Note: This article is the twelfth 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.
There are as many different approaches to angel investing as there are investors. Some investors will tell you they invest based on their gut. After a 30 minute meeting with the entrepreneur, they are either in or out. They like to invest in people and that initial meeting guides their decision-making process. Other investors like to dig deep. They will spend significant effort digging into every aspect of a company from team, to market, to competition, to intellectual property and so on. And, there is every variation in between these extremes. For the sake of brevity we will leave out discussing the approach of investing in whatever your buddy is investing in!
Before Christopher joined the world of angel investing, he spent much of his career acquiring smaller companies for the NASDAQ listed enterprise software company where he was the CFO. He knows what real due diligence is first hand. At Launchpad, he adapts those skills in a way that fits for the type of early stage investing that we do. That said, Christopher will admit that he doesn’t always follow his own rules.
Q: Christopher, can you give us some big picture perspective on what diligence is and how it relates to risk?
Mainstream use of the expression “due diligence” dates back to the Securities Act of 1933 which provided a liability defense for broker dealers who did a reasonable investigation before recommending a stock. What constitutes thorough due diligence today varies greatly by context and type of deal. For example, big complex companies with long operating histories take a ton of work to evaluate before an acquisition. However, for early stage companies it is really a process of fact-checking, scenario outlining, and model-building.
Due diligence boils down to the notion of having some kind of process for what you are doing as an angel investor. With angel investing, as with most types of investing, it is almost impossible to directly control your returns, and, try though you might, it is really hard to manage risk fully. But as well-known angel investor John Huston likes to point you, what you can manage is your process. Diligence is the fancy word for the process you use as an investor. A good process can help improve your returns.
By gaining experience evaluating startups as potential investments it is possible to learn how to spot the really big flaws that are highly likely to defeat a company. But to do that, you need to develop some kind of a process which allows (forces?) you to ask the necessary questions and give things the necessary thought. If you don’t, you will inevitably make mistakes. These mistakes will be of the variety that is sometimes called “type 1 errors” - investing in companies you shouldn’t have, and taking a loss on that investment. A good process consists of:
Thinking about issues,
Looking for obvious flaws and unjustified assumptions.
This is a critical part of investing, and that process is typically referred to as due diligence.
Note on The Risk of Getting Too Good
Your due diligence process must be calibrated, however. The devilishly tricky part of angel investing is that it is actually possible to get too good at spotting flaws. With angel investing you are investing in companies at a very early stage. These companies are bound to have some incompleteness, some seriously rough edges and many uncertainties and assumptions. If your ability to spot flaws outstrips your ability to put those flaws into context and weigh the important ones from the unimportant or fixable ones, you may end up talking yourself out of every “flawed” investment. Investing in something you shouldn’t is a type 1 mistake. The kind of over-zealous fault-finding leading you to fail to invest in things you should have is a type 2 mistake.
I like to think about it this way: early in an angel’s career, the primary challenge is to learn to build a process, evaluate deals and spot fatal flaws. Later in an angel’s career, the primary challenge is keeping alive the sense of wonder and staying open to the possibility. Sometimes I have to force myself to say “sure, these will be challenges, but if they could be overcome, how big could this be?”
In time you will find a balance. Diligence ultimately should be synonymous with a well-calibrated process. You want to create steps and develop enough experience to spot obvious critical mistakes, but you want the perspective to invest in things even when they have some flaws.
Q: Give us three reasons why it’s important to do some diligence before you invest in a startup company?
For some reason, in life it seems like at first blush it is always easier to imagine the obvious ways something might work than it is to grasp the sometimes subtle and complex ways things could go wrong. Perhaps people are optimists, or perhaps it is the tendency to want to believe an earnestly and passionately-told story from someone who is betting their livelihood on it. But whatever the reason, more time spent on due diligence always yields a more balanced and nuanced view. Additional time allows you to get the perspective of different experts, spend time with the team, educate yourself on the market, understand the psyche of the target customer. If you do not take the time to put in a little work, you are just making a blind bet during that overly optimistic honeymoon phase, and you are giving up the chance to consider very easily-discovered issues and to ponder whether it is realistic to expect a team to work around them.
