DX Tips: The DevTools Magazine

DX Tips: The DevTools Magazine

So You Want To Be A Devtools Angel

Returns, failures, value-add, and other advice for new angels

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swyx
·Oct 16, 2022·

17 min read

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I've been running the devtools-angels group for a couple years, and have made over a dozen devtools seed investments including 5 that have been marked up to Series A or B, and 2 that have essentially shut down. I'm clearly no expert but I do see a lot of interest in angel investing from my network, and get questions about how to start every so often. Here's a grab bag of what I've learned and some thoughts for newcomers.

What is Angel Investing?

I have trouble explaining this because to a certain extent, if you don't already know from context/your own personal network/life experience, you probably shouldn't do it, for your own good. Seriously. There is very little investor protection here, you are swimming in the deep end, if you drown or are screwed over by unfair business practices nobody will cry for you. You do not get any sympathy points for being new at this.

But still - everyone starts somewhere, and often people get something out of me explaining things from first principles and adding context, so here goes.

Angel Investing isn't a legally defined term; it is a colloquial term for individuals investing (usually) their own money into startups, (usually) at a very early stage. To give you a picture, here are some of the most famous angel investments of all time:

The Math

Most modern angels bear as much resemblance to old school angels as chickens do to their dinosaur ancestors.

  • In the days of Markkula, Angels got their name because they historically swooped in to "save" or "breathe life" into the company at its earliest stage before any institutional capital would even take a look at them. These days, enough accelerators and preseed/seed funds exist, and there is enough interest in/knowledge of startup investing, that it is not nearly as dramatic.
  • What happens more often is that startups will secure a "lead investor" for their round, and then look to fill out the rest with small "strategic" angels like you and me.
  • Since "angel investing" has been normalized, these days we have developed new terms for the new, powerful "Solo Capitalist" individuals that are "superangels" (e.g. Dharmesh Shah, Nat Friedman, Daniel Gross) and "solo GPs" of their own funds (e.g. Brianne Kimmel, Elad Gil).

Some illustrative numbers:

  • Startup raising $2m for a seed round priced at $20m post money.
  • Lead investor commits $1m, smaller funds commit $0.5m, angels will fill in the remaining $500k with checks ranging from $5-100k. Sometimes you get SAFEs instead of valuation caps. Let's say you invest 20k, you now have 0.1% of the company.
  • Startup sees some success after a year, raises next round at $100m with 20% dilution. Your 20k is on paper worth ~80k. Not bad.
  • Startup is a hit after 3 years, gets to $1b with another 20% dilution. Your 20k is on paper worth ~640k. You start boasting about it to your friends and writing advice blogposts.
  • Startup goes into unicorn limbo for the next 5 years, never exits (too expensive to buy), never raises another round (growing too slowly), never turns profitable (never figured out unit economics). You realize your 20k is not yours and stop following the company.

From a personal finance point of view, Angel Investing is a very high risk, opaque, illiquid, and financially questionable approach.

  • Minimum investment: The legal paperwork and operational overhead isn't worth having you on the cap table if you are investing less than $5-10k (which AngelList RUVs are helping to bring down to $1k, but this is still not common enough in hot rounds).
  • Minimum diversification: Since X0% of startups die, achieving decent diversification means you probably want to spread your money across at least 10-20 companies per year
  • Countercyclical investing: You should want to invest more when the economy is doing poorly (nominally because valuations are presumably lower, but really because the people who start startups in recessions tend to be very determined).
  • Very long time horizons: You should be prepared for your biggest wins to take the longest lengths of time to return any money. Stripe has minted many paper multimillionaires, but has stayed private for >10 years. (You may be able to sell or borrow against your stake).

