March 2009  
  
 _(This essay is derived from a talk at[AngelConf](http://angelconf.org).)_  
  
When we sold our startup in 1998 I thought one day I'd do some angel
investing. Seven years later I still hadn't started. I put it off because it
seemed mysterious and complicated. It turns out to be easier than I expected,
and also more interesting.  
  
The part I thought was hard, the mechanics of investing, really isn't. You
give a startup money and they give you stock. You'll probably get either
preferred stock, which means stock with extra rights like getting your money
back first in a sale, or convertible debt, which means (on paper) you're
lending the company money, and the debt converts to stock at the next
sufficiently big funding round. [1]  
  
There are sometimes minor tactical advantages to using one or the other. The
paperwork for convertible debt is simpler. But really it doesn't matter much
which you use. Don't spend much time worrying about the details of deal terms,
especially when you first start angel investing. That's not how you win at
this game. When you hear people talking about a successful angel investor,
they're not saying "He got a 4x liquidation preference." They're saying "He
invested in Google."  
  
That's how you win: by investing in the right startups. That is so much more
important than anything else that I worry I'm misleading you by even talking
about other things.  
  
**Mechanics**  
  
Angel investors often syndicate deals, which means they join together to
invest on the same terms. In a syndicate there is usually a "lead" investor
who negotiates the terms with the startup. But not always: sometimes the
startup cobbles together a syndicate of investors who approach them
independently, and the startup's lawyer supplies the paperwork.  
  
The easiest way to get started in angel investing is to find a friend who
already does it, and try to get included in his syndicates. Then all you have
to do is write checks.  
  
Don't feel like you have to join a syndicate, though. It's not that hard to do
it yourself. You can just use the standard [series
AA](http://ycombinator.com/seriesaa.html) documents Wilson Sonsini and Y
Combinator published online. You should of course have your lawyer review
everything. Both you and the startup should have lawyers. But the lawyers
don't have to create the agreement from scratch. [2]  
  
When you negotiate terms with a startup, there are two numbers you care about:
how much money you're putting in, and the valuation of the company. The
valuation determines how much stock you get. If you put $50,000 into a company
at a pre-money valuation of $1 million, then the post-money valuation is $1.05
million, and you get .05/1.05, or 4.76% of the company's stock.  
  
If the company raises more money later, the new investor will take a chunk of
the company away from all the existing shareholders just as you did. If in the
next round they sell 10% of the company to a new investor, your 4.76% will be
reduced to 4.28%.  
  
That's ok. Dilution is normal. What saves you from being mistreated in future
rounds, usually, is that you're in the same boat as the founders. They can't
dilute you without diluting themselves just as much. And they won't dilute
themselves unless they end up [net ahead](equity.html). So in theory, each
further round of investment leaves you with a smaller share of an even more
valuable company, till after several more rounds you end up with .5% of the
company at the point where it IPOs, and you are very happy because your
$50,000 has become $5 million. [3]  
  
The agreement by which you invest should have provisions that let you
contribute to future rounds to maintain your percentage. So it's your choice
whether you get diluted. [4] If the company does really well, you eventually
will, because eventually the valuations will get so high it's not worth it for
you.  
  
How much does an angel invest? That varies enormously, from $10,000 to
hundreds of thousands or in rare cases even millions. The upper bound is
obviously the total amount the founders want to raise. The lower bound is
5-10% of the total or $10,000, whichever is greater. A typical angel round
these days might be $150,000 raised from 5 people.  
  
Valuations don't vary as much. For angel rounds it's rare to see a valuation
lower than half a million or higher than 4 or 5 million. 4 million is starting
to be VC territory.  
  
How do you decide what valuation to offer? If you're part of a round led by
someone else, that problem is solved for you. But what if you're investing by
yourself? There's no real answer. There is no rational way to value an early
stage startup. The valuation reflects nothing more than the strength of the
company's bargaining position. If they really want you, either because they
desperately need money, or you're someone who can help them a lot, they'll let
you invest at a low valuation. If they don't need you, it will be higher. So
guess. The startup may not have any more idea what the number should be than
you do. [5]  
  
Ultimately it doesn't matter much. When angels make a lot of money from a
deal, it's not because they invested at a valuation of $1.5 million instead of
$3 million. It's because the company was really successful.  
  
I can't emphasize that too much. Don't get hung up on mechanics or deal terms.
What you should spend your time thinking about is whether the company is good.  
  
(Similarly, founders also should not get hung up on deal terms, but should
spend their time thinking about how to make the company good.)  
  
