Angel Investing

Hello everyone, and welcome to this master class sponsored by Xillion, featuring the expertise of Steven Roussey. Steven and I have known each other for nearly seven years, a friendship formed during my tenure at Weebly. Steven is a seasoned technology veteran with an extensive career in Silicon Valley. He's worked with a myriad of startups, both as a contributor and an investor. Today, Steven will share valuable insights, experiences, and cautionary advice he's gathered over his years of investing in startups.

If you have just joined us, please note that this session is being recorded and we'll distribute the slides as well. There's no need to take extensive notes; we'll make all materials available on our website within a few hours, including the video recording, the transcript, and the slide deck.

Before we begin, let me cover some housekeeping rules. Feel free to ask your questions using the chat function or simply unmute yourself to ask directly. This session is intended to be interactive and question-driven, so don't hesitate to interrupt if something isn't clear. We understand this material might be new to many of you, and we encourage open dialogue.

Now, let's dive in. I'll hand over the virtual floor to Steven for an introduction, and we'll move on to the slides after that.

Steven: Sure. I'm an engineer by trade, but I also have a keen interest in the inner workings of companies. I've been an entrepreneur, selling a company even before I started with Weebly. I enjoy collaborating with budding entrepreneurs, which led me to establish a network of individuals who were either founders themselves or showed potential to be. Interestingly, many from my network transitioned into venture capitalism, providing me with a vast pool of connections to tap into for investment opportunities. I've been investing for around twelve years now, gradually increasing my involvement. As returns came in, I reinvested, allowing me to participate in numerous deals across various sectors.

Thank you for the warm welcome, Gagan. Last we counted, I have invested in over 300 deals, an achievement I'm quite proud of. Despite seeing returns over 30%, I'm always striving for higher outcomes. I guess I'm not easily satisfied.

Gagan: That's an impressive accomplishment, Steven.

Now, let's move on to our presentation. As I've mentioned, we'll be distributing the video and the presentation after the session concludes. So, relax, listen attentively, and please ask questions whenever they arise. We've got you covered.

Allow me to introduce myself a bit more. I'm Gagan Sandhu, the founder of Xillion. I established Xillion about a year and a half ago, inspired by the realization that many people could benefit from guidance in their financial decision-making processes, whether it concerns debt management, investment strategies, real estate, stocks, angel investing, or any other financial matters.

At Xillion, we're creating a suite of products to help you make smarter financial decisions. For instance, if you're looking to optimize your 401K, we have a tool that digs into your 401K and assists you in making advantageous decisions. We also offer a comprehensive tool for tracking your vacation budget or any other financial goals. For those contemplating homeownership, we have a useful tool that helps you determine whether it's the right move for you. We've integrated AI into this tool to guide you on what to look for when buying a house.

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Now, I'll hand it back over to Steven.

Steven: As I mentioned earlier, my background is in engineering, and I've worked in organizations like Weebly. However, I think we've covered most of the details on this slide. Perhaps we should move on to the next one.

Today, I'd like to focus our discussion on startups. By 'startups', I'm referring to small companies that are either experiencing fast or efficient growth, or have the intention to do so. This doesn't encompass all types of businesses; there are numerous small businesses out there that operate under different growth models. Certain industries, like consulting, can face challenges in achieving explosive growth due to the linear nature of needing to hire more consultants as the business grows. In contrast, software businesses tend to have great scalability.

My focus generally lies in investing in startups, although I've also invested in companies that fall closer to the borderline, like consumer product goods, where my decision-making may not have been as optimal. The variety of companies out there is truly remarkable. When I began investing, I spread my funds in small increments across a broad range of companies to facilitate learning and identify areas where I might excel.

In today's discussion, we'll primarily focus on startups and angel investors' role in these enterprises. In a more traditional sense, angel investors invest directly, meaning they have a relationship with the founder, and their names appear on the company's cap table. However, the modern approach also includes investment in startups through intermediaries, like syndicates, which we'll delve into shortly.

A few cautionary notes to consider: predominantly, angel investing is designed for accredited investors. There are some exceptions, but as a general rule, this form of investing is intended for accredited individuals.

