I have been thinking a lot lately about the best way for angels interested in making pre-seed stage investments to put money into start-up companies. I’ve come to the conclusion that investing in accelerator funds is better than joining an angel group.
Angel groups are investor collectives that pool funds and management. Back in 1994, when the first angel group got started, they were an important organizational innovation in early stage finance. By pooling their efforts, investors were able to get access to better deal flow, evaluate and monitor companies better, and strike better deals than they could alone. However, since business accelerators — organizations that provide capital and mentoring to pre-seed stage companies — were introduced in 2005, angels have been reallocating their capital from angel groups to accelerator funds for three reasons.
The Benefits of Investing in Accelerator Funds
Investing in accelerator funds dramatically reduces the price that angels pay for their investments. The 2016 Annual Halo Report shows that the median valuation of a start-up by an angel group in 2016 was $3.65 million. The typical accelerator provided $25,000 in return for 6 percent of the equity in the companies. That’s a valuation of approximately $417,000. Even after 20 percent carried interest, the valuation of the typical angel group company is 7.3 times that of the typical accelerator company. (It is true that the accelerator is getting common stock and the angel group is probably getting preferred stock.)
For a rational investor to put money into a company through the typical angel group instead of the typical accelerator fund, he or she needs to believe that the company will have a seven times higher likelihood of a positive exit or a seven times better exit. That’s pretty unlikely.
Investing in accelerator funds dramatically increases the amount of diversification that angels get. The American Angel Survey, which reports on information from just less than 1700 angels, shows that the median portfolio size of an angel is seven. According to analysis of angel investment data, that’s too small a portfolio to ensure that the investor will generate an acceptable financial return. Monte Carlo simulation of return data indicates that investors need to build a portfolio of more than 50 investments to have a greater than 90 percent probability of a two times return on investment.
With accelerator funds, angel investors are getting a high degree of diversification. The typical accelerator fund is making about 12 investments per year, about five times higher than the rate of the typical angel. By investing in an accelerator fund, a business angel has a much higher likelihood of achieving the diversification necessary to generate a worthwhile return on angel investing.
Investing in accelerator funds dramatically reduces the amount of time angels need to spend to make investments. When angels invest as part of an angel group, they need to attend meetings to see founders pitch, participate in due diligence to determine whether they want to invest, negotiate term sheets with the founders and monitor their investments. With an investment in an accelerator fund, the angel does not have to do any of these things. The managing director of the accelerator is undertaking these activities in return for earning carried interest. Therefore, the opportunity cost of the investor’s time is far lower with accelerator funds than with angel groups.
In short, angels spend less time, invest at a lower price and get more diversification by investing in accelerator funds than by joining angel groups. Getting a more diversified portfolio at a lower price with less effort is a better way to invest in start-up companies.