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
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.