Gagan: To provide a bit more context, an accredited investor, as defined by the U.S. government or the Securities and Exchange Commission (SEC), is a person with $1.1 million or more in net assets if they're single, or $2.2 million if married. These totals exclude your primary residence but include your 401k, stocks, rental properties, or any other assets. There are alternative routes to achieve accredited investor status. One is through owning your own business, and another is by passing a particular exam - the Series 65. By doing so, you become an accredited investor by regulation. Thus, you don't necessarily have to amass $2.2 million in wealth to begin investing.

Steven: Correct, Gagan. Another avenue is through income, with a threshold of around $200K for individuals or $300K for married couples, averaged over the last two years. But bear in mind, most of this is indeed intended for accredited investors. It's also important to remember that this form of investing is not liquid, and you should be prepared for some of your investments to depreciate to zero. It's a reality of startup investing; many investments may not succeed. When I document my investments, I immediately mark the net present value to zero. This mindset helps in accepting potential losses.

Gagan: Out of curiosity, what percentage of your total investments have depreciated to zero?

Steven: I'd estimate around 10%, which is relatively low. It's a good figure on one hand, but on the other, it might suggest that I should be making more high-risk, high-reward investments.

My rate of investment failures is relatively low, although it has increased over the past year. This is due to some companies struggling to raise funds or encountering issues with their business models, and not securing the necessary runway to adapt and survive. Generally, about 95% of startups fail, resulting in a total loss of investment. While that may seem daunting, your goal as an investor is to identify the 5% that will not only survive but also thrive. However, it's crucial not to be so risk-averse that you miss out on potential big winners.

Company failures are unfortunate. No one likes to lose money, and it's especially hard on the entrepreneurs who must shutter their businesses. However, from a portfolio perspective, failures are expected. It's important to approach investing with the right mindset, and avoid blaming entrepreneurs when a company doesn't succeed. After all, no one feels the failure more deeply than the entrepreneur.

As a founder myself, I can affirm that I'm far more invested in my business than any investor could be. Regarding your last point about never investing more than 10% of your net worth in startups, I agree. I might be even more conservative, suggesting an investment of no more than 7%.

If you are regularly making large, direct investments, you might consider a higher percentage. If you're investing significant time in researching and evaluating hundreds or even thousands of startups each year, then you might allocate more of your net worth to this venture. However, for those just starting, I'd recommend a more conservative approach.

There are many investment opportunities available, and it's easy to spend your entire investment budget quickly, but remember that your resources aren't infinite.

A typical angel investor, or a "direct investor" as I refer to them here, makes investments under SEC Regulation D, which requires accredited investors. You perform your due diligence on the company, the market, and the founders, and invest in a spirit of partnership. You'll likely provide mentoring and establish regular contact with the founders, helping to facilitate introductions and other resources for success.

Over the years, I've found that the minimum investment often depends on the founder. Generally, $25,000 is the minimum, although I've managed to invest as little as $10,000 in some instances. These figures can increase dramatically depending on the round of investment.

If you're just starting, a reasonable guideline might be to plan on a minimum investment of $25,000 per company, spread over 25 to 50 companies. This approach should span several years, and your per-company investment would be your total planned investment divided by the number of companies you wish to support. If that amount seems too low, there are other avenues to explore.

Another SEC regulation to consider is Reg Crowdfunding, introduced as part of the JOBS Act, to encourage investments in early-stage startups. This was followed by Reg A and Reg A Plus, which permit companies to raise up to $20 million and $50 million, respectively. These options don't require you to be an accredited investor.

Under Reg Crowdfunding, Reg A and Reg A Plus, investments must be made through a "portal"—a third-party that vets the companies. While this offers some level of protection, you should still perform your own due diligence. Remember that unless you invest directly, you're unlikely to have direct access to the founders.

Occasionally, third-party platforms may arrange interactions between a group of investors and the founders. However, such interactions generally occur during the investment period and are not sustained. Also, your rights to information about the company are limited, and you'll receive much less detailed information, except in the case of Reg Crowdfunding.

