Angel investing is one of the most rewarding ways to participate in the start-up ecosystem. If you have the means, you can engage with founders in their earliest rounds, offering strategic advice and introductions. For some, Angel Investing is an art form that takes years to master. For others, it’s a numbers game.
Take Richard Moore, for example. Richard is the Deals Coordinator for Brisbane Angels, Australia’s most active Angel group. He’s made 50+ Angel investments in the past two years, earning him the award for Australia's most active Angel investor.
Richard presented at _SOUTHSTART’s Angel Investor Summit and spoke to a room full of Australia’s best and upcoming Angel Investors. His talk was an enlightening explanation of his sophisticated investing process.
Richard is a self-professed mathematician. His professional background includes work in funds management, derivatives trading and equities. Angel investing, to Richard, takes elements of both of these. Much like an out-of-the-money call option, early-stage start-ups are exceptionally hard to value. Much like a stock, narratives and stories sell way more securities than pure analysis. But it’s Richard’s perspective as a mathematician that has possibly had the greatest impact on his current investment strategy.
According to Richard, angel investing is a numbers game. “Two-thirds of the time, you will lose money. A quarter of the time, you will make some money, and 10% of the time, you’re going to make most of the money”.
Imagine you had a 10 sided die, which had zero on nine sides and a 30 on one of the sides. That’s what angel investing is like”, says Richard.
But, what if you keep adding new companies? If you make 30+ investments, the portfolio will deliver returns in a more consistent and predictable fashion, which Richard expects should be between 20-30% per annum. Not bad. Richard, like many of his kin, is playing a numbers game.
It’s now clear why Angel investors are, confirmed by their most active participant, incentivised to see as many deals as possible. They need to ensure their top-of-funnel is full and their due diligence process is fast and efficient. With less resources than a large VC firm, they often build structured processes using experience from previous successful investments. These ultimately screen out companies and focus investments with a perceived higher chance of upside.
The Strategy of Pattern Matching
Pattern matching is the process of identifying common traits in successful start-ups and filtering new opportunities for similar traits. Those dynamics can be anything, but often in the early stages are focused on the founding team experiences, industry, business model and rate of growth.
The assumption is that companies demonstrating these "patterns" have a higher likelihood of success. This approach is primarily used for deal screening, which helps investors decide if they’re interested in taking the start-up further.
This is where pattern recognition plays a role by helping to identify the characteristics that spell success. But does this strategy hold the key to the next big breakthrough, or is it potentially a double-edged sword that inadvertently perpetuates bias and screens out potential innovators?
Challenging the Pattern
At a later session during _SOUTHSTART’s Angel Summit, we heard from several investors who were challenging the status quo.
Nicola Hazell, founder of The Sunshine Effect and equality leader in the start-up ecosystem, joined the stage to offer suggestions. She argued the idea that although pattern matching is a valid strategy, investors should constantly adjust and reflect on their processes. Hazel felt that many investors may be inadvertently excluding founders from nontraditional backgrounds. To screening out businesses in new frontier industries.
While it's not fair to exclusively blame pattern matching for lack of diversity in the allocation of start-up funding, there is some merit to challenging how our earliest investors consider their investments.
According to Cut Through Venture’s 2022 report, only 10% of all capital went to start-ups with female founders. Double-clicking on this, only 3% of capital went to start-ups with an all female founding team. Cut Through also reported that the founding team was the top consideration for 84% of Australia's Angel investors. While Angels may not be the largest percentage of capital deployed into the ecosystem, they’re often a bridge into a venture capital firm that may have a later stage mandate and deeper pockets to go with it. For many start-ups, they’re the initial lifeblood that kicks off a business.
So, how can investors harness the power of pattern recognition while minimising the risk of perpetuating bias? One solution is to commit to a diverse portfolio of investments. This can be done by setting portfolio diversity goals and reviewing quarterly. Giant Leap has a great best practice policy available here.
Another suggestion was to review the top of funnel patterns and questions that investors ask. Are these questions perpetuating bias and limiting the type of founders or industry that will make it through to deeper due diligence?
However, the most poignant suggestion in the Angel Summit was for investors to develop a growth mindset. By embracing the reality that change is constant and that past patterns may not always hold true in the future. Australian Angels can avoid falling into the trap of rigid mental models that limit new possibilities. Having a malleable investing thesis and framework will allow Australia’s earliest investors to fuel frontier innovation, positive diversity and in many cases, outsized returns.