This article is by Sam Simpson, COO, FounderCatalyst
Finding your feet in angel investing isn’t easy – you need to work out where to find potential investees, how to do due diligence, understand the complex tax regimes and find out for yourself what ‘market standard’ is for angels.
I came to angel investing three years ago, following a long career in large-scale IT project management (including the dramatic collapse into administration of the company I’d worked for for 13 years), and more recently, as an entrepreneur and founder of one of the UK’s fastest growing tech companies.
I exited this business in 2017 and made my first angel investment in March 2018. I was lucky enough to be introduced to some very seasoned angels who helped me ‘learn the ropes’. Since then I have invested in 20 companies and made three follow on investments.
One of the first pieces of advice I received was to have the ‘right sized portfolio’, in order to get the best return and spread risk. But how big that portfolio should be was up for debate – some angels would say 10, others 20, others nearer 30.
It became clear that my new investor friends were speaking from experience rather than drawing on any sort of evidence. I was surprised there was no science behind this fundamental facet of investment.
The UK Business Angels Association (UKBAA) and British Business Bank have recently released their annual report: The UK Business Angel Market 2020, and it’s fair to say that it makes for fascinating reading. Weighing in at 43 pages, it takes some time to digest, but figure 26 jumped out to me as immediately of interest – showing investment exit multiples from 2018/19 covering 300 exits during the period.
I wanted to use this data to dig into that ‘how big?’ question. I made some sensible assumptions about the UKBAA data, including assuming that all investments were made under the Enterprise Investment Scheme (EIS).
I then ran a Monte Carlo simulation using the expected return percentages and the level of return from that outcome in order to model a real world portfolio. I ran 10,000 simulations and modelled the outcomes against various sizes of investor portfolios.
The outcomes provide evidence-based answers to the following questions:
Q: What is the optimal number of investments to have in an angel portfolio?
A: Returns start gently tailing off after 15 investments, but we consider 25 to be an ‘optimal’ portfolio size. This is higher than the actual average number of investments made by angel investors, which is 17 (according to the UKBAA report), showing that many angel investors could optimise their portfolio by increasing its size.
Q: What return can you expect from a sufficiently large portfolio?
A: On average, we expect a portfolio of 25 companies to return x2.7 the money invested. This rises to x2.77 if you invested in many hundreds of companies.
Q: What is the overall impact of EIS on an investor portfolio?
A: Assuming your entire investment portfolio is based upon EIS investments then the expected return jumps from x2.77 to x3.19 times.
The power of the stellar start-up
Given the outcomes of the simulation, it seems obvious that having too few investments will mean, on average, your portfolio won’t reach the optimal return.
But the numbers also show that if you only made one investment then you could be very lucky and yield a surprising 21x return! However, statistically, it is much more likely that the return from a single investment would mean a x 0.5 return. Ouch! On that basis, angel investment wouldn’t be a popular asset class.
That’s not to say that if you have 25 investments you’ll be certain to get a 21x return investment in your portfolio, but there is a fighting chance that one of your investments falls into the magical 21x return bracket.
Of course, getting the best return isn’t all down to luck. It’s important to optimise your portfolio performance by undertaking extensive due diligence before investing, by understanding the market in which the investee company plays, by negotiating an ‘optimal’ valuation and by supporting your investments once you’ve made the investment.
Investing in uncertain times
The findings suggest that, despite the Coronavirus pandemic, UK start-ups are an attractive asset class for investors, especially given the SEIS and EIS tax relief. And though increases to Capital Gains Tax and Inheritance Tax look likely in 2021, SEIS and EIS investments are exempt from both.
It would be remiss not to acknowledge that angel investing isn’t for everyone – it is a relatively illiquid asset class – and to take advantage of the SEIS and EIS schemes you need to hold the investment for at least 3 years.
I will personally be continuing my effort to build a broad portfolio of investments rather than have a concentrated set of larger investments, diversifying my investments across markets, verticals and business models.
To see the underlying data and analysis please go here