Business

The 4 most preventable mistakes first-time angel investors make

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Angel investing is the quintessential definition of risk versus reward. The reward is you might own part of the next Google; the risk is you have a statistical probability of losing every cent you put into the deal. So why do it? Economic stimulation aside, the answer is diversification.

It’s not for everyone, but if you’re considering angel investing, you can reduce your risk to some degree by watching out for some common problems. Here’s a checklist of prerequisites you’ll want to make sure an entrepreneurial team hits before you make a deal.

1. Ensure the entrepreneur is in it for the inevitable marathon

Here’s what first-time angel investors don’t get: You just bought equity. Equity is not a percentage of the company’s revenue or profit; it is the all-encompassing ownership of the business. Those shares can’t be traded, can’t be taken to the bank, and can’t be cashed in when you need the money like a public stock could be. What you’re doing is making a bet that the company will eventually reach a liquidation event; this typically means it’s being bought by a bigger company (acquisition) or it’s going public (IPO). On average, it takes 6.5 years to liquidate successfully.

Since an investment has to last the better part of a decade, the entrepreneur must be passionate about the problem that the business is solving. Money isn’t enough motivation to do something as difficult as early-stage entrepreneurship for 6.5 years.

I recently asked Erik Wullschleger, the managing director of the Sprint Mobile Health Accelerator powered by Techstars, how they picked leaders they knew could handle the marathon. He emphasized the importance of a mission-driven attitude that transcends other types of motivation.

“All 43 of our entrepreneurs have literally put their lives on hold and moved to Kansas City from all over the globe to build solutions to problems that they’ve personally been impacted by,” Wullschleger said. “In some cases, they’ve watched their relatives struggle with a disease. In another, they’ve seen better ways for their grandparents to live independently.”

Founder pain, re-location of the company, mission-driven attitudes — these are all examples of things that will ensure the entrepreneur won’t quit when times inevitably get hard. If you’re not seeing these signs in the founder, move on.

2. Make sure the entrepreneur is personally invested

It should be an automatic red flag if the leader isn’t personally invested in their own company. This prerequisite is complementary to the first argument in that a personal investment will help ensure they’re in it for the long-haul. But it’s more than that. As an investor, you want every dollar the business spends to sting. This won’t happen unless a percentage of every dollar spent is the their own. The result is money is deployed more efficiently.

Rachael Qualls founded the Angel Capital Group, the largest network of angel investment groups in the country, and she insists on personal investment from founders.

“I think it is very important for entrepreneurs to be personally invested in their ventures,” she said. “Early mistakes (and you will make them) should be made with your own money. If you can’t make rent, you will find a way to sell your product. This instills resourcefulness that will serve you well into the future. If you can’t personally bear the financial risks of running your own company, entrepreneurship isn’t for you.”

3. Pay to scale, not to test

A startup is nothing more than a series of guesses. You assume you know what your customers want. You assume you know how to get it to them. You assume you know how much they’re willing to pay. It’s the entrepreneur’s job to empirically test those assumptions with their own money — or no money at all. Data will start to pour in that validates or refutes the entrepreneur’s hypotheses. The aspects of the plan that are validated will remain or be leveraged; the aspects that are refuted should be tweaked to mirror the feedback from the market.

After a marathon of experiments and tweaks, a business model has been found. All those things that were originally just guesses are now facts. More importantly, they’re facts that the entrepreneur can replicate. This inflection point is called product/market fit — it’s when the offering slides into the market like a much-needed puzzle piece. Now that a sustainable business model has been found, it’s time to add gasoline, which is when an angel comes in. Before product/market fit, an investor is gambling; after product/market fit, they are scaling.

Ash Maurya, a prolific entrepreneur and author of “Running Lean,” cautions investors to wait for product/market fit before putting money into a startup.

“[Investors] are growth-driven and care about traction above everything else,” he said. “The best time then to raise a significant investment round is when you are closer to product/market fit. That is when both the entrepreneur and the investor’s interests are similarly aligned around growth.”

4. Examine the cost of customer acquisition

Debatably, a startup’s most important metrics center around its engine of growth – specifically, how much it costs to acquire a customer. Once that is known, angel investors can extrapolate the impact their cash will make and whether an investment would be worth it.

Diane Kander, a senior fellow at the Kauffman Foundation, warns founders about ignoring the cost of customer acquisition: “Revenue is exciting, but it doesn’t mean much if it costs you more to generate the customer than you stand to make. An entrepreneur can sell their way out of business if they don’t know their numbers.”

Weston Bergmann is the Lead Investor in BetaBlox, a for-equity business incubator in Kansas City. He’s acquired part of 80 companies in the last three years alone. He’s a radical lean startup practitioner, and his dog’s name is Bootstrap.

 


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7 comments
Ward Chandler
Ward Chandler

I wholeheartedly agree with points 1 and 2.  And while an investor would certainly minimize their risk by only investing in companies that have found product market fit and are scaling with a known customer acquisition cost, they would also dramatically limit their upside.  There is an investment risk / reward curve in every deal.  The key is finding the right match for the stage the company is at and the appetite for risk that the investor has. Fortunately for startups, there are investors willing to fund long before product market fit.  Fortunately for angels, plenty of founders need capital to validate their "guesses" are willing to give up a big slice of equity to get there.  

Phill Sly
Phill Sly

Completely agree. In my experience great success comes in helping the founder navigate to a product-market fit and then helping them to commercially execute. A good angel should see the potential business model and then advise on how to close the gap. Then you have a choice to add VC rounds or organic avenues to scale.

Weston Bergmann
Weston Bergmann

Angel investors are mathematically going to lose money unless they get into 117 deals. That is the statistical inflection point for which this asset class averages black. This article's aim is at people who only have several million dollars to spend on this vehicle. That amount of money will only cut them in to 10-20 angel investments - which is a very small portfolio. When you only get to make 10-20 deals they have to be done with an incredible amount of discipline, and thus should bend more towards growth-stage ventures. When you've got tens of millions to invest than you can deviate towards the earlier-stage. There are many reasons to do this, but they wouldn't fit into my word count limit - so I apologize for not having an exhaustive playbook. I myself almost exclusively invest in early-stage ventures that aren't ready to scale - but only because I have a platform that will allow me to acquire part of hundreds of companies. Statistically speaking, quantity is the only way to fight the early-stage risk. I assumed that the average reader would benefit in hearing it from the vantage point of a disciplined angel's  thesis. All that said, I don't agree that the angel will lose the deals. They'll just have to buy-in at higher valuations further up the road when a larger percentage of the entrepreneurial gauntlet had been slayed. That means less equity for the angel, but way less risky, and sooner exits. 

David Quiec
David Quiec

Angel investors come in early, likely before product market fit. Investing small amount and expecting scale is highly unlikely.

Jamie Bailey
Jamie Bailey

If you are an Angel who only invests in companies that are scaling, then you will miss out on a LOT of (good) deals.  Companies who are hitting the "scaling" phase are looking at VC money and larger rounds, not Angel rounds.  Too many Angel investors want the risk of growth equity with the upside of venture capital.  It does not work that way.  #3 is describing an Angel participating in a Series A round (or Series B), something you won't get an opportunity to do for great deals unless you bring a lot more to the table than just money.  

Maxime Calouche
Maxime Calouche

@Jamie Bailey Well said and one thing to consider is that there is a risk/return tradeoff. If the investor takes more risks he will take more equity to ensure a higher expected return.