Q: What areas do you focus on when you are looking at a company? Is there one area that is most important to you?
As I have written in another article, team is by far the biggest focal point of my inquiry. Other factors are important, but none has the make-or-break importance of questions around team quality. The issue comes down to a simple realization that an “A team” with a “B plan” will outperform a B team with an A plan every time. Rising market “tides” do help all boats, but not enough to save boats with holes in them or boats with no captain. How do A teams do it? An A team is reading the market all the time. They can tell that it’s not coming together. They pivot before they’ve gotten themselves into such a capitalization hole that there’s no way the company can ever perform for investors. A good CEO will pivot, but a great CEO will pivot in a capital-efficient way. She will recognize that the data and the progress are just not there and start to move early and decisively before the company has raised and spent so much money that the cap table is just irretrievably screwed up. That takes vision, courage, humility, communication skills, analytical skills, listening skills, business management savvy, leadership skills, tenacity in the face of disappointment, and grit and determination. Plus maybe a sense of humor and some healthy perspective. These are the the things you are looking for. Team chemistry and dynamics are also key - a group of high functioning individuals is different from a high-functioning team.
Secondarily, I focus on market size and segmentation with a particular attention to the number of potential customers for whom the company’s solution is a top pain point and a top buying priority. Too many diligence efforts stop at “yup, I am satisfied that there are lots of people out there who would buy this.” The question is, where does it lie in their priority list? Are there enough of them who view it as a “need to have” rather than a “nice to have” that reasonable market share represents a big market?
Beyond that, there are a host of other issues you need to consider like the company’s defensive and offensive IP situation, the business’ inherent margins and long-term defensibility, exit scenarios, capital intensity, deal terms and investor dynamics (read more on the key factors of Due Diligence in Stones Unturned: An Investor’s Guide to Due Diligence in Early Stage Companies.)
As you can see, there are plenty of things to ponder once you start to create the space to think things through beyond the “yeah, I see how that could work” stage.
Q: How do you go about figuring out the key areas to perform diligence when the companies you look at are in different industries and different stages of development?
Team is always a constant, but on the market analysis side, different industries require different ways of getting into the head of the customer in the target segment. It is not a question of whether you will look at those things, but rather a question of how. For example, some types of opportunities really require grey-haired experience and connections on the founding team in order to understand the problem and break into the market. But in other really disruptive opportunities, such “knowledge” will only serve to limit the team to an “it cannot be done this way” mentality.
Beyond team and market, some opportunities present very specialized issues. For example, life sciences companies always involve very critical regulatory and reimbursement questions as well as peculiar go-to-market paths and different exit timing and dynamics. Ed Tech companies have very special types of buyers and product adoption patterns. Some technically-innovative companies may present extremely complex technical or scientific questions that are going to require close study by someone with expertise. So beyond a basic set of common-denominator themes, you are always going to need to adjust your approach to make sure you are giving thought to the key risk factors and not wasting time on less important issues.
Q: How and when do impact investors assess the impact intentionality of a potential investment? Is it incorporated into the Due Diligence process?
Impact evaluation is a two step process. The first step is finding companies that are focused on your impact thesis area (or at least have significant impact on it.) This first step occurs very early in the process. It is really a part of the deal flow and screening stage. Investors looking for improvement in very specific societal goals are going to need to get involved in the problem area and become a part of the community in order to find social entrepreneurs focused on fixing a particular issue. Screening companies is not altogether different from what ordinary investors do, but the more specific the focus, the more work it is to find applicable companies. The second step is part of the due diligence process, and it is more about validation than discovery.
