Summary: We currently live in an era with an unprecedented money supply, which has contributed to soaring asset prices and sky-high security valuations. These price increases coincide with low interest rates and high inflation that have rendered many investment opportunities like fixed income securities money losing and stock market investments risky. Since traditional avenues for investing now present enhanced risk, I am making the case for a role of an angel investor in early stage technology companies. The fast growth of such assets can function as a hedge against the multiple compression risk associated with rising interest rates, and empirical evidence shows that angel investors can beat the returns of most other asset classes with sufficient diversification.
Disclaimer: This article is not investment advice and for educational purposes only. Do your own research before making any investment decisions.
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Three years ago, I started 10x Value Partners as my personal investment holding. Since then, the company has initiated over 20 investment positions that have increased my initial capital a hundredfold on paper, achieving phenomenal returns. In the last months, I have seen extreme gains in public equity markets and also the crypto space, which made me review our asset allocation. At the same time, I believe our economy faces the threat of inflation and rising interest rates. After extensive research, I concluded that the ideal way to deploy our dry powder in the current environment is doubling-down to invest in fast growing technology companies. They provide the best returns — regardless of monetary policy going forward. I will lay out my thoughts on this in the lines below.
The Case for Investments in Startups
Ten to twenty years ago, companies went public in the early stages of their life cycle to gain access to additional capital and to provide enhanced liquidity to investors and employees. For example, Amazon went public in 1997 at just a $438 million valuation. Google went public in 2004 with a valuation of $24 billion. Since their Initial Public Offerings (IPOs), both companies have provided phenomenal returns to investors, and they are now valued over $1 trillion.
Today, it would seem inconceivable for companies to go public so early and at such low valuations. Large investors like Softbank, Tiger Global and other growth investors with deep pockets can provide a cash runway and overall liquidity, reducing a private business’s need to go public that fast. Furthermore, there exist now very liquid secondary markets that can provide liquidity to early investors and employees. These variable changes make going public a nuisance rather than a necessity, compelling companies to stay private longer.
For example, Uber went public in 2019, 10 years after its formation, at a valuation of $82bn. It is now trading at $85bn, shifting almost the entire value creation to private markets inaccessible to small investors. Hence, to participate in the rise of technology companies, one needs to invest in private companies (or become an employee with stock options).
Early-Stage Start-up investing in 2021
There are a couple of reasons why I believe start-up investing is particularly attractive right now:
1.Start-up investments work amazingly well in a high inflation / low interest rate environments
Investing your money in an environment with high inflation and low interest rates is very tricky. Typically, in a high inflation environment interest rates should not be low. As the money is losing its value, lenders should not be accepting low interest rates, because it implies real, net-negative returns. Due to the current monetary policy of quantitative easing, there is so much supply of money that the price of money (=interest) is still very low (typically, in a high inflation environment, rates increase in-kind).
Each of these factors means a loss of value:
● If you have cash sitting in your savings account, you are losing money.
● If you invest in fixed-income securities, you are losing money.
● If you invest in the stock market, there is a high risk of losing money when valuation multiples drop because of rising interest rates.
Asset pricing theory tells us that we can derive company valuations through a Discounted Cash Flow (DCF) or multiples based approach. DCF determines the value of a company as the sum of the discounted future cash flows plus the terminal value, with the discount rate equal to the risk-free rate plus a risk premium. If interest rates rise, risk-free rates rise, causing future cash flows and the terminal value to get discounted more. The sum of all the cash flows will lower, leading to a drop in company valuations. It is similar for multiples — they get compressed with rising interest rates as the discounted terminal value falls. Multiples function like a simplified method for company valuations in place of a DCF.
