Dealflow Best Practices for Angel Investors
Part of Our Research Series for Angel Investors
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The goal of screening is to whittle down potentially thousands of investment opportunities to those that are eligible for consideration given an angel’s investment philosophy, sector preferences, and other criteria that define the interest of the investor. Between the offer of a term sheet and closing of a deal, preliminary and final due diligence are conducted to ensure the risk and return potential are appropriate. To many experienced investors, a large percentage of investment opportunities can be eliminated from consideration in minutes due to the screening processes in place.
As we discuss below and in more detail throughout our content, an obvious but often overlooked question for startups is whether or not external capital raising is necessary. In addition to a more thorough review of the team abilities, product, and market size, there are important and necessary questions to ask as an angel to determine if the founders are best served to bring on an involved angel (and dilute their own ownership in the company). While it may seem obvious that the answer is always, “yes!” as it means more investment opportunities for angel investors, it is important to keep in mind that it may not be appropriate or the right fit.
The initial screening process can be formal or informal, but for angel investors, the screening process tends to be more informal than formal. This is because there exists both a lack of track record for the company (i.e. available data) and this is often a solo endeavor, meaning there’s no chain of command to present memos or thesis.
No matter how formal this process is, the quality of screening, also known as deal flow, is a critical component to success. “Sourcing” a high quality deal flow is not only challenging but also requires significant amounts of time, so having strong screening practices in place can help angels become more efficient and focus time on potentially more value-add activities to existing portfolio companies or fund operations. Like most practices across the early stage investing sphere, there is no formal screening process. It can be as informal as a conversation between an angel and a third party or as formal as an in-depth review of a company pitch deck or business plan. Most screening processes start with the compatibility of the investment with the persona of the angel and quality of key aspects of the venture, known as strategic fit.
Strategic Fit
Like the companies in which they invest, angels often try to differentiate themselves by developing a unique investment philosophy, sector-focus, founder-connection, or geographic tendency. This makes screening out ideas easier based on some of these categories.
While VCs will often lead these categories as broad as possible in order to view as many deals and opportunities as possible, angels are often better served focusing on select sectors given many angels generated their wealth from past business experience — i.e. they are leveraging domain expertise. It is important, therefore, before beginning to invest as an angel, to identify the high level, strategic plan for investing your hard-earned dollars. This will inform the screening process.
The following is an overview of the common screens applied at this step.
Philosophy
The philosophy may change over time, but often captures the sentiment towards the markets in which angels seek to address. The challenge in clearly identifying a philosophy is that at the end of the day, angels are first and foremost investing in people and ideas, not just products and companies. Given the rapid rate of technological development and velocity in which trends change, investors can only consume and understand so much; and it is often the case that there may be great opportunities that simply do not align with the areas of expertise, sentiment, or ability of the investor.
A great example of a philosophy is from Renaissance Venture Capital, whose website clearly explains their belief that certain major regions of the United States are overlooked — lending to the possibility of discovering opportunities where others may have not sought. These philosophies can be developed further, like Renaissance, into smaller segments or more broadly, such as Andreessen Horowitz’s famous “Software is Eating the World” motto.
Another example of philosophy is impact investing, where companies are delivering solutions to under-served areas or populations. Examples include microfinance loans in third world countries, educational and food-based resources and services, and many others.
Industry/Sector
VC Funds are often considered specialists or generalists. The same can apply to angels. Generalists will be receptive to ventures across almost any industry or sector, while specialists are just the opposite: they consider themselves experts in a select few domains and look for leading opportunities given known problems in the vertical.
Moderne Ventures and MetaProp are two Real Estate focused venture funds on the East Coast. Moderne’s website reads, “We’re looking for companies with strong teams that can execute on bold mandates to advance the multi-trillion dollar real estate, insurance, finance, hospitality and home services industries, and provide value to our strategic investors and partners within them.”
By focusing on specific industries and sectors, investors believe they can form opinions on the probability of success of an opportunity more quickly and better understand the forces of nature that will dictate success of failure. Pitch decks and business plans that do not focus on these areas can be easily discarded.
Geography
Like business sectors, location can play an important role in understanding the risks and opportunities of a potential investment. Beyond the well known headquarters of venture capital flows in general that is concentrated on the coasts in the US, different geographies may be more appealing to funds given the actual venture.
