How Angel Investing Is Different Outside of Silicon Valley
Many aspects of angel investing are the same in places with relatively few high-potential startups as they are Silicon Valley, the epicenter of high-potential entrepreneurial activity. However, both research and personal observation suggest that, to be successful, angels outside of the valley need to do several things differently from their counterparts in Northern California. Angels outside of Silicon Valley (and perhaps Boston and New York) need to focus on less capital-intensive deals; make investments across a wider geographic area; become less involved with their portfolio companies, and keep start-up valuations low.
Angels outside Silicon Valley need to focus on deals that do not demand much follow on venture capital.
Financing risk – the risk that subsequent investors will fail to put in the follow on capital needed to grow a company – is much larger outside of Silicon Valley because venture capital is concentrated there, with the National Venture Capital Association reporting that 49.1 percent of all VC dollars were invested Silicon Valley companies in 2014. For angel-backed businesses elsewhere, the concentration of those dollars in the valley makes growth much harder than for angel-backed companies that do not need additional funding. By concentrating on companies that do not need much follow on capital, angels outside of Northern California can minimize financing risk and improve their investment chances.
Angels outside of Silicon Valley need to be flexible about the geographic proximity of their portfolio companies.
In most places outside of Silicon Valley, New York, and Boston, there aren’t going to be a high enough number of high-potential startups for angels to both invest within a two-hour drive from their homes and be sufficiently diversified. Monte Carlo simulations show (https://www.quora.com/Angel-investors-are-advised-to-diversify-and-invest-in-at-least-20-startups-How-is-the-20+-affected-by-the-stage-of-investment-If-I-could-participate-in-Series-A-rounds-would-the-minimum-be-less-than-20) that angels need a portfolio of approximately 100 companies to be adequately diversified, given the risk of investing in early stage companies. Because few businesses can meet angels’ return expectations, angels invest in only about two percent of the companies they see (http://billpayne.com/2010/02/22/angel-group-deal-flow-statistics.html). That means that to produce a portfolio of 100 companies, angels need to examine 5,000. Even if the portfolio is produced over a decade, the math means that angels need to investigate 500 high-potential companies per year. Few parts of the country create high-potential companies that that rate.
Angels outside of Silicon Valley need to be less actively involved in startups as those in the valley.
If angels outside of Silicon Valley need to invest across a wider geographic footprint to create enough deal flow to be properly diversified, then meeting with portfolio companies is much more time-consuming for those angels. In addition, angels located outside of the entrepreneurship centers have less experience building successful companies, and have fewer connections to investors, managers, and customers of portfolio companies, making the value of their assistance lower than that of Silicon Valley angels. Together, these two factors suggest that angels outside of Northern California should be less hands on.
Angels outside of Silicon Valley need to keep valuations down.
Companies outside of Silicon Valley tend to exit at lower prices than those located in the valley. Startups that go public exit at a higher value than those that are acquired, and startups in entrepreneurial centers are more likely to go public than those in more peripheral locations. Moreover, startups outside of Silicon Valley tend to raise less capital and therefore are typically acquired at a smaller size than those located in Northern California. Because the exit value of Silicon Valley startups is higher than those outside of the valley, investors outside Silicon Valley need to invest at a lower valuation to generate the same return multiple.
While much of angel investing is the same everywhere, angels outside of Silicon Valley need to do a few things differently to be successful. They need to focus on less capital-intensive deals, make investments across a wider geographic area, become less involved with their portfolio companies, and keep start-up valuations low.
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Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).