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In a panel on angel return data at the Angel Capital Association Summit recently the speaker went back and forth between data using ROI (multiples of the original investment) and IRR (internal rate of return).  These metrics are very different and it is important for angels to have a good understanding of how using each of these will impact their investment strategy – in many cases for the worse!

Why Hunting for Unicorns May not be a Good Strategy for Angel Investors

Angel Investing Unicorn

 

There is a mythology among angel investors about going for “unicorns” (private companies with a valuation of $1 billion or more) in their portfolios.  In many cases, real returns from unicorns may be less than hitting solid singles and doubles that exit at under $100 million. Here’s why:

 

While unicorns may appear to give great returns, our speaker gave an example.  He had invested in DocuSign which is now readying itself for an IPO.  (Initial Public Offering)  After multiple follow-on rounds after his angel investment, his percentage ownership had been significantly diluted, but even worse – it took twelve years for DocuSign to get to exit from the time of his investment.  While he expects to receive an investment ROI multiple of 4.8 times his original investment, that comes out to only a 15.3% IRR. Getting $480,000 back on a $100,000 investment sounds good initially. When the amount of time that the investment takes comes into the calculation, the unicorn doesn’t look as good as some of the same investor’s exits that came along in five or fewer years and yielded $100 million or less.  In fact, his average IRR over his portfolio was 27%, so this unicorn was bringing his average down!

 

Angel Investors should think about their investments from a portfolio strategy viewpoint.  

Smart angels will target 10X their investment back within five years or less – that’s a 58.5% IRR.  After calculating winners and losers over time, angels who invest through angel groups will typically see a portfolio return in the 23-37% range, or about 2.5X.  Getting 4.8X your money back sounds good, until you think about what you could have done with that money if you could have reinvested it after five years.  

 

What if the investor had taken his $100,000 and NOT invested in DocuSign, but rather invested in ten deals at $10,000 each with half of them returning nothing and the returns from the others averaging 2.5X return over five years?  And what if he had reinvested the returns from those investments? At that rate, including winners and losers, he would have received $850,000 at the end of twelve years for an 8.5X return or 27% IRR. Clearly, taking time into account, but also taking the opportunity to recycle exits into the next deal increases profits.  

 

The likelihood of any one investment being a unicorn is something like 1,800 to 1, but the most prolific angel investors I know have portfolios of maybe 100-150 deals.  On the other hand, getting a 2.5X in five years on a ten company portfolio is fairly common among angels. Unicorn hunting, even when successful returned almost half the cash that the diversified angel did.  Using IRR instead of ROI helps angels to understand the best way to think of their strategy.

How do Venture Capitalists Differ from Angels?

Venture Capital funds often talk about how they need to go for the big multiples “because they need to return large amounts to their Limited Partners.”  This is partly true, but not for the reasons they would have you think. Angels have the same return targets as VCs, and, when they invest in groups, they tend to outperform Venture Capital funds by a good margin.  Over the past fifteen years VCs have been hunting for unicorns and missing out on the singles,doubles and triples that angels enjoy, but their returns averaged 9.98% – less than half of what angels have earned during the same period.

 

VCs are limited by time in their investments.  The average VC fund lasts for ten years, and many funds have a policy of not “recycling” their returns into new investments, so they are motivated to get large multiples of ROI rather than focusing on quick returns with high IRR.  It’s better if a fund can recycle its returns into new investments, with the caveat that they must return all capital to Limited Partners within ten years.

 

VCs also shy from using IRR to measure their fund’s performance because of the “J Curve” which refers to the shorter period between investment and failure compared to the longer period between investment and large-multiple success.  Using IRR can make the fund’s performance look sub-par early in the fund’s lifecycle.

 

Finally, the institutional investors that are the VC’s Limited Partners often earmark their funds for long investment periods and the last thing they want is to get a 30% IRR on an investment that comes back in the first year.  They would rather deploy the capital for longer periods for larger returns. Because institutional investors have a high cost of analyzing investment opportunities, it’s not as easy for them to re-deploy as it might be for angels.

 

So, angel investors differ from VCs in investment strategy, and if they invest in groups and pay attention to using IRR as their performance metric, they can outperform VCs and create significant returns for their own portfolios.