Q: Is the due diligence process different for impact investors? If not, where in the impact due diligence process does the impact assessment occur?
The impact due diligence process is not intrinsically different from the due diligence process of an ordinary early stage investor, but it does have some additional focus areas. It tends to put different weights on certain of the topics. Let’s look at weighting first. The ordinary early stage investor is focused on a diligence process that will answer the question: “Can I get a good time and risk adjusted financial return here?” The impact investor is trying to answer a slightly different question: “Can this company do well enough financially to have meaningful social impact?” That leads to differences in the weight put on various due diligence topics. Ordinary investors put comparatively more weight on market size, team skills, financial plans, capital efficiency and speed and size of exit. Impact investors put comparatively more weight on team motivations and passion and urgency of market (societal) need. They put comparatively less weight on the skills of a passionate and committed team, the strictest financial measures like capital efficiency and strength of product margins, and the speed of exit/liquidity.
In terms of due diligence topics, a comparison of an ordinary due diligence checklist against an impact due diligence checklist shows tremendous overlap, but also that the ordinary checklist is the subset and the impact checklist is the superset. Impact investors are looking at additional topics such as alignment with their goals, the broader set of stakeholders for the company, whether there are any negative impacts of the company that are externalized, what the key metrics or KPIs are for measuring and monitoring the social impact of the company, and how such KPIs should be calculated.
Q: Can you describe an issue you missed during the diligence process that ended up coming back to bite you when the investment failed a few years down the road?
The most painful issues I missed have clustered around two core areas:
(i) Confusing likability or prior accomplishments on the part of an entrepreneur with the competence needed to pull off the current task. I’ve lost money with entrepreneurs who are great guys or great gals and had accomplished good things in their prior career endeavors, but were completely over their heads and unable to adapt when driving the new opportunity. As a result, I try to think hard about what skills the coming opportunity will require, and make sure the entrepreneur has, or is willing and able to get, those particular skills.
(ii) Confusing early adopter excitement with true market pull. It has been said that “anybody can get the first 10% of a market” and Geoffrey Moore’s Crossing the Chasm stands for that proposition, but the key to growing a company is finding a big enough market of willing buyers who can be accessed in an affordable way (relative to their lifetime value). The product may be good, and there may be lots of people who might buy it, but unfortunately a company’s true market is limited to those customers for whom that purchase is a top pain point and a top buying priority. Often a marginal improvement on a marginal cost is not enough to drive buying behavior in all but the earliest of adopters. So the key is to recognize when you are looking at what is sometimes called false traction and doing some further digging. There is no substitute for talking to real customers and prospects before doing the deal in these situations.
Q: Fess up… I know you invested in companies without doing any significant due diligence. Why did you invest in those companies?
Naturally I prefer to do an appropriate amount of diligence before digging in, and more often than not pass on a round where proper due diligence is not an option. Sometimes it is not possible or feasible and I decide the potential upside of the opportunity is worth the added risk. Situations where diligence is not possible might include attractive rounds that are nearly full and closing imminently or situations where the market does not yet exist or the product category does not yet exist and your diligence conversations would be entirely hypothetical. You can do that work, but it can sometimes be an exercise in confirmation bias - wishful thinking and hearing what you want to hear.
In situations where you are not going to be able to do an appropriate amount of diligence, you can:
Rely on your own experience
Look to make sure there are other high quality investors in the round
Look extra hard at the quality of the team and the personal opportunity cost they are incurring by going after it, and
You can manage your initial check size and plan to follow on more heavily once there is a bit more data and track record.
It is not a perfect or a desired way to go about things, but sometimes you have to make compromises if you want to build a diversified portfolio with a variety of interesting opportunities.
Want to learn more about building an angel portfolio and developing the key skills needed to make great investments? Download these free eBooks - Angel 101: A Primer for Angel Investors, Angel 201: The 4 Critical Skills Every Angel Should Master, and Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies, or purchase our books at Amazon.com.