IN YOUR FACE RISK

fear-color-tby John Jonelis

“Oh, you’re an angel investor! Isn’t that risky?”  I hear such drivel all the time.  Are people afraid of outsized returns?  Or perhaps they don’t understand risk, don’t know how to measure it, or how to take control of it.  Yet all that is quite easily done and it’s a real charge to play the game using a Monte Carlo simulation (MC).  I’ll show what’s likely to happen if you follow three simple rules.  Then I’ll break one rule—just a little bit—and we’ll use the simulator to see what happens.

Rules of the Game

Rule #1 – Diversification and the Law of Large Numbers—This is the only free ride in the investment world.  Invest in as many dissimilar companies as possible.

The portfolio technique known as the Efficient Frontier suggests you indulge in alternative investments to the tune of 10% of your overall portfolio to maximize return and minimize risk—that’s right, both!  Angel investment is definitely in the alternative camp, so restrict your fun to 10%. No more! It’s true—angels are like anybody else.  They also own stocks and bonds, futures and options, currency spreads and real estate, antique cars and art collections.

Rule #2 – Identical Minimum Sum—Nobody knows whether a company will succeed or fail. Nobody.  Even the best, most experienced, wisest, most savvy investors can’t tell.  So out of your alternative portfolio, invest the identical minimum sum in each and every deal—no more, no less—no exceptions!  Make it as small as you can.  2% is a good number to shoot for.  Ideally, with profits taken along the way, you’ll eventually own 50 to 100 companies!

Rule #3 – Join an Angel Group—Contrary to public opinion, most investors aren’t multi-millionaires.  An angel group allows you to invest small sums in concert with others in the group, and coincidentally, it makes it possible to obey Rules #1 and #2.

I also assume that a personal research staff isn’t in your budget. A good angel group solves that problem by splitting the workload among its members according to their particular expertise.  A strong group will accelerate your learning curve.  The trust and camaraderie you build with other members makes angel investing a real joy.  My own experience as a member of Heartland Angels has broadened my horizons and given me so much more than I could ever contribute.

It’s not a rule, but read the book ANGEL INVESTING by David Rose. You’ll be glad you did.

dice

Beware

If you don’t like to help companies grow from raw idea to industry leader; if you aren’t willing to participate in the fascinating and often perplexing details of a new business venture; if you can’t stand people; if you’re afraid—then invest in a mutual fund or put your money in gold coins and count them every day, just for something to do.

 

Picture Your Risk

I’m visually oriented. To paint the picture of risk, I use a Monte Carlo engine.  MC is a sophisticated and arcane statistical tool that any child can use.  If you’re a spreadsheet whiz, you can set it up yourself.  I downloaded a program called Equity Monaco that makes it easy to enter investment outcomes, and analyze results.

NOTE:  If you find yourself gazing at a bunch of confusing readouts with a vacant stare, read my paper, ALTERNATE HISTORIES.  It’s written in plain language.  It’s short. You’ll be an expert in no time.

angel

How Angels Make Money

Angel investing is long term—3-10 years. But like any investment class, you’ll cash out of one deal and put that money in another.  It’s a continuing cycle.  It’s also a homerun strategy.  Can a homerun strategy be a winning strategy?  Let’s run the numbers and see.

First, we need a data set of ordinary, average, run-of-the-mill trade results. Turns out, the Kauffman Foundation keeps statistics and publishes them.

Here’s the bottom line, according to Kauffman, 38.1% of startups grow and get acquired by a larger company, at which point all the investors throw a party! 11% become lifestyle businesses.  These may provide a nice living for the employees but it takes the investors a really long time to cash out.  50.9% of companies go belly-up.  Of those, 0.9% just disappear!

startups

Actual Angel Returns

Let’s keep this simple. From the investor’s perspective, all the returns from Kauffman’s wealth of past data boil down to five distinct outcomes.  I express these as multiples of cash invested.  (“10x” is a return of 10 times your investment.)  Then I list the probability of each outcome.

return-vs-probability

Return as a multiple of investment vs. probability

Kauffman Foundation

 

Using these numbers, and applying our rules, it’s simple to build a simulated portfolio that represents likely outcomes.

Let’s assume that 10% of your portfolio amounts to $50K. Your angel group’s minimum investment is 10K.  That means you need to plunk down 10% of your stake per deal, rather than the recommended 2%.  You’re undercapitalized!  Your Identical Minimum Sum, is high.

What does that mean to you? You’ll participate in fewer trades than some rich slob.  All other things being equal, your results will be less predictable.  The rich get richer, etc. etc.  But you’re young and aggressive.  Let’s say you go ahead anyway.

