Angel Investing 4 – Why You Need Deep Pockets to Win Big

Posted on Sep 16, 2010 | 31 comments


This is the fourth article in a series on what it takes to be a great angel investor (and why this should matter to entrepreneurs).  Part 1 – Access to Great Deal Flow – is here.

The first three skills I espoused were: access to the highest-quality deal-flow, domain knowledge of the topic area in which you’re investing and access to VCs to help fund the next stages of development.

As I’ve highlighted I believe we’re in a unique period similar to 2005-08 where the biggest tech firms of Silicon Valley (and some media companies) are scooping up small software companies as “talent acquisitions” versus accretive revenue / profit generators.  Markets like these are very kind to angel investors because you get taken out early and see a nice pop on your investment.

But consider periods of time where the average time a company exists before acquisition or IPO is 7-10 years.  This is actually the norm.  I know some people think the whole market has been disrupted and startups and funding work differently these days.  But then again I remember in the late 90’s when people were talking about the “new economy” and the “old economy” and how the old rules didn’t apply.  How’d that work out?  Easier to start companies, yes.  Total disruption on the funding market?  I doubt it.

I can tell you many angels I know – and really sharp ones with more than enough capital to put to work – are telling me, “I’m currently going to sit on the sidelines for a while.  I have too many portfolio companies without exits and I want to see some returns before I put too much more money into this category.”

And these are people with deep pockets.

4. Deep pockets – In the previous posts I’ve compared tech startup investing with poker taking analogies of The Big Short & Delivering Happiness.  I’ll continue with that analogy.

To win in poker you need to see enough hands until you’re dealt cards where  the odds are stacked in your favor.  If your two pre-flop cards are strong enough and if the opening bets are small enough you want to see your hand after the flop (3 more cards) before deciding whether to up the betting and put more money at risk.  Ultimately if you stay in the hand you get to see the sixth care (the turn) and the seventh (the river).  Each card reveals more information to calculate your odds of success.

When the cards align and your odds of winning increase you “lean” on your investment and take a more bullish stance.  This is hard to do when you don’t have enough chips on the table.  Imagine being at a poker game, seeing the hand of a lifetime – a straight flush – (call it Zynga or Facebook) and not having enough chips to protect this investment.

But often times your early hand isn’t strong enough and you fold before the pot becomes too expensive.  That’s OK, too.  You want to conserve cash to bet stronger on hands down the line where the odds are more in your favor.  This is the same with angel investing.  Protecting every investment – including bad hands – is a losing strategy in poker & in angel investing.

From an investment perspective you need to absorb three scenarios in angel investing that require deep pockets.

a. the diversity problem.  You can back great teams and concepts but sometimes they simply don’t win.  So just like in poker you can have two kings in the pocket pre flop and still come up empty.  This is why you need to be able to do a large enough number of investments to create enough deal diversity.  Angel investing has a high risk / reward profile so if you only make 5 angel investments your chances of success are greatly diminished.

b. leaning on your best deals – The second scenario is the one we’ve already discussed – the ability to “lean” on deals that are doing well.  In the worst case you want to protect your prorata investment as much as possible (e.g. avoid being diluted).  But the best investors are those that spot their best hands after the flop and find a way to increase their ownership before the turn or river.

Roger Ehrenberg of IA Ventures talks about this in a recent post:

“One of the biggest issues I have as a small venture fund is how to reserve for follow-on investments. While some have strategies of making extremely large numbers of small investments and following on in none or very few, IA Ventures’ strategy is a much more traditional “lean hard into winners” approach (albeit with extreme domain focus)

and

“When our capital and participation has helped de-risk a business to the point where it is appropriate to follow on and finance growth, we want to step up to do our pro rata and beyond.”

c. avoid being crushed – We all know what happens as company lifetimes elongate, which is the norm.  Companies ultimately go through multiple rounds.  If they raise in good times angels do fine.  If the companies hit a rough patch – and let’s be clear that most companies DO hit a rough patch, even successful ones – then angels are vulnerable without deep pockets.

VCs will often put in punishing terms to those investors unwilling to dip their hands into their pockets.  I’m not defending this behavior – sometimes it is appropriate, sometimes it is not.  But it is.  So know that going in.

And if you’re not busy being crushed (diluted) you might not notice that the people above you in the cap table (e.g. more senior to you) might be piling up liquidation preferences and tilting returns in their favor.  Only deep pockets can protect this from happening.  It’s why I’ve taken to calling angel investing “a mug’s game” unless you have deep enough pockets.

In summary …

A few great hands is all it takes to win big.  But if you’re going to play make sure your table stakes are large enough to be sure you’re not taken advantage of with people who brought more chips to the party.  If you’re the sucker at the table – others will smell it.

