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startup wealth[Editor’s Note: Seattle-based author Josh Maher shares an excerpt from his newly released book, Startup Wealth: How the Best Angel Investors Make Money in Startups, with GeekWire. In this excerpt from chapter 10, The Voice of Value with Christopher Mirabile, Josh shares a small piece of his interview with Launchpad Venture Group’s Christopher Mirabile exploring the different models that startup investors fall within. We’re publishing this excerpt, with the permission of the author, as a special bonus for GeekWire readers.]

“Investing without research is like playing stud poker and never looking at the cards.” ― Peter Lynch

“In my experience, momentum and social proof can be extremely poor indicators of round quality.” ― Christopher Mirabile

Christopher and I spoke in April 2014. I connected with him about the same time I connected with David Verrill, Jim Connor, and Allan May, all of whom are on the board of directors at the Angel Capital Association. All four of these angels are leaders in the angel group community and have spent a fair amount of their lives thinking about how to improve the practice of angel investing. I was glad they all operated in their own space and had their own opinions and approach to angel investing. Christopher and I got into an interesting discussion about investing on momentum and investing on value that I’ll include here as an introduction to the value investors section.

At the end of the interview, Christopher told me, “I think you should throw this book away and write a book about this investment dichotomy instead. I would get up and defend the value investor who’s not chasing fads. I think Warren Buffett said, “You find out who’s swimming naked when the tide goes out.“ Right now, the market is hot and there’s all this happy bullshit—I don’t know if you’ve looked at some of the extreme cases of people just indexing the market.”

Obviously I didn’t scrap this book, but you’ll note that what Christopher is saying is exactly one of the insights I found through all my interviews and one that this book is structured around. To understand more about value investing, I wanted to explore how Christopher thought about his portfolio.

How do you think about angel investing in the context of portfolio management?

I will say that virtually everything that’s been written on the subject, whether it be a blog article or a book, is deeply unsatisfying because the reality is that angel investing differs so much from country to country and region to region within a large country like the United States, and from industry to industry, that people tend to write about what they know, speak about, or pontificate about what they’re familiar with, and invariably their perspective omits other key perspectives, so you end up with advice that’s only good for someone coming at it in the same way as you, and irrelevant for everyone else.

You’re probably wise to go with a multi-perspective approach the way you are because I think it gives you at least a fighting chance of writing something that’s relevant.

By way of example, one of the biggest dichotomies right now is there’s this rift between this somewhat consumer-led, consumer-mobile kind of deal flow that is prevalent in Silicon Valley and the rest of the world. In Silicon Valley, you have all these young investors who have money from big success stories like Google and Facebook. They are chasing trends similar to what they know. Some of the resulting deals are almost like popularity contests and it’s all about moving fast, and there’s really no emphasis on diligence or helping the company do anything other than “growth hack.” There are lots of good investors and good companies amongst all that hype, but a lot of it just feels really bubbly and insubstantial. There’s this perspective that you could almost analogize to day trading or momentum trading.

Christopher
Christopher Mirabile

Then you have the angels who have been in the game a bit longer, maybe a bit more group-centric and process-centric, who are more similar in behavior to value investors or stock pickers, if you were going to use that same stock-picking analogy.

This second group of angels aren’t day trading or momentum trading, they aren’t trying to play the market. They’re trying to find great teams and great opportunities at good companies—need-to-have products, rather than nice-to-have products, and do it in a thoughtful process–oriented way, and then – and this is crucially important – help the companies afterward. I’ve done a number of interviews, been on Frank Peter’s show, blogged about this, and talked about it in various contexts.

For me, it kind of boils down to this idea that angel investing is a lot saner when done analytically and on a risk-adjusted basis, where you’ve got a reasonable expectation of return for the amount of risk you’re taking. To me, angel investing is more analogous to adopting a puppy than buying a lottery ticket. It takes time and work with these companies to help them become successful over a number of years. There’s a lot of people buying lottery tickets right now—they have this idea that they can sit at home in their pajamas and their bunny slippers and they can be an angel investor by clicking their mouse. I sometimes worry that “curation” is becoming the new due diligence. Might work for a while in a cresting market, but needless to say, I see that ending badly.

I think the lottery ticket mentality (is) a very dangerous way to go at this, and it’s going to lead to a lot of people getting badly burned when the cycle turns. Now, in a rising market, like in 1998, 1999, 2000, you could have bought a basket of any tech stocks and as long as you got out quickly, you could survive. It may be that some of those people who are angel investing today will make out okay just because they got diversified enough and something will succeed in a big way. But they’re probably taking on an awful lot more risk than they need to for the overall returns they’re generating.

The funny thing is the two schools of thought appear not to have a lot of respect for each other. The momentum guys are like “if you’re not in the cool rounds with Ashton Kutcher, you are missing out – it is all about who you know. If you’re not investing in mobile and consumer, Instagram and WhatsApp, you’re doomed to failure.” That crowd also invests in a lot of stuff that by its very nature is hard to do diligence on because you can’t really call up a customer demographic and ask how they like the product, right?