With Reg A and Reg A Plus, because they're open to non-accredited investors, the government requires a certain level of quarterly filings, although these are significantly reduced compared to those of public companies. I believe that all companies should update their investors regularly in a similar manner, even if they're not engaged in Reg Crowdfunding, but this isn't always the case.

The great thing about crowdfunding platforms like Reg A and Reg A Plus is that you can start with low minimums set by the companies themselves. This provides an excellent opportunity for you to explore available startups, read their materials, and start to familiarize yourself with the information they provide. As the investment amounts are often relatively small, you can begin investing and tracking the results without committing large amounts of capital.

Companies that use crowdfunding platforms like Reg A and Reg A Plus tend to have a more consumer-focused bent. They often seek to turn their existing customers into investors, which can be a strong strategy. If you're already a fan of a company and have the opportunity to invest in it, it can be a compelling proposition.

I've invested in a few such ventures myself. For example, Bill Gross started a solar company that I invested in via Reg A or Reg A Plus. The company later went public via a SPAC, and I ended up with a 25-fold return on my investment.

In response to the question about platforms for direct funding, aside from knowing a founder personally, you can find opportunities on platforms like AngelList.com, Republic, and Equities. We'll delve into this in more detail later in the conversation and provide links to these platforms to help you get started.

One final note: the world of investing is filled with jargon, so it's important to start exploring and familiarizing yourself with these terms early. Don't wait until you reach a certain wealth milestone before you begin learning about and participating in this space.

The learning process in startup investing starts early, and it's crucial to begin this journey sooner rather than later. It's all about finding your own niche and speciality. Instead of waiting until you're 50, start in your late 20s or early 30s. At the end of this discussion, I'll suggest a couple of books to help you start this learning process.

The question about finding investment opportunities, or what we call 'deal flow', is an important one. Each investor often has their own unique source of deal flow. This typically comes from your network - your friends, colleagues, and fellow investors who share deals. Today, a lot of deals are sourced this way.

Then there are things like 'demo days'. Y Combinator, for example, has a demo day. In fact, every startup accelerator does, and there are thousands of them. Universities also hold demo days. Once you start investing, the founders you invest in will likely become your best source of new investment opportunities.

The reverse is also true. If you're a founder looking for investors, your best bet is to network with other founders who have already raised money, ideally those who are one stage ahead of where you are. In terms of referrals, a recommendation from a founder is the most valuable, far exceeding that of fellow investors.

Now, let's briefly talk about Special Purpose Vehicles (SPVs) via syndicates. This is a way to invest in a single company, and it often happens through portals. Many venture capital firms create SPVs for what they consider to be their winning investments. When these companies go to raise more money in subsequent funding rounds and the VC firm doesn't have enough cash available to participate, they might create an SPV. This allows them to bring in additional investors without giving up their right to invest in the next round.

An SPV, or Special Purpose Vehicle, is an LLC created with the sole intention of investing in one entity. All the names of the investors that are brought together for this SPV end up as a single line in the company's cap table. Even crowdfunding regulations like Reg A and Reg Crowdfunding now use SPVs for their investments, something they didn't do in the past.

Syndicators are people who syndicate deals, and they can be found both on portals and privately. You need to identify and get to know them. Some portals promote their preferred syndicators, and we'll discuss those portals later. Bear in mind that this process is very much sell-side; both the company and the syndicator have a vested interest in attracting investors, which often results in hyped-up deal memos and founder presentations. It's crucial to sift through the hype and emotion to make informed investment decisions.

Reading numerous deal memos over time helps familiarize you with the terms and norms of these deals, allowing you to recognize anomalies. This is why I recommend starting the learning process as soon as possible.

Next, there are funds. This is an option for those who prefer not to spend hours investigating individual companies and markets, and would rather invest in a fund managed by professionals. There are many small funds run by emerging managers who are usually in their first fund phase, and these first funds tend to perform well. Identifying these funds can be challenging, due to restrictions on promotion, but some are available on platforms like AngelList. These funds often have a specific focus, like climate change in the U.S. or fintech in South America.

