So You're Ready To Be An Angel Investor

You are financially set. You have a great career with a stable, long term job security. Perhaps you’re a doctor or an attorney. Maybe you’re a sports or entertainment celebrity. Your income clearly puts you in the 1% or the 3 million or so Americans who have far greater income than expenses. After you've maxed out putting money in IRAs and 401(k)s, spent generous amounts of money on friends and family through buying toys for nephews and nieces, flat screen TVs for all your friends, yearly family vacations to exotic countries, you still have a growing nest egg of cash.

What are you going to do? First, it's a wonderful problem to have. You’ve already bought shares in Google and Tesla, maybe a couple of smaller cap stocks, threw money into companies closer to your line of work, and yet, there’s still 6 to 7 or more figures of cash sitting idle in your bank account(s). Maybe you’re a heavy supporter of your local cultural arts: the symphony, the opera, ballet, museums. You now want to spend both your time and money to do good deeds, because you have both, and want to help others get there.

What is clear to you is that leaving money in a bank that pays you nothing is not a good use of your money. Being too materialistic isn't good either. You want to make something of the money. Welcome to capitalism!

You decide that you want to dabble in the world of Angel investing. Why not? You’re smart, you’re successful. You have the brains, drive and experience. You just don’t have the time or maybe a specific skill (like coding or manufacturing or marketing) to actually be an entrepreneur doing a start-up. So the next best thing may be being an investor in one. Then, you can play an active role as a member of the company's Board of Directors, mentor the start-up team and help them succeed.

You’re what is called an accredited investor. You earn more than $200,000/year, you have more than $1 million in net worth, not including your primary residence. And, you have some savvy in investing: you took the risk 16 years ago to buy Apple at $9 a share, and you've kept it until it's now 80x. Now, you want to get your hands a bit dirty investing at the ground floor, while still having both feet firmly planted in your primary profession. What could possibly go wrong?

Well, if you’re a doctor or a lawyer or a sports or entertainment star, then historically, your outcomes in angel investments suck. As a group, doctors, lawyers and celebrities have the worst return in investments. It’s so bad that the losses almost outweigh the gains from the 401(k)s and other safe bets. I would guess that the best advice to this group would be, “DON’T DO IT!” Just keep your money sitting idly in a bank and watch your IRA grow. I’ve seen this happen time and again, and see these apparently smart people put themselves over a barrel with their financial dealings. They over stretch themselves, they throw good money after bad, and their arrogance prevents them from listening to sound advice.

One option for you could be as a limited partner to a venture capital fund. VCs are always looking for wealthy people to invest in their picks. The problem here is two-fold. First, VCs are terrible investment vehicles. Sure, they tout their wins with Facebook or Google, but the past ten years' average return among VCs in Silicon Valley have been 0% APR. That's right, 0%. For every one hit, they got perhaps 100 misses and the wins balance out the losses. You will actually do better, financially, keeping the money in the bank.

Second, giving your money to a VC is no fun. You don't get to see the deals. You don't get to sit in on the pitches and you have no say on what start-ups to invest in. You entrusted your money to the VCs to pick the right deals. Heck, you'll get better returns and more active fun by day trading on the NYSE.

A more proactive option would be joining an Angel Investment group. Here, you meet other people in your same wealth level, and you will have an active role to play assessing the prospects of deals that come your way. There are problems here as well. For example, what kind of start-ups would pitch to you? Already, there is a natural filter within this group that pushes out a certain class of start-ups. (Suppose you got wealthy running a very successful restaurant business. Restaurants are very risky endeavors. If you join an Angel group, you're not likely to see a restaurant pitch, even though you might have both insight and expertise to see whether the plan is sound or could be truly innovative and can revolutionize the space.)

A problem with Angel Investment groups is personality conflicts. These groups were formed by the original members and they carry a lot of weight. You might think your voice carries weight, but ultimately, it's your money's participation that they're after. Discussions and emotions can get rather heated and people's individual preferences might not be aligned.

So here, in a nutshell, are some sound advice.

1. If you want to make money by using your money, the safest, most secure, and easiest way is to dollar-cost-averaged buy-and-hold into a diversified equity portfolio. Invest in mutual funds. Or, create your own "mutual fund" consisting of a portfolio of various stocks. Then religiously put money into that portfolio and let it ride. My IRA last year, 2014, returned just a little over 21%. It was slightly less than that for 2013 and slightly more for 2012. My IRA is held by Vanguard and I have been in those funds since the mid-90s. I don't do any buying and selling, except one time when I rebalanced my portfolio in early 2013.