Another factor in asset pricing is the growth rate of a company. High-growth companies experience less negative effects from a rise in risk-free rates because the growth rate plays a role in the terminal value calculation as well. I can explain through an example: Amazon currently trades at 60x EV/EBITDA and is growing its EBITDA 57% year-over-year. If we assume interest rates rise and the multiple of Amazon gets cut in half (mean reversion, EV/EBITDA of technology companies in the S&P 500 have doubled between 2018 and 2021). A drop of this kind would, in theory, cut Amazon’s value in half. But, as the company has an EBITDA growth rate of 57% year-over-year, they would return to the previous valuation in roughly 18 months. As for many other public stocks, the outlook does not look rosy, as the average EBITDA growth rate of the S&P 500 is 9.5% per year, which means it would take the average company 7.5 years to recover from a 50% haircut of multiples.
In summary, if interest rates rise, multiples get compressed. If multiples get compressed, slow-growth companies get f***ed.
Rapid growth players can weather the storm, and companies with the fastest growth rates are early-stage tech companies. For me, this makes startup investments the best hedge against inflation and rising interest rates.
It is to no surprise that the smart money on Wall Street is capitalising on this dynamic. According to Goldman Sachs, hedge funds provided 27% of all capital put into private companies, a massive increase from the historical 2–5% allocated. My former boss, German billionaire Oliver Samwer and his fund Global Founders Capital, have joined the race, and their number of completed deals has gone in just one direction.
2. Investing in startups can operate like a savings account
Startups usually have several types of shares, one or more classes of preferred shares and common shares. Investors typically get preferred shares with liquidation preference, meaning they receive any returns and capital repayments before common shareholders get paid. In effect, as long as a company does not go bankrupt, you will likely get your money back.
In an environment with negative interest rates, investment opportunities with preferred shares can protect the value of your money, unlike public markets that only offer purchases of common stock. Of course, there is still risk involved with the strategy as early stage tech companies can fail, voiding the benefit of the liquidation preference and implying a total loss of capital. But, overall, there is good empirical evidence that angel investors achieve average returns of 2.5x or more, provided they have sufficient diversification (we will come back to this later).
Moreover, I believe if you select startup companies with care, you can limit the risk of an 0x outcome. In fact, this line of thinking is a core element of our investment strategy at 10x Value Partners. Some good arguments explain why the failure rate of start-ups has decreased over the last decade, with most people mentioning the increase in better, more experienced executive talent, lower operating costs due to SaaS and the faster consumer adoption of new technologies.
We now see plenty of companies that reach early profitability, for example in the recent batch of YCombinator. If companies have proven profitability at small scale or have a low burn rate (and all other factors on our checklist check out), there is a low probability of negative outcomes due to the liquidation preference. Note: your money can remain locked/illiquid for an extended period of time. However, you can receive compensation for the illiquidity with the potential for gains at the magnitude of several thousand percentage points. I believe with many startup investments these days, the risk/return profile is highly asymmetric.
“Venture capital is interesting because you can only lose one-time your money. People gasp, but you have to look at the other side. If you can make 50-times your money and only lose one time, that’s a pretty good deal,”
3. Large multiple arbitrage between early-stage to late stage and public
Once you have realised that startup investments can provide a hedge against inflation and rising interest rates and offer highly asymmetric risk-return profiles, the remaining question is when to invest, early-stage or late-stage? I see several advantages in late stage investments, such as a faster path to liquidity and lower downside risk. But, I see overall better value creation potential with early-stage strategies. There are two reasons for this:
a) Public market (i.e exit) and late stage valuations have risen faster than early stage valuations.
There is some data from PitchBook showing such late-stage increase dynamics.The dataset is limited up to 2018, and I could not find more recent information, but from a subjective perspective, this trend has perpetuated. I now hear about SaaS and payments companies valued at 100x annual revenue at the late stage, whereas you can still invest at a more affordable multiples in the early stage. While early-stage valuations have increased in the past 2–3 years, late stage valuations have risen much more, so early-stage investors stand to make better returns compared to before.
b) There are more unicorns (i.e billion dollar companies) created now than ever before.
