A great question with some surprising answers

One of the most intelligent questions I’ve been asked by an entrepreneur in a while was “How do angel investors evaluate an opportunity?” Often the best questions are the most obvious ones. Duh, know the rules of the game you’re trying to win.

I think most entrepreneurs visualize an intensive due diligence process similar to what one might expect from a venture capitalist. Here’s a secret for you – angel investors don’t typically spend that much time on any given deal.

Obviously, all angel investors do not evaluate opportunities in the same way. Here are some common ways that investors tend to think about particular opportunities.

Most investors have a few simple litmus tests that act as a filter during or before an initial meeting. Common litmus tests are:

  • Was this deal referred to me by someone I trust? If not, they won’t look at it at all. They figure if you can’t reach me through their trusted network, then you are either not motivated or not bright.
  • Was I immediately impressed by the entrepreneur? Many investors reason that if you can’t impress them in the first 5 minutes, then you can’t run a company. They want to hear who you are, what you’re doing, and why they should care and they want to hear it right away.
  • Do I instinctively trust the entrepreneur? Many investors will immediately dismiss an opportunity if they get any inkling that the person they’re talking to may be anything less than perfectly trustworthy. Would you give money to someone you didn’t fully trust the first time you met them?

Certainly, there are many more such litmus tests that I’ve seen investors use. Sometimes it’s enough just to be a bad dresser (or a good dresser in Boulder). However, I think the majority of investors use some form of the above tests as an initial screen.

Assuming you make it past that first meeting and still occupy some of the investors mind share, then you have entered the “getting to know you” phase of the relationship. There are a couple of styles here that I have seen investors use.

  • Ask for all kinds of stuff and pose all kinds of questions. In this case, the investor is looking for preparedness on the part of the entrepreneur. They often want to see how responsive you are and whether or not you answers are well reasoned, pretentious, overly optimistic, or just plain stupid.
  • Sit back and let the entrepreneur sell the investor. Many investors are just too busy to follow up. They’re the ones with the gold in the relationship, so they’re going to make you follow up with them. They want to see if their second, third, fourth, and fifth impressions of you are just as favorable as the first. Remember, much of what they’re evaluating is just you.

Assuming that the getting to know you period is successful and that you have addressed the investor’s major concerns, the decision process begins. Here is where many entrepreneurs will be surprised by the processes that investors use. They are:

  • Gut feel. At this point, many investors simply make a gut feel decision. These investors typically do very little real due diligence themselves. Often they rely on the lead investor to do the due diligence and wait for that person to nod his head in approval. They typically don’t even review the materials that have been collected. This type of investor is going primarily on instinct and relies heavily on the people he or she trusts.
  • Expected values. Many investors will now pass the opportunity through some sort of expected values analysis (see below). In the end, this is a bet. Wise investors know that you don’t make a few big bets, you make many small ones. That’s the name of the game.

Here’s how an expected value calculation works. To analyze the expected value, the investor must assess (you might say “guess”) two things. The first is the likely value at some point in the future. Generally this is arrived at by averaging (and often discounting) comps (values at sales of companies in a similar or related space). The second thing they must guess/assess is their faith in you to do accomplish something of a similar magnitude to the comps, generally expressed as a percentage. So, for example, the investor may arrive at a statement such as “I believe there is a 10% chance that this company will sell for $10M.” Multiplying these provides an expected value at the time of such as sale of $1M (10M x 10%). The reasoning further continues that if I own 5% of the company, then the expected value is $50,000 ($1M x 5%). Therefore, the investor should not and will not invest more than the expected value. In theory, if an investor uses an approach like this then they never bet an inappropriate amount. However, they are still involved in many deals that have enormous upside potential. Some investors use their own modified financial analysis, but it’s often based on a similar model.

Generally, if you make it this far, you’re going to get an investment. Each of these three levels (initial meeting and filtering, getting to know you period, and decision process) can take very little time or a great deal of time depending on the style of the investor.

As a side note, it’s probably worth mentioning that there are plenty of angels who bypass this entire process completely, and simply co-invest with a trusted friend. Sometimes if you get one investor, you may really be getting two or three in a small and informal syndicate.

Like anything in business, it helps to focus. If you’re an entrepreneur you really have no control over the style of each individual investor. However, if you can remember four things and practice them consistently with your investors, you will be ahead of the game. These things are:

  • Make a strong first impression.
  • Always be responsive and follow up completely.
  • Do what you said you would do.
  • Be honest.

Most investors will dump you quickly if you fail them in these areas.

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