5 Pitfalls of Angel Investing

Tatyana Gray interviews Tracy Chadwell

Hey everybody. It’s great to be back. I hope you’re all okay with me moving to a bi-weekly schedule for the podcast. I’m happy to report that I’ve done a lot of work on the upcoming online course about start-up investing with the time that I got freed up by moving to this new podcast schedule.

As far as the course, what do you think of the name ‘Start-Up Investing Unplugged?’ I’m going to cover the whole start-up investing process from 6 modules from finding start-ups to invest in through to the due diligence deal negotiation, and what happens after you write the check. I will also lead a syndicate for the course participants so we can actually make one start-up investment together. I’m planning to partner up with an angel group, VC firm, or an accelerator incubator to bring the experts to you, and walk you through the nuances of this deal. Of course, I will invest my own money alongside with you. That’s coming in March or April. I will keep updating you on every podcast episode, but to learn even more head over to startupinvestingunplugged.com and get on my email list.

Now, I’m excited to introduce today’s podcast guest to you. Her name is Tracy Chadwell. Tracy is a member of Golden Seeds, an early stage investment firm that focuses on women-led start-ups. Tracy’s also a lawyer by training, and you know how I have a soft spot for lawyers. Tracy spent many years in the private equity adventure capital world as a partner at Baker Capital and now as a founding member of Coyote Capital. During these years, Tracy identified 5 major pitfalls that start-up investors often fall into and she’s going to share these pitfalls with us today. Without further ado, here is Tracy. Hi Tracy, how are you?

I’m great, thanks. How are you, Tatyana?

Pretty good, too. Thank you so much for being on the show. Where are you joining us from today?

I’m excited to join you from outside New York in Greenwich, Connecticut.

Nice, nice. Very wonderful. I’ve had quite a few people from the New York area on the show already. There is a lot of entrepreneurial stuff going on in that area around New York. Of course, lots of entrepreneurs and lots of angel investors, so really cool environment to be in.

Yeah, it is. It’s a really fantastic ecosystem. I’m lucky to be here.

Definitely. Well Tracy, as you probably know, I love to start the show by getting to know my guests a little bit better.

Yeah, absolutely.

Yeah, for me and for my readers as well, we would love to hear your story of how you got involved with angel investing and what you did before. What is your background?

Well, I absolutely love being a part of angel investing. It’s such a fundamentally positive area, being part of growth. My background has been in the legal and then venture capital area. I was lucky enough to join an investment bank, which was in the go-go time during the 90s. While I was there, I got exposed to some of the best venture capital funds that were out there, but also I saw what was happening in terms of all the technology companies growing. They were pricing deals for IPO, you know 3 or 4 at a time per day. It was really quite a different time, and all the metrics were around eyeballs. I think we have come a little further today, and really know that that’s not the best metric.
Then, I was able to join a growth capital fund called Baker Capital, so I am a professional investor. Baker Capital was focused on the telecommunications industry.

Well, thank you. That’s a great, great story. From more professional VC background, was there a particular event, organization, or class, that got your interest transferred more into angel investing side where it’s more about investing money out of your own pocket rather than being with a firm and investing your clients’ money?

Yeah, absolutely. One of the most interesting things that happened is that the advent of the female entrepreneur has been happening. As a woman myself, I thought that this was really exciting. Back when I first started, really didn’t see too many women entering the start-up area. Over the last 5 years, we’ve seen female start-ups grow from about 2% of all start-ups to female founders accounting for about 17% of the start-ups. There’s an incredible opportunity now to look at companies that have a diverse team. That’s what really inspired me to get involved in and to start putting my own capital to work.

That’s a great point, and I think you know Adam Quinton, he was on the show earlier.

Yes, I did.

He gave us some pretty interesting statistics, too: start-ups with diverse teams, with female founders or co-founders, actually provide better returns. It’s not just about gender bias or charity.

Right.

It’s about really good financial sense to look for really diverse founding teams.

Yeah, absolutely. Diverse founding teams tend to be more creative. They tend to be more cooperative, and absolutely tend to outperform their peers.

Yes, that’s a good point. Tracy, before we get in the meat of our conversation, and related to this topic about diverse teams, female co-founders, I know that you’re involved with Golden Seeds as well.

Yes.

We’ve had a few mentions of Golden Seeds on the show, but can you tell us a little bit more about that organization; just so we can gain the insight into it?

Sure, absolutely. Golden Seeds is a fantastic angel investor group. It’s one of the largest in the country, and the focus is on investing in a company that does have a female founder or a female in a leadership position. You think that it would be all women investors, but no, there’s about 20% of which that are gentlemen as well. We’re a group that accepts everyone from across the country as long as you’re an accredited investor. There’s offices on the West coast, and in the middle of the country, a big group in Texas, and the home office is here in New York.

It sounds like a great group, and as part of the Pipeline Angels fellowship that I’m doing right now, we had a lady from Golden Seeds to come and give us a presentation. I believe it was -

Loretta McCarthy, maybe?