Between 2018 and 2020, a new unicorn was created every 3 days. In 2021, that rate increased to a unicorn every single day, and the total number of unicorns tripled. The more unicorns there are, the better for early-stage investors. In the best case, it means that more start-ups make it to unicorn level in general, or more start-ups make it to unicorn level faster. At the very least, the more startups that achieve unicorn status, the more needles there are in the haystack to find, offering better odds to find a winner.
Noting the increasing gap between early-stage and late-stage valuations along with the higher number of unicorn startups, I believe that early-stage investing is the right strategy.
Why You Should Invest as a Business Angel and not in a Fund
Since we want to invest into early stage tech startups — due to the large value uplift potential, asymmetric risk/return potential and the hedge against rising inflation and interest rates — it is important that we determine how to best invest in the asset class.
There are two methods for investing in an early-stage startup: through a fund or through direct investment. In my opinion, the direct investment route is the ideal way for several reasons:
- There is empirical evidence that shows direct investments/angel investments can outperform venture capital (VC) funds. The Angel Resource Institute found that angel investors achieve returns on average of 2.5x Multiple on Invested Capital (MOIC), data further corroborated by the Kauffman Foundation. Pitchbook puts the average return of VC funds in the US between 2002 and 2013 at just 1.7x MOIC. There is similar data from a 2004 research paper from Weidig and Mathonet, showing that VC funds return 1.3x MOIC on average, while direct investments return 1.5x (the time period of their research likely including dot-com bubble write-offs).
- It is near-impossible to get investment allocation in the top VC funds that provide returns above the mean (think of the Sequoias and Benchmarks of the world). Most likely, out of all the possible VC funds available, your expected returns will be at or below average. If you still want to back a VC fund, I would recommend backing an emerging manager, as they tend to outperform.
- It is easier for angel investors to get allocation in hot deals. VC funds need to deploy large amounts of capital to make their economics work, and they often target a 10–20% stake. For angel investors, no limitations apply. You could invest varying amounts, whether that means $50k, 200k or $500k. In addition, if you bring added value, a strong reputation, and the ability to support the startup founder, you can likely get allocation to rounds most VC investors would not receive access to (albeit with a small check).
- Angel investors can also gain early liquidity through secondaries that drive up your Internal Rate of Return (IRR) and provide early liquidity for further reinvestment. VCs are usually precluded from secondaries as they are large shareholders whose actions bear important signalling.
- It’s more fun :)
How to Make Money as a Business Angel
Current empirical research depicts four primary drivers of success for angel investors, identified by Robert Wiltbank in his 2007 paper Returns to Angel Investors in Groups. If you invest in just 2–3 startups, your risk of catastrophic losses is high. To increase the odds of receiving a 2.5x cash-on-cash return in this early-stage asset class, experts recommend a portfolio of at least 10 investments, though we believe that 30 to 50 over a five year period is a more appropriate number of total investments.
As a side note, Alex LaPrade analysed how diversification affects returns using the largest available dataset from the Kauffman Foundation’s Angel Investor Performance Project (AIPP). The chart below shows the results with a portfolio size of at least 20 different companies, an investor earns a 99% chance to break even and a 67% chance of achieving a greater than 3x return. At the extreme, investing in 500 companies creates near certainty odds to break even and a 96% chance of a 3x return.
Beyond diversification, the other three factors that contribute to the success of an angel investor are due diligence, experience, and investor activity. Wiltbank found that doing proper due diligence (as in >40 hours per deal) had an average return of 7.1x MOIC. Investors who performed little due diligence earned just 1.1x MOIC. He also found that investors who had direct experience in the industry they invested in had a materially positive impact on returns. Finally, Wiltbank stated that investors who actively engaged with the companies they had a stake in could help increase the average return to 3.7x MOIC, a healthy increase compared to the 1.3x MOIC of investors who elected not to participate.