Final point worth noting …

While reading one of David Lerner’s comments on my last blog post it made me realize that sometimes it’s OK to play poker just for the sake of playing & enjoying and knowing that you might lose some money.  And sometimes along the way to becoming a professional poker player you need to be able / willing to lose some money to learn the ropes.  Pay to play.  Either of these are obviously fine in angel deals.  Just be clear on why you’re playing.

And I responded to David about my own angel investing this way:

“When people ask about my personal angel investing I often tell people have have non-traditional motives. Of course I’d like to make good returns. But I often also want to learn about a market, get to know other investors, help promising entrepreneurs get their first break as I once did, etc. I tell my wife to assume that money is lost.”


  • drorm

    So in summary, you need to be knowledgeable, well connected, have tons of money and spend quite a bit of time if you want to be an angel? So most people shouldn't be angels even if they can afford it unless they're doing it for the fun.

    One problem though, is that while I agree with this, it's all based on gut feeling, rather than hard data. I'd love to see some tracking of how various kinds of angels and VCs do over a period of 10 years. Do VCs do that much better than angels?

  • http://how2startup.com/ Roy Rodenstein

    Agree on a., doing enough deals so that you don't get killed by the odds.

    On b. and c., if as an angel you invest, say, at a $3M pre, and the company eventually sells for $15M (random example), sure the dilution hurts but you should still be in the black (assuming non-draconian multiple liquidation prefs, etc.), right? You may not make the full 5x but you should make 2-3x.

    Also on c. how does having deep pockets as an angel protect you against VCs piling on liquidation preferences? From the B round on, and in some cases even from the A on, you're not going to get the same treatment as an angel, are you? Or are you considering “deep pockets” to be enough to do your pro-rata all the way down the line… which could be $1M on a Series C or D, etc.? I don't see how an individual angel can do that, even for super angels it would be difficult.

  • http://bothsidesofthetable.com msuster

    Most VCs fail, too. There is plenty of data available about VC performance – I haven't seen it split out by angel performance. If anybody has seen it I'd love to know.

    But to your point, this is obviously a qualitative & subjective POV on angel investing. Yes. It's still right ;-)

  • http://bothsidesofthetable.com msuster

    on b & c… life doesn't seem to work out that way from many angels I've spoken with. As I outlined, in companies sold within the first 3 years for a “quick flip” it works. But when companies go through many rounds over time the angels get squeezed. Particularly if you need money in a bad market. You see down rounds, pay-to-play provisions, multiple liquidation preferences, etc.

    And if it's a really good deal you want to be able to increase your investments for your biggest 10-20% of outliers. That's where the biggest returns come from. Hard to do if you don't have deep pockets. Balancing deal breadth with “lean into” takes a lot of dough.

  • drorm

    Yes, I've heard some of the data about VCs. A few years ago I watched a presentation about analysis of VCs returns. They were grouped into 4 groups. 25% lost money over the life of the fund, 25% broke even, 25% did as well as the S&P500, but the last 25% was the one that carried everyone else by having stellar results, resulting in the fact that VCs overall did way better than the S&P500.

  • http://pixelbits.wordpress.com/ Mona Nomura

    Ever tried. Ever failed. No matter. Try again. Fail again. Fail better. – Sam Beckett …or my life motto. Live, learn, and move on; because what don't hurt you will only make you stronger!

  • http://how2startup.com/ Roy Rodenstein

    Agreed. Rather than “built to flip” startups, I do evaluate companies for having a higher than average chance of controlling their fate to some degree… either being relatively cash-efficient and/or having a reasonable shot at break-even without millions in funding.

    Of course even in these cases companies can then go on to need millions to sustain growth, so the issues you raise can still come up. That's also partly why I'm not a fan of overly inflated valuations. Taking the highest valuation possible is not always your friend as an entrepreneur.

  • dshen

    I was just thinking about this today. I was thinking that if I thought that a potential investment would take multiple rounds of financing, that I would actually bet less in the beginning but then made sure I followed on for as long as I could until the follow on amounts either grew to some amount which I could not invest in one chunk at that time, or if for some reason it grew so fast in a given timeframe (ie. a year) where it would make multiple investments in that timeframe not make sense.

    In this way, I thought that I could preserve a smaller % longer, which would have resulted in any case if I had bet bigger in the beginning and gone with a “no pro rata investment strategy”. Upsides and downsidest:

    1. upsides are:

    a. It would allow validation of the idea further before betting bigger, total sums of money across time.
    b. rights of future rounds may have more advantageous terms.

    2. downsides are:

    a. if I was wrong about timing of the exit, then I would reduce my return.
    b. same goes for if I was wrong about how many rounds of investment it would take.
    c. some rounds have a minimum investment amount to retain pro rata rights which would halt this strategy.