Sounds familiar, but don’t quote me on that. It was a great presentation, and so what I’ve learned from that is that Golden Seeds, you ladies, and a few gentlemen there, are very organized and streamlined.

Yeah.

There are some great processes in place. For our readers, it’s a great place to check out and like you said, people can apply from all over. I think for anybody, it would be, if accepted, a great opportunity to not only learn about angel investing and really good processes involved in that, but also to see some amazing opportunities to actually invest in.

Yeah, the deal flow is pretty incredible. They look at 400-500 companies per year, and then the ones that come to screening are the ones that have passed the test, the initial run. Of screening, there’s probably 20 companies that go through screening per month, and then the companies that do make it to forum, that which is before due diligence, is about 4 or 5 companies per month. Really, the benefit of Golden Seeds is learning that you can do through being there, and being exposed to other members.
Then also, each member is a fantastic asset in and of themselves, because they come from all different areas of expertise and are usually some of the top in their asset class. If you’re looking for someone that’s an expert in molecular science, we have one. If you’re looking for an expert in oil drilling, we have one. If you’re looking for an expert in retail, there’s one at Golden Seeds. You have all that industry expertise, but then also, too, investment expertise, and it really makes for a nice group.

That’s a great point, just having enough people that have that kind of diverse expertise across all areas of investment.

Yeah, it really helps with due diligence.

I bet, yes. As we’re learning in Pipeline Angels, and doing some due diligence, we can see the holes in our backgrounds where we have thought “Oh, it would have been nice to have somebody who’s an expert in this area, or that area.” When you have a group of a big enough size, like Golden Seeds, then that becomes less of an issue because pretty much every area is covered.

Yeah, the critical mass really helps.

Well, Tracy, that leads us to what I consider the educational part of the show. You and I talked a little bit earlier, and through your experience in the angel investing over the years, and also in venture capital as well, you told me that these 5 things emerged that really you’ve noticed that investors kind of should be aware of these particular 5 areas, and especially new angel investors. I think it would be amazing to hear that from you for our readers and for me as well. I would love to hear your areas that we should be aware of.

That’s why this is a very exciting time, because we have access to all this information, and that really helps with investing as well. I’m really happy to share the information that I have, things that have stretched back 20 years because hopefully it can help some other people and maybe they’ll reach out to me and help me in a certain way.
I’ve definitely through the years, I’ve seen that there are some real pitfalls and I don’t want to be the wet blanket at the party, but we are talking about really significant amounts of money that are going into these companies. I’d rather see people, if they’re interested and excited about this asset class, do it in an educated way.

Of course.

There are 5 real pitfalls of angel investing that I have come across. The first one I think a lot of people have talked about in the past, which is due diligence, and really the amount of due diligence that you do correlates with much better returns. You really need to start with looking at things that you, first of all, you understand; but then also, that you have some way of looking into the company.
At the very least you want to do background checks, but then also you want to look into the market opportunity, make sure it’s there. You want to do customer calls to make sure that if they are reporting that they have customers, that they’re actually in place. You want to take a look at customer agreements to make sure that they’re there. That’s where sometimes an angel group can come in as really helpful, because you have a lot of people to come help you do a lot of this due diligence.

Definitely. On that, can I ask you quick question?

Sure.

You said background checks, and for different people it means different things. Can you elaborate? Do you mean an actual criminal type of a background check, or asking for references, and just checking the references?

It depends on how you’ve been introduced. If this is a absolute cold call, and it’s something that you think is interesting, sure, I absolutely do a background check that’s criminal. Most of the time, this is going to come through friends or through an investment that I’ve already made, or through my angel group. Then what I’ll do is, I’ll do more reference calls and try to get a little better feel for the person and their background.

No, that’s a great rule of thumb.

Yeah. The next thing that I see that’s a real pitfall - number 2 - is that people, think they’re investing in a good idea, or a good company, but it’s not necessarily a good investment. Something can be a really exciting, really necessary thing for a subset of the population, but when you’re dealing with a market opportunity that’s really small, it makes it much more difficult for the company to grow and much more difficult for the company to actually exit. When you fall in love with a company, make sure it’s a company that can actually scale, not just something that you yourself would use.
Then, for number 3, I think one of the biggest mistakes that people really, really don’t look to this one. This is kind of scary. It’s not having an accurate assessment of the capital that’s required to scale a company. What can happen here is if you don’t have a plan laid out with the entrepreneur about how much capital they’re going to be needing, at least on a general basis, you can really run into some pitfalls. This is the worst of all, which is completely running out of money and not being able to raise it again. In which case, the entrepreneur has shut the company down, and that’s a zero in your portfolio.
Something that maybe we’re not as much aware of, which is follow-on financing. Follow-on financing, while it seems attractive to have big venture capital funds come in that seems very sexy, if you have 2 or 3 additional rounds, what’s going to happen to your piece is that you continue to get deluded. If things aren’t performing as well during the last round, a lot of times, the venture capital funds can get a lot of terms that are very advantageous to them, but not so good for the initial capital that’s come in. The initial angels can get basically deluded out. There’s these things called preferential distribution rights, so if the venture capital fund comes in, in a later round and the company only sells for 2 times what they’ve invested, sometimes they have a right to 2 times their money. So, they take it all, which leaves the initial investors with nothing.

