On this episode of The Full Ratchet Nick covers the first element of Best Practices for Seed & Angel Investing. This series will be covered in five sections from before you begin until you are managing an active portfolio. These sections include:
Before you begin… An Overview of Seed Investing- Developing an Angel Investor Strategy
- Finding startups to invest in: Deal-flow
- Evaluation & picking startups
- Structuring the Deal & Terms
Today we will cover the first item, and we will address the remaining sections in coming episodes.
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With that said, let’s launch in…
Welcome everyone to the Full Ratchet episode 22. Very happy to have you listen as today is a unique episode where I’ll be covering part one of Best Practices for angel and seed-stage investing. A lot of you in the audience have recently reached out to me about this subject and I appreciate the e-mails. Absolutely keep them coming… it’s great for me to hear what topics you want covered and what provides the most value.
The best practices that I will review today are an aggregate from the Full Ratchet interviews as well as a breadth of content that I’ve absorbed over the past few years. I’ve chosen to focus on the experts viewpoints and not that of my own, but I will share my perspective where appropriate. I have some experience with a range of these items, but there are some that I don’t and in that case, I will include the best practices that are most often promoted by those with breadth and depth of experience. For those loyal listeners, some of this will be review, but trust that there is new material as well.
”HIDE/SHOW:
While I’d typically recommend resources, such as the many books and blogs from our guests, today is not about sending you off to 20 places to go do homework. Today is about consolidating the consistent and persistent messages that I’ve heard from the experts and delivering that in a focused way. And while I typically bring a guest on and will do so for the vast majority of topics, this is one topic where there was too much great information residing in a range of places, so consolidation seemed more appropriate. I’ve spent many hours reading on this topic and while I’ve found tremendous resources, I did not find one that covered every item that we will address today. That said this list of best practices is often presented as such.. as just a list. It could also easily be covered in an entire book. I’ve edited down the first version of this to about 1/3 the original length… so I hope that it’s the right balance between enough information and not too much. And the podcast audio will cover this info in two parts.
Remember as I mentioned early-on, this is not advice on what startups to invest in. Please always consult your lawyer when making investments. This is a compilation of strategies and best practices that should help inform those decisions. Following these guidelines will not guarantee success. Rather they should help make the successes a better outcome, ideally for both the seed-investor and for the founders. And also they should help one avoid bad investments. As Imran Ahmad said in Episode 19 on Due Diligence, there is a little bit of hair on every deal, and there are things you are going to miss. But, if you have a strong working knowledge of the following, there should be fewer oversights and stronger confidence in the deals that are made. And for the entreprenuers… I know there are some founders that listen to the show to learn more about the startup fundraising process, so hopefully today’s list will help you better understand what seed investors are looking for.
Naturally, some of the key takeaways and tips that we’ve previously covered and will cover in the future will show up in some of these best practices. And remember that nobody’s got a crystal ball, nobody can predict the future… but there are strategies and principles that the best establish, stick to and execute on all of their deals.
Section 1: Before you begin… an Overview of Seed Investing / “What game are we playing?”
- What is “Seed?”
- Accreditation
- Selection
- Minimums
- Success Rate
- Speed & The Fast No
- Diversification
- Liquidity
- Consensus vs Black-swans
- The Role of Angels
HIDE/SHOW Section 1: An Overview of Seed Investing
- What is “Seed?”: Unless a founder has very wealthy friends and family, this will typically be the first professional money invested, coming from Angels and/or micro-VCs. At times, it may be preceeded by a friends and family round, typically quite small. The definition of seed has fluctuated over the years and it may be different depending on type of business and industry… but recall that Ann Winblad said the average company raising a seed round is raising around $0.5M and if they price the round, it has traditionally been under a $3M valuation. Depending on the current funding environment, founder track record, actual progress-to-date and other factors… that valuation can fluctuate 50% or more up or down. The actual progress of the startup varies significantly at this stage. At times, the seed round will fund just an idea on a piece of paper. At other times you will see startups that have proof-of-concept and market traction/validation at the time of a seed financing. Labeling a financing as seed or series A is less important than the amount being raised, the price (ie. valuation), the investors participating and the actual progress of the startup.
- Accreditation: Seed investors must be accredited. Angel investing is not currently available for the unaccredited, although it may be, in the form of crowd-funding, in the future. If you do not know the definition, please refer to episode 3 and the accredited definition link in the show notes. The simplified, summary definition is that one needs to have $200k of earned income in the two prior, consecutive years and/or $1M of net worth excluding the value of one’s home.
- Selection: Nothing teaches you about angel investing like experience. Starting out with a few small investments will take you a long way. And picking winners is the single most important element of all. If you can’t pick winners, you will lose. If you don’t think you have the chops to evaluate startups and find the best, but still want to invest in startups and innovation, consider joining a group. If a group is not the best option, maybe you want to participate more passively or you want to put more money to work, then spend a little time upfront finding a venture fund and fund manager that’s a good fit.
- Minimums: Typically the minimum amount to get into a seed round is 5-10% of the total raise. So if the startup is raising $150k, the minimums will likely be different than if they’re raising $500k. If you’re investing independently make sure you have enough per investment to make these minimums. If you are a part of a syndicate or an angel group, you can get by with lower minimums and diversify further. Often for lone, direct seed investments, the minimum is around $25k. While in syndicates they can be as low as $1k, like on AngelList. There are a few reasons for minimums, but ultimatley, startups can not have a large number of investors on their cap table. The larger the number, the more difficult to raise subsequent rounds and eventually a company may be forced to go public, like Facebook, b/c the #of investors on the cap table exceeds the allowed amount for a private company. When you’re in a syndicate or angel group, you can invest as one entity, thus occupying one line of the cap table instead of the actual number of angels.
