Is angel investing upside down?

As far as human memory reaches back, rich people have always financed the wild ideas of all sorts of inventors and artists. Today, it is called “angel investing,” and as one might guess, it became a complicated or, to be precise, bureaucratic process. A new book by Alejandro Cremades, “The Art of Startup Fundraising,” intends to help business founders to get through this maze. Mr. Cremades can be considered an industry insider; he founded Onevest, a successful online platform for matching startups with angel investors. He preliminarily addresses his book to young people starting their first business ever; hence, he sprinkles it with a lot of basic common-sense business advice. His paternalistic tone can be a little annoying sometimes to readers with some business experience. On the other hand, the author provides comprehensive insight into the fundraising process, with many helpful details, which made reading the book worthwhile.

Obviously, one may ask why the fundraising for a startup became so complicated, and does it have to be this way? Mr. Cremades does not have this kind of seditious thoughts. Eight years ago, as a young man he arrived in New York from Spain; he figured out how things are done here; he mastered it and wrote a book about it.

My experience has been drastically different. Almost exactly 30 years ago, 11 months after arriving from Poland, I started my first small service business in Chicago. I had no money, so for the first few months I barely survived from job to job. Then, one of my customers gave me a big job that kept me going for the next few months and allowed him to make some profit, as well. As a result, he offered to help me financially in exchange for 50% equity in the company. In the following few years, when needed, he wrote several checks. Also, he brought me a few good customers and helped with advice, when asked. We cashed out 10 years later, splitting the money 50/50. His return was about $5 for each dollar invested. That is slightly above the $4 that, according to Mr. Cremades, angel investors average now. But we did not call it an angel investment then. We did not spend thick thousands of dollars, which, according to Mr. Cremades, one needs to spend to prepare a company evaluation, financial reports, term sheets, and other documents. We spent nothing because the whole deal was made on a handshake; nothing was ever written on paper.

Obviously, it is unrealistic to expect that most angel investment deals would be sealed by only a handshake, but I recall that many other businesses I knew received seed funding in a similar manner. I do not hear about this kind of arrangements anymore. Maybe I do not ask the right people, but it could be as well that the financial strength of the middle class has diminished. There are fewer people having extra cash to invest, and those who do are less inclined to fund risky startups. The organized angel investing filled the gap, with a whole network of intermediaries and advisers around them.

I am familiar with this new industry also because I have a startup seeking funding, unsuccessfully so far. I realize that my critique of the system of angel investing, as presented by Mr. Cremades, can be interpreted by some as colored by my personal negative experiences. Nevertheless, I decided to share my comments, as they might supplement the book for its most likely readers, business founders who still seek funding.

Angel investing is the very essence of the capitalist system. An affluent individual seeks the next big investment opportunity. In order to maximize the profit, this individual hunts for the most innovative idea. The individual’s investment decision is based more on the strength of the idea and the belief in the entrepreneur’s ability to pull it off than on the formalities. If an investor gets lured into a promise of converting lead into gold, his or her investment is lost. If repeating this kind of mistake, this individual is out of the angel investing.

As a remedy, angel investors form groups, either less or more formalized. The thought is that with more eyeballs looking, it is easier to sort out obviously bad deals. Also, less skilled investors, or those simply not having enough time to evaluate the investment, can join those who are more experienced in picking startups that are worth investing in. As a result, more capital is available for startups. The reverse side of this rosy picture is that, to a lesser or greater degree, the group makes decisions collectively. In order to lower the risk, commonly, these groups do not fund startups in the conceptual stage. They tend forgetting that the simplest way to kill a good idea is by forming a committee. If someone is the next Steve Jobs in the making, has a concept of the caliber of the next iPhone and seeks seed money to build a prototype, this person will be turned away by angel investor groups. She will be told to come back when there will be some traction. It is beyond their comprehension that if somehow she builds this prototype, she might not need to call them; she might be even too busy to answer the phone if they would call her. Unfortunately, “The Art of Startup Fundraising” is of little help to an entrepreneur in this predicament.

In their talk, angel investors always stress that they look for the next Facebook kind of a startup, which will bring a return in the range of $100 for each dollar invested. If a startup with this kind of potential is fortunate to get some momentum by bootstrapping or thanks to money from founders, it does not need advice from Mr. Cremades, as most likely it is expediently funded by the first angel investor group it approaches. This takes it out of the market almost immediately. Consequently, most of the remaining applicants for angel investments who meet the basic criteria are mediocre business propositions. The book by Mr. Cremades provides many helpful hints for startups in this category. The author implies that, on merit, most of the startups in this group are of a similar value proposition; consequently, the art of getting funded relies on the effectiveness of the sales tactics.

This puts in question the logic of the whole system that Mr. Cremades so diligently describes. It is just good luck when a startup with a strong idea, which got some traction on its own, knocks at the door of a given angel investor group. As long as the investors do not drop the ball, their high return is almost certain. Any of the remaining crowd of mediocrity unlikely will bring a 100:1 return, or it is a fluke if it does. Where can angel investors search systematically for their dreamed-of 100:1 return potential? They should look exactly where they are not looking, in the pool of startups in the conceptual stage that are seeking seed funding. This is where they will find the diamonds that the sieve of the current system is letting slip through.

Following this approach would mean turning the current system upside down. The problem is not with founders not dancing properly around angel investors as Mr. Cremades assumes. The problem is with angel investors who do not have perseverance in hunting for the business opportunities before they reach the stage where it is a no-brainer to see it. A founder is most likely good at whatever his or her business idea is. He or she most likely has very little experience with the funding process. The question is whether he or she should. On the other side of this equation, angel investors do nothing else but funding startups. Should not one expect that they have mastered the art of finding startups worth investing in? After all, their money is at stake.

Those rebellious thoughts came to me gradually during my interactions with angel investors and a variety of intermediary and training organizations. The book by Mr. Cremades gives me a good inside view from the other side of the same coin. I found it worthwhile matching its yin to my yang.