Key Risks of Angel Investing

Note: This article is the fourteenth in an ongoing series for angels new to investing. To learn more about building an angel portfolio, download this free eBook today Angel 101: A Primer for Angel Investors or purchase our books at Amazon.com.

Angel investing risk management
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Early stage investing is an inherently risky way to invest. The list of high level risks is long and includes financing risk, technical risk, and market risk. As angel investors, you need to be aware of the key risks you are taking with your investment. By understanding the risks, you have a way to monitor the progress of the company and provide human capital assistance in areas that will matter for the long term success of the company.

With his legal training and through his CFO role managing a public company board, Christopher is all too familiar with the issues around risk management. With the understanding that managing risk in a large corporation is quite different from managing it at an early stage startup, we asked him what keeps him up at night after he makes an angel investment.

Q: Will you give us a quick summary of the key risk areas that you focus on with startups?

This is not an easy question to answer because every startup situation is a little different, and there are so many nested layers of risk with any start-up. For example, you might wonder “is there an opportunity here?” or you might wonder “is this team good enough to go get it?” or you might wonder “is this company being smart about how it is writing contracts with customers?” or “does this company have complete and up to date personnel records and fiscal controls?”  

Every start up is going to present a mix of the major categories of risk: team risk, market adoption risk, technology risk, intellectual property risk, financing risk, regulatory risk and all the myriad specific issues within each category. Obviously, you cannot evaluate and put equal weight on every risk at once, nor would you want to. The key is to focus on the major risks first and leave the secondary and tertiary risks to the side to be addressed at the right time. For example, there is not a lot of point in worrying about the form of the board minutes of a company that does not yet have product/market fit.  

So as a general matter I try to establish comfort on the big things like whether this is a great team, whether there is a likely big market here and whether there is a smart, defensible and differentiated product. I try to document the key assumptions necessary (what, at Launchpad, we refer to as WNTBB or “what needs to be believed” in order to invest) to get an overall sanity assessment.  

Then, once I have a general comfort level on that stuff, I try to get a handle on details around the go-to-market approach, marketing methods, and defensibility of the solution. Only then will I spend time on the financial model to make sure it makes sense. Ultimately, I try to think through the exit options: who are the likely buyers, what aspects of the business will they want, what will they be prepared to pay, and what milestones are going to need to be achieved in order to get bought.  

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Q: Are there any of those major categories of risk that concern you to a level that you might decide to pass on an investment in a company?

Regulatory risk is obviously a biggie. If the company’s legal right to execute its business plan is in doubt for regulatory reasons (for example, FDA approval is required), or the proposed plan is potentially illegal (for example, the SEC might decide it is a regulated activity) or it is very dangerous (for example, a product associated with ultra hazardous activities or extreme sports that could give rise to huge product liability issues) or the business model is just yucky or misleading (as with certain spammy or privacy invading activities, or certain business models preying on young consumers) then I am probably not going to be interested. One of the nice things about angel investing is that you get to pick whom you do business with and what you get involved in.  

Q: Are there certain red flags which, if spotted, mean you will absolutely not invest in a company?

Yes. Most of them are going to come in the team risk area or the market risk area because in my view, those are deal-breakers - product issues can generally be figured out by a great team going after a real market opportunity (assuming no show-stopper regulatory issues as noted above.)  

In the team risk category the biggest showstopper is any whiff of integrity issues. If I feel a founder is being dishonest or misleading about something (for example, overstating customer traction or investor commitment levels are things you regularly see), I will walk.  Another walkaway issue is the IQ/EQ question. If the founder just does not appear to have the intellectual smarts or the emotional people skills to succeed in the endeavor, there is no point in backing him or her. EQ includes communication skills, of which listening is a biggie, as well as leadership potential and a sense of tenacity and drive. I also look for major skill deficits on the team (particularly in sales, marketing and product management), especially when the team does not recognize the deficit and plan to hire for it.