There's a second less obvious component of an angel investment: how much
you're expected to help the startup. Like the amount you invest, this can vary
a lot. You don't have to do anything if you don't want to; you could simply be
a source of money. Or you can become a de facto employee of the company. Just
make sure that you and the startup agree in advance about roughly how much
you'll do for them.  
  
Really hot companies sometimes have high standards for angels. The ones
everyone wants to invest in practically audition investors, and only take
money from people who are famous and/or will work hard for them. But don't
feel like you have to put in a lot of time or you won't get to invest in any
good startups. There is a surprising lack of correlation between how hot a
deal a startup is and how well it ends up doing. Lots of hot startups will end
up failing, and lots of startups no one likes will end up succeeding. And the
latter are so desperate for money that they'll take it from anyone at a low
valuation. [6]  
  
**Picking Winners**  
  
It would be nice to be able to pick those out, wouldn't it? The part of angel
investing that has most effect on your returns, picking the right companies,
is also the hardest. So you should practically ignore (or more precisely,
archive, in the Gmail sense) everything I've told you so far. You may need to
refer to it at some point, but it is not the central issue.  
  
The central issue is picking the right startups. What "Make something people
want" is for startups, "Pick the right startups" is for investors. Combined
they yield "Pick the startups that will make something people want."  
  
How do you do that? It's not as simple as picking startups that are already
making something wildly popular. By then it's too late for angels. VCs will
already be onto them. As an angel, you have to pick startups before they've
got a hit—either because they've made something great but users don't realize
it yet, like Google early on, or because they're still an iteration or two
away from the big hit, like Paypal when they were making software for
transferring money between PDAs.  
  
To be a good angel investor, you have to be a good judge of potential. That's
what it comes down to. VCs can be fast followers. Most of them don't try to
predict what will win. They just try to notice quickly when something already
is winning. But angels have to be able to predict. [7]  
  
One interesting consequence of this fact is that there are a lot of people out
there who have never even made an angel investment and yet are already better
angel investors than they realize. Someone who doesn't know the first thing
about the mechanics of venture funding but knows what a successful startup
founder looks like is actually far ahead of someone who knows termsheets
inside out, but thinks ["hacker"](gba.html) means someone who breaks into
computers. If you can recognize good startup founders by empathizing with
them—if you both resonate at the same frequency—then you may already be a
better startup picker than the median professional VC. [8]  
  
Paul Buchheit, for example, started angel investing about a year after me, and
he was pretty much immediately as good as me at picking startups. My extra
year of experience was rounding error compared to our ability to empathize
with founders.  
  
What makes a good founder? If there were a word that meant the opposite of
hapless, that would be the one. Bad founders seem hapless. They may be smart,
or not, but somehow events overwhelm them and they get discouraged and give
up. Good founders make things happen the way they want. Which is not to say
they force things to happen in a predefined way. Good founders have a healthy
respect for reality. But they are relentlessly resourceful. That's the closest
I can get to the opposite of hapless. You want to fund people who are
relentlessly resourceful.  
  
Notice we started out talking about things, and now we're talking about
people. There is an ongoing debate between investors which is more important,
the people, or the idea—or more precisely, the market. Some, like Ron Conway,
say it's the people—that the idea will change, but the people are the
foundation of the company. Whereas Marc Andreessen says he'd back ok founders
in a hot market over great founders in a bad one. [9]  
  
These two positions are not so far apart as they seem, because good people
find good markets. Bill Gates would probably have ended up pretty rich even if
IBM hadn't happened to drop the PC standard in his lap.  
  
I've thought a lot about the disagreement between the investors who prefer to
bet on people and those who prefer to bet on markets. It's kind of surprising
that it even exists. You'd expect opinions to have converged more.  
  
But I think I've figured out what's going on. The three most prominent people
I know who favor markets are Marc, Jawed Karim, and Joe Kraus. And all three
of them, in their own startups, basically flew into a thermal: they hit a
market growing so fast that it was all they could do to keep up with it. That
kind of experience is hard to ignore. Plus I think they underestimate
themselves: they think back to how easy it felt to ride that huge thermal
upward, and they think "anyone could have done it." But that isn't true; they
are not ordinary people.  
  
So as an angel investor I think you want to go with Ron Conway and bet on
people. Thermals happen, yes, but no one can predict them—not even the
founders, and certainly not you as an investor. And only good people can ride
the thermals if they hit them anyway.  
  
**Deal Flow**  
  
Of course the question of how to choose startups presumes you have startups to
choose between. How do you find them? This is yet another problem that gets
solved for you by syndicates. If you tag along on a friend's investments, you
don't have to find startups.  
  
