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.
> They figure if you cant reach me through their trusted network,
> then you are either not motivated or not bright.
David,
aside from friend-of-a-friend networking at cocktail parties and hunting for mutual acquaintances via linkedin, what are the most effective methods you propose for an entrepreneur to contact an investor via his trusted network when that person is a complete stranger?
sean
Before I answer, let me clarify something. I’m not saying that the investors who think this way are necessarily right. It’s just their system. There are many who think this way. For some, it’s a simple filter because their dealflow (deals they’re exposed to) is just too large to manage fully.
LinkedIn is a good start if you’re using it correctly (not accepting links from those you don’t really know well). Surely through resources such as CTEK, BIC, RVC, etc you can meet and have the opportunity to pitch to some angel investors. Once you find one or two who show an interest, ask them who else in their network they might be able to introduce your opportunity to on your behalf. Recommending deals is a form of currency between investors.
Also, talk to your own network to see who you might be one or two degrees from. For example, perhaps a former manager or professor of yours founded a company previously and was helped along by angel investors. If this person values your relationship, he’ll surely provide an intro to those investors he or she knows already.
We’re lucky, because Boulder and even Denver are really small communities in the grand scheme of things. Get creative, and manage your network. I bet you’ll find a few hidden gems.
Oh, and of course there’s always posting a thoughtful comment on their blog to start up a conversation. 😉
yea i’ve heard that works too.
I’ve also heard there’s a startup in Phoenix that has a disruptive technology that could change the way applications are deployed… http://www.scrollinondubs.com/?p=101
know any investors who might be interested 😉
sean
David,
I generally categorize VCs into “people investors” and “market investors” – what you appear to be saying is that most angels are “people investors” in that what they care about is the quality of the people. I would think that’s generally true, although I believe there are angels who are very focused on the market/technology area where they first made their money, and those will tend to be more focused on the details of the technology, market introduction, etc. Those would be the most *useful* investors aside from their cash, because they’ll be valuable advisors and can provide introductions.
I have come across some angel investors. My experience is some what different than you said about their investment decisions. Here its a group of angel investors so that might change the things. They wanted to me show some revenue or what you could call as proof of concept, so show me customers who will pay for this. Basically the offering was a service, consumed by corporations and it is very difficult to prove that (get beta customers). Another advice I got from these guys is that if you can’t pass through us, (means they are not funding the deal) then you will never manage the angel funding any where else. I was told that various angel communities will first ask this question, why did angel co. so and so did not fund you since u are from that area. Then they will contact that angel group verify the reasons and reject just because that group did not fund it. As u said before importance of networking is there, but is it really that hard once your area angels decide not to fund you. You mentioned about individual angel, what about angel groups.
That’s an excellent explanation by someone who clearly knows the players [grin]. You’re 100% on target about the gut feel/trustworthyness/bet on the entrepreneur factors. In addition to the points you’ve mentioned, however, I think there are three other things that figure into the analysis:
(1) Market size/scalability. While these are really two separate things, they both speak to the question of how big the company has a chance of realistically getting. If the worldwide market for whatever you’re selling is only a few million bucks, it’s unlikely that you’ll be able to grow the company large enough to provide the investor’s necessary return. Similarly, even if the market is large, if the business is not scalable (say, you’re a local dry cleaner, or a personally-producing consultant), it also won’t be an attractive investment.
(2) Type of Business. Regardless of whether the plan makes sense or the dollars work out, most angels have relatively (or even very) specific preferences as to businesses in which they want to invest. Some are only high tech, some are only non-tech. Some like consumer products, others prefer ASPs. Some thrive on potentially giant, risky, exciting, long-shots; others will only look at boring, been-there-done-that, traditional (lower return but safer) businesses. In general, it’s an impossible task to get someone to invest outside his or her comfort zone.
(3) Valuation. While you covered this concisely and pretty accurately (although the subject actually is a LOT more complicated), the requested valuation is often the very first ‘reality check’ that an angel will look at. If you come to me with virtually ANY startup deal where you’re looking to raise money at over a few [low] million dollars (let alone $10 million, or even $20 million, which I’ve seen), it immediately tells me that you’re not familiar with the market, and thus probably not ready to run a real business with my money.
But the bottom line is that David is right on target: I’d much rather invest in a smart, savvy, experienced, energetic, passionate, COMPLETELY TRUSTWORTHY entrepreneur with a mediocre plan, than I would with a perfect plan but a second rate entrepreneur.
Kedar, you asked about angel groups. Angel groups are really just made up of individual investors in most cases, unless they are operating some sort of pledge fund. These individuals still have to make up their own minds about each deal. You’ll almost always notice a natural flock mentality. Once a few investors get really serious about a deal, there are almost always others from the group that jump in to that deal. This is because the angel group is one big social network.
Really, in most cases, angel groups just serve as dealflow for investors. At that point, you’re still dealing with individuals.
I like Dave Jilk’s categorization of “people investors” and “market investors” (comment #4) Certainly, if you’ve got an investor who comes (successfully) from the same space that you’re now playing in, they’re going to be more knowledgable and will often end up the lead investor for a round. They are certainly going to “smart money” as Dave points out – providing more than just capital.
There are many investors who use the market as an initial filter (I bet that I missed many more litmus tests – this is one for sure). For example, an investor may only be interested in SaaS/ASP type software models and will filter out everything else right away. Great point.
Thanks for the additional thoughts David (Rose, #6). I completely agree – I think each of these things often happen during the “getting to know you” phase. If the opportunity is not significant enough or the team can’t execute it in the opinion of the investor, you’re probably toast right there. I also think David’s point out valuation is a great one – If you hear $10M right up front for a company with no customer validation, no product on the market, etc, then you know you’re dealing with unrealistic entrepreneurs right away. Thanks David!
Question about franchises. I have found a real gem in a niche market that I am POSITIVE will really do well in my area (there is zero competition and it would be a much needed resource). I have 0 dollars capital (planning on offering to take a large salary cut to compensate), but tons of experience. However, the real sticking point that I am struggling with is that the franchise will not release their data (full business plan, market analysis, and more) until I sign. The best I can get from them is that I am “on the right track”. I can’t submit a business plan and am hesitant about putting data out there that may be inaccurate if there numbers are different.
How can you provide good, rock hard information to an angel in this case – that they can depend on?
Angela, I don’t know much about franchises, but this doesn’t sound right to me. I would think the franchiser would offer full financial details and provide any supporting documents to you in advance of your investment in them. In any case, I’m not expert on franchising, so take that for what it’s worth.
So well put I didn’t have much to add.