Dear reader,

This is the sixth of many blogposts in a series that I’m calling the Investor Pitch Deck Series. I am creating a post about each investor pitch slide, why it is important, the common errors, and how to communicate that you have what it takes to achieve your goals for this company.

Posts in this series

(note, this is NOT a suggested order for sides in your deck)

 

 

 


The mantra for this series is, “Above all, make sense.”


 

The Customer ROI Slide

The customer ROI slide is a new take on the old business model slide. By the end of this slide, your audience will feel confident that your user will use your product, and your payer will pay for it.

 

User: The person or business who uses your product.

Payer: The person or business who pays for your product.

 

With traditional consumer goods, the user and the payer are the same person. However, with many business models, the user and the payer are totally different entities and you have to acknowledge both for your investor to really GET your business.

Think about your toothpaste at home on your bathroom sinktop. It’s a simple product. It’s pretty basic. Do you buy the same kind every time you run out. Do you switch between brands? Why? Your investors will need to know why potential users will switch from whatever they are currently using (or not using) and start using your product. This value to the new user is called the User’s ROI or Return On Investment. Users are not investing capital; they are investing the energy required to make a change in their habits. Identify the User’s ROI and your venture capital or angel investors will feel much more comfortable with your product.

Now about the Payer’s ROI. It’s graduation season so I’ll use a college analogy about parents who send their kids to college. Parents are paying for the education, but not directly using it. Of course there is a benefit for Mom and Dad. By paying for college, their kid is more likely to get a degree thereby lowering the odds that they will move back into Mom and Dad’s basement bedroom. How do the parents choose which school to send their child to? The Payer’s ROI often a complicated answer when they are not also the User. The Payer wants a good deal financially, but they also want a perceived value for their dollar that has nothing to do with direct use of the product.

Other examples of payers who are not users:

  • Insurance Companies
  • Companies that pay for advertisements
  • Companies that purchase the data collected from free software
  • Governments who provide free public services
Your goal with this slide is to uncover who your users are, who your payers are, and why these entities are willing to use and/or pay for your product.

Cringe Factors

Cringe Factor #1 – You have a few paying customers and they aren’t increasing in number over time.

Why this makes us cringe:  Status quo, apathy, and disuse are the reasons that products die.

How to do it right:  Your investors want to be reassured that you are a realist. A realist knows that a new product, no matter how sexy, inexpensive, functional, or perfect, will not become instantly adopted by the world. There are plenty of products out there that consumers are happy to use for free, but will abandon when a financial transaction is required. If you are in revenue, you must show your potential investors a trend of increasing paying customers over time. If you cannot show this positive trend then you must have a good reason for a lack of increasing adoption. Alternatively,  you can devise a way that you can monetize your product without the user having to pay.

 

Cringe Factor #2 – You aren’t clear about WHY people will pay for your product.

Why this makes us cringe: Investors are afraid that no one will be willing to pay for your product.

How to do it right: Make the Payer ROI very clear in your pitch. If your product is faster to install and cheaper to run than the current solution, then you have a great argument. Visually show your audience that a payer can currently expect to pay $2000 a pop for the current solution and would only have to pay $800 for yours. Further, you can install yours in minutes instead of days.  We want specifics with the Payer ROI description. Beat us over the head with your Payer ROI.  Don’t leave it to the imagination.

 

Cringe Factor #3 – You aren’t clear about WHO pays for your product.

Why this makes us cringe: Many products are free to users these days. (Thanks, Google!) So, who are you planning to get your revenue from. It’s not always obvious.

How to do it right:  Even if you are selling a product directly to users, be explicit about who pays for your product. You can go one step farther and discuss your price point. It’s a lot easier for investors to picture a successful transaction when they understand whether the cost of the product is reasonable.

 

Example Customer ROI Slide

 

One of the simplest ways to show customer ROI is to create a graph of potential savings that a customer might experience if they were to switch to your product.

If your user is not going to pay for your product, you will need to describe a non-financial ROI. It’s not enough to have a better product. People need a very compelling reason to change their habits.

 

 

 

Article by Nicole Gravagna, PhD, Director of Operations for the Rockies Venture Club as part of a series on the elements of an investor pitch deck. The next in the series is ….