Sophisticated investors in high potential start-up companies generally take one of two approaches to angel investing, which I call “power ball” and “money ball”. Either of these approaches can yield high financial returns, but their success requires angels to stick to the rules of the game they are playing. Investors do poorly when they confound the two games.
Types of Investment Philosophies
What I call power ball, after the multi-state lottery of the same name, are two prevailing Silicon Valley investment philosophies. The core principle of this approach is that angels make money off of a very small fraction of their investments in start-up companies, maybe one-in-thirty companies. But the low probability of hitting a winner is offset by the enormous magnitude of the returns on the winners. In angel power ball, the one winner goes public or is acquired at such a huge price that it more than makes up for all of the failed investments.
Money ball, named for the statistical approach to assembling a winning baseball team, is the most common investment philosophy of many East Coast angel investors. In money ball, investors pay close attention to the numbers. They look investment opportunities that have the right combination of potential outcomes, valuation, and terms. Because most external-equity-backed startups exit through acquisitions at less than $40 million, getting in at a low valuation is important for these investors to earn a return commensurate with the risk they are taking.
If you are playing power ball, little matters to your investment philosophies other than getting into a great deal. That means investing in a team and an opportunity that stands a chance of being a unicorn. The valuation of the pre-seed round investment in company like Facebook or Alibaba makes very little difference. Whatever the valuation is, the investments will be a homerun. The early round valuation never be unrealistically high and terms can never be too entrepreneur-friendly because you need to be in the Unicorn deal at any cost to succeed.
The game is different if you are playing money ball. The deals have zero probability becoming unicorns. As super-angel David S. Rose, author of Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups, explains angels have to look at the statistics to play money ball. Valuations that are too high or terms that are too entrepreneur-friendly will undermine the deals.
To play power ball, an angel needs to see start-ups that have the potential to be moonshots. That means investing primarily in Silicon Valley companies. If the angel is located in a place like Cleveland, Ohio (where I am), he or she has to be willing to invest out of region. There just aren’t the right types of companies locally for the power ball strategy to work.
For an angel to play money ball, he or she needs to stick with terms that permit a high return on modest exits. That means avoiding overvaluation. It also means stricter deal terms, such as protective provisions, cumulative dividend rights, participating preferred stock, and founder vesting.
Investment Philosophies Need Consistency
Angels can make money playing power ball or money ball, as long as they stick to the rules of the game they are playing. That means being internally consistent. Mixing and matching elements of the two games is a recipe for disaster.