The problem is not finding startups, exactly, but finding a stream of
reasonably high quality ones. The traditional way to do this is through
contacts. If you're friends with a lot of investors and founders, they'll send
deals your way. The Valley basically runs on referrals. And once you start to
become known as reliable, useful investor, people will refer lots of deals to
you. I certainly will.  
  
There's also a newer way to find startups, which is to come to events like Y
Combinator's Demo Day, where a batch of newly created startups presents to
investors all at once. We have two Demo Days a year, one in March and one in
August. These are basically mass referrals.  
  
But events like Demo Day only account for a fraction of matches between
startups and investors. The personal referral is still the most common route.
So if you want to hear about new startups, the best way to do it is to get
lots of referrals.  
  
The best way to get lots of referrals is to invest in startups. No matter how
smart and nice you seem, insiders will be reluctant to send you referrals
until you've proven yourself by doing a couple investments. Some smart, nice
guys turn out to be flaky, high-maintenance investors. But once you prove
yourself as a good investor, the deal flow, as they call it, will increase
rapidly in both quality and quantity. At the extreme, for someone like Ron
Conway, it is basically identical with the deal flow of the whole Valley.  
  
So if you want to invest seriously, the way to get started is to bootstrap
yourself off your existing connections, be a good investor in the startups you
meet that way, and eventually you'll start a chain reaction. Good investors
are rare, even in Silicon Valley. There probably aren't more than a couple
hundred serious angels in the whole Valley, and yet they're probably the
single most important ingredient in making the Valley what it is. Angels are
the limiting reagent in startup formation.  
  
If there are only a couple hundred serious angels in the Valley, then by
deciding to become one you could single-handedly make the pipeline for
startups in Silicon Valley significantly wider. That is kind of mind-blowing.  
  
**Being Good**  
  
How do you be a good angel investor? The first thing you need is to be
decisive. When we talk to founders about good and bad investors, one of the
ways we describe the good ones is to say "he writes checks." That doesn't mean
the investor says yes to everyone. Far from it. It means he makes up his mind
quickly, and follows through. You may be thinking, how hard could that be?
You'll see when you try it. It follows from the nature of angel investing that
the decisions are hard. You have to guess early, at the stage when the most
promising ideas still seem counterintuitive, because if they were obviously
good, VCs would already have funded them.  
  
Suppose it's 1998. You come across a startup founded by a couple grad
students. They say they're going to work on Internet search. There are already
a bunch of big public companies doing search. How can these grad students
possibly compete with them? And does search even matter anyway? All the search
engines are trying to get people to start calling them "portals" instead. Why
would you want to invest in a startup run by a couple of nobodies who are
trying to compete with large, aggressive companies in an area they themselves
have declared passe? And yet the grad students seem pretty smart. What do you
do?  
  
There's a hack for being decisive when you're inexperienced: ratchet down the
size of your investment till it's an amount you wouldn't care too much about
losing. For every rich person (you probably shouldn't try angel investing
unless you think of yourself as rich) there's some amount that would be
painless, though annoying, to lose. Till you feel comfortable investing, don't
invest more than that per startup.  
  
For example, if you have $5 million in investable assets, it would probably be
painless (though annoying) to lose $15,000. That's less than .3% of your net
worth. So start by making 3 or 4 $15,000 investments. Nothing will teach you
about angel investing like experience. Treat the first few as an educational
expense. $60,000 is less than a lot of graduate programs. Plus you get equity.  
  
What's really uncool is to be strategically indecisive: to string founders
along while trying to gather more information about the startup's trajectory.
[10] There's always a temptation to do that, because you just have so little
to go on, but you have to consciously resist it. In the long term it's to your
advantage to be good.  
  
The other component of being a good angel investor is simply to be a good
person. Angel investing is not a business where you make money by screwing
people over. Startups create wealth, and creating wealth is not a zero sum
game. No one has to lose for you to win. In fact, if you mistreat the founders
you invest in, they'll just get demoralized and the company will do worse.
Plus your referrals will dry up. So I recommend being good.  
  
The most successful angel investors I know are all basically good people. Once
they invest in a company, all they want to do is help it. And they'll help
people they haven't invested in too. When they do favors they don't seem to
keep track of them. It's too much overhead. They just try to help everyone,
and assume good things will flow back to them somehow. Empirically that seems
to work.  
  
  
  
  
  
  
  
**Notes**  
  
[1] Convertible debt can be either capped at a particular valuation, or can be
done at a discount to whatever the valuation turns out to be when it converts.
E.g. convertible debt at a discount of 30% means when it converts you get
stock as if you'd invested at a 30% lower valuation. That can be useful in
cases where you can't or don't want to figure out what the valuation should
be. You leave it to the next investor. On the other hand, a lot of investors
want to know exactly what they're getting, so they will only do convertible
debt with a cap.  
  