So, if you want to make active use of your money, realize that you're not likely to be as successful as putting your money in stocks and bonds. Angel investing is not easy and not going to be a financial success. You might hit the big one, but understand that there's a lot of luck and just plain serendipity and not much smart decision making, as much as we all like to think that. If people were to just realize that they are not going to make money through Angel investments, everybody will be better off. In fact...

2. If you’re a friend-or-family investor, understand that you’re just going to give the money away: expect zero return. Your prodigal nephew calls you up to ask for a loan or an investment in his new endeavor: delivering pizzas by skateboard to beachgoers in Santa Monica. You love your brother and his kids, you’re all one big family. You’re a friend to your nephew. If you have the money, be gracious and offer the $50,000. Just mention sternly that if he succeeds and pays you back, you’ll be grateful, but he should expect never to ask you again for any additional funds.

That said, if you have the wherewithal to actually inspect the business plan, you might be able to see whether there is value in it. A year after I got my math PhD, while I was working for an R&D company in Silicon Valley, a good friend from graduate school who was just finishing up his math PhD contacted me. He was the "gamer" guy in our math department: every night, we would be in the lounge playing one game or another. So, he contacts me with a business pitch. He sends me this cryptic email with arcane descriptions of a new game: “…different dimensions… combat… dragons and wizards…” He asks if I could invest $3,000 (per share!).

At that time, I was no investor by any definition, and without $3,000 to play around with, I passed. That friend and fellow PhD student is Richard Garfield, and the game he was pitching was the hugely famous and wildly successful Magic: The Gathering card-based game from Wizards of the Coast. That $3,000 could have easily turned into $3,000,000 or more, which leads to:

3. whatever you're investing in, make sure the founders are truly experts in that space. In most business spaces, reputation is deservedly earned. It’s never just looks or pedigree. Instead, it all rests on being known by everyone else because that person is the foremost expert. And of course, being the go-to guy, that person enjoys the limelight and therefore, has a greater passion to do well in that space. If your nephew loves pizza and skateboarding and enough people want him shooting by, dropping off a box of pizza with them, then yes, your nephew has a viable market. If there is ever going to be a successful skateboarding pizza deliverer, he's gonna make it happen.

So as an investor, you need to determine whether the team is passionate about the business. If they’re in it just for the money, then it’s your money that is all they'll ever get. Before and during his math PhD program, Richard Garfield was a hardcore gamer and game-reviewer within the gaming community. He wrote in various gaming magazines, was a well-known play-tester, and also designed many games of his own. (Magic: The Gathering was one game he designed that I never had the opportunity to play. Had I played it, I might have scrounged up the money to invest, but only as a friends-and-family-here's-some-money-don't-ask-me-again investment. It was not a sound investment back then.)

But how do you conduct the assessment of a deal? All too often, professionals with deep knowledge in their chosen fields think they can extend their smarts into entrepreneurship investing. And the super-successful professionals think very highly of their ability to sniff out the winners from the losers. The problem is not that they're too smart for their own good. The problem is that there will always be a bias in their methodology. Just like regular stock investments, people pick based on what they know, whether that's tech or energy or automobiles. They stick to their field of experience and pick from that. It has already been shown, by Vanguard founder John Bogle, that diversified portfolios, such as an index fund, beats out everything in the long run. Likewise, deal assessments are best performed by a diversified group rather than by one person or a group of people within a herd mentality (i.e., Angel Investment groups). Where can you get a diversified group of people to analyze your prospective deals? And how much would it cost?

That brings us to diversified start-up assessments. Someone pitches to you an idea. Give the information to an independent due-diligence group, such as the IZE Innovation Group, and the outcome will be less biased than your own due diligence, no matter how smart you are. The IZE Innovation Group has members from all across the world with specialized expertise and knowledge in various spaces. We can assess the startup and determine whether it has actual potential, or whether it's just a very cool pitch you received. Our primary goal with startups is to see how they can actually succeed in the real playing field: the market. Once the market and their role in it are determined, your decision to invest will have a much strong basis for analysis.