Investing is a low-barrier to entry, poorly-regulated business so it should come as no surprise that many fund managers say crazy things when talking about their historic returns. Similarly, retain and angel investors prefer to glorify their returns even if it does not benefit them financially.

Recently, I have heard a number of investors refer to their ‘cash-on-cash’ rate of return. When this is specified without any reference to “the time period” it is utterly meaningless, and likely deliberately misleading. Investing is about ‘rate of return over time’. If you fail to mention the time period, you are talking gibberish, and trying to mislead. A very common retail example of the same behaviour is people talking about how much they have made owning their own home, but without any reference to the duration of the investment or its annualized real rate of return (after inflation).

One of the most significant trends of the past generation has been the ‘democratization of capitalism’. What I mean by that is that we are all, by necessity, required to try to ‘make money from money’ (which is the essence of capitalism). We are all investors now. Ands everyone has much more stake than ever before in a) saving, and b) investing these savings successfully, for retirement – and all taxpayers, as guarantor of various public sector pension plans, also have a much higher stake in understanding the liabilities that flow from weak investing returns. Sadly, the financial literacy of most people – including of most people who are nominally “investors” – has not kept pace with this transformation. We need the financial equivalent of mandatory high school – a mass education program that improves financial literacy among all adults.

Neil

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There is a common myth that ‘all start ups are good’, followed closely by the implication that “all” or “most” start ups succeed.

In my experience, founders universally assume that their start up will be a blazing success. Accordingly, if you fail to see the light and invest in the founder’s company the founder deduces that you, the angel investor, must be both stupid and rude. The truth is, I probably am both rude and stupid, but the fact that I did not invest in your start up is not evidence of these traits.

From an investor perspective, start ups evolve into one of three types of companies:

• Stars
• Dogs
• Zombies (Land of the Living Dead companies)

Numerically, there are very few stars, lots of dogs, and the vast majority of all start ups evolve into zombies.

The vast majority of companies are not great companies, but even a company that is great for its employees and customers and still be a terrible investment. Only a company that makes its investors more money than they could have made elsewhere, adjusted for risk and lack of liquidity, is an investment star.

Only a very rare set of start ups generate positive investment returns for their initial investors, and only a subset of this rare breed generate good returns when you consider the compound annual rate of return from investment to exit (which is what you must consider as an investor).

Making double your money may sound great, but if it took 10 years, that is only a 7% compound annual rate of return for enormous risk and not nearly enough to justify the risk assumed by most angels. Making a 20% compound annual rate of return requires 6x in a decade, 36x in 20 years – and hence high investor returns are strongly correlated with rapid exits. If the time from genesis to exit is long, almost by definition the investment returns will be mediocre at best.

Investors need to realize the very low odds of a start up being an investment “star”, and act accordingly.

Founders need to realize that what they have to offer may not be the wonder investment they think it is. Put another way, I believe that many founders would benefit from understanding that they may be starting a great company, but it is very unlikely that they are starting a great investment opportunity. If they did, they would spend less energy cashing capital and more energy chasing customers.

Neil

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Milton’s First Law of Angel Investing: Most Start-ups Are Terrible Investments.

Start-ups start small, weak, and of no real value, and they either die fast or they stumble along small, weak and of dubious value for years, and this has very little to do with how smart, well-intentioned, or hard-working the founder is. Only a minute fraction of start-ups ever return any value to shareholders as investors. Making a good start-up investment really is as rare as winning the lottery (and probably, about as predictable).

This brutal truth is very important to angel investors who want to increase their odds of success.

It is also a very useful reminder for entrepreneurs and founders to be realistic about their chances.

Lastly, it is a dose of reality for people in the innovation/incubation/start-up ecosystem who might be tempted to glamorize start-ups and over-estimate their prospects for success.

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Angel investing cannot be charity investing. Angels need to earn a return on their investment commensurate with the risk that they take, if angel investing is to be sustainable. If they do not earn sufficient return, then they will run out of capital or appetite and invest elsewhere.

It is instructive to think about what the target rate of return should be. Venture capitalists frequently target 35% per annum rates of return.

In my view, as angels are in earlier than VCs and thus assume more risk (of all kinds, including execution risk, financing risk, and technology risk), angels should target a rate of return at or exceeding 40% per annum.

In any event, regardless of the right target rate of return, angel investing needs to be approached with a business-like manner if it is to have any hope of being a sustainable, growing source of capital for innovators.

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I am no angel, but I know a thing or two about losing money as an angel investor. Hopefully I have learned something along the way.

There is a very dangerous myth afoot that small investors are being held back from investing in start-ups by evil securities regulators who are intent on denying small investors the golden opportunity to get in on the ground floor of the next great success.

This is rubbish.

When it comes to investing, people really do need to be protected from themselves, and that is one of the key roles of securities regulation. Most people are terrible investors at the best of times, and when it comes to investing in a start-up story, very few people have any idea how likely they are to lose everything. This principle should not be dismissed lightly in the rush to make crowdfunding happen. At the very least it strongly augers in favour of a hard cap on the amount any investor can invest in any one crowdfunding deal.

Angel investing is a brutal crapshoot. It most certainly is not for the faint of heart or those who cannot afford to lose their investment. Facebook and Google are the exceptions that prove the rule. Most angel investments are complete, total losses – and I don’t mean small drops of the “I feel terrible because my portfolio of stocks went down 10%” type of whinging. I mean >90% of angel investments are total losses – complete, 100% loss of principle.

Of course, this is not to say that for investors ‘affluence = sophistication”, which is the basis for our current ‘accredited investor’ rules (only accredited investors, folks with financial assets >$1M or income >$200k/yr can invest in most private placements). But it does mean that we need to be very careful as we try to craft appropriate regulation to govern crowdfunding.

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Is there really a ‘shortage’ of venture capital? If so, where is the evidence?

If there is a problem, is this something that government can/should try to solve?

Asking start up founders if they would like more money is not evidence – it is just proof of unmet demand.

Proper consideration of the supply side of the equation leads to the strong inference that the issue is bad returns. The capital markets are reasonably efficient and highly competitive. If there really is an acute shortage of venture capital, then existing venture capital investors should be able to ‘name their price’ and thus should be able to make healthy returns. If venture capital investors were making healthy returns, capital chasing these returns would flood into the space.

The reason that there is no more venture capital is that returns from VC investing have traditionally been weak – it is easier to make higher returns with less risk in other areas of the capital markets (including other areas of private equity).

The lack of venture capital is therefor not a market failure that government should fix – it is the market screaming out ‘returns are lousy, so capital is tight’.

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