    Anyone do the math on this? I'll have to pull out Excel soon!

  • sks

    hey mark- what's your opinion on how deep pockets one's pockets should be to have fun as an angel investor?

  • http://bothsidesofthetable.com msuster

    This is precisely why I'm writing this series. VC returns are only strong in the top decile (not even quarter). And my very strong instinct is that angel investing will follow a similar pattern. Yet when you read the press you'd think everybody is rolling in it from angel investing. I think it is stacked in favor of the few. Those that have: access to deal flow, domain knowledge, good VC relationships, deep pockets and …. (5, published this weekend ;-)

  • http://bothsidesofthetable.com msuster

    Funnily enough on the best deal it is hard to do more than your prorata rights so you'd need really close relationships with the CEO's to lobby hard for you to do your super prorata investments.

    For some people perhaps the best angel strategy would be to invest in companies that are capital efficient and don't plan to raise a ton of rounds. You'd have less Twitters in your portfolio but perhaps less wipe-outs?

  • http://bothsidesofthetable.com msuster

    “to have fun” you don't need deep pockets at all. You can have fun just being an investor and working with the company. To make great returns on a consistent basis you need deep pockets. several million deep.

  • http://twitter.com/ronsamuelson Ron Samuelson

    Great post, same applies in the diamond business. The ones with the deep pockets who are willing to roll the dice get the big payoffs…

  • Venugopal Sathya

    Hi Mark,

    Great post as usual.

    Can you also mention other point/s that one should keep in mind if one wants to become a good/ successful angel investor ?

    Cheers,

    Venugopal
    Vengo Ventures

  • http://hdemott.wordpress.com Harry DeMott

    The more you invest in your circle of competence – hopefully, the less you are going to suffer many losses.

    That said – one thing you learn in poker is that you have to be able to fold a bad or marginal hand and understand how to maximize a winning hand – and just playing is not always the proper strategy.

    Investing – like poker – is all about making decisions and committing capital based on incomplete information. As an insider at the table – you should have more information than the next guy coming in – and you need to use that information to your best advantage.

    Getting crushed by a guy with a larger stack is a very bad outcome indeed – but even worse is not fully understanding the concept of pot odds and implied pot odds.

    When you get to an investment decision – and are shown a term sheet – you will have the opportunity to do your pro-rata share (assuming normal venture investment docs) – so you have more information than the guy putting in the term sheet by your association with the company – and you know how much it will cost you to protect your position – and what will happen if you do nothing. You also probably have an idea as to the value of the company at that point – and can make a guess as to the value of the company once it takes the new capital and uses it to build the business (is it a first round? a second round? does the company already have traction? revenue? profits? etc…) This is your pot odds. What am I putting in today (incrementally) and what am I getting out of the deal if it works.

    What is more subtle is the implied odds. That is to say, what if it isn't the final round of capital – and you will need 2 more rounds to get to profitability. How large are those rounds going to be? at what valuation are they likely to come? do I have the stack able to support my position in these cases? If I don't just how much dilution am I likely to suffer in the future? If I have to suffer that dilution, what sort of returns will I generate if I win? These are the implied odds – if I keep investing – and will get more information and will likely get more opportunities to invest – what sort of returns do I generate in the end relative to all I have to put up to get there.

    Truth be told – poker is a bit of a tough analogy for venture investing – because too many things can change in venture. You can structure deals in all sorts of ways to crush earlier rounds. You can call it debt or equity. When you bet, you need to either match or raise – as opposed to just taking your pro rata part of the pot. You can change the valuation of the company in every round – with up or down rounds. And people can come in and out of the hands at will. The outcome is also not very fixed in terms of its payoff – nor is the finish of the game in any way. Poker – for all its vagaries and intrigues has a very set rulebook – and is highly structured. After all the cards are dealt – there is a winner – period.

    Poker however, is a reasonable lens through which to look at venture investing – and without fully understanding not only the pot odds or implied odds – as well as having a large enough stack to see a winning hand through – you might as well sit out the game – or play for the sheer enjoyment of it.

  • dshen

    hmm i hadn't even thought about getting more than my pro rata later, only up to pro rata. getting super pro rata rights would be tough although i've never tried to get some. i should give it a shot sometime ;-).

    yes definitely capital efficient startups are great assuming i could predict which ones were. sometimes you can and sometimes you're can't!

  • robchogo

    Great post and great series Mark.

    It does make sense to pile in on your winners. As you said, if you have a lifetime hand, you want to have more capital behind it.