- Success Rate: Hit rate is very low. Treat it as an investment, but one needs to be comfortable loosing the entire investment. This reduces the pressure on every investment and allows for investing more decisively and confidently… and if they fail, that’s okay. And whether you are an angel investing in startups or an LP investing in a venture fund, ask yourself if will you judge mediocre returns as a failure? Did a venture fund that returned 5% to investors under-preform the much less risky S&P 500? Sure. But did it also provide it’s investors an opportunity for very high returns? Yes. Just b/c every angel investment and every venture fund investment doesn’t return 100%, doesn’t mean they didn’t provide the opportunity for that. And if your capital gets returned, you can have another opportunity.
- Speed & The Fast No: Practice, unfortunately, doesn’t make perfect in this game… but it will make your No’s a lot more clear, you’ll get to them faster, and the deal structures for your Yeses will set you up much more favorably down the road. And know that one has to say no much more often than they say yes. I myself have fallen victim to “falling in love on the first date,” and this only has set me up for disappointment and reluctant Nos down the road. The best angels are decisive. They say no early and they say no often. And the questions required to get to Yes are asked and processed efficiently. If you are in-decisive, this may not be a good fit.
- Diversification: This is an investment class that merits a portfolio. Again it is very hard to pick, so spreading investment dollars across a number of high-potential startups is recommended. Most advocate a minimum of 10 investments. Some recommend 20, 30 or more. And trying to time the market, rarely works. Investments should be spread over the course of several years. This is great for the economics of a portfolio but also help one build a network of co-investors and build a brand as an active investor. Also, more deals = more at bats. Remember that even one homerun can make a portfolio. And as an investor builds their brand, do you think that other investors judge them by all the failed investments or by their big successes?
- Liquidity: Assume these investments will not be liquid for 10 years. Early exits are great, but they’re not always possible. And typically, when a VC gets involved on the investment-side, that only lengthens the amount of time to exit. A key tip here on liquidity that Dave Berkus has shared as one of his keys to success, is that he never lets his money sit. If he experiences an exit and there is no roll-over or immediate angel investment, he puts that money into highly liquid places that produce steady returns. Letting money sit idle can severely limit a portfolio’s eventual IRR.
- Consensus vs. Black Swans: There is a surprising lack of correlation between how hot a deal a startup is and how well it ends up doing. There’s been a lot of chatter lately about concensus investing and how one should avoid consensus deals, as Sam Altman has advocated… targeting “Black Swans” This is a difficult one to take a firm position on. On one hand, the message is to create connections, trust and a good track record of investing so that you can get into the best deals. On the other hand many argue that a consensus baby unicorn, by definition, won’t be enormously successful b/c in this industry the great successes aren’t consensus deals early-on. Also, of course, the consensus deal valuations will be driven up… ultimately yielding lower returns. Ultimately, the world today is very different than the world tomorrow. And consensus thinking is too rooted in the the dynamic of the current market as opposed to that of the future. Some investors have proven to have that unique ability to make educated predictions about different possible future-states and the startups well positioned for that. I think the most important message here is that if you are a strong believer in a startup and you’re met with furrowed brows and dismissive comments from others, don’t sweat it. All the black swans start that way.
- The Role of Angels: If you “lead” a deal, that means that you have negotiated terms and set the price. If you decide to lead, you should also expect to help the startup find other investors to complete the round. If you are a “follower” in a deal, that means that terms and valuation has been set by a lead investor and you participate in the deal at those terms. Paul Graham has said about Angels: “… they’re probably the single most important ingredient in making the Valley what it is. Angels are the limiting reagent in startup formation.” Want a better startup ecosystem, create a better Angel ecosystem.” So whether you prefer to lead or follow, you will create value. Whether it be in the companies you invest or the ecosystem that results from it.
Many investors will talk about how they pick from the gut. That ultimately, you have to trust your gut when picking. If you’ve read Malcolm Gladwell’s book, Outliers, he talks about factors that contribute to high levels of success. In another of his books, Blink, he discusses the ability for experts with deep domain expertise, to make immediate decisions or assessments without spending time thinking about those decisions. One of the key takeaways from Gladwell’s works is that it takes time, immersion, study and a lot of practice to become great at anything. Sort of the 10,000 hours rule. He talks about how the Beatles spent years and years playing music together in mediocrity before they began releasing the albums that we all know so well today. He also outlines a situation in Blink, where a statue, that passed all tests of authenticity, was immediately identified as counterfeit by an expert… without any specific reason as to why it was fake.
And from my own experiences, a friend of mine talks about the thousands of deals his seen in our angel group and how evaluating each of these deals has made him tremendously faster and more confident with his decisions. So you will find that experienced angels and Venture Capitalists that have exceeded the 10,000 hours, maybe multiple times over, are able to make fast decisions b/c much of this analysis is built-in. They don’t have to consiously walk-through each evaluation item… it becomes second-nature. Doesn’t mean that their evaluation process is going to produce great outcomes, it just means they can do it more efficiently. So the reason I call attention to this is because choosing from the gut is certainly a viable approach, if you’ve seen thousands of deals. If you are like me, the more prudent approach is to learn the best practices and key evaluation criteria and put them into practice. Will I arrive at the point where I can make gut calls on the non-obvious NOs ?…. I hope so. But until then, I owe it to myself, the startups I invest in, and my co-investors to due my homework and make decisions without reservation.