Entrepreneur

Guidelines for potential angel investors

(Editor’s note: Will Herman is an entrepreneur who has founded or held senior roles in several tech companies.This story originally appeared on his blog.)

I did my first angel investment in 1994 and I’m now in the process of wrapping up my 31st (individually, that is, not as part of a fund). It’s also my third in the past six months. I’ve probably done about 30 more as a limited partner in seed funds and incubators along the way as well.

All in, that probably makes me a second tier angel investor, at least in terms of deals done. Third tier if you count the “super angels” who have knocked off hundreds of deals in shorter periods of time. That said, I was recently “voted” as one of Boston’s best angel investors – though I think that says more about Boston’s investment community than it does about me.

I invest because I have a blast doing it. It’s about 75 percent of the fun of running the company yourself with only 5 percent of the stress. I get to meet smart, energetic people with great visions and boundless energy. It keeps my head in the game. And when I can add value (in addition to money) and help a startup weave it’s way through product, market and management mine fields, I avoid feeling like the least productive member of society for another day.

The difference between a second tier the first tier guys and investor like me (other than brains and talent) is the first tier investors actually work at finding investments. I’m dangerously more passive about it, reacting to the investment opportunities that come to me.

I get to see my fair share of potential deals, but by selecting from a smaller set I not only miss loads of opportunities,  my comparative perspective is likely skewed – the best companies I see may be among the worst potential investments out there.

Fortunately, I’ve been moderately successful with this type of investing. A little over one third of my investments have provided reasonable returns over time with a few big successes doing most of the financial heaving lifting for my “fund.”

While I don’t have any absolutes when it comes to investing, I do have some guidelines that I loosely attempt to adhere to, at least when they’re convenient. Some of them are general and are similar to those used by many angel investors. Others are more personal and, for one reason or another, I’ve picked up over time as a result of my investment experiences.

The general ones:

  • “Drill more holes” – I once heard the CEO of Shell Oil speaking with analysts at a conference. When asked how Shell was going to diversify in the coming year, the CEO responded with the statement, “we’re going to drill more holes.” Investing in many companies is the only way to balance the risks of markets, teams and competition. Maintain a relatively large portfolio.
  • Invest in stuff you understand – Bright shining objects attract attention (“we have the basis for a cure for cancer”), but the more you know, the less shiny those things often look. If you can’t judge the team, market and product thoroughly, it’s probably not a wise investment.
  • Keep some powder dry for subsequent rounds – While the best return in a successful investment comes from investing earlier, holding some cash back to see how the company does and to play alongside institutional money that comes into the company can mitigate some risk. It also ensures you’re playing on the same terms as the rest of the investors.
  • Everything looks good during the honeymoon – Don’t make assumptions that the problems you see will go away or that things, in general, will get magically better. They won’t. While making an investment, you’re probably seeing the company in its best light. Things will likely get worse before they get better.

My Personal Guidelines:

  • I don’t like convertible debt – The investor takes on an inordinate amount of risk with a convertible note which he/she is generally not compensated for. Think about a note holder who waits 18 months before a conversion is triggered with an equity investment at a higher valuation. For a small percentage (8-10 percent), the “investor” takes all the risk in funding the company without participating in most of the potential uptick in valuation. Some strange debt instruments are being created now to fill this and other holes, but for all their complexity, the company should just do a seed round.
  • Team over idea – Ideas are cool, but quality teams are cooler. A great team can make a mediocre idea soar or morph it into a better one over time. Often, mediocre teams struggle to create success even when they start with a great idea. I have to believe that the team can knock the ball out of the park. Only then do I consider the idea itself. As a corollary to this, I need to trust the CEO. Surprisingly, I find this to be a real issue from time to time.
  • There has to be a grownup involved – For all the energy, drive, brains and talent in most startups, there’s often a dearth of wisdom. Someone needs to be involved to provide it and be a sounding board for the startup team. This person or these people should be on the company’s Board of Directors. They can come from inside or outside of the investor group (inside preferable).
  • I hate leading a round – Someone has to be in charge of representing the investors in the seed round. Negotiating the fine points of the deal, working with lawyers, getting everything signed, communicating every step of the way, etc. I hate doing it, but once in a while, I draw the short straw. I like investing along side seed or angel funds as a result. They’re pros and do it all the time. It’s not even heavy lifting for them. Most importantly, they’ll do all the herding of the investment cats required. It’s often a real pain in the ass.
  • You can’t and don’t even want to try to tie up every loose end – As much as you’d like everything in the investment to be taken care of and completely thought out, it ain’t gonna happen. Things change along the way.  The investor and founding team need to feel like they will make adjustments together as warranted.
  • Friend’s before business – This is a personal rule of mine that I’ve broken more than once. Fortunately, it’s never backfired on me. I take both my friendships and my involvement with companies seriously. As such, the potential for conflict is high if I mix them – things never go the way you plan. There are always going to be situations in which the investor needs to support either the company or the management team. Can you support the company over your friend? Your friend over the company? Why even put yourself in that position?

This is hardly a definitive list, of course, but hopefully it’s a starting point for anyone wanting to get involved in angel investing and for anyone looking for an angel investment.


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