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.