I need to invest in something!

In the investment world, leaving your money sitting on the sidelines is pretty painful. If you could get 10%/y and instead you aren't invested, for every $1B you have sitting on the sideline, you are losing $100M/y. We wouldn't want that to happen.

As it turns out, the same problem exists for small investors. If I have $100K sitting in a bank account earning less than 1%/y and I could invest it in something earning 10%/y, I am losing $10K/y by sitting on the sidelines.

Angel investments, according to historical studies, earn something like 24%/y (9x in 10 years). Venture earns about 11.7%/y according to a venture investor I spoke with some time ago (3x in 10 years). So why wouldn't every venture firm go to angel investing?

Did I mention risk and liquidity?

One of the interesting things about statistics is that they do not apply to individual instances. That is, the average return is not the individual return. It turns out that in the angel arena, the average is higher because of the rare "unicorn" companies that return more than 30x the investment - about 4% of them, again according to historical statistics. In order to get the average, you need to invest in enough angel investments to gain the benefits of the law of large numbers.

Did I mention that these returns are for companies where the investors undertake good due diligence, invest in groups, and help the companies prosper? That means you need to spend time on each company making a reasonable decision about investment - unless you are part of a group - in which case you can share the workload.

And then there is the liquidity issue. Earlier stage investments don't show returns for a lot longer, and there is usually no way to sell your equity before exit. Early stage investments are typically 10 years to exit, while angel level averages in the 4-5 years to exit, and venture comes 1-2 years later.

The smaller you are, the harder it is to do this well, because you typically do not have enough buffer to wait it out for 5-10 years in case of an economic downturn or financial emergency. And it's a double whammy because you also cannot afford to invest in 50 companies at $25K/ea (1.25M) every year. So you have higher risks and less liquidity, but you can get higher returns - on average.

The law of large numbers applied

Here's a problem:

In other words, to use the law of large numbers (say one investment per week), you need to spend a lot of money (or time and effort) on each investment. That again favors investors who invest more in each opportunity, because the larger the investment, the lower the proportion required for due diligence.

Another strategy is to follow other investors. Just like the smaller earlier stage angel investors who work in groups to share the due diligence load, larger investors investing later, are benefitted because the percentage of investment spent in due diligence is lower.

How much time and rejections?

To do a serious due diligence (DD) on a company takes about 30 days (assuming the company is extremely cooperative and ready for it) and 5 experts (putting in 5-10 days each). If an expert being leveraged for a $5M investment costs $500/hr, that's 200 hours (minimum), or $100K per DD. Even if they do it for free, that's the effective minimum value involved. However, about half the DD efforts terminate early because of inadequate information or responsiveness, terms not being reasonably agreed, fatal flaws for the investor, personality conflicts, or other reasons. So the real cost is more like $75K/ea completed DD.

When looking at companies for investment, many of the applicants do not get funded by any given investor. In order for the investor to do sensible due diligence, they have to start by rejecting many of the applicants sooner rather than later. Otherwise, here's what happens:

As a result, in order to make sensible decisions, you need to do less diligence on more early stage rejections.

The investment sieve

The rational buying sieve for investment goes something like this (note the actual rejection rates and remaining potentials may vary significantly):

Number PhaseDescriptionCost
5000 LeadsCompanies apply for funding$1/ea = $5K
500 QualifiedMinimal qualifications of size, makeup, sales, type, etc.$10/ea = $5K
250 PitchesPitches and discussions started$1K/ea = $250K ($260K total to here)
200 Initial negotiations Initial pricing and related discussions $5K/ea = $500K ($750K to here)
100 DD performedDue diligence is performed with final negotiated terms determined$75K/ea = $7.5M ($7.75M total))
50 ClosedThe investment is made and all paperwork completed$50K/ea = $2.5M (~$10.5M total)

So the cost per investment for this sieve is about $10.5M/50 = $200K/ea $5M invested, or about 4% of invested capital. Of course this is only a theoretical sieve, and there are other costs of doing this sort of thing on an ongoing basis.

Also note the volumes involved. 250 pitches/year = 5/week, with the following weeks in initial negotiations. This will take a few administrative people to support as a full time activity. DD, at 30 days (minimum real time) taking 200 hours of people time (150 hrs average including drop-offs) done 100 times/year is 10 full time people just doing DD.

Again it's better for those who invest larger amounts. However...

Of course it can be more cost effective

There are several approaches that angels and smaller investors use to reduce the cost of diligence. These include, among other things:

The only approach I am aware of today for bending the curve on costs for medium and small investors is increased efficiency.

How many good investments per year are there?

And then we have the problem of finding thousands of good investments in any particular area of interest for mid-range investors. Of course it's easy to find people asking for money. But if there are say $100B available for private equity investments, and the average is $10M each, that means there have to be 10,000 companies suitable for making those investments. To be suited to making a $10M investment, a company has to be running in the range of at least $10M/y in most cases. There are exceptions of course, such as drug companies that are in FDA approval, but we will ignore those for now. These companies, to justify these investments, have to be able to expand by something like a factor of 2 every year for the next several years and either go public or be acquired by a larger company.

I couldn't find statistics on this very easily, but according to Pitchbook there are not enough of these. Instead, venture capital investors are investing larger amounts in fewer companies. 94 financings were for more than $100M in the first half of 2018, so that's $10B in less than 100 companies and, for the whole year, $20B in 200 companies. The total number of deals closed per year is dropping from 10,000+ in 2015 to more like 8,000 per year now. That matches up with the $20B out of $100B of investments going to the top 200 companies.

A strange situation indeed!

So there is a fundamental problem in the investment world that the cost of DD in the angel and lower venture range is less economically efficient, even though the returns from doing this are far higher in the long run.

And there is another major problem in that the 8,000 venture investments per year at the lower end (and the 10 times as many angel investments at the even lower end) require 8,000 (and 80,000) DD efforts that, even of done inexpensively, still cost $50K or more each. That's $400M+ in DD costs ($4B+ including the angel level) and more capacity than is apparently actually available to do the work.

Equity for diligence

And then we have the equity for diligence approach. In this approach, instead of spending cash for diligence, equity is spent. That is, if an investment is made, the DD team can be paid in equity rather than in cash, or in some combination of the two.

Here we run into a major issue, in that equity arguable means that the DD team has an interest in the company they are doing diligence on. Thus a potential conflict of interest with the company. If they give a higher valuation and a good report, they gain equity that may be able to be sold on the private equity market for cash. On the other hand, if they favor a company over others because of that equity, they are also betting on the company on their own. Thus they have an alignment of interest.

Of course all of this also relates to who pays for the DD. If the company pays for the DD, it is not "Due" diligence in that it is not independent of the company. If the investor pays, it is "Due" because it is independent of the interest of the DD team. Their interest stems from getting paid by the investor, as long as they get paid regardless of the outcome.

In summary

Investors have to invest or they are losing money relative to the opportunity they are missing. But better investment stems from better due diligence, which is the most expensive part of investment. DD alone is worth 6% or more of the investment value for small investment amounts, and 2-4% for investments on the order of $10M. But even doing DD is hard to accomplish because of the volume of investment and the amount of money on the market.

The combination of the need to get money working and the limitations of DD are working to drive up the size of investments and drive down the number being undertaken. It is also driving valuations even at the bottom of the market, where people putting in time must work on higher valuation investments to justify the sweat equity they are putting into the process. People doing the work at the bottom of the market are also being exploited by those at the top of the market, which is to say, the rich get richer. Hardly a surprise...

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