Operationalising Angel Investments
While diversification is an easy success factor for any business angel to optimise, due diligence and active participation require much more effort, especially for individuals who have not fully dedicated themselves to angel investing. Angel investors can mitigate these barriers and still earn the benefits of each return booster by joining an angel group. Angel groups have a leader who runs diligence efforts and acts as a sparring partner to portfolio companies, helping drive business growth and improved returns.
At 10x Value Partners, we run syndicates that allow accredited/qualified investors to participate in the deals we underwrite. We have a team of six investment professionals who perform due diligence on each deal and take active roles with our portfolio companies. If you struggle with dedicating the time needed to generate deal flow or perform due diligence, or if you do not have the minimum ticket size required for most deals (50k), diversification and high returns will be harder to achieve.
An angel group or angel syndicate can mitigate both these problems. The American Angel reports that nearly 90% of angel investors find investment opportunities through angel groups. Angel groups can help filter deal flow, run due diligence and also pool capital to jointly participate in the best deals.
The Polish VC Kogito Ventures stated the following seven benefits you can take advantage of by joining an angel group:
- Collective deal flow
- Access to larger deals
- Ability to build a wider portfolio
- Better due diligence
- Better value creation
- Shared transaction costs
- Great networking and knowledge sharing
Enter 10x Syndicates
I started 10x Value Partners as my personal venture studio, and I built it to focus on company building. Over time, as we realised gains through exits, we started doing more financially-oriented angel investments. Our friends and business partners saw our success, and many asked to participate in our deals. To facilitate the requests, we created Special Purpose Vehicles (SPVs) for pooling capital and it enabled us to accomplish more competitive deals. The club has grown over time and as of today, we have completed over 10 investments with a group of 50 investors.
After my research in early-stage angel investing and the financial environment of 2021 (low interest, high inflation), I have decided to scale the number of angel investments we make further. We have already expanded our team of investment professionals to up to six people to accommodate the influx of work. If you believe in the case I made above for angel investing, you can request more information about joining our angel investor syndicate here.
In the current environment of low interest rates and high inflation, the best investment to make is in high-growth companies, as rapid expansion can counteract the compression of multiples related interest rate increases. In particular, private early stage companies provide the best return potential and capitalise on the robust growth of late-stage valuations seen in recent years.
Accessing private companies is best achieved through direct angel investments, as they can provide better returns than a VC fund. To unlock these returns, diversification is key (one should invest in at least 10 to 20 different companies). Also, it is of great importance to do proper due diligence and provide value-add to any portfolio company.
If time and capital are limited, an individual investor can join an angel group or angel syndicate to participate in the asset class of early stage technology companies.
Epilogue: What to do Besides Angel Investing
Angel Investing should only be a small part of your portfolio allocation. Here are the next best investment opportunities:
- Invest in fast growing public companies: Take advantage of low entry barriers and low maintenance costs. You will assume some risk with short-term capital loss, but in the long run, most investments should be fine.
- Invest in a VC fund of funds or a private equity fund: Those investments tend to be less volatile and present a historical return of about 2.0x MOIC. Large entry tickets are required, typically $250k per deal. I put 10% of my portfolio in such funds for low-risk diversification.
- Invest in real estate: Real estate can function as a phenomenal investment in periods of high inflation. Rents tend to increase faster with inflation and you can short debt, which is also a great strategy in high inflation environments. Make sure you have a fixed rate mortgage rather than a floating rate linked to an interest index like LIBOR or something similar.
- Start or join a technology company to get company stock: It is easier than ever to raise funding, and company valuations can rise quickly. Founding a company is a good way to gain equity upside, but not as scalable as investing. 10x Value Partners can help you build your own company if this is the route you wish to go.
- Crypto: My view on crypto is that it involves a lot of gambling, but the odds are probably stacked in your favour. Only invest a small fraction of your portfolio and diversify. Try to hustle your way in early token sales. I have a friend who made more than $10m from this.