To me, it feels a bit like chasing hit records or hit movies. Plenty of money gets made in the music and movie industries, but it’s awfully hard to predict which ones are going to be successes, and those who do succeed tend to need a lot of capital, so they’re taking on a lot of subsequent financing risk, and they’re very much sort of feeders for VC. Whereas I think that those in the other school of thought are being a lot more deliberate around issues like: who is going to lead this, how do we stage capital, who is going to sit on the board, do we want to bake VC dependency into our deal?

For example, at Launchpad, we’re pretty careful and analytical about doing a deal that’s really going to need a lot of capital down the road. Sometimes we will decide not do them or, when we do, we try to identify strategics or non-dilutive grant financing that’s going to come in, or where we understand who the VCs are going to be and if possible we get them to all invest with us at the same time on the same term sheet. The type of angel investing where the basic model is, ”Let’s just throw a little bit of money at this deal, they can mess around for a while and then we’ll go get real money” – that’s crazy investing. Unless you have a very good sense where the big Series A is coming from, you’re likely just throwing your money away.

Keeping the options open is the key. You can always go big if the situation merits it, but once you slam a ton of capital into a deal, there’s no reversing that. We had a classic case where we invested in a mobile analytics company. We found and seeded this company that provides analytics for mobile apps that are similar to the kinds of web analytics that are common—if you’re a publisher of a web page you need analytics to figure out what you’re doing, what’s happening on your page, and if you’re a big publisher of an app, you need analytics to figure out what’s going on with your user base and your app—and so we invested in these guys, and at first the investors and the founders capitalized the company pretty lightly.

Everyone kept the option of selling early by not putting too much money into the company, and we decided we’d play it by ear. But what ended up happening is they really took off and they found an adjacency to what they were doing that was even bigger than the original market.

They began to get tremendous traction and landed some really major customers, and so it made sense at that point to say, never mind, we’re all going to go big on this thing and so the founders and the investors agreed to bring in a VC round with a 12x greater valuation and then later the company brought in a bigger round at a 5x greater valuation than the previous big round. The lesson here is that you can always add money quickly later if it makes sense but you can’t take it out – once a company is over-funded and its cap table is ruined, you cannot go back and fix that without pain all around. But you can always quickly and easily pour coal on the fire if called for. Epilogue to the story: at this point, the company’s tools are on nearly three billion mobile devices and counting.

The interesting thing a lot of people don’t really understand is that if you take a million bucks from somebody modeling a 10x return and you give away half your company to do that, you need a $20 million exit or they’re not going to be happy. And $20 million, coincidentally, is what the average M&A deal in this country goes for, and that’s just for $1 million in capital.

A lot of people blithely throw money into companies and put two or three million bucks into a company at four, five, six, eight, nine million–dollar valuation, which is what’s going on in very hot markets like Silicon Valley, and they don’t even understand that they have no reasonable prospect of a big multiple unless this thing gets sold for two, three, four, five, ten times the size of the average M&A deal. The farther above that average you go, the lower the frequency and likelihood goes.

Now they may say, I don’t care. I want to make 100 bets because I only need one to deliver a thousand times and I’m made. That’s fine. It’s their money, they can do that if they want.

That is the common argument that, statistically, making enough small bets will pay off. Isn’t that true?

They’d better get really diversified then, because those big exits—you’d think they come up all the time if you read TechCrunch; you’d think those exits are falling out of trees, but the reality is statistically, they’re one in a million. These things are called unicorns for a reason, and you better be putting a lot of money into a lot of deals. And you’ll need one 100x hit for every 99 mistakes just to break even. Not to mention the amount of money you’re tying up and the amount of uncompensated risk you’re taking.

Author Josh Maher
Author Josh Maher

We take a slightly more deliberative approach. You try to share the risk with the entrepreneur and capitalize the company lightly so you have some options, and allow them to take a little bit of money, de-risk the company, increment the valuation up a little—take a little bit more money at a slightly higher valuation—so they can keep control and don’t really pour on the rocket fuel until we figure out what’s going on. And as I said, we also tend to invest in stuff where it’s a need-to-have for the company, for a particular identified customer, rather than nice-to-have for a demographic. We tend to look at and try to understand buying priorities of the targeted customer segment.

I think this mouse-click, lottery-ticket stuff is an accelerating trend. It’s getting a lot of coverage – it’s the ”it” topic right now – and I think it’s only going to accelerate with various forms of crowdfunding. Which is not to say that the proposed title three rules as they’re written are workable—I think as currently drafted, they are dead on arrival. But that’s a whole other topic. I just worry that this is going to lead to a significant angel crash and possibly even some fraud and the result will be regulatory reaction and backlash. It has some of the makings of a tulip-mania in some areas.

Christopher’s Launchpad Venture Group meets regularly in Newton and Boston, Massachusetts, and invests $350,000 to $1 million per round in companies around the Northeast. Their current portfolio includes a wide range of companies such as Localytics, Boston Heart Diagnostics, Crowdly, ezCater, Groupize, Mobius Imaging, Pixability, QStream, and PunchBowl.

Josh Maher’s new book, Startup Wealth: How the Best Angel Investors Make Money in Startups, is available in paperback and e-book formats.

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