Why do Charlotte angel investors like to invest in certain industries and not others?
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(Note: This is a monthly startup series authored by Charlotte investor Greg Brown, the administrator of the Charlotte Angel Fund, where he will discuss the current batch of startups presenting to the fund’s membership as well as topics that may be of interest to those who care about Charlotte’s entrepreneurial community.)
Entrepreneurs are often frustrated when they hear the following from a potential angel investor.
“Your industry just isn’t one that is a good fit for angel investment. That doesn’t mean that your business cannot be successful, but it isn’t the sort of high return opportunity that angel investors require.”
In order to understand what makes a particular industry appropriate for angel investment, we must first understand the basic math related to angel investing.
Looking for 20% IRR, and 10x opportunities
You will often hear that angel investors and venture capitalists are seeking an internal rate of return (IRR) of 20% or greater on their portfolios. The reason why that required rate of return is so high is that the return has to be that large to justify taking the extraordinary amount of risk associated with investments at a company’s early stage.
In 2012, Willamette University conducted a study of US and UK angel investing returns. Their findings are shown in the following chart.
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In summary, the findings were:
- Average return on angel investments is 2.5x the amount of capital invested (i.e. $100,000 invested would return $250,000).
- In any one investment, the angel investor is more likely than not to lose money.
- The production of cash is highly concentrated in winners, with 90% of all cash returns produced by 10% of the exits.
For the overall portfolio math to work, the angel investor needs a portfolio where the successful companies have the opportunity to return extraordinary amounts of capital. This is commonly referred to as 10x, meaning that if the company is reasonably successful there should be an opportunity for the angel investor to receive a $1,000,000 return for each $100,000 invested.
The truth of it is that the portfolio winners have to cover all of the angel investor’s losses, plus provide all of the portfolio gains. This is why an angel investor would never want to invest in something where the maximum gain potential was a doubling of the investment. If half of the investments are going to fail, having the other half double in value is not nearly enough to bring the overall portfolio to a return of 2.5x the invested capital.
Here are the attributes of interesting industry sectors for angel investors
In looking for investment opportunities that have the opportunity to return 10x, the savvy angel investor will consider the following relative to the startup’s sector:
- Is the potential market large enough to support a 10x return at reasonable (5% or less) market share attainment?
- Is the business able to scale in a capital efficient manner? This is important because any future capital that is required will dilute the angel investor’s ownership stake in the company, and likewise the return received when the business is eventually sold.
- Can the business produce high enough profit margins to entice an acquiring company to pay a large multiple of revenue or profits?
Thinking about the above, it is easy to see why angel investors love software companies. They can typically scale easily (no geographic limitations) and in a capital efficient manner (no brick and mortar facilities) while having an opportunity for high profit margins (small incremental costs to add another customer). Conversely, the following industries can be seen as relatively unattractive for angel investors:
Real estate: 10x returns typically not possible, and expansion requires a lot of additional capital.
Brick and mortar retail: Geographically limited with high cost to expand.
Services: Relatively low margins due to additional labor cost for each new customer, difficult to hire fast enough to allow for explosive growth, and geographic limitations.
Who is presenting to the Charlotte Angel Fund in August?
Our lineup of presenters this month is as follows:
This Charlotte-based company is developing devices that harvest energy from unique sources, and converting that energy into electricity. Its initial product is PhelTex, which is a cloth-like material that captures heat and motion energy.
This Huntersville-based company has a software solution that provides automated, online exam proctoring for educational institutions, certification bodies, and businesses. This company, and its founders Mike Murphy and Velvet Nelson, have been long-time members of the Charlotte startup scene.
uVision 360
This Triangle-based company has developed a hysteroscopy system designed to allow more gynecological procedures to be performed in an office vs. hospital setting. They are raising capital to fund what they hope to be the final stages of their FDA approval process.