The points mean, from a portfolio standpoint, you need at least $50-200k in cash to invest each year and to have a very stable financial situation in a recession. You should also be prepared to look very stupid compared to peers who put that money on a house or a cryptocurrency instead and got higher returns than you while being more liquid. Estimates for average VC returns range between 15% and 57% a year, but the range is incredibly wide: Venture-capital funds typically have a 50 percent failure rate — half of the investments lose money, with half of those being total losses. The third quartile breaks even, or returns two or three times their money over five to 10 years. The real action is in their top quartile, which can generate return on investments of anywhere from three- to 1,000-fold (Uber from seed to IPO was a 5000x).

If you prefer a more personal account, you can read about an individual angel's perspective.

This sounds terrible. Why do it?

  • Because you want to be involved in a founding journey. Many of the best startup founders give regular updates to their investors on how things are going, and share their progress and problems along the way. This is essentially a very expensive paid newsletter, but I have learned a lot from investor updates. You can and should also try to build real working relationships with your founders, offering advice, feedback, connections, and other value adds.
    • I've also seen people convert themselves from angel investors to employees, which is (for individuals) the best way to double down on a winner because they were able to see growth numbers and understand the quality of the founder/idea before anyone else.
    • One popular caveat - it is debatable if angel investing helps prepare you to be a founder at all, since watching people do the job isn't really the same thing as just doing the job.
  • Because you really know something others don't. Maybe the founder is one of those people that you just know is going to be successful at whatever it is that they do and you want to be along for the ride. Maybe you're an expert in this industry and you just know that this new tech is going to take over the world.
    • Whatever it is, you have to be intellectually honest, because it is easy to fall in love with an ideal that hasn't yet met reality.
  • Because you want to give back to the ecosystem. This is where many founder-angels are, who have themselves benefited from great angels and now want to do the same for other founders. This not always an altruistic thing either - often as a founder-angel you are building alliances (that may lead to real business partnerships) and learning from other startups in your ecosystem that gives you useful information for your day job. Google, Stripe, Slack, Netlify, and even RedwoodJS have all established "venture arms" that do that at the corporate level, but founders themselves may also do it out of their own money.
  • Because you want to be a VC/Solo Capitalist in future. It probably helps to have some early investing wins that you can talk about in an interview/fundraising documents. In that sense, angel investing is actually a surprisingly cheap way to build optionality for a future professional investing career.

If you work as a senior employee in the startup ecosystem, there's an abstract but meaningful way in which you should regard your own work choices as angel investing your time instead of just your money. In a sense, where you choose to spend 40hrs a week with a 4 year vest/1 year cliff is the highest stakes angel investing you can do, particularly as your compensation starts to come more in equity than in cash. I have seen the effect of my own angel investing experience bleed into my own career discussions, where I started to be able to ask questions and have discussions that were quite frankly way above my level as an employee, because I was now thinking like an investor/company builder.

The Basics

This is ripped from my Q&A with a friend who sent along these questions.

  • It Depends™. Mostly, no. But some platforms/companies will ask you to be certified as accredited investor in the US (basically get a lawyer or accountant letter confirming you as such). Many will not.
  • Formal certification aside, you should know the SEC requirements for accredited individuals:
    • 1m liquid net worth
    • or 200k/yr income (if single, 300k/yr if married) for last 2 years
    • the full details have more nuance

Note that you do not always have to be an accredited investor to invest in startups. Reg CF opened up the channels for small (<5m) fundraises, and with them, the rise of crowdfunding platforms like Republic and Wefunder.

Just note the general rule that the quality of the investment opportunity does loosely inversely correlate with how easy it is for you to get in. The startup market has huge exceptions to the norm (where a monster idea is roundly rejected by investors), but is often surprisingly efficient.

Q: What kind of stake should I expect with a $5,000 to $25,000 investment? How do I evaluate this?

The stake depends approximately on what the valuation cap is, and more precisely the number of shares you have vs the fully diluted shares outstanding. If you put in 20k on a $2m valuation, you have 1%, 20k on $20m is 0.1%, and so on. The valuations for preseed and seed startups range wildly (2m to 100m), which is worth a separate article.