There are also funds of funds, which invest in multiple other funds, providing a broad exposure across the sector, akin to an index fund. However, investing in such funds generally requires a higher level of wealth than just being an accredited investor, often around $5 million net worth. The minimum investments are typically higher as well. If you have the right connections, you might be able to negotiate lower minimums, but this is rare.

A word of caution: always do your own diligence and consult your attorney before investing.

One fund of funds I can mention is Decile Capital. They've bundled together a group of excellent emerging managers into a single investment. If you're interested, you can contact me for an introduction.

One point that we haven't touched upon is the time commitment required in startup investing. The further you move down this list, the less time you need to invest. For instance, if you're investing in a fund of funds, you're essentially delegating the responsibility of due diligence and decision making to the fund managers.

Investing in funds or funds of funds requires minimal time commitment. After writing the check, you simply wait for the periodic updates, letting the professionals handle the rest. For example, if you invest in a fund of funds from Sequoia or Bain Capital, you trust their expertise and just sit back. Similarly, if you invest in a fund managed by an emerging GP who's focusing on a geographical area or industry that you're interested in, you still get to sit back and await periodic updates.

However, direct investing demands significant time and effort. You might need to evaluate hundreds, if not thousands, of startups before deciding on one to invest in. For example, I review around 3,000 decks per year. If you're not prepared to put in this time, it would be more sensible to opt for the lower-involvement investment options mentioned earlier.

Another strategy I've used, given my background in tech, is to invest in companies whose products or services I personally find impressive. For instance, I like what Patreon does and resonate with their mission, so I bought some pre-IPO shares on EquityZen. This isn't exactly a startup investment as Patreon isn't a startup anymore, but it's not a public company either.

So, instead of reviewing thousands of startups and investing in a few, you could occasionally scout for companies that create products you admire and explore opportunities to invest in them. This could be through direct investments, SPVs, or buying shares from secondary markets like EquityZen. It all comes down to the amount of time you're willing to invest.

In my experience, I've also participated in secondary market purchases. I knew someone who knew someone at Palantir in the early days, so I bought secondary shares, which I held onto until they went public through a direct listing. This allowed me to sell off 20% immediately and wait out the lockup period for the rest.

Secondary marketplaces include platforms like Forge Global and EquityZen. For investing in funds, there are newer platforms such as EKI, Prometheus, Velvet, and Access. However, this is a relatively recent area in the investment sphere, and it will be interesting to see how it evolves. Because funds and funds of funds are somewhat opaque products and have strict regulations about how they can be marketed, they can be hard to find, which makes platforms that provide access to them even more valuable.

As for crowdfunding and accredited investor portals, we have WeFunder, StartEngine, Republic, and SeedInvest, along with AngelList, OurCrowd, Forge Global, and EquityZen. These portals provide a platform for investors to connect with startups and other investment opportunities.

I've been compiling a list of these portals, updating it frequently and putting it on Embark.com's Capital Portal page. Most of the data comes from the SEC database, which I update daily. Although not all of the tools I personally use are available on this website yet, I aim to provide a more user-friendly version for others to use.

Now, let's move on to a critical concept in startup investing: portfolio theory. The fundamental goal when investing in startups is to invest in a company that will yield a 100X return. If you invest in 25 companies, and one of them offers a 100X return, even if the rest go to zero, you've made a substantial profit.

In reality, any of the 25 investments that don't go to zero will boost your overall return. Given the high failure rate among startups, it's safe to assume a significant portion might go to zero. Therefore, you can't invest with the expectation that a company will return just 3X, as that won't compensate for the ones that fail. It's essential to diversify and invest in at least 25, if not 50 companies over time to balance the risks and the potential rewards.

Secondary marketplaces such as Forge Global and EquityZen offer platforms for dealing with secondary shares. Similarly, for funds, there are newer platforms emerging. Despite being in relatively nascent stages, these platforms are becoming increasingly popular. However, they are navigating complex rules around marketing funds to non-accredited investors, leading some of them to become exclusively available to accredited investors.

