Winning Angels: Insight Into Entrepreneurial Financing: Part 1: Sourcing
Sourcing is the first of seven in a miniseries that is aimed at exploring the fundamentals of early- stage investing. Sourcing refers to identifying entrepreneurial projects that represent potential upside value and positive future returns.
One way to think about sourcing is to consider it as an evaluation tool that actively manages a balance between quality and quantity of potential investment opportunities. Hence, fine-tuning a successful sourcing strategy can prove be a great competitive advantage. Additionally, a successful sourcing strategy should maximize the time investment necessary to sift through hundreds, sometimes thousands, of investments each year.
Generally speaking, weathered professionals agree that increasing the number of deals per year positively correlates and is statistically favorable to a successful strategy. In other words, the more deals an investor looks at, and subsequently undertakes, the higher the chance of success. This is especially true for new investors who might not be as effective at differentiating the good from the bad.
Let’s look at the numbers. “If you’re the best person going on these things, you’ll hit it out of the park 10-15% of the time. That’s one of the scariest things about angel investing” - Howard Tullman. Mr. Tullman is a prominent serial entrepreneur and venture capitalist. Considering these odds (10%), investment in one venture has only a 10% chance of success. Compare this with 20 deals and we get 88% statistical success rate for at least one of the twenty to “hit it out of the park”. Of course, it’s likely that more than one will be successful.
Statistical rate of success is useful for yet another important concept when it comes to sourcing a potential venture. Expected Value (EV) is important in determining the value of future return upon exit. Back to the 10% success rate: A venture valuation of $1M, if successful, is worth $100K. Investing more than $100K is statistically irrational.
“The best way to think about sourcing is to think about it as panning for gold. You need to sort through a lot of rocks to get to the nuggets” (Amis & Stevenson, 33) - by now this concept should easily make sense. With a relatively low chance of finding a big winner, successful investors carefully evaluate hundreds of opportunities to only select a few. Out of the few selected, even less will prove their worth.
Interestingly and somewhat counterintuitive at the same time, the pros seem to agree that, for new investors, failing beginnings are of higher value than being successful right from the start. The rational is based on the hard yet valuable learning experience via failure vs. getting lucky on the first deal. “Sourcing strategy should be based on fundamentals of good angel investing, regardless of whether you get it right the first time” (Amis & Stevenson, 57)
So what to winners do? The short answer is: it depends on the investor. Although the individual formula for success varies, many investors have some commonalities. The good ones prepare, and prepare well. Never go into battle without solid intelligence. This is one reason many recommend to invest in familiar industries. As such, personal experience is a huge factor and great personal asset to many investors. Successful investor poses the ability to formally or informally network within his/her domain. The spectrum includes investors that advertise, to ones that are simply known for what they do well – invest in successful companies. Visibility is an important component of networking. Some investors write books, e-articles, participate as speakers/gurus in various conferences, as well as other activities that demonstrate their personal acumen in the venture capital world. This technique will bring in more deals and potentially better ones also. Lastly, in order to increase chances of success, new investors align with and join other notable/proven investors. The learning experience alone is paramount.
Above all else, in a sea of prospects, successful investors are masters of managing quantity and finding quality opportunities of great value.