There is a school of thought that the valuation doesn't really matter, because you only get any money back if the startup is a success, and it's a binary choice between "a lot more" and "zero". As an angel, you are a price taker, meaning often the valuation is already agreed with the lead investor so you have no negotiation points here beyond a simple yes/no decision.

Q: How do I get started as an angel investor? I’ve heard of angel investor groups. Can they be worthwhile or a good place to start/learn?

Yes, mostly because you need a private place to share dealflow, discuss companies, and ask questions.

The Devtools Angels Discord is an invite-only group, but there are plenty of angel communities out there, not least AngelList and the Hustle Fund Angel Squad. Each city or vertical might have its own angel investment community if you are interested in local impact, however, the devtools industry in particular is usually SF- and online-centric.

Other ways to "learn" about angel investing and get dealflow:

  • Start a "paper portfolio". Evaluate early stage tools (I mean early - most people have no idea how bad early things can look) - not the big names everyone already knows, but the Show HNs, the "I hacked this together over a weekend" repos, the YCombinator Demo Days, the seed stage Techcrunch announcements.
    • You won't know the entry price, but take note of when you found them and your invest/no-invest decisions and why. (btw, many VCs hire based on this)
    • Check back every 6 months and try to understand/improve your "hit rate" (you also won't really know if they have a valuation markup, but you should develop the ability to understand if they have made significant progress since you "found" them)
    • The learning on this is still limited because you never put skin in the game, but the upside is you don't need anyone's permission or cooperation to do this
  • Get involved in a syndicate: Some very active angels also lead syndicates, where they get a larger allocation, more influence, and can get you invested in hot deals in exchange for taking 20% of your upside. Crowdfunding also fits here, but often the fundraising is less rigorous than in syndicate memos.
  • Cold email angels and ask for coffee chats: In general I myself don't really do this as it doesn't scale, but other people have different preferences (e.g. Christina Cordova famously does walking 1:1 advice convos) and it really is a great way to learn if you can make clear you're serious.
  • Do equity advising: Basically trade time for equity rather than money for equity, as a part tIme contractor. This is one way to have no cash downside while still getting to understand how to add value for founders at an early stage. The caveat to this is that most founders have been extremely jaded by equity advisors that ended up being huge disappointments, so you will have to work extra hard to overcome the industry bias.

Q: How do I find companies to invest in? How do they find me?

To start with you can simply announce to your existing network that you are now angel investing, and hope that message reaches the right ears. You can also add yourself to the various angel lists out there for people to find.

However, being one of many, many cash sources out there doesn't tend to lead to very good dealflow on its own. You will want to work on other ways to stand out and find the best startups before others:

  • Inbound (they find you on their own): Be such a well known domain expert in your field that founders naturally hit you up for advice, even without knowing that you are an angel investor. I don't know how much volume the top people have, but for what it's worth I do 1-2 casual advice calls a week with founders like this at my level, and usually they are one-off calls. I only bring up investment if I sense that it is on the table and we can have a meaningful ongoing connection. Clearly content marketing is the main way to improve inbound dealflow here - offer the most broadly applicable 80% of your insights for free online, and people will come to you for the remaining 20%.
  • Relationship based (they find you through others): As your angel career grows, your investing-specific network starts coming alive and VCs and founders will start sending deals to you simply because you are a known angel investor (who will make them look good by association). You will also want to do the same in return. I will say that the best founders also tend to make incredibly good angel investors, and have learned to take very seriously any referrals from good founders I already invested in.
  • Outbound (you find them): There are a few forms of this. You could see potential in a startup and reach out to enquire about their fundraising status. You could see business potential in an open source project and coax the project leads to start a company around it. You could see a huge opportunity in a market and nothing existing to solve it, and push a friend into starting to solve it. The more activist you are in the deal, the more you will have earned your right to be in the deal while also making it more likely that you've found an investing opportunity others may have missed.

