Find your investment sweet spot.
Going wide or narrow.
🖖 Welcome to Closing The Gap by JVH Ventures. After founding multiple companies, investing directly in 50+ startups and 10+ funds, we realized that a common understanding between founders, angels, and VCs is often missing.
We want to close this gap and combine perspectives from all sides.
Our goal is to look behind closed curtains and tell the honest truth.
Follow along to gain insights from all directions!
Over the last weeks, we already discussed some fundamentals of portfolio building for angels, especially determining a matching ticket size for the portfolio. While following the power law is definitely one option to maximize returns, there are of course others paths successfully followed by angels.
Most angels are former entrepreneurs, which are driven by entrepreneurial passion and involvement. They come from a certain industry, with a certain set of expertise, which most often enables a quick start due to incoming deal flow and fast, experienced decision-making capabilities. After their first investments, they want to be involved and contribute with their unique skills and knowledge.
However, this approach limits you to your own area of expertise and hence also to a smaller investment scope. Is this really a smart approach for angel investments? When it comes to building your investment strategy (and the corresponding portfolio), one of the first questions you need to answer is if you should go wide or narrow with your investment sweet spot.
First, let’s look into both approaches and compare them.
Going narrow
This might be the most intuitive way for new angels to start: You specialize in specific sectors, technologies, geographies, business models, etc. Going narrow implies that you set yourself restrictions and only focus on a certain topic with your startup investments, while neglecting everything else.
Advantages:
Targeted network building: Building a network in depth is difficult. So building a strong network within a niche can be an effective and efficient advantage. It will grant you better access to deal flow and also leverages better portfolio support after you invested.
Reputation and track record: Being known as an investor in a particular field can make you the go-to person for startups seeking knowledgeable and influential backers. In turn, your reputation and brand is probably the most important deal flow factor next to your network.
Streamlined due diligence process: Familiarity with the ins and outs of a specific sector can make it easier and faster to evaluate new opportunities.
Strong portfolio synergy: Investments within the same sector or stage can benefit from each other, through partnerships, shared resources, or collective problem-solving.
Focused expertise: As discussed in depth here, expertise can be a double-edged sword. However, in specific contexts, deep understanding of an industry can enhance the quality of due diligence, helping to uncover risks and opportunities that others might not see.
Disadvantages
Sector-specific risks: A downturn in a specific industry could negatively impact the entire investment portfolio, unlike a diversified investment approach.
Constrained deal flow: Specialization can mean seeing fewer deals, potentially leading to longer periods between investments and fewer chances to invest. Here you need to be patient and wait for the big opportunities to occur.
Insularity: Focusing on a single sector can sometimes lead to an echo chamber effect. That means you are not exposed to diverse ideas and may become resistant to innovations that fall outside your comfort zone. In addition, the whole sector faces a risk of becoming disrupted from the outside as well.
Opportunity costs: This one is obvious, but focussing a lot on a niche, will make you miss-out potential groundbreaking developments and investments.
Going wide
A wide investment sweet spot is basically the generalist approach to angel investing. You remain open to explore a variety of sectors, business models, etc. While most of the advantages and disadvantages are the exact opposite, there are some specific points to consider.
Advantages
Portfolio diversification: The obvious one: Investing across a spectrum of industries and business types will distribute and mitigate your risk.
Educational breadth: Exposure to a broad range of business ideas, models, and entrepreneurs offers a rich learning experience that grows your ability to spot potential in unexpected places. In addition, you remain open to change and “strange” startup ideas that might become the category leaders of tomorrow.
Adaptive investment strategy: Generalists can pivot and allocate capital to different sectors as market trends evolve, ensuring they're not left behind in quickly emerging next categories.
Access to a larger deal flow: A broad investment focus allows for reviewing more pitches, which in turn not necessarily correlates with deal flow quality, though.
Disadvantages:
Lack of specialized knowledge: Without in-depth knowledge of a particular industry, you might miss nuances that could be crucial to a startup's success or failure. However, less expertise can also be an advantage, as we described extensively here.
More difficult competition: A wide net catches opportunities that more investors are also likely to see and pursue, which can reduce your leverage in deal negotiations.
Indecision risk: With so many potential investments to consider, it can become more challenging to make confident decisions, as you have less basis of comparison among deals.
Divided attention: Investing in various sectors forces you to follow understand follow a large set of market dynamics, which can be demanding and time-consuming.
You can see that both approaches are substantially different. That’s why they often result in two different portfolio building strategies.
For the sake of simplicity, we focus on the two extreme cases here to illustrate the main differences for angels: The Concentrated Portfolio, represented by the “Expert hands-on investor”, and the Outlier Portfolio, represented by the “Open-minded outlier seeker”.
Building a concentrated portfolio
A concentrated portfolio strategy involves investing larger tickets, into fewer companies. This approach aims to maximize returns by allocating capital to downside risk optimized companies that heavily profit from your involvement and support. That means you as an angel typically should have a deep understanding of the industries you invest in and are able to conduct thorough due diligence.
In contrast, an outlier portfolio strategy focuses on identifying and investing in startups with the potential to become game-changers in their respective markets. For this strategy, you must be willing to take on higher risks in exchange for the possibility of generating exceptional returns. It normally involves following the rules of power law, which implies more investments with smaller ticket sizes in this case. While you must remain open-minded to find these outliers, you also need to have an extensive network and sufficient reputation to attract enough high quality deal flow.
Both concentrated and outlier portfolio strategies have their own advantages and disadvantages. The choice of strategy depends on the risk appetite, expertise, and investment goals.
How to determine your sweet spot and strategy
The easiest way to orientate yourself between the two strategies, is by reflecting about your preferences for the following three dimensions:
1. Determine your risk tolerance (deal basis)
Risk tolerance is something very individual. While entrepreneurs have a high risk tolerance in common, they still vary quite a lot when it comes to investing.
Trigger questions: Are you ready to lose all your money at 80% of your deals? How high is your loss aversion / pain of losing? Are you willing to cut loose or rather jump in and save at least some money, when a startup is about to go bankrupt?
2. Determine your return expectations (portfolio basis)
Everything has two sides. If there is less risk, there is normally less return potential. Even if you are the greatest investor on earth, you should not gamble on beating this law.
Trigger questions: Is it important to you to find the next unicorn? Are you comfortable with following a never ending fundraising journey? Do you enjoy more to work in a successful bootstrapped business?
3. Determine your level of involvement
A lot of angels treat their investments as a side-job, so it’s important being honest about the availability and capacity to contribute to a startup.
Trigger questions: Is it important for you to always know what is going on at an investment? Do you want your feedback to be incorporated? Do you want to attribute X (e.g. 10h) per week on average to support your investments?
While in reality these borders become blurred, it’s still extremely important to formulate a concise strategy and be aware of the do’s and don’ts of each. For example, it will be rather difficult to follow a concentrated strategy with little to none personal involvement in the startups. In this context, we think it’s valuable to start off with one strategy at first. In case you want to divert from it later, be aware of the consequences and how it affects your portfolio in total.
What’s next?
How do you actually construct your optimized personal portfolio? And what number of startup investments is the best for your budget?
We will try to answer these question in our continuous series on portfolio building.
Don’t miss out!
Thank you for reading! If you liked, feel free to share it with someone else who could profit from it - angels, founders, VCs, anyone :)
PS: We are always happy to answer your questions or take on topics you want to hear about to close the gap! Just let us know.