Taylor: Lottery tickets and rat holes — all part of the game for angel investors

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This past week, I read “ Angel: How To Invest In Technology Startups — Timeless Advice From An Angel Investor Who Turned $100,000 into $100,000,000.”

First published in 2017, this book — by Jason Calacanis — still feels current. The author’s claim to fame in the angel investing world is built on backing Uber with $25,000 when it was worth only $5 million, operating in one city and with a few cars in its roster.

You can read the book in a few hours. Calacanis writes with a breezy, brash tone, recounting his successes and failures. He makes the case that anyone with a reasonably comfortable net worth could follow his path and advice to build extraordinary wealth through angel investing.

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Angel investing means funding untested startups, plunking down $25,000 to $250,000, in the hopes that those small companies will grow large enough to reap returns many times larger than one’s initial capital. Angel investors are passive, meaning they don’t run anything at the companies they back. They knowingly invest in risky ventures. The game, as Calacanis describes, is to make enough small bets on a sufficient number of plausible opportunities and funders that a few winners can compensate for the majority of investments, which will fail.

I liked a few things about his book.

First, he is realistic about the high probability of failure on any given investment. My favorite part of “Angel” is near the end as he recounts investments that went terribly wrong, despite great founders with a great initial concepts.

Calacanis describes key aspects of his businesslike approach to angel investing:

  • What due diligence can be done.
  • The four big questions to ask founders.
  • How to properly size your bets.
  • How to protect yourself in the case of success.
  • How to network professionally.
  • How to systematically track successes and failures.
  • How to learn from both results.

I especially like his advice regarding due diligence to shut up and let others talk, as you will become smarter and avoid being a nudge. (This is great advice for friendships, marriage and life in general.)

Calacanis makes the important distinction between founders who are delusional — a common and even useful trait in disruptive innovators — and founders who are fraudulent. While it’s sometimes not clear in advance where the line is drawn, it is clear that fraud will always lose you money.

Rat holes

When I was raising money from angel investors in 2004 for my own investment venture, a potential backer told me that he was in the habit of “throwing money down a rat hole,” a pungent description of his attitude toward backing me and others like me attempting to fund our startups.

“Throwing money down a rat hole” remains my favorite succinct description of angel investing.

My main objection to the premise of “Angel” is that Calacanis, having bought a winning lottery ticket in Uber, purports to teach others how to buy lottery tickets. There’s an attribution problem inherent in this thesis: Was he lucky or good?

He claims in his book that he was good and that others who adopt his methods can also find success. But I remain deeply skeptical that a “professional” approach to angel investing will be profitable in the long run for a majority of people. It is probably more useful to be lucky than good.

Playing a passive game

Michael Girdley actively engaged in angel investing from 2012 to 2020 and co-founded Alamo Angels, a San Antonio-based angel investing group. He now focuses more on control transactions through his holding company Girdley Enterprises and other partnerships. Why did he quit angel investing? He cited two reasons.

“Angel investing can be fun but also frustrating. In the end, you sometimes watch founders make mistakes, and you can’t force them to change,” he said.

The essentially passive nature of the game made him more interested in investing where he could more directly influence outcomes. While that takes more work than angel investing, getting active suited how he thought he could make money.

“With angel investing, you need to understand your edge,” Girdley said. “I’ve seen many get in trouble investing without a viable plan to win.”

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Lew Moorman, a fellow San Antonio-based member of Alamo Angels, also moved on to a more active role in growing companies. Today, Moorman is a founding partner of Scaleworks, a San Antonio-based company that invests in software-as-a-service companies.

Moorman is humble about his experience as an angel investor.

“I was no good at it. Startups are a crap shoot. And, when you can see how to fix things, you are under the delusion you can fix them,” he said. “You can’t. Founders are a crazy breed, and their belief is part of what you are betting on. So if you don’t believe in them and their approach, don’t invest.”

Moorman is not opposed to angel investing, but he strikes a cautionary tone for those tempted by a book like Calacanis’.

“It is a hard asset class, period,” he said. “Most angel funds deliver subpar returns. And they are full time focused on it. Can you do better? Unlikely. But, it is fun and exciting — so hard to not be drawn to it. So, if you want to do it, partner with someone knowledgeable and only invest what you could afford to lose. It could be a happy upside surprise.”

When I argue against Calacanis’ main thesis that “angel investing is for everyone,” I should note that I think angel investing is great overall from a societal standpoint. Creative destruction is a key element of capitalism. Backing untested ideas, trying and failing, getting lucky, innovation — the more we have of all this, the healthier the economy. An innovative and vibrant economy is built atop the ruins of failed startups.

As personal finance advice, however, Calacanis maybe should have more honestly named his book “Rat Hole?” Most of us can reap the social benefits of innovation without buying lottery tickets for our portfolios.

Michael Taylor is a columnist for the San Antonio Express-News, author of “The Financial Rules for New College Graduates” and host of the podcast “No Hill for a Climber.”

michael@michaelthesmartmoney.com| twitter.com/michael_taylor