A Warning to Angel Investors
I was 11 years old when I went skiing for the first time. It was a school trip. I had never taken a ski lesson but didn’t think it looked that difficult. So I rented my skis and followed my friends onto the slopes. Down the slopes I soared, gleeful, until I realized I had a big problem: I didn’t know how to stop. I crashed into barricades at the bottom of the slope and was rushed to the hospital. I still have a scar on my right knee to remind me of this youthful foolishness.
I started helping companies invest in and acquire startups when I was in college. One week after I graduated college, I started my first company — to help SPACs (then called blind pools) acquire target companies. And I have been investing in and advising startups ever since (33+ years).
Just like the skiing accident, I have also been hurt by some of the hundreds of investments I’ve made. I have investment scar tissue. It reminds me every day of the importance of due diligence.
Investing in startups without doing deep due diligence is like skiing down a mountain without having learned the requisite skills. It can feel thrilling, but it’s foolish, it’s dangerous and can often lead to bad outcomes. And scar tissue.
Why am I telling you this? Because I am concerned. Concerned about the current startup investing environment, concerned about the lack of due diligence, concerned about the impact of FOMO (fear of missing out) overcoming investors’ good judgment. I feel it is incumbent on me to alert you to an alarming practice that has cropped up across several angel investing platforms: syndicate leads are syndicating deals without doing any due diligence. In fact, many times, the companies are not even aware that the syndicate has syndicated the deal. The companies have never spoken to the syndicate lead and have not authorized them to syndicate the deal. The syndicate gets an allocation from another investor in the deal and decides to syndicate it on one of the investing platforms. As a result, they have done zero due diligence. And yet you are relying on syndicate leads — and paying them, in the form of carried interest — not just to source deals, but to perform rigorous due diligence. I fear you may not even be aware of the fact that they are often doing no due diligence at all.
There is a lot of capital in search of startups to invest in — and a rush to deploy it. Investors have FOMO if they miss what seems like a great deal. Startups are able to raise capital without giving investors the opportunity to perform due diligence. This can lead to foolish decisions and harmful outcomes.
Just yesterday, we were at the tail end of our due diligence on a deal we were excited about. But I had a nagging sense that something wasn’t right. So, I kept pushing. The company claimed to have just signed a deal with a major restaurant chain for $20M. I asked them to connect me with the restaurant chain so I could verify this. They said too many investors had already spoken with them and they did not want to request yet another reference call. My nagging sense turned into full-on, red-flag worry. I asked some connections I had at the restaurant chain to investigate for me. They came back and told me they had no deal with the startup. They had one quick call with them and it went no further. We had caught the startup in an outright lie. One that many investors have already fallen victim to. In fact, another group has syndicated the deal.
Here’s another recent example. One of our portfolio companies raised a follow-on round. Another group syndicated the deal and the platform later withdrew it because the syndicate misrepresented many of the deal terms and facts about the company. Our portfolio company was unaware of this group, had never spoken with them nor given them the authority to syndicate their deal. And if you had invested with them, you would have done so based on incorrect information. This scenario is playing out weekly.
You may be wondering if due diligence really matters, if it really affects your investment returns. The answer is absolutely! According to the largest study of angel investors ever, conducted by the Angel Capital Association and the Kauffman Foundation: “Spending time on due diligence is significantly related to better outcomes. Simply splitting the sample between investors who spent less than the median twenty hours of due diligence and investors who spent more shows an overall multiple difference of 5.9X for those with high due diligence compared to only 1.1X for those with low due diligence. The exits where investors spent more than 40 hours doing due diligence (the top quartile) experienced a 7.1X multiple.”
The importance of due diligence is clear. That’s why our due diligence process is so rigorous. And yet we are seeing more and more syndicate leads sharing deals where they have no relationship with the companies. (Some syndicates rely on lead investors to conduct due diligence, but large firms often do only cursory due diligence on early-stage deals where they are investing small amounts in order to have the option to invest in the winners at a later stage. And you have no transparency into their level of due diligence and no opportunity to ask questions). These syndicates have not done even the most basic due diligence. They do not give you access to the founders in an exclusive webinar, as we always do, so you can meet the team and ask them questions before making your investment decision. They do not secure pro-rata rights, like we always do, so you have the opportunity to invest in future rounds. And they certainly do not have a written guarantee to receive regular investor updates from the company, as we always do, so you can keep up to date on the company’s progress. And they don’t do anything to help their portfolio companies succeed after investing, like we always do. How could they do any of these things? They have literally never even spoken to the companies.
Where does that leave us? We clearly have a problem, but what can we do about it? At a very minimum, I propose that investor platforms should require all syndicate leads to have a signed statement from the startup specifically giving the syndicate permission to syndicate the deal. That would at least address the issue of syndicates not having the startups’ permission to share the deal. But it doesn’t address the issue of due diligence. That can only be solved by you. If you are selective about the deals you invest in and invest only in those where the syndicate lead has done extensive due diligence, you will not only earn much higher returns on your investments, but you may also force more syndicates to start protecting their investors through proper due diligence. You may also want to ask syndicate leads to share their entire track record. We share ours with our members and encourage others to as well.
I understand that a skeptic could read my warning and interpret it as self-promotional. My goal, though, with this letter is not to encourage anyone to invest with Forefront. My goal is to share what I’ve seen unfolding so that you and other angel investors can use this information for your benefit when evaluating any deals you see, from whatever source.
Phil Nadel is the Co-Founder and Managing Director of Forefront Venture Partners. Follow him on Twitter: @NadelPhil or on Medium at https://medium.com/@pnadel or connect with him on LinkedIn.
