Foundational Issues for Angel Investors

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The angel investment community in Wisconsin has been growing steadily for several years now, and given the limited availability of professional venture capital in the state this is good news. My purpose today is to offer some of the newer and prospective angel investors in our state some ideas they should think about in terms of what they want to get out of their angel investing activities, and some of the things they should consider in terms of accomplishing those goals. As in all of my blogs, the focus is on high impact angel entrepreneurship and investing.

Realistic Objectives. Most angels, while looking to make some money, also have other objectives, ranging from keeping busy to “giving back” to other entrepreneurs, to supporting regional economic development. That is all good, because with the odd exception that proves the rule, high impact angel investors generally don’t generate the kinds of returns that professional seed/early stage venture capital investors generate. Still, even if your core objective is not about financial returns, it is a big mistake to invest in any deal that does not pass the blush test as a financial investment. Take marginally more risk than a professional investor playing with other folks’ money might take, and pay a modest premium for the honor; but never invest in a deal, or on terms, that don’t make sense as an investment. If you do, you won’t be doing yourself, your community or the entrepreneur any favors. And you probably won’t have much fun, either.

It’s All About Deal Flow. Consistently successful angel investors share a critical trait with their consistently successful venture capital cousins: great deal flow. That is, they get the “pick of the crop” of available deals. So, as a new angel, how do you get access to the best deals?

Good angel deal flow is almost always a result of a solid value added investment proposition. That is, angels that bring something valuable to their portfolio companies beyond capital almost always have better deal flow than those who don’t. Maybe you have great connections with downstream investors. Or maybe you are a great management coach with deep industry knowledge and networks. Whatever. As a new angel investor, if you want to get quality deal flow – the sine qua non of successful angel investing – you must establish and deliver a value proposition for entrepreneurs over and above writing a check.

Find a Good Niche. Angel investing and investors come in a bewildering array of flavors. Some angels are lone wolves, while others run better in packs. Some have very specific industry preferences, while others may focus on investment/business stage. These choices should, of course, reflect the value add investment proposition of the particular angel. They should also reflect a variety of other factors. For example, rational angel investing, as rational venture capital investing, is based on diversifying investments across a portfolio of deals. Ten is the “rule of thumb” but you should consider five a minimum portfolio objective. Well, if you have $500k, and you want to make at least five investments, you either need to limit your per company investment to $100k (and that, typically, in multiple tranches) or you need to find a pack to join to leverage your personal capital pool. The size of the capital base also impacts whether you will look to be a leader in the angel round, or a follower – which in turn will impact how much say you will have (in the strict follower case, little or none) in setting the terms of the deal. If you find yourself in a pack, consider whether you want to be a committed fund – that is, a fund with pool of available capital committed – or a “pass the hat” operation, where each member of the pack makes their own investment decision. (All other things equal, entrepreneurs – here is that deal flow issue again – prefer committed capital funds, with or without side cars, to pass the hat funds.) Finally, consider what your time horizon is. If you want to see customer validation sooner rather than later, stay away from most early stage biotech deals, for example, even if they otherwise fit your criteria.

Learn the Rules Before You Break Them. Whatever your objectives are, do yourself, entrepreneurs, other angels and downstream investors a favor: don’t try to tell the repeat players already in the business how to go about the business. While there is always room for improvement (well, almost always) the “conventional rules” of angel investing in terms of deal terms are conventional for a reason: they more or less work, and they are more or less easy/cost-effective to implement (assuming both sides have experienced counsel). If as a newer angel you want to do something materially different from the industry norm with the terms of a deal, be ready to explain just what the problem with more traditional terms is in the specific instance – and why your tweaks won’t complicate raising downstream capital. If you are honest about this, you will most likely never propose terms that are materially different from the conventional wisdom.

A Final Thought. The “big four” risk factors in deal due diligence are team, market, technology and financing. A word to the wise: twenty-five years in and around the venture capital, high impact entrepreneurship, and angel investing world has taught me one lesson above all others: the most important factor in success is the team. If you are not good at, and serious about, team due diligence, find another angel who is, and don’t write a check without her.

© MICHAEL BEST & FRIEDRICH LLP