Okay. I have a quick question here. From an angel investor perspective, what is the best way to find out on both of the issues whether the company might run out of money before next round of financing? Especially, that one I think is a little more straightforward.

Right.

Then with the follow-on financing, as an angel investor coming at early stage, how can you figure out what’s going to happen in the future?

Yeah, that’s a hard one. Like you said, with the initial round of financing and making sure they have enough to get to the next stage, that’s fairly straightforward. You just take a look at their burn rates and see how long they have. You really usually want to have a cushion of 3–4 months at least before raising another round, or ways that you can throttle back on marketing, or throttle back on personnel so that you can stretch a little bit longer.
My favorite is looking at a company that only may need one round of financing. The situation that we’re in right now, everything is so compressed that companies can actually reach profitability on one round of financing. That’s one of the reasons why the angels space is so interesting.
As far as the other avoiding all these multiple rounds, that’s something you just have to look at and ask: is this a real capital intensive business, just fundamentally? Are you going to have to build out plants and things like that in order to make this thing work? In which case, that would be a business I would avoid. Or, you just have to take your risk that things will all go well.

As far as I think that this would be a great point for me and for our readers. Capital intensive, I think we can all understand enough, it’s a company that actually requires building plants, maybe a manufacturing of some sort. Any other capital intensive businesses that you can identify for us that might be in this space that requires multiple rounds of financing?

Well, fortunately because of the internet and because of software, and automation, we’re having fewer and fewer of those opportunities come forward. No, I think those oil drilling businesses and things like that are becoming a thing of the past.

Okay, well that’s still a good rule of thumb. Basically if it seems like it requires any type of creating your own infrastructure, rather than using somebody else’s infrastructure. One of the reasons I personally love investing in software is because you don’t need to be building plants. Nowadays, you don’t need to be building your own data centers, you can just use somebody else’s. That’s a very great point to keep in mind.

Well, and also, too, you got to test out your entrepreneur when you’re talking to them. Some of them are really excited, and I have to be honest with you, I’ve seen a lot of these come out of the accelerator programs. Some of these entrepreneurs are really, really excited about raising money more than building companies. If that’s really who you’re talking to, I would run the other way, because that is not going to have a great result for the angel investor.

That’s interesting, I never thought of it this way. I’m pretty new, so I guess I haven’t seen enough companies to really pick up on that issue. Plus, I’m in Idaho, so we’re little isolated. Our deal flow, of course, is not like what you guys have in the New York area; but that’s a great point as well. We can move on to pitfall number 4.

Pitfall number 4 is the exit. It’s really easy to get in. It’s awfully easy to sign a document and to write a check, and say “yes.” What’s much harder is being able to get your money back. I always make sure whenever I’m evaluating a company to know where specifically the exist is for this company. Is this a space where a lot of companies have been sold lately? Are there a lot of larger companies that are interested in taking out development? Are they outsourcing their R&D? A lot of times, a company just won’t get to the scale where it’s interesting to be acquired or interesting as an IPO option. You really have to target something, I always keep as a benchmark in mind, “can this company reach $100 million a year in annual revenue?”
A second thing is that you have to watch out again, back to testing out your founder. Some founders don’t actually want to exit. Some of them are building what I like to refer to as a lifestyle business. Something that’s great for them, maybe $5 million a year in revenue where they have a great salary. They’re running a great business, it’s a really interesting, exciting business for them. That’s not going to be interesting to a large company. It’s not an order of magnitude where it could move the scale for Microsoft or Cisco, and you’re stuck. There’s no way to get out. Sometimes you can negotiate some distributions out to the partners at the end of the day, but that can take a really long time. That’s basically at the blessing of the founder.
I really like to test my founders out and ask them, “So what are you thinking about for an exit? When are you thinking of? What are your plans for getting the money back to the investors?”

But wait…there’s more!

This post has been adapted from the Angel Investing with Tatyana Gray podcast. Listen to this recent episode for more great information from TRACY CHADWELL!

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About Tatyana
When Tatyana learned that out of almost 9 million accredited investors in the United states only 300,000 (about 3%) were active angel investors, she made it her mission to attract, educate, and inspire the next wave of angel investors in this country.
As a new angel investor herself, Tatyana loves to learn the craft of investing in startups from experienced angel investors. It was only natural to share this process with a broader audience via her Angel Investing podcast.

Follow Tatyana on Twitter at @tatgrayid. We welcome your comments.