2.7 million dollars liquid. That’s an extra million dollars of liquidity the Australian investor needs before they can start compared to their US counterpart. I actually think this is one of the biggest reasons that Australian angels start later, it’s because housing is so expensive. The Australian property market increases the hurdle for how much capital you need to have.

But we’ve already established that when you start angel investing, you need to make a lot of investments to have a portfolio. 76 investments to have a large enough portfolio to maybe achieve 2 unicorns in that portfolio but at least 1 unicorn with any kind of precision. If the angel writes an average angel investment cheque size of $20k per company, this means 76 X $20k = $1.5m. The angel needs an extra $1.5 million dollars liquid to have a large enough portfolio to make money angel investing.

This is a really good base rate when you add it all up. To invest $1.5 million dollars across 76 investments at an average cheque size of $20k, this person needs to be worth $4.2 million dollars in Australia and $3.2 million dollars in America. This is liquid capital to cover their lifestyle and losses. This person needs to be comfortable losing about 1/3rd of that angel investing.

That’s a lot of money. Something that most people would never see in their lifetime. So this is already a very special world we’re talking about. People who are rich enough to lose lots of money. If you’re not that rich, you probably shouldn’t be doing it. I’d even go so far as to say it’s irresponsible for angel investors to be investing with less than that in liquid funds as their life won’t be able to cope with the amount of money that they need to be comfortable losing.

Famously though, many of the world’s top angel investors started investing with a lot less than that. But they were taking on a lot of extra risk to their lives by doing that. Because let’s remember that startup investing is not a liquid asset class. You can’t change your mind and take your money back out once it’s invested.

If it takes 7 years on average to become a unicorn, it might take another 3 years to get any liquidity via a sale or IPO of the business. So it might be 10 years before you can realise any of the returns from the winners. These lockup periods are very long and often the rates of return may not even be that good. You might be better investing in any other asset class.

Valuation and Luck Matters

When you invest $1.5m into 76 companies at an average cheque size of $20k. You’ve invested that $20k at the particular valuation of the company at that point in time. Because these are small cheques the startup is probably small with a low valuation. Anywhere from $2m – $10m is probably the range. When markets are bubbly valuations trend up and during downturns valuations trend down.

According to this the average seed stage investment is at a valuation of about $5m. So the $20k is invested at a $5m valuation and you’ve bought 0.4% of the company. I’m going to assume the company goes through another 4 rounds of financing before it becomes a unicorn, diluting shareholders by 20% each time. So by the time the startup is a unicorn, this angel owns about 0.1% of the company when it sells.

If you’re good at math you would have already seen the problem. If you own 0.1% of a $1 billion startup, when it sells you get back $1 million dollars in the sale. You’ll pay tax on that and be left with less but let’s ignore tax. While $20k to $1 million is an amazing return of 50X over 10 years, that works out to a 40% return per year compounded.

But that $1 million is less than the $1.5 million you spent investing in startups to begin with. So even after getting a billion dollar unicorn, something only 1 in 1,538 tech startups even become, you’ve still lost money angel investing. You haven’t even broken even or made any money yet and you got the unicorn.

What actually needs to happen is this has to become a $2 billion dollar company or greater or you need 2 X $1 billion dollar startups in the portfolio just to break even. The real money is made if you get more than 2 unicorns or get a massive unicorn, a company that hits $10 billion or more in value. Amusingly called decacorns.

But the problem is there aren’t that many unicorns founded each year. According to this, there are only an average of 150 billion dollar companies founded each year. Within which there are only 5 decacorns with market value over $10 billion founded each year. So there’s 150 unicorns and only 5 decacorns founded, in the whole world. And you need to get at least 2 of the 150 or 1 of the 5 to make any money angel investing.

But what you have on your side is time. To try to see more companies. If you invest your 76 investments over 20 years and only do 4 investments per year. You’ll have seen a lot more unicorns and decacorns come into existence from the simple fact of being alive longer. So in any given year it means can you hit 1 of the 150 unicorns with your 4 investments that you’ll make that year, in the whole world?

These probabilities are terrible. This is the problem with angel investing in a nutshell. The odds are so bad that you’re almost always better off investing in anything else. If you took the same $1.5m and invested it into the S&P 500 index fund compounding at 10% for 20 years, you’d have $11 million dollars after 20 years. A much safer and predictable 10X return.

The only reason venture capitalists make any money is because they are able to invest more dollars into each individual deal further along when there’s less risk. So they get a lower percentage return than if they invested earlier stage but because they can moderate the amount of money invested. They can put millions of dollars into the deal instead of just thousands of dollars like our angel investor.

Because the VC is managing other people’s money, who themselves have risk offsetting portfolios to absorb the losses if the VC fails. An angel investor doesn’t have that. They only have their house and their income. And maturing companies who need tens of millions of dollars don’t want to accept small $20k cheques from angels.

So why do people do it? It’s because the upside can be enormous. Like beyond comprehension enormous. If you do hit the decacorn or the $100 billion dollar company or more, the sky is the limit on how much money you can make. You can almost make practically infinity money without having to put in the hard work of actually building the company. Investors can turn a $100k cheque into a billion dollars. That’s a return that just isn’t possible in any other field.

So what happens is many wealthy people with liquid assets of more than $4m realise that they’re not on any trajectory within their own lives or careers to turn amounts such as $1.5m into a billion dollars. But they can afford to lose 1/3rd or less of their money without it really affecting their lives so maybe, just maybe they can find those unicorns and change the world in the process. It perfectly encapsulates both survivor bias and irrational optimism and idealism.

Isn’t that a beautiful thing? I would certainly do it and I recommend for everyone too once they’ve crossed the hurdle of having enough money to be secure in their lives. In fact I think everyone who has crossed that hurdle of liquid capital should become an angel investor. Because you’ll have a disproportionately high impact of birthing new companies and products into the world. Products that impact and change people’s lives.

Why I Don’t…. Yet

I haven’t crossed the liquid capital hurdle yet is the primary answer. The secondary answers are because I’m in real estate I use a lot of leverage. That means there’s a lot of balancing and I have to maintain a lot of liquidity to not go bankrupt. I can’t handle a lock up period of 10 years on capital and when I invest in anything I need to be able to take it out in case something bad happens. Developments have a bad habit of always costing more than your contract says it’s going to.

The third tier answers are in addition to that I’m trying to bootstrap a technology company and I need to spend money week on week to be able to build that business into something meaningful and worthwhile. I’m hoping that every $1 I put into it now will yield much more in the future but at the moment it’s losing money.

The final answer is I just got married and my wife and I are thinking about starting a family. There isn’t an amount of money that we would feel comfortable losing that could also give us the sufficiently sized portfolio to make angel investing seem less like gambling and more like actual investing that we have at the moment.

What I hope happens is that this technology company or real estate company succeed and get me to a place in life where I have the required $4m hurdle to begin investing the $1.5m over 20 years to probably lose that 1/3rd of our money trying to change the world and find the unicorns.

I think I have that irrational idealism to try to change the world while losing an insane amount of money doing so. I’m just not quite there yet. Hopefully someday.