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What do angel investors look for in new investments?

Posted on
liz@frontierangels.com Mar 3, 2015

Angel investors are wealthy persons who invest time and money in startup companies. In recent years, angel investors have become more effective by forming and joining angel groups, such as  the Frontier Angel Fund in Montana. Angels in groups are easier for entrepreneurs to find and can bring more resources to entrepreneurial ventures.

So, what do angels look for in fundable deals? Here are ten characteristics of startup ventures that investors consider when looking at deals. Some attributes are clearly more important than others, but all the qualities of new companies must pass the “smell test”, that is, based on our experience as entrepreneurs and investors, does the company have a reasonable chance of succeeding in growing a viable company?

  1. The entrepreneur and the management team – Angel investors are betting on the jockey, not the horse – at least for the earliest stages of startup. Does the team have integrity? Are members of the team coachable? Does the team have leadership experience? Do they have a deep understanding of the business segment of the startup venture? Has the team worked together before? Is the team balanced? That is, do they have most of the bases covered (technology, sales and marketing, leadership, finance, etc.)? Most investors believe the entrepreneur and the team are the most important consideration for fundable companies.
  1. Scalability – Can the company grow rapidly to revenues greater than $20 million in five to eight years? Why is this important? Investing in startup companies is risky business. Fifty percent fail, usually within three years. Nine out of ten will, at best, return the capital for ten investments. Less than 1 in 10 angel-funded startup companies provide all the upside returns for investors in this asset class. To achieve a return commensurate with this level of risk, that one winner in ten investments must be a home run – a company that returns 20X or more of invested capital to angels. If angels invest in ten companies, one of which must be a home run, and we don’t know which company will, indeed, be successful, then all angel investments must demonstrate the potential to become a home run.
  1. Angel investors tend to invest in local companies. It is easier to do our “due diligence” in local companies before writing checks. We are motivated to help our local economy by investing in nearby companies. Furthermore, mentoring local companies is convenient for angels, who are part time investors.
  1. Potential investments must be customer-ready, that is, have some validation by potential customers that the new offering is a “must-have,” not nice-to-have product. Investors will talk to potential or existing customer to validate importance of the product to those clients.
  1. The products of target investment companies must have a competitive advantage: trade secrets, patents or trademarks or a big head start. A competitive advantage precludes competitors with deep pockets from reverse engineering our new company’s products and entering the market with a “me too” product with much greater sales and marketing clouts within months of our product introduction.
  1. We angels prefer investing in companies whose intended marketplace is not dominated by one or two huge players with the resources to quickly duplicate or even improve upon new product introductions. Fragmented markets with small, weak players are always preferred over well-defined markets with dominate players.
  1. Candidates for funding must have a detailed sales and marketing plan. What is the size of the addressable market? Who are the players in the market? What are the strengths and weakness of these players? What channels will the company use to market and sell new products into this market. How will the team manage sales and marketing?
  1. Angels are equity investors and anticipate harvesting their investment by selling the company to a large, wealthy company through a lucrative exit. Angels are not lenders and do not expect portfolio companies to buy back their investment with interest at a later date. Consequently, investors expect entrepreneurs to have given adequate consideration to exiting the company, even before the investment is made. When might an exit occur? Who might be willing to purchase the company? Are those exit candidates actively purchasing small companies now? What valuation methodologies are used to price exits?
  1. Is their regulatory risk for the company? Angels generally don’t invest in companies that must await government approvals before initiating revenues because the timing of such approvals can be long and the wait frustrating. The level of regulatory risk varies from industry to industry, but angels interested in funding companies in those business sectors are often quite familiar with the required approval processes.
  1. The willingness of angels to fund companies is impacted by the size of the round and the total amount of capital required for the target company to enter the market and achieve positive cash flow (from earnings). Angels generally fund round sizes between $200,000 and $1 million and can often muster the resources necessary to fund two or even three such rounds. Angels seldom fund deals that require more than $1 million in a single round or more than $2 million in total. There are simply too few investors with deep pockets who are funding larger deals, in Montana and elsewhere. Providing angel funding to deals that will eventually require much more funding simply adds to much risk to the deal.

Written by Bill Payne, Active Investor, Frontier Angel Fund II

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