Why Angel Investing Is Not for Everyone

Understanding the game of losses

Early stage investing is a risky game. Statistics show that 90% of startups fail. Of those who start a company, 1% will be able to secure seed funding, and of those who are able to secure funding, 1% of that pool will likely become a unicorn. Becoming a unicorn is almost as hard as winning the lottery.

So why do investors play this game?

Despite the slim chances, many people do and and many are successful. Some classify it as gambling, while others believe there’s a science to it.

People have shown success after success in early stage investing, and you might ask how they do it given these chances.

The reality is that when you look at those who have succeeded, their wins far outweigh their losses—despite experiencing many failures. Some of the top solo capitalists, such as Elad Gil, Naval Ravikant, and Harry Stebbings, have lost so many times that anyone might assume they were simply lucky. Yet, their net worths continue to grow, and they keep finding more and more winners. How?

Seed investing is a game of losses. When you deploy money into a startup, there is a 1/10 chance that it survives, and even if it does, there is an even smaller chance that it becomes a high growth performer. This means the probability that you hit a home run is slim. That’s why starting a company is mentally tough—you’re playing against the probabilities. Yet, many founders push forward with strong conviction. As a founder, these probabilities keep me up at night.

Being an angel investor means going all-in on the long game, spreading risk across multiple businesses knowing that only a handful will succeed. For every check you write, you know the chances of winning are slim. The path to success comes from being somewhat diversified with a few chances of hitting homeruns that more than compensate for your losses, and by a wide margin that is.

Let’s say you had $500,000 to invest, would you invest in a few opportunities or many? The answer depends on the risk / return dynamics you seek as an investor.

If you’re investing in startups with product-market fit and a clear path to profitability, you’ll likely spread your capital across a few—betting that some will thrive while others may not be total losses.

If you’re investing in pre-revenue startups at the frontier of knowledge and technology, where markets are unproven, you’re playing a game of extreme risk and extreme returns. This would require diversifying to compensate for concentration risk on the unknown. Of course, there are rare exceptions. Founders Fund, 8VC and Lux Capital are examples of this. These guys don’t look for 100x their money, they look for 10,000x their money and accept the risks associated with that.

In both cases, early-stage investors know that losing is part of the game. This applies to all types of active investing. Stanley Druckenmiller, one of the greatest investors of all time, once said about his mentor George Soros “I’ve learned many things from Soros, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

Be careful labelling someone for making a single wrong bet. It’s the overall return that matters.

In the early stage game, investors seek what’s called a fat-tail. This means, a tiny proportion of their investments make up for the losses of others. This is also called the power-law, which is a probability distribution that reflects a small number of occurrences will have the largest impact on a data set, in this case your portfolio companies.

Let’s go back to the $500k example.

Let’s say an investor deploys capital across 10 startups, investing $50K per company at a $3M valuation, they gain exposure to 10 equal bets. But in a fat-tailed world, most will fail (let’s use 90% based on statistics).

To just break-even (keeping dilution out of the equation to keep it simple), the one surviving company must return at least 9x the original investment ($450K). That means a $3M company must grow to at least $27M in valuation. But most top-quartile venture funds target 3x to 5x total fund returns, which means one or two investments must return 50x or more to drive meaningful gains.

Remember, this example doesn’t incorporate dilution. If a company raises multiple rounds, the investor’s initial stake shrinks. So, a 9x valuation uplift doesn’t mean a 9x return. Investors often lose up to 50% ownership through follow-on rounds after all is said and done.

What’s the bottom line of all this? Winners need to be extreme – It’s not just about one 9x exit, but rather a few 50x+ or even 100x+ outcomes to drive performance.

This is why early-stage investors don’t expect wins. They expect losses. The strategy isn’t about picking many small winners but more about finding the rare, overlooked outlier companies that can return the entire fund or more.

Now, there are exceptions. For example, there is a new world of early stage investors focusing on young cash flow positive (traditional) businesses, which I find interesting. Losses in these case are fewer, but upsides are not as extreme. It’s a space that is not as sexy but proving to be successful. Just think of Berkshire Hathaway of Warren Buffett, but on a micro scale. Here are some examples.

Why am I saying all this?

I say this because I often meet people who ask if they can join a specific deal, without realizing that investing isn’t about any one deal, but about a series of bets that make the opportunity interesting. Sure, a single deal might be exciting, but its real value lies in the context of the entire portfolio.

I know that despite it being interesting, there is a strong chance that it could be a dud, and I would have to live with it. Even the most promising investments have a high chance of failing, and I have to accept that. This is hard to explain to someone who isn’t in the game full-time, especially if they’re risking half their savings on a single startup. If they don’t truly understand the risks of individual deals, they probably shouldn’t be investing in early-stage companies.

Too often I hear investors mention that they expect their money back 100% of the time, but that’s not how it works. The best investors I know understand that losses are part of the game, and there are no hard feelings if investments end up as duds.

Many people have asked me why I never brought them into certain deals. The reason is simple: I don’t know too many people who can bear the risk of early stage exposure. Honestly, I can probably name no more than 15 within my circle. With that in mind, I would not want to disappoint anyone. The irony is, when a deal succeeds, those who missed out ask why they weren’t invited early, thinking early entry is a free lunch. But it’s not. Those people took risks that are unbearable to most, and they should be compensated for that courage through a higher return on capital.

I have seen companies go through multiple funding rounds, from seed to Series A, B, C, and eventually IPO. At each stage, later investors often get thrown off by the higher valuations they must accept compared to seed-stage investors, without realizing that from a risk-return perspective, investing at a later stage can be more attractive: management teams are in place, product-market fit is strong, products have been accepted in multiple markets, with growth on the horizon. At this stage, the most critical factor is entry price. Sure, return expectations won’t be as high as the seed stage, but neither will your risk, as long as you come in at a fair price.

This is why I don’t like bringing in family to early opportunities (except a handful who I know are professionals and are willing to bear the risk). Some can and history shows that many of the first checks of some of the greatest founders were from family (Bezos is an example). Capital is scarce, and if it is the only source you have, then you have no choice, but it should be the last choice. I think in Bezos’ case, his dad considered it a write-off with no expectations.

If I’m in control of a company and it reaches the growth stage (where much of the risk has been mitigated) I feel more comfortable involving family and friends, as long as the valuation is more than fair. And as a founder, it is probably better to give a good deal to investors. In the long run, it will pay back.

The next time you see a deal, it probably makes sense to understand how that one particular deal fits with your overall portfolio. No two persons are the same, and everyone has their own personalized portfolio. Knowing how a single deal fits into that overall portfolio is more important, because at the end, it’s not about being right every time, it’s about making sure that when you are right, it matters.

ABOUT THE AUTHOR

Keenan Ugarte is Managing Partner at DayOne Capital Ventures, an independent private holding company that invests in and builds high-growth, early-stage businesses that serve the underserved Philippine mass market. He is also the Co-Founder of The Independent Investor, a media platform spotlighting early-stage companies and innovation within the Philippine startup ecosystem.