One thing that is likely true is that there is no one "best" approach in all times. For every formula for success you can find someone else who did the opposite and still succeeded. Benchmark is famous for "thesis driven investing", a16z is famous for content marketing, lesser known firms like IA still return top tier results based on relationships. There may yet be other ways to change the game, for example YCombinator's accelerator reputation and EntrepreneurFirst's founder dating model gives them access to companies that would not form elsewhere.

A lot of this dealflow stuff is exactly the same as what professional investors do, except you are doing this on the side and they are doing it fulltime. So think about how you can find and create opportunities in a way that fits your expertise, network and resources, and collaborate, rather than compete, with the professionals.

Q: What happens after I write a cheque? What kind of communication/involvement should I expect?

It varies between founder and angel. It is usually agreed that the best founders often send frequent (~monthly) investor updates, but the correlation/causation isnt firm, and I've had some only essentially update every 6 months when they are launching stuff and they are doing just fine. 2 out of 2 of founders who ended up shutting down were more "radio silent".

The more interesting involvement (and the bulk of the value-add for small angels) is helping the founder on a 1:1 basis. A short list of things I have done:

  • upvote/retweet/comment on company blogs and launches on social media (this is regarded as the most useful thing you can offer, that is worth more than most VCs)
  • trying out beta product/features/docs and giving early user feedback
  • give feedback/ask questions on the investor updates
  • DX advising sessions on devrel/devcommunity/etc
  • pass along relevant, not-NDAed market intel on competitors and potential partners
  • introduce potential hires and media (podcasters, newsletter writers, etc)
  • explain the startup's vision and potential better than they can (essentially Packy McCormick's business model)

You can also think about Avichal's Level 1-2-3 angel framework:

One thing I've started doing is simply offering a standing calendar link to founders so they can book a chat with me anytime with no need for back and forth. Some founders use this occasionally, some don't. For weekly regularly scheduled chats, I've switched to equity advising since the time commitment is a lot higher but neither side really needs cash.

Q: What kind of timeframe should I expect to get any money back from a successful investment? Since we’re talking very early stage startups I’m guessing it can take a long time.

Yup. 3-5 years for a quick exit, 7-10 years is "normal", >10 if your startup happens to be extremely successful (and/or a zombie?)

Q: What about follow on rounds?

It's common for professional investors to have "pro rata" investment rights when the startup raises the next round, basically investing more money at the higher valuation, with the intent of keeping the same ownership percentage (or even increasing it). I don't get the sense that this is common for angels, but every time I've turned down a followon offer I have probably missed out on incremental gains.

The general argument for doubling down is that winners tend to compound and you as an early investor have a privileged abilIty to invest more. This is the generally accepted wisdom in professional investing for maximizing total dollar returns (usually invested out of a separate "growth fund" pool with a lower risk profile).

The more objective argument against doing this is that you are now probably investing more money than you initially invested, at the higher valuation, in such a way that if the startup then stalled, your initial seed-stage gains could easily be wiped out, much like a Las Vegas gambler doubling down after a "hot hand" and giving back all their winnings because they didn't know how to stop. Keep in mind that even unicorns and Series C, D and E startups can and do fail.

If your goal as an angel is not maximizing financial return (as it shouldnt be), then followon investment also means taking money away from other startups you could have invested in. So, as tempting as it is to say yes, I've tended to decline all such opportunities, with the full understanding that I may regret them.

The Most Important Part

This piece has mostly been an overview of angel investing mechanics and norms, however we've left out the most important piece, which is "deciding what's worth investing in". You probably want to stay away from playing pretend Shark Tank, and to take advantage of your domain knowledge/technical understanding to go deep on the quality of the idea, the size of the market, and the ability of the founders. This is essentially the real "secret sauce", that you'll want to develop on your own.

I probably shouldn't comment on the founder portion, but I have been thinking often about how every developer and investor needs to have a "Theory of Value of Software". If this is of interest, or you have comments you'd like me to include, please comment below.

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