Follow-on Funding: A Dilemma for Angel Investors

Bill Payne , Angel Investor , Frontier Angel Fund

31 Jan 2012

In 2007, Professor Rob Wiltbank reported in Returns to Angel Investors in Groups that angel investors made follow-on investment in about 30% of their invested companies. It was surprising for me to learn that follow-on investments correlated with lower returns, that is, angels that made follow-on angel investments saw returns of 1.4X their investment, while those that did not make follow-on investments enjoyed 3.6X returns.  The time to exit for both groups was similar.

Frankly, the conclusion that angels who make follow-on investments can expect lower returns is distressing to me.  At a time when venture capital, on average, has moved to later stage investing, angels need to plan on making multiple investments to help startups survive to positive cash flow and eventually to exit.  Fifteen years ago, angels typically invested $250K to $500K in startup companies while the average venture capital investment was $2-3 million.  As we saw in Average Round Size in Angel Deals, the average angel investment is now about a bit over $300K but venture capital is now investing $7-8 million per deal.  While it may not have been true in the past, angels now need to provide startups with enough runway to get to positive cash flow, to venture financings or to an early exit through several rounds of angel capital.

How does a “one and done” investment strategy by angels provide higher returns?  I think there are several contributing factors, such as:

• There are a few angel funded deals that take off so quickly that the startup entrepreneur can easily raise $5 million or more in venture capital in the next round.  These deals are likely to provide early investors with very high returns.
• On the other hand, too many of us angels “throw good money after bad,” that is, we don’t pull the plug early enough.  We become convinced that our funded startup is just about to turn the corner…when they really aren’t.  So, we fund the company a second or perhaps even a third time before we acknowledge that the company simply cannot be successful.  These follow-on investments have a significant negative impact on portfolio returns for angels.  And, candidly, this is an important area of improvements for angel investors.
• Some angels invest in only one early round of funding, strategizing that the early rounds provide the highest returns.  Investing in later rounds only reduces the total return from any single portfolio company.
• Lastly, some angels choose to invest in more companies rather than multiple rounds in the same company.  With a fixed amount of capital reserved for the angel asset class, these investors look for improved returns through a diversified portfolio.

Acknowledging the results of the Wiltbank study, the reality of angel investing today is that we can expect to provide multiple rounds of investment for new ventures.  Without multiple angel rounds, startup entrepreneurs simply cannot hit the milestones necessary for either an early exit and venture funding. We angels need to be more diligent before providing second and third round funding to startups with little chance of success.  More objective due diligence on portfolio companies prior to second or third rounds of angel investment has become a best practice for higher angel returns.

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