    At a portfolio level, I wonder how this strategy really pays out. For the extra dollars gained from participating in a great investment in the series C, D, etc, how much is lost in other follow-on investments that shouldn't have happened. I blogged about some of these reasons in an old post: http://www.robgo.org/post/967096088/the-perils-of-follow-on-financing-decisions

    Do you know of anyone who has ever done any analysis to compare the returns of series seed and series A investments vs. follow on rounds? You'd obviously have to find a way to adjust for the impact of the preferences so it's as good of a comparison as possible. At the fund level, I'd love to see this data for a few firms and see how the follow-on dollars perform in aggregate vs. the initial seed/series A dollars.

  • Ken

    Mark – this is a great series and echoes our view here at Industry Ventures on early stage portfolio construction.

    Rob – interesting thoughts here. You're right the follow-ons likely don't perform as well since they are done at higher prices – assuming we're talking about a “winner.” But a lot of good investors lose sight of what it takes to produce overall portfolio level returns. You need your winners to produce a multiple on the invested capital of the winners AND the losers. In the end, this is what it's all about.

  • http://twitter.com/mattamyers Matthew A Myers

    Oh good, you found my wallet!

  • robchogo

    Thanks Ken. Yep, follow on's will perform worse for the winners. The question is, how much worse in aggregate? If only marginally worse, then it's a great strategy, since a later stage investment should have less risk and protects earlier capital. But if it's much worse, perhaps the fund was better off concentrating on only the seed or A. Of course, this differs significantly by industry too.

    My uber point though is that I'm surprised this analysis hasn't been done to really test the wisdom of conventional lifecycle investing. I think it made sense in enterprise software and com equipment, but less so in consumer or in capital efficient software businesses.

  • http://www.dogster.com Ted Rheingold

    Great series. Thx.

  • http://www.howardlindzon.com howardlindzon

    you told me humor and marketing put me over the top. i dont have pockets like this.

    great post but now depressed on yom kippur

  • Dan Deppen

    I like your poker analogy. Another way to put it would be to say that you want to have big implied odds, which you can only have if you are playing with a deep stack of chips.

  • http://www.victusspiritus.com/ Mark Essel

    How much do you restrict your angel investing to Mark? Do you have a sense of what fraction of a private portfolio should be put aside for protection of angel investments?

    Deep pockets make sense when they are balanced with an upper limit. If there's no hard limit to how much you pour in to protect your position, there's no clear boundary as to how much you'll risk.

  • http://twitter.com/BrowseMob Matthew Hurewitz

    multi-part question:

    1) Is a Super-Angel fund similar the equivalent to testing traction? Are today's $10-$30 million dollar funds going to be tomorrows $100-$800 dollar funds?

    2) How you feel about q 1) will probably influence your answer to q 2). Is it likely the angel / super-angel trend will cause more companies NOT to go the distance (pressure to flip)? Is there enough data to draw a conclusion one way or the other?

    3) If you were building a company today (for a big exit), would you take angel/super-angel money or seed money from a VC?

    -Matt

  • http://twitter.com/gatorcris Cris Bjelajac

    Open question on this thread: If an entrepreneur came to you with an idea they were certain would need ~20 million to be successful, would you then shy away? Are angel investors -only- for small ideas/executions that could somehow get big?

  • http://www.victusspiritus.com/ Mark Essel

    There's no time for regrets, as an unbiased third party your humor and marketing put you way over the top. Every interview I've seen you do has been respectful, sharp, and fun on stocktwits.tv.

    F' the market if you're not sitting on a pile of G$ld, you can't take it with you and folks will remember you for your great sense of humor and generous nature long after you're gone. In the mean time your charisma opens doors that other angels don't have the keys to, no matter how deep their stack of chips is.

  • http://www.howardlindzon.com howardlindzon

    Too kind. Thx

    CEO of StockTwits.com and founder of Socialleveragellc.com

  • dshen

    the answer is not a simple yes or no. as mark suster would say, there are many reasons for investing and not all related to making money (although i would say that most angels would almost always answer they are investing to make money).

    there are some angels who are looking solely for cash efficient deals that don't require lots of money, especially since the internet has lowered the cost of starting businesses and raised the probability that a big biz can be built with less money.

    but there are others who aren't just looking for those kinds of deals.

    i personally have not shied away from any business that requires a lot of capital, either predicted or not predicted. i think it's harder than you think to predict whether a business is one that will reach profitability and grow to greatness on less or more capital. The twists and turns of startups make it pretty darn hard to predict how much capital a startup needs. I will say that it's probably easier to predict that a startup will require more capital than less….

  • Fahd Bangash

    How big are deep pockets? Say you've put in $50K and have another $50K ready to double down, should you have another $500K ready down the line? I've noticed that angel amounts can be very small so wondering what deep pockets mean.

  • http://terezan.tumblr.com/ Tereza

    Your photo of the big, fat wallet really speaks to me. Takes your post from good to great. ;-)