Another major red flag is the team which says “we don’t need a board yet; we’ll get one on the next round.” Or “we only want a 3 person board with two founders and one investor.”  If you are taking outside money and you are trying to build a company, not only do you need the governance function a proper balanced board provides, but you can always benefit from the additional perspective, advice, mentorship, connections and experience a board provides. Young companies don’t need large boards by any means, but a 2-2-1 board (two founders, two investors, one independent) is a terrific balance for getting started. When I hear resistance to that idea from a founder, particularly after I’ve shared my views on the benefits, I assume the worst in terms of hubris, coachability. And I may have concerns about the CEO feeling insecure in the leadership role. I’ve walked from that kind of investment opportunity, and will continue to do so.

On the market risk side, I look for markets that are going to be big enough to support a decent company and ultimately a decent exit. (We’ve talked at length about market size, e.g. here and here, but suffice it to say, given reasonable market share assumptions, it is almost impossible to make the investment math work with a market size below about $100M and still challenging below about $250M.)

I also look for indications of market readiness. There are countless examples of visionary companies which arrived before their time and spent all their resources trying to develop a market before it was ready only to fail and then watch later movers capitalize on the market they staked out. To avoid investing in this kind of company, you need to see some proof that the customer is really ready to buy. Hope is not a strategy.  

Another key part of the market assessment is to make sure the go-to-market is reasonable. That has two dimensions: (1) will it be effective and (2) can the company afford the intended approach. You cannot break even spending $1,000 in cost of sales to sell a $100 product (or even a $100 subscription product with an LTV of $500). You need a go-to-market that is appropriate for the opportunity. Related to the go-to-market are situations where the team is fuzzy on the value proposition. They have too many value props they are juggling, or, worse, none at all. Or the value prop is focused but very weak. For example, the company’s offering really boils down to offering a marginal savings on what amounts to a relatively marginal cost. With good execution you can certainly sell a product like that and build a viable business around it, but you are never going to grow fast enough to work out well as an investment for outside risk capital investors.  

Are there other turn-offs that are not in the team or market realm? Yes, and most of them are deal related: I will almost always refuse to invest on bad deal terms (e.g. ridiculous valuations, convertible notes and SAFEs, etc.) or where the investor mix is off, (e.g. weak or non-existent lead investors, or co-investors I am not comfortable or aligned with.)

Q: What approach do you take when you advise a CEO on how to manage risk?

To be brave and recognize that they are paid the big bucks to take measured risks, that they have to take risks to be successful, and so they cannot obsess about eliminating all risk. After all, if you don’t fall down, you are not skiing hard enough (I’ve meditated on this subject before). But I also advise them to focus on the really big existential risks and delegate the smaller ones to capable team members. Too many CEOs hold on too tight, to too many silly things, for too long and don’t leverage a strong team well enough.  

Once the company starts to grow, the risk-taking attitudes will mature and the situation will require a little more conservative and thoughtful approach - in the beginning when the business is nothing and it has no assets, risking it all on a hunch doesn't mean much because the “all” isn’t yet a valuable going concern. Once it has a big revenue stream and assets and is responsible for the livelihood of many people, it can be harder to “bet the company”. It is still going to be necessary to take big risks, to innovate, to pivot, but it is generally going to take more strategy, planning and thought.   

Q: As a board member or advisor, what do you do to help the CEO manage risk?

Ask lots of questions starting with “Have you thought about…” or “Have you considered what you’d do if….” or “What are your thoughts on….” Since I am unburdened by the day to day distractions of running the business, it is easier for me to step back and look a little farther down the road. Together we can spot issues a bit earlier and plan for them so that we can take advantage of them rather than just reacting to them in permanent crisis mode.  

Q: As a board member or advisor, how do you work with the CEO to monitor and track the progress on risk mitigation?

By helping them develop a good dashboard of all the key performance indicators and monitoring it regularly. If you have the right measures on your dashboard, and you keep your measurement set up to date as the business evolves, it is just a matter of looking at the numbers that are out of whack relative to the initial assumptions and asking “why?”  and “what are we missing here?” (Read more on the roles and responsibilities of Board Members and Advisors).

Want to learn more about building an angel portfolio and developing the key skills needed to make great investments? Download Angel 101: A Primer for Angel Investors and Angel 201: The 4 Critical Skills Every Angel Should Master, or purchase our books at Amazon.com.