you might consider if you wish to invest in small unquoted companies without the same level of risk and involvement. These are discussed later in the chapter.
Portfolio considerations
Before you make unquoted investments you should give serious thought to the importance of spreading your risk through a portfolio rather than making one or two isolated investments in an unstructured way.
Modern portfolio theory
Modern portfolio theory (MPT) is one of the most influential economic theories about investment returns. It was first published in 1952 and has been widely used ever since. It addresses the concept of spreading risk through several investments and was developed for investors in quoted stocks who invest in large markets with many investment opportunities.
The theory says that it is not enough to look at the expected risk and return of one particular stock. The risk with each individual investment is that the return will be lower than expected. The risk in a portfolio of diverse individual stocks will be less than the risk in holding any one of the individual stocks.
MPT quantifies these benefits mathematically but put simply the theory argues for not putting all of your eggs in one basket, which brings us to the angel investor.
The relevance of the theory to the angel investor
Earlier in the chapter, I drew attention to angel investment returns reported in an academic research study. That data, together with my own simple analysis of the enhancement to investment returns from use of EIS tax reliefs, showed that angel investing can make attractive returns.
However, 56% of investments in that study failed to return the amount invested and most of those lost it all. At the other extreme, around 10% of investments returned more than ten times the amount invested. This means that 80% of the total cash flow from the investments came from less than 10% of them. If the angels in the research sample had known which investments would return more than ten times their money they would not have made the others.
These results starkly illustrate just how hard it is to pick winners and that money needs to be spread across a number of ventures to have a decent chance of enjoying an attractive overall return.
It is clear then that you must spread risk by investing in a portfolio of opportunities if you want to make an attractive overall return with a minimised risk of losing all your money, which is exactly what MPT says you should do.
How big should a portfolio be?
How many investments?
The range of possible returns on a single investment is from zero to ten or more times the money invested, with perhaps only 10% of investments achieving the highest returns. So a sensible strategy is to invest in at least ten ventures and to invest roughly equal amounts in each.
How much to invest in each?
Alongside the decision to diversify your risks, you need to give thought to how much you are prepared to invest in your portfolio. As part of this thinking you should consider the difference between the amount you invest and the net cost of that investment after tax reliefs, as it may well influence the decision on the amount you invest.
For example, you might decide you are prepared to invest a total of £250,000 before tax reliefs. That will cost you £175,000 after upfront EIS income tax relief of 30%.
However, if you had paid capital gains tax at 28% in the preceding three years or are expecting to do so in the next 12 months, you can claim capital gains tax rollover relief as well. That might reduce the upfront net cost of the investments by a further 28%, or from 70% to 42% of the amount invested.
So were you to decide to make approximately ten investments with your £250,000 that would imply a unit investment size of £25,000 at a net cost of £17,500 per investment without rollover relief and £10,500 with it.
However, you also need to plan for further investment rounds. There are lots of good reasons you might invest more in your developing portfolio and sometimes you have little choice unless you are prepared to accept a complete write-off. If your total risk amount before tax reliefs is £250,000 you might put aside from £50,000 to £100,000 to invest in further rounds. This could reduce your typical initial investment unit to £15,000.
If, on the other hand, you decided to risk £250,000 net of upfront tax reliefs and you can claim rollover relief the unit size could rise to over £35,000 (£15,000 divided by 42%) on the same analysis.
Whether to invest more
As the ventures develop and ask for more money, there are easy decisions such as how much to invest in a rights issue when the venture is developing well. There are also hard decisions, such as do you invest more in a venture which has missed its plans and needs more money just to survive?
The decision to invest more and still see the venture fail – the good money after bad scenario – clearly lowers returns in a portfolio.
It is always easy to invest more. The company executives argue passionately that they will achieve success with just one more round of investment and the investor wants to believe them or he loses all his investment. The decision is made harder if the investment terms are such that those who don’t invest are effectively diluted to valueless stakes – this is often referred to as the wipe-out or put up or shut up round.
Other portfolio issues
Alongside a plan to offset the high risks of any one venture by building a portfolio, you need to be clear about sector and stage of investment.
You might decide to only invest in software because you understand it. Whilst your risk would then be concentrated in one industrial sector, that may be more than offset by your sector knowledge, your ability to do due diligence and to understand exit valuations, and the possibility of adding value post investment.
On the other hand, you may decide to invest across a number of sectors of which you have no intimate knowledge. In that case, one way of offsetting risk is to only invest in companies that are already established with customers and revenue. Another is only to invest alongside people who do understand the sector.
It goes without saying that the earlier stage that a venture is at, the higher the risk of failure and vice versa. Though if an established company has large amounts of debt it too can be in the higher risk category.
Time spent deciding how much to invest, in how many companies, at what stage of development and in what sectors is time well spent. As is reviewing this profile from time to time.
Other approaches to investing in unquoted companies
You may decide that being an angel is a step too far for you but you still wish to have exposure to unquoted companies in your portfolio. Or, as an angel, you may want to diversify the risk in your unquoted portfolio with some fund investments.
In either case, there are many opportunities to invest which are less time consuming than angel investing – though also much less fun and satisfying.
