Wednesday, April 28, 2010

Is Angel Investing In A Bubble?

(image appears courtesy of Aeioux)

I've done about 10 angel investments in the past couple of years, and there is definitely a trend towards higher valuations and more competitive deals.

The problem is that every investment asset class obeys Newton's Law: "For every action, there is an equal and opposite reaction."

The logic many follow goes something like this:

1) As an asset class, angel investments have delivered a great historical return.

2) Therefore, we should allocate more funds to angel investing.

The result is more money chasing the same number of deals, which changes the valuation equation. Deals are getting done at higher valuations.

But hey, you may say, even if company valuations are up, if you exit for $200 million, does it matter whether you paid a $2 million or $4 million premoney?

Unfortunately, the answer is yes. If you pay twice the price for an asset, for the same eventual exit, you're cutting your returns in half.

If the premoney valuations double, that attractive 20% long-term annual return that angel investments returned suddenly turns into a much-less-interesting 10%.

My response has been to be extremely disciplined at passing on deals, even attractive ones, if the valuations exceed the traditional limits of seed stage investments.

I predict that those who do not follow the same discipline will eventually come to regret that decision. To quote Casablanca, "Maybe not today, maybe not tomorrow, but soon and for the rest of your life."

(originally posted as a comment on this GigaOm post)