Now create a list of outcomes, based on Kauffman’s stats.

how-deals-shake-out

Notice that you follow all three rules. You invest exactly the same amount each time.  Using an angel group, you invest the smallest amount you can get away with, and you participate in as many attractive deals as you can.

 

The Face of Risk

We’re ready to run our simulations. Feed those numbers into your MC engine and let the computer do the work.  (I apologize for omitting legends from the charts, but the numbers in my program are too tiny to read.  Hey, these are actual screenshots from my software package.  So permit me to clue you in:

  • The X axis is about 100 deals.
  • The Y axis runs from zero to almost $2,500,000.
  • All equity lines start at $50K—your alternative portfolio.

std-10-long

10 possible equity curves

Here’s an MC output of 10 runs from the set we just built. Each line is a distinct equity curve that represents your portfolio.  All are possible.  Notice that two of them go negative quickly and never recover.  But the rest do quite well.  This isn’t enough data to draw any valid conclusions.  Let’s run more simulations, using the same data set.

std-30-long

30 possible equity curves

Here we have 30 equity curves. The projections are getting clearer.  Let’s run a few more, using exactly the same data set.

std-100-long

100 possible equity curves

Ah! Here we go—100 outcomes.  The variation is nice and tight.  Kurtosis is evident in the plot—in other words, the most likely results cluster around the mean.  Looks like a good experiment to me.  Let’s use this one.

 

ANALYSIS

Analyzing these plots is amazingly intuitive. For this experiment, the equity lines all start at $50K—your portfolio.  A few outcomes go negative, but most look quite promising.  The luckiest investor walks home with $2,450,000.  MC plots don’t necessarily follow a standard distribution, but the mean looks to be about $1,450,000.  Let’s focus on that number.

If we achieve the mean, we’re looking at an average return of 28 times investment. Does 28x get your attention?  It gets mine!  It even raises suspicions about possible survivorship bias in Kauffman’s numbers.  But these are the best statistics we have so we’ll go with them.

How much is 28x as an annual percent return? That depends on turnover of deal flow.  The shorter the hold time, the larger the IRR.  3 years is better than 10.

By the way, you may be wondering which curve is yours. There’s no answer to that question. But since your portfolio is so small, you’re more likely to find yourself on the fringe.  An investor that’s filthy rich and participates in many more deals, enjoys a more predictable outcome and probably lands close to the mean.

 

BREAKING THE RULES

Let’s find out what happens if we break just one rule. And who doesn’t do that?  So you invest $100K in a really juicy deal.  It’s the best prospect you’ve ever seen and you figure it’ll make you rich.  This thing can’t miss!  Hey, it’s just one investment—how much difference can it make?  You have just violated the Identical Minimum Sum rule.  I know.  I made this mistake once.

We add it to our data set and run the simulation. For this, we increase your portfolio size and retain all the same trades from the last run.  This is what the hotshots call sensitivity analysis.

undis-100-long

100 possible equity curves – breaking one rule

Whoa! Look at what that one lapse in discipline does to your projections!  The mean is now flat—zero times return!  Half the outcomes are negative.  No, I don’t’ want to play in this sandbox.

Successful investing is primarily adherence to a solid set of rules. That’s called discipline.  The goal of discipline is to keep the probabilities in your favor.  Discipline defines success.

That doesn’t mean that a successful angel can get by without a good skillset. You need to exercise brilliant judgement.  You must perform your due diligence.  Knowledge and experience are huge.  Always keep the human side in mind.  And you need to follow-up.  Watch your companies closely as they pivot and grow.  I leave you with this thought:

david-rose-quote

Also read – ALTERNATE HISTORIES

 

John Jonelis is a writer, investor, fisherman, author of the novel,

THE GAMEMAKER’S FATHER, publisher of Chicago Venture Magazine, and editor of News From Heartland.

The term IDENTICAL MINIMUM SUM is from the author.

Thanks to David Rose and his book ANGEL INVESTING.

Statistics from the Kauffman Foundation.

MC plots from Equity Monaco by TickQuest.

Graphic courtesy MS Office.

DISCLAIMER – Do your own due diligence. It’s not my fault if you lose money.

Chicago Venture Magazine is a publication of Nathaniel Press www.ChicagoVentureMagazine.com Comments and re-posts in full or in part are welcomed and encouraged if accompanied by attribution and a web link. This is not investment advice. We do not guarantee accuracy. It’s not our fault if you lose money.

.Copyright © 2016 John Jonelis – All Rights Reserved

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