[2] The expensive part of creating an agreement from scratch is not writing
the agreement, but bickering at several hundred dollars an hour over the
details. That's why the series AA paperwork aims at a middle ground. You can
just start from the compromise you'd have reached after lots of back and
forth.  
  
When you fund a startup, both your lawyers should be specialists in startups.
Do not use ordinary corporate lawyers for this. Their inexperience makes them
overbuild: they'll create huge, overcomplicated agreements, and spend hours
arguing over irrelevant things.  
  
In the Valley, the top startup law firms are Wilson Sonsini, Orrick, Fenwick &
West, Gunderson Dettmer, and Cooley Godward. In Boston the best are Goodwin
Procter, Wilmer Hale, and Foley Hoag.  
  
[3] Your mileage may vary.  
  
[4] These anti-dilution provisions also protect you against tricks like a
later investor trying to steal the company by doing another round that values
the company at $1. If you have a competent startup lawyer handle the deal for
you, you should be protected against such tricks initially. But it could
become a problem later. If a big VC firm wants to invest in the startup after
you, they may try to make you take out your anti-dilution protections. And if
they do the startup will be pressuring you to agree. They'll tell you that if
you don't, you're going to kill their deal with the VC. I recommend you solve
this problem by having a gentlemen's agreement with the founders: agree with
them in advance that you're not going to give up your anti-dilution
protections. Then it's up to them to tell VCs early on.  
  
The reason you don't want to give them up is the following scenario. The VCs
recapitalize the company, meaning they give it additional funding at a pre-
money valuation of zero. This wipes out the existing shareholders, including
both you and the founders. They then grant the founders lots of options,
because they need them to stay around, but you get nothing.  
  
Obviously this is not a nice thing to do. It doesn't happen often. Brand-name
VCs wouldn't recapitalize a company just to steal a few percent from an angel.
But there's a continuum here. A less upstanding, lower-tier VC might be
tempted to do it to steal a big chunk of stock.  
  
I'm not saying you should always absolutely refuse to give up your anti-
dilution protections. Everything is a negotiation. If you're part of a
powerful syndicate, you might be able to give up legal protections and rely on
social ones. If you invest in a deal led by a big angel like Ron Conway, for
example, you're pretty well protected against being mistreated, because any VC
would think twice before crossing him. This kind of protection is one of the
reasons angels like to invest in syndicates.  
  
[5] Don't invest so much, or at such a low valuation, that you end up with an
excessively large share of a startup, unless you're sure your money will be
the last they ever need. Later stage investors won't invest in a company if
the founders don't have enough equity left to motivate them. I talked to a VC
recently who said he'd met with a company he really liked, but he turned them
down because investors already owned more than half of it. Those investors
probably thought they'd been pretty clever by getting such a large chunk of
this desirable company, but in fact they were shooting themselves in the foot.  
  
[6] At any given time I know of at least 3 or 4 YC alumni who I believe will
be big successes but who are running on vapor, financially, because investors
don't yet get what they're doing. (And no, unfortunately, I can't tell you who
they are. I can't refer a startup to an investor I don't know.)  
  
[7] There are some VCs who can predict instead of reacting. Not surprisingly,
these are the most successful ones.  
  
[8] It's somewhat sneaky of me to put it this way, because the median VC loses
money. That's one of the most surprising things I've learned about VC while
working on Y Combinator. Only a fraction of VCs even have positive returns.
The rest exist to satisfy demand among fund managers for venture capital as an
asset class. Learning this explained a lot about some of the VCs I encountered
when we were working on Viaweb.  
  
[9] VCs also generally say they prefer great markets to great people. But what
they're really saying is they want both. They're so selective that they only
even consider great people. So when they say they care above all about big
markets, they mean that's how they choose between great people.  
  
[10] Founders rightly dislike the sort of investor who says he's interested in
investing but doesn't want to lead. There are circumstances where this is an
acceptable excuse, but more often than not what it means is "No, but if you
turn out to be a hot deal, I want to be able to claim retroactively I said
yes."  
  
If you like a startup enough to invest in it, then invest in it. Just use the
standard [series AA](http://ycombinator.com/seriesaa.html) terms and write
them a check.  
  
**Thanks** to Sam Altman, Paul Buchheit, Jessica Livingston, Robert Morris,
and Fred Wilson for reading drafts of this.  
  
[Comment](http://news.ycombinator.com/item?id=506671) on this essay.  
  

