Top Angel Investors Reveal Their Secret Sauce

Angel investing is a field rife with uncertainty. Writing cheques to literal nobodies with the hope that their startups will flourish someday is risky business. However, some investors seem to get it right, doing significantly better than their peers. What's their secret? Have these people discovered a winning formula that helps them spot the most promising startups?

It turns out that successful angel investors have developed straightforward rules of thumb to inform their decision-making and stuck to them no matter what. Luckily for us, these people are not reluctant to talk about their thought processes, giving us a glimpse into the reasons for their continued success. Here is a look at the three most important parameters high-performing angel investors put a special emphasis on:

Market—Look out for a tide that will take you far

There are several parameters angel investors take into consideration while deciding whether to put money into a project. The founder, his team, and the idea undoubtedly play significant roles in this decision. However, what angel investors care about the most is the market. Andy Rachleff, formerly of Benchmark Capital and now the executive chairman of Wealthfront Inc., sums it up the best:

• When a great team meets a lousy market, the market wins.
• When a lousy team meets a great market, the market wins.
• When a great team meets a great market, something special happens.

One of the first questions angel investors ask a founder tends to be the size of the "total addressable market." Founders can earn brownie points if they can provide figures proving that there is a sizable, underserved market when they are asked this question. A startup entering an uncontested market space ("blue ocean") and leveraging a current trend to gain an exceptional boost, just like a surfer catching a wave, is sure to intrigue angel investors.

The reason why angel investors put so much value on the market has to do with Power Law. They are looking for the next iPhone or Zoom, something that will revolutionize an industry, become an integral part of people's lives, and earn its investors an enormous return on investment while most of their portfolio generates losses. Ron Conway predicts the failure rate of angel investors at 40 to 60 percent. To compensate for that high risk, he chose to invest in internet technology in the early 90s, hoping for growth at thousands of percent a year. Conway always goes for the big hit because once you score it, "you start playing with house money."

This is typical angel investor behavior: Spreading the wealth over a wide range of investments and shooting for a few big hits that can cover the losses in the majority of investments and result in a sizable profit. With the internet and software becoming almost traditional sectors no longer offering the returns they did in the past, angel investors are looking for the next big market. That's why investors like Peter Thiel follow the same pattern, investing in utopian projects in budding sectors like biotech, nanotechnology, space exploration, and robotics.

Speed—Be ready to act

Angel investing is a race against time. An angel investor spends her days meeting founders, listening to pitches, making decisions as to whether to write a cheque, and then moving on to the next project. Repeatable success in this kind of endeavor takes a methodical approach and a lot of preparation to speed up things.

Michael Seibel advises fellow investors to study prospects beforehand so that they can always be ready and make decisions quicker. As the investments you made a couple of years ago mature and either fail or succeed, you must move forward with new investments that will hopefully pan out in a few years. Therefore, there needs to be a deal flow and a steady supply of projects coming your way so that you won't spend your time looking for new projects. Seibel writes his friends a cheque to create that flow and avoid FOMO (fear of missing out) at the same time. And he is all the more wealthy for it.

FOMO features heavily in Pejman Nozad's thought process, too. That's no surprise considering that the Iranian-born investor missed out on a chance to invest $50,000 in Facebook at around $80 million valuation in July 2005. Nozad passed on the deal because the two sides couldn't agree on the terms of a 5-year lease agreement involving an office Facebook would rent from Nozad's company. Nozad must have had many sleepless nights talking to himself about "shoulda, woulda, coulda." He now believes that an angel investor should go ahead and invest in a deal when he feels it is the right thing to do:

"If you met an exceptional outlier, those outliers who are actually from Mars, do not overanalyze the situation. Just get on the rocket ship and go."

Ali Partovi, who had an enviable track record of investments in Facebook, Dropbox, Airbnb, and Uber, agrees with Nozad's point and expresses his conviction in even more serious terms:

"When you have a strong intuitive feeling, you should go with it. This industry is not very sympathetic to people who hum and haw and take a long time to make decisions."

Taking weeks to make decisions hurts your reputation as an investor. It reduces your chance of getting good deals because founders take note when they are taken for a ride.

Reputation—Play the long game

One of the most reliable ways to secure a deal flow, as Michael Seibel suggests, is to ensure that your reputation is untainted. Smart angel investors who realize that they are in this for the long-run act accordingly.

Aaron Harris, an entrepreneur and investor who was a Y Combinator partner for more than seven years, argues that an impeccable reputation is a must for a chance to invest in the hottest startups. Harris draws attention to a virtuous cycle of reputation: A good reputation helps you create a good deal flow, giving you a better chance to invest in better startups, which brings about more success and breeds a better reputation.

Reputation is an investor's scorecard, the end result of all his deeds, good or bad. Building a good reputation requires doing the right thing for a long time, even if that might hurt one's short-term interests. It entails small things like being on time when you meet a founder, or when you reject an entrepreneur, doing it with quality and telling them why, as Ben Horowitz suggests.

Aaron Harris warns against petty maneuvering in the last phase before a deal. Sometimes angel investors may make outrageous last-minute demands after an agreement is reached. This puts the founders in a dilemma between giving up something they shouldn't be giving up for the sake of getting the deal done or not raising money at all. However, Harris believes the hit an angel investor's reputation suffers from such a move is not worth the tiny gains achieved. Geoff Ralston puts it even more succinctly:

"Don't be pennywise and pound foolish."

Do not take advantage of entrepreneurs. Do the sensible thing and think of your investment as a long-term partnership. Nurture that relationship. Look for ways to contribute by helping the founders hire people to plug in the existing skills gaps, mentoring them in the day-to-day running of operations, and introducing them to other investors.

Final thoughts

The angel investor role is a synthesis of a visionary; a shrewd, hard-working business person; an understanding friend; and a candid mentor. You know the happy-go-lucky angel investor archetype, right? The one that virtually stumbles into good deals and tells funny stories about them later. It could not be further from the truth. Luck may play a role, but it's not any bigger than what Louis Pasteur assigned to it when he said, "Fortune favors the prepared mind." The best angel investors find a way to be prepared at all times.