Angel investing: not aiming for the next Unicorn.

As an Angel Investor, I invest in two different types of startups. The first type of investment is in companies that are too early for larger investors. Hopefully, my investment, together with the investment of my fellow syndicate members at Apollo Informal Investments , will allow the company to gain some form of traction that makes the company of interest to larger investors. The idea is that in 8-10 years’ time, after multiple follow-up rounds, there will be an exit.

Angel investing is highly risky (expect a 70% failure rate) and the investments are illiquid. On a diversified portfolio, I aim for a yearly return of 15-20%. I did some Monte Carlo modeling to test assumptions. Provided you make SEIS investments and keep the first-round valuation below ￡1 mln, a return (IRR) of 14-15% is achievable.

https://www.dhirubhai.net/pulse/seis-asset-class-why-you-should-consider-early-stage-investing-smith/?trackingId=bUE%2FdP1vTiybo%2B7pcxWacg%3D%3D

The second type of investment is in companies that aim to become cashflow positive after investment and don’t necessarily need follow-up funding. These companies are of little to no interest to most VCs as the absolute returns are limited. However, for Angel Investors these investments can be highly attractive if the company can generate a dividend and the founders use their share of the dividend to buy out the investors. Let's call these companies lifestyle plus companies. Companies that generate enough Free Cash Flow to generate a return for investors but not enough FCF to justify (later stage) VC investment.

For example, if an Angel Investor invests ￡100k in a Company in exchange for 10% of the shares the post-money valuation would be ￡1 mln. If the company can generate ￡150k in dividends in years 4 and 5, the founders would receive ￡270k and the investors ￡30k in dividends. At the end of Year 5, the founders can use their share of the dividend to buy back the shares from the investors. The investor invests ￡100k and gets ￡15k in year 4 plus ￡285k in year 5. This will generate a very tidy 24.87% IRR.

You need to correct this return for both risk and SEIS. If you use the assumptions below

Investment ￡100,000?

Pre-Money Valuation ￡900,000?

Post-Money Valuation ￡1,000,000?

Dividend Yield (Post Money Valuation) 15%

Investors ownership % 10%

Founders ownership % 90%

SEIS tax refund upon investment 50%

Default Risk 70%

Tax Rate (loss reduction upon failure) 40%

The pre-dividend tax IRR will be:

Cashflow

2023 -￡50,000?

2024 ￡ 0

2025 ￡ 0

2026 ￡ 0

2027 ￡4,500?

2028 ￡99,500?

IRR 15.92%

Below is a table of expected IRRs based on different Dividend Yields and Default rates.

As you can see the returns of investing in startup companies, that are not aiming for large VC follow-up founding, can be quite lucrative. They can possibly generate a higher return than investing in the next Unicorn. There is less dilution, lower default risk and faster return of the funds.

A few notes

• SEIS is key to generating returns for early-stage investors but make sure you get good legal/financial advice. You don't want to jeopardize your SEIS eligibility.
• Valuation is key. I struggle to see how you can generate a good return on SEIS investments if valuations are too high. The default risk is too high, the time to exit too long, the ability to generate sufficient FCF too limited, and strong possibility of future dilution.
• I regularly see the argument that founders should not dilute too much as they will create an upside-down share cap table which makes later-stage VC funding difficult. I understand the argument but that implies that some founders and VCs think Angels should act as charitable organizations with low or even negative IRRs to create an ecosystem.
• Some VCs understand that Angels add the most value at the earliest stage and offer an early (part) exit to Angels. If Angels get (partial) exits after 3 years, they will create good returns on SEIS investments even on relatively low exit valuations. Angels should almost act as feeder clubs that transfer their best investments to bigger investors and then look for the next big thing in their local ecosystem.
• Time is important. Smaller quick exits might generate a higher return than larger, highly dilutive exits that take 8-10 years.