Angels, on the other hand, can be flexible as they are more geographically diverse, so they can easily build intimate knowledge of their backyard and build relationships with key players to build a sustainable advantage.
Beyond these features of geographic preference and proximity is the value of network effects within startup communities. It is not a coincidence that Silicon Valley has continued to dominate as the land of VC — there are real benefits to being able to leverage shared networks, talent pools, resources, and information within a well-developed ecosystem. It may be the case that VCs invest in companies in certain areas due to the VC’s belief that those resources will be more readily available to founders and companies, increasing the probability of success. Conversely, this may be a reason why VCs may look to ‘underserved’ areas of venture capital — to lead the way in developing these networks. Angels, as the forerunner of capital to Venture, can look for potential hotspots ahead of Venture funding as a potential way to uncover high-potential investments. This, in effect, leads to investing in geographies as much as specific companies.
Given that underserved areas will lag areas saturated with venture funding, angel investors represent a unique opportunity for startups to establish their local cities as investment hubs. This means angel investors can be the genesis of momentum that can be very beneficial to them down the road — a first mover advantage of sorts.
Quality
Now that we have discussed fit, assuming it exists, the next step of the screening process is to review the quality of the potential opportunity. This spans the quality of the origin and related parties.
Source and Origin
Dealflow is a numbers game, and the more chances to play means the better the odds of winning. However, not all prospective deals are the same. Referrals, warm leads, and introductions from trusted sources are almost always preferred to cold outreaches.
Sourcing ideas from experienced and trusted contacts within the industry can help de-risk the opportunity, especially if the referrer has already conducted some preliminary research and due diligence into the business or can vouch for the strength of the founding team. When your reputation is on the line, especially when money is involved, information tends to be high quality.
Professional contacts, especially referrals coming from the same industry in which that person is an expert, should be highly considered as well. It is likely the referrer has experienced the same problem the company is trying to solve, and an angel’s wide network across business professions can help in sourcing ideas.
Outside of the source of opportunity is the genesis of the idea itself. Some investors may prefer to invest in ventures started by successful and well known entrepreneurs of business leaders. This is viewed as a more calculated risk than an unknown. Similarly, how was the problem in which the venture intends to resolve identified? Was it personally experienced by the founders? Does the management team have experience solving similar problems in the past through other ventures or their current job? Angels should look to patterns of success with the founding members in order to understand in whom they are investing. We will discuss this in more detail in other areas of due diligence, but suffice to say for a preliminary screen, the ideal source is a commonly applied screen.
Partners and Business Associates
Similarly, capital is often provided to a company but is then redistributed by means of strategic partnerships, spent on accountants and lawyers, and used to acquire customers. All of these areas have both direct and indirect influences on the investor’s role within the company and need to be considered as well.
Who and of what quality are the other investors in the round, if any at this stage? An impressive lineup of co-investors are often indicative of a high quality opportunity, and one that has been scrutinized by other quality VCs down the line. The quality and value of the networks brought to the table through other investors can add a significant amount of value on top of capital. All of this points to the potential to gain an “information” advantage with the venture — an advantage even those with perhaps better products or plans may not be able to topple.
The quality of the company’s legal counsel, accountants, and other professional services should be considered as well. Especially at early stages, companies need good legal counsel. Poorly structured corporate entities, employment contracts, customer agreements, and negotiations can have material impacts down the road and need to be seriously considered when reviewing operating risk of the venture. Similarly, the quality of financial record keeping (especially as it relates to taxes and cash flow management) are critical in review. By outsourcing much of these tasks to reputable professionals, companies can focus on where they should: creating value and building their company. Knowing these tasks are being handled appropriately can remove significant risk.
Last but not least, does the company have any significant and impressive customers or have they identified who are going to be their first customers? If the company has secured, for example, an exclusive agreement with a market leader, this may often trump other considerable risks. Having a secure sales channel, already developed brand, or cost advantage can be immediately impactful when it comes to the ability to develop a sustainable competitive marketplace. Look for letters of intent or finalized contracts to gauge the quality of customers, but also take into account the potential customer concentration risk. Is the company relying on a single customer? What happens if that customer relationship ends?
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