Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Expected Returns to Stock Investments by Angel Investors in Groups

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Expected Returns to Stock Investments by Angel Investors in Groups

Article excerpt

Working Paper 201044 August 2010

Abstract: Angel investors invest billions of dollars in thousands of entrepreneurial projects annually, far more than the number of firms that obtain venture capital. Previous research has calculated realized internal rates of return on angel investments, but empirical estimates of expected returns have not yet been produced. Although calculations of realized returns are a valuable contribution, expected returns, rather than realized returns, drive investment decisions. We use a new data set and statistical framework to produce the first empirical estimates of expected returns on angel investments. We also allow for the time value of money, which previous research has typically ignored. Our sample of 588 investments spans the 1972-2007 period and contains 419 exited investments. We conduct extensive tests to explore potential bias in the data set and conclude that the evidence in favor of bias is tenuous at best. Our results suggest that angel investors in groups can expect to earn returns that are on the order of returns on venture capital investments. Estimated net returns are about 70 percent in excess of the riskless rate per year for an average holding period of 3.67 years. This estimate is reasonable compared to Cochrane's (2005) estimate of 59 percent per year for venture capital investments, which tend to be in lower-variance, later-stage projects. Returns have a large variance and are heavily skewed, with many losses and occasional extraordinarily high returns.

JEL classification: G24, G20

Key words: angel investor, expected return, private equity

Expected Returns to Stock Investments by Angel Investors in Groups

I. Introduction

An angel investor can be defined as a person who provides funds to a private business which does not have publicly traded stock and is owned and is operated by people who are not relatives or friends of the investor. Acting as informal venture capitalists, angels invest billions of dollars in thousands of fledgling companies annually. What returns can these angels expect to receive on their investments? Although previous work has explored realized returns, this paper is the first to obtain estimates of expected returns on angel investments in a form comparable to reported expected returns on stock or venture capital.

Until recently, research on the returns to investments by angel investors and angel groups has been limited because suitably large data sets simply have not been available. For example, Goldfarb, Hoberg, Kirsch and Triantis (2009) have just 32 angel-only investments in their study of private equity, and not all of them are exited investments. The Angel Investor Performance Project recently has produced an informative database on angel investments. In contrast to Goldfarb, Hoberg, Kirsch and Triantis (2009), these data have 588 investments of which 419 are exited investments.

We use these data to explore the expected returns on angel investments. Our paper is similar in spirit to Cochrane (2005), who estimates the returns on venture capital investments, and to Barnhart and Dwyer (2009), who estimate the returns on traded stock in new industries. It differs from Wiltbank (2005) and Wiltbank et al. (2008) because we estimate expected returns rather than realized returns. Thus, our paper combines these strands of the literature by estimating expected returns on angel investments. The distinction between realized internal rates of return and expected returns is critical. Realized internal rates of return do not drive financial decisions. Expected returns drive financial decisions.

II. Prior Literature

Angel investors and their investments are not well documented. This is partly because individual investments tend to be informal, so there is little or no documentation or data. Also, practitioners and academics have not reached a consensus concerning even the definition of an angel investor. …

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