Are Angel Investors Primarily Attracted to Companies With a High Potential Return?

The question of whether angel investors prefer companies that promise a high return has been a topic of much discussion in the startup world. This article aims to explore the principles guiding angel investors' decision-making, using the formula proposed by Peter Thiel and the concept of power distribution as explained by David S. Rose.

The Investment Formula and Its Implications

One of the key arguments supporting the notion that angel investors focus on companies with high potential returns comes from the work of Peter Thiel. He introduced a simple formula to assess the net Return on Investment (ROI) weighted by the odds of success. The formula is:

R r1-q

where:

R is the net ROI weighted by the odds of success (q). r is the current ROI (return on investment). q is the probability of success.

Let's illustrate this with two examples:

Example A: r28, q0.1

In this case, the net ROI (R) can be calculated as:

R 281-0.1 1.9

Example B: r5, q0.9

Here, the net ROI (R) is:

R 51-0.9 4.4

While Example A has a much higher ROI, it also comes with a greater risk of failure. This means that Example B, which has a slightly lower ROI, is actually a better investment because it has a better chance of success.

The Concept of High Potential Companies

Another perspective, provided by David S. Rose in his book Zero to One, suggests that companies often exist at one of two extremes: they are either exceptional or unsuccessful. This concept of power distribution encourages investors to seek out the 'David' companies that have a high potential for success.

According to this theory, only a small percentage of companies have the potential to significantly outperform the market. Angel investors, therefore, focus on identifying and financing these high-potential companies.

The Dollar-Valuation Ratio: A Measure of Appeal

Angel investors are not just interested in the absolute value of the potential return. They are more concerned with the relative value. A company that exits for $10 million, for instance, may be an attractive investment if the angel investor invested a small initial amount, such as $50,000, in exchange for a 15% ownership stake.

Using the simplified example provided:

The company requires $50,000 to fund its operations until sale. The investor contributes $50,000 for 15% ownership. The company is sold for $10 million in 5-7 years.

In this scenario, the investor receives 15% of $10 million, or $1.5 million, on their initial investment of $50,000. This results in a 3 return on investment, making it a highly attractive proposition for any savvy angel investor.

The Role of Dilution and Growth

It's also important to consider the effects of dilution that angel investors face as the company grows, potentially reaching Series B fundraising. The initial 0.50 share holding might dilute to 0.25 by the time the company reaches Series B, but this can still result in significant returns if the company is successful.

For instance, if an angel investor's 0.25 share is worth $250,000 by Series B, and the company's valuation is $100 million, this translates into a vast potential return if the company exits at $100 million.

Conclusion

In summary, angel investors do indeed look for companies with a high potential to generate superior returns. However, they also consider the risk and the likelihood of success. The examples provided here demonstrate that while high returns are desirable, a smaller, higher-probability success can sometimes be even more attractive.

Angel investors invest with the hope of achieving massive returns but also understand the importance of selecting companies with a realistic chance of becoming successful.