May 12, 2017
Last year, I started dipping my toes into the mythical pool of angel investing. Unfortunately, I found little resource anywhere about how this whole thing actually works. Lots of what I’m writing here comes from my personal experiences and talking to experienced angels/mentors.
Angel investing, like any other type of investing, is all about probabilities and numbers. The Law of Large Numbers definitely dictates here; at the end of the day, it’s all about diversification. The difference is the risk factor, which is magnified exponentially. Most of your returns will come from 5–10% of your portfolio that actually exits with ridiculous valuations (5x, 10x or even more). You can assume the rest to go to zero.
An angel investor’s portfolio will follow a J curve, just like typical venture capital funds. Companies tend to fail early; successful companies tend to take a long time to emerge and exit. Since most angels get their money back during liquidation events, and the average holding period for an angel is around 5–10 years, it’s definitely a long term commitment. It’s quite likely that after 5 years, your portfolio will still be worth less than your principle.
Quite a few people I met confuse angels with VCs. It’s important to understand that angels are mostly individuals who are investing with their own money. Hence, they may take things a little more personal. Also, this means that they tend to have limited amount of capital. However, the upside is they usually make decisions quicker and there are probably a lot more of them around. Also, if your company is at seed stage, it’s highly unlikely for a VC to talk to you (excluding super angels and incubators).
To a former entrepreneur, sitting in a pitch session can be both familiar and foreign. When speaking with entrepreneurs, you have to constantly remind yourself that it’s now your job to ask as many difficult questions as possible, especially questions that you previously feared as an entrepreneur. Here are things I tend to ask for:
- A quick 5-to-10-minute pitch, accompanied with a demo of the product, live demo preferred: I’m a CS nerd. I like to ask about how the product is built. I also appreciate any kind of data.
- Financial projection: short term only. There’s no reason to ask for anything > 6–12 months, it will be totally off and basically bs.
- How will the money be used, and how much more will be required before launch: It’s important to understand the operational budget, current/projected revenue and projected raises. Similar to the point above.
- Customer list (if any): I would love to call them up and see if they are actually paying customers, and if they are happy with the service.
- Cap table: I like numbers, and I like to know my potential ownership of the company.
** It’s important to note that in a seed/angel round, there’s usually no requirement for the startup to provide disclosure schedule or prospectus. Don’t expect any.
After the pitch meeting, I’ll usually go home and do more detective work online and offline about the following:
- Market size, competitions, regulations: basically, does the founder know everything about the market he/she is entering into. It helps if you know domain experts who can help you answer some of the more technical questions you will have.
- Team: who are they, what have they done, integrity check. Also helps if you know someone who knows the team or have worked with them in the past, and can vouch for their “legitness”.
- Books and legal docs: go through the accounting matters, corporate records, employee payrolls, assets and leases, loans and grants, existing contracts.. Sure, these are usually done by lawyers, but I think it’s immensely helpful if an angel takes the time to go through it as well.
There are many methods to calculate the valuation of a startup. It’s a very complicated topic, which definitely deserves its own series of posts. Keep in mind that no matter what methods you use, valuation is always going to be subjective. All the math in the world can only get you a ball park figure. It’s completely up to the entrepreneur and the investor to figure out what the compromise should be. Personally, I use a combination of methods listed below to find an average.
Besides understanding basic valuation, an angel should also understand the more complicated math behind varying/changing valution in the same round, most notably, a rolling close of convertible notes with different values. Not all angels are valued equally.
Briefly, some of the common methods to calculate startup valuation are:
- Scorecard method
- VC Method
- Chicago Method
- Dave Berkus Method
- Risk Factor Method
A good resource to look into is Bill Payne’s blog. I believe Golden Seeds also has some writings on startup valuation.
The terms of investment vary greatly on a case by case basis. I’m not a lawyer, so please see my disclaimer at the bottom of the post. Generally, you should familiarize yourself with these concepts:
- Common/preferred stock: Understand who (founders, investors) benefits from what (holding common/preferred, and from which round) in an up or down scenario.
- Discounts: A typical discount for seed can be anywhere between 10–30%. It’s definitely an art, since you do want potential series A investors to be comfortable, which means you will have to have a good estimate of how much series A should be. At the same time, you are also greedy, and want as big of a discount as possible.
- Cap: Again, if you are expecting the company valuation to soar, setting a cap can be quite tricky. It’s a balance of protecting your self interest as an angel, and not limiting future growth of the company.
- Debt/notes: Understanding debt and what you can leverage at different stage of the company, specifically regarding a repayment clause. Obviously, angel investors are investing because they are optimistic about a company, so they are always hoping to convert their money into equity eventually. However, in a down scenario, repayment clause is a good defensive weapon to shift the balance of power, and bring your founder(s) back to the negotiation table.
- SAFE by YC and KISS by 500 startups: Some open source docs to read up on.
Two of the more common structures I’ve seen recently are:
- Discounted convertible note with cap
- Seed convertible preferred (equity round)
The choice of whether to go with equity round largely depends on the size of the round, and like all things, how much it would cost (time/money).
Since angel investing is such a broad topic, I don’t think covering it in one post would do it justice. Here are some of the topics I hope to cover with more depth in later posts:
- Negotiations: Different rights an angel should ask for (pro rata, information…) and what are the pros and cons for up/down rounds. I’ll also cover liquidation preferences, pay-to-play etc.
- How to add value as an angel: What do entrepreneurs really need from you.
- Economics vs. Control: A concept first introduced to me by Bred Feld and Jason Mandelson in their amazing book, Venture Deals.
- “New Age” aka syndicates, angel groups, crowdfunding: Is this where the industry is heading?
- Student-led funds: I want to explore the inner workings of funds like Dorm Room Fund (FirstRound), House Fund (U.C. Berkley), Rough Draft Ventures (MIT/Harvard), A-Level (Hopkins).
- Investing as an engineering nerd: How to utilize your special skill set to differentiate yourself from other angels.
I’m not a lawyer and I do not provide legal, business or tax advice. The accuracy, completeness, adequacy or currency of the content is not warranted or guaranteed. This post is not a substitute for the advices or services of an attorney. I recommend you consult a lawyer or other appropriate professional if you want legal, business or tax advice.