Regarding crowdfunding regulations, there are several platforms such as WeFunder, StartEngine, Republic, and SeedInvest. For accredited investors, platforms include AngelList, OurCrowd, Forge Global, and EquityZen. Funds have access platforms like EKI, Prometheus, Velvet, and Access. These platforms are all relatively new, having been introduced in the last couple of years. I've compiled a list of these on the Capital Portal page of Embark.com, a free website that repurposes mostly public data, including information from the SEC database.

Now, let's touch upon portfolio theory. The aim when investing in startups is to find companies that will yield a 100X return on your investment. If you invest in 25 companies and one of them offers a 100X return, you end up with a 4X return on your total investment, even if the other 24 investments fail completely. Any of the 25 that yield even minimal returns help boost your overall return. Given the high risk associated with startups, with perhaps 60% going to zero, your portfolio needs to include some large returns to be successful. You can't plan on a 3X return from your investments, as that simply won't compensate for the failures.

To balance the risks and potential rewards, you need to determine how much to invest and ensure you diversify this across at least 25, or ideally 50, companies over a certain period.

Investing in startups often involves saying yes to strangers – the founders. Even if they are your friends, you will inevitably move past your immediate network as not every friend is starting a new company every year. Trusting unknown individuals with your hard-earned money can be challenging. Consequently, you might find it difficult to say yes enough times to form a complete portfolio where portfolio theory comes into play. It's crucial to recognize and overcome these psychological hurdles.

Regarding valuations, achieving a 100X return becomes challenging if the starting valuation is already $100 million. The age-old advice of buying low and selling high applies here. In this context, 'selling high' usually means that the company you've invested in gets acquired or goes public - an event that is generally out of your control. This somewhat simplifies the "sell high" aspect of investing in startups.

Early-stage investors need to be aware that subsequent investment rounds will introduce dilution. While new investments should ideally increase the company's overall value, they will also proportionately reduce your stake. Thus, capital-efficient companies are more likely to offer a 100X return because they require less investment over time and thus lead to less dilution. This is why different types of companies have different valuations. For instance, hard tech companies and consumer products might require substantial capital, leading to significant dilution.

An example is a company in which I invested at a $6 million valuation. Excluding dilution, it went up by 200X. Factoring in dilution, the actual return was closer to 50X. They went public with a $1.2 billion valuation. However, despite generating hundreds of millions in revenue, the market didn't respond well to this consumer product company, and its valuation plummeted to $30 million. When a company goes public, you often can't sell your shares immediately due to a lock-up period.

Also, while it might be tempting to take out loans against the value of a 'winning' investment, I would generally advise against it unless the only collateral is the stock in the company itself.

In the interest of time, I want to mention some books that Steve has recommended. "Angel" focuses on angel investing, making it an obvious pick for anyone interested in this topic. "Venture Deals" delves into the mechanics of the startup world, providing valuable insights on fundraising and industry jargon.

You can also interact with Steve on Xillion. For instance, if you're contemplating investing in a new venture like a Shaving Club, you can ask Steve for his thoughts. You can access Xillion for free at Xillionapp.com. Some of you might already be customers, so thank you.

We received a question about the exit strategy for investing in startups. As mentioned before, these are long-term investments. You should expect to stay invested for at least ten years, if not longer. Your exit options are quite limited. If you're investing through a third party, they typically determine the exit point. If you're investing directly, you might have an opportunity to sell when the company is raising their next funding round, potentially to an incoming investor. However, this requires agreement from the founders and the new investors, so there are no guarantees.

Investments in startups are very illiquid, typically for ten or more years. You have little control over when a company decides to go public or get acquired, which means you might need the money back but not have access to it. This is why they call it "patient capital" - you need to be patient.

We are open to any other questions. Steve has seen it all and can provide valuable insight. For example, I have invested in about 20 companies, some as a direct investor, but most through secondary markets or as part of Special Purpose Vehicles (SPVs), and in one fund.

I used to be skeptical about funds, but now I see their value and appreciate what they do. Thank you everyone for attending and for your questions. We will share the video and the presentation in the next few hours. Feel free to reach out to me or Steve with any further questions. I'm on the Xillion app, and Steve can be found there as well. Thanks again, Steve!

You're welcome. Goodbye!