The Golden Rules of Angel Investing

I was recently asked by a friend who is considering investing in startups if I had any golden rules; anything to consider when making angel investments besides the often quoted “great team”.

As part of the Investment team at Seedcamp I have come across multiple Investors who have individual investment criteria or an investment thesis. The difficulty with rules is that they exclude many factors. They may not consider experience, the preference or value add of an investor, chance, or the unpredictability of markets. They don’t allow you to factor in a business’ ability to pivot or the infinite number of incidental factors that could mean that an excellent business could be missed if an investor sticks stringently to fixed rules.

I personally prefer to take an investigative approach rather than follow golden rules. By covering a number of key questions I believe you are in a better position to assess an investment opportunity. Here is a list of questions that I suggested to my friend:

1. What are your looking to achieve by investing in startups and can you add value?

Seeking financial return appears to be the obvious answer to this question. However, investing in startups is high risk by nature, especially when compared to other investments, such as equities. Institutional investors try to offset these risks in multiple ways, for example through in-depth due diligence, multiple investments, reserving capital for follow-ons or spreading investments across a large portfolio. As an angel investor you are less likely to minimize those risks the way an Institutional Investor would. Other, let’s call them “non monetary incentives”, can therefore play an important role. Do you enjoy working with entrepreneurs? Do you want to learn about or engage in a specific sector or technology? Do you have specific sector expertise? Are you considering angel investing as an approach to get a job in Venture Capital as recently proposed in a blog post by Matt Turck from FirstMark? Can you support a startup with your industry connections or experience? Have you been a Founder yourself who can pass on knowledge?

There are many different reasons for becoming an Angel Investor, but the role of an Angel can also take many different forms. Addressing some of the questions above will help you find where you can add the most value to actively contribute to the success of a company.

2. Do you understand the product and business model?

Investing in a company where you don’t understand every key aspect of its business model or the product itself is tricky. Being able to assess potential risks of failure is hereby as important as the ability to derive your own fair valuation and the price you are paying to invest. In particular investments in “deep” tech companies appear attractive due to their uniqueness or defensibility. These businesses are often a lot harder to evaluate in light of future demand and growth prospect, and in regards to their “fair value”, unless you bring a deep understanding of technological trends in the specific sector.

3. How capital efficient is the business you are investing in and how high is the cash burn?

The more capital efficient a business the less capital it will require to scale, which means that investors generally achieve a higher return on their investment. Part of the attractiveness of internet or software based businesses is their low customer acquisition costs, and their ability to scale quickly. However common mistakes that Founders and Investors make are underestimating those capital requirements, inaccurately forecasting monthly cash burn and the inability of a company to raise future funding. As an Angel Investor you should therefore have a very clear picture of what the company is planning to do with its funds, how long the cash will last, what KPIs the business needs to achieve in order to raise the next funding round, and how likely it is that the company will achieve its targets.

4. Are you investing at a fair valuation?

Company valuation is always subjective. You often know you have reached a “fair valuation” when the company and the investors agree on a value that feels slightly uncomfortable for both parties. But there are also other ways to approach the question about a “fair” value for a business. How does it benchmark to valuations of comparable companies raising a round, for example for those raising on Angellist or other equity crowdfunding sites such as Seedrs and Crowdcube? Are the financial metrics and growth prospects justifying the value? What kind of exit value does the business need to achieve in order to generate a return on the valuation you invest in and how likely is the exit scenario?

5. Are you eligible for tax incentives?

Tax preferential treatments for angel investors offer downside risk protection and an incentive for investing into startups. A number of countries offer income tax relief for investments into startup schemes, for example the UK (SEIS/EIS). It’s definitely worth researching what incentives are available in your native country.

6. How good is the team?

Good CVs don’t necessarily translate into good Founders. However, the chance of a serial, or second time, entrepreneur starting a successful business is likely to be a lot higher. Teams with deep domain expertise are often better when it comes to assessing competition, market dynamics, customer needs and behaviours and other important success factors. Another key feature of a good team is their ability to execute. This is particularly important in the early stages of a company, as ideas alone don’t generate value unless they are well executed.

A good founding team is crucial for the success of a business and I personally would look for proactive, problem-solving co-founders, with complementary skill sets and a strong team dynamic. I believe the ability to make the right decisions is key because there will always be unforeseen eventualities, and having a mixture of skills across the founding members of a team allows startups to better handle these surprises.

The above list of questions is in no way all encompassing to fully evaluate an investment opportunity. It is rather a starting point. Other relevant questions which I haven’t further discussed in more detail at this point include:

  • What’s the size of the Total Addressable Market?
  • How competitive is the space?
  • What are the market dynamics?
  • What rights do you have as an angel investor and what are the specific terms in the Term Sheet?
  • Who are the other investors in the Cap Table?
  • How scalable and defensible is the business model?
  • Is the tech in-house or outsourced?

The list can be endless and there will always be concerns about some of the possible answers. The final bit of gut feel is therefore equally important for your overall perception of the business, which ultimately cannot be pinned down to a conclusive list of investment criteria. A good investor is able to see the magic of a business beyond common concerns and take the risk of investing when their gut instinct comes into play. A good balance of instinct and evaluating the right questions can help you decide what early-stage companies you should invest your capital and expertise into.