On this episode of The Full Ratchet Nick covers part 3 of Best Practices for Seed & Angel Investing including:
- Overview of Seed Investing
- Developing an Angel Investor Strategy
- Identifying startups: Deal-flow
- Evaluation & picking startups
- Structuring the Deal
Today we address item #3, Deal-flow, identifying startups to invest in.
Welcome back for another edition of best practices on the full ratchet. In part 3 of best practices, we will be covering, Deal-flow. The Evaluation section will follow in the next installment.
And next week in our series on Angel Investing, we welcome Christopher Mirabile, chairman-elect of the ACA. We started this series with lessons learned from Gabriel Weinberg and it only makes sense to cover Angel evolution and the future roadmap with Christopher. I am very much looking forward to this interview with such a key individual in the angel ecosystem.
With that, let’s launch into the episode with:
Section 3: Identifying Startups to Invest in… Deal-Flow / “Hunters vs. Gatherers?”
- The Pre-Screen
- Upfront Info
HIDE/SHOW Section 3: Identifying Startups to Invest in... Deal-Flow
- The “Pre-Screen”: Have a multi-stage process. Your first stage of filtering is often called the “pre-screen.” And most advise that this is not a phase of evaluation for measuring risk. Rather this includes the gating factors. The answer to all of these is a Yes or a No. Is that startup’s valuation in my acceptable range? Is it in my target geography, vertical, etc. If you have 10 total gating factors, you might say a startup must meet all 10 for you to begin evaluation. You may say that 8 out of 10 must be met, to take a deeper dive. Whatever the case, this gating phase or “pre-screen” can be enormously helpful for your time, for startups time, and for other syndicate investors so that they know what deal-flow to send your way and what not to. If you are worried, that advertising your target startup profile is going to limit your opportunity to see other new and interesting technology in other areas, don’t. I guarantee that you’ll still see a ton of deal-flow outside your core, you’ll just move through it quicker. The two components of a typical Pre-Screen are:
- The Investment Thesis (addressed above)- this is what you can easily advertise to startups and co-investors
- Filters- these are additional items that have objective answers and can help triage deal-flow including, but not limited to:
- Valuation range that’s acceptable
- Previous amount of money raised
- Must the company have Revenue?
- Do you require a founder to have domain or market expertise in the target market?
- Do you require that a certain % of the raised capital is used for growth as opposed to product development, operations, etc.
- My angel group, for instance, focuses on startups using the money for growth activities, not for product development.
- What an investor answers to the above questions is up to them. No one can tell you what your criteria is. But what is critical is that you answer these and use them as a way to filter fast. Naval Ravikant asks: “Can you make a decision on whether to pass or proceed to deeper questions in less than 20 minutes?” The best practice knowledge-base would indicate that you should be able to.
- Timing: Structure your deal-flow in a way that allows you to meet startups very early… even before they’ve founded a company. If you’ve done this, then when they start a company and come to you, you’ll have first access to structure the round and/or invest early. Recall that, on average, Charlie O’Donnell has met his founders 26 months before making an investment. While all cases might not be like this, it is great to try and meet potential founders early-on.
- Sources: Have more than one source of deal-flow (other angels, angel groups, startup events, pitches, accelerators, gust, angelist). This is a referral business. Talk with other Angels… they will be a significant source of deal-flow. When you build a brand as a reliable, useful investor, you will get deal-flow. And clearly groups and syndicates will help one attract more deal-flow… Plus they provide more purchase power, more evaluation breadth, and more individuals to contribute to due diligence.
- Referrals: Related to previous bullet on Sources, is referrals. Some will advise angels to only pass along deal-flow to other angels that they themselves are going to invest in. I tend to disagree with this. My criteria is quite different than some of my friends. For example, I do not invest in medical or healthcare startups b/c I do not understand the vertical, the regulatory process and the key drivers of success and failure. I know other angels that specialize in this sector. Conversely, I look at industrial and device markets whereas many of my counterparts do not. I regularly encourage my network to pass along deal-flow that doesn’t fit their profile, if there’s even a slight possibility that I would be interested.
In a study conducted by Christopher Mirabile, when he analyzed Angel Group sources of deal-flow, he found the following in order of the most to the least number of startups identified:
- Referral from members
- Random submissions
- Referrals from other angel groups
- Demo Days / Pitch Competitions
- Service Providers
- Syndication Calls and Events
- So, this illustrates that the network, at least for angel groups, is still the #1 place to find new startups. The message here is to connect with other angels and seed investors.
- Volume: Probably not surprising the same study by Christopher found that deal-flow and # of deals completed per year are strongly correlated. Not only is quality deal-flow important, but volume is critical as well.
- The Bozo Filter: There are many groups out there that will charge entrepreneurs to pitch. Many refer to this as the “bozo filter.” Apparently used to weed out the startups that aren’t serious or make those that are serious put in the work on their pitch b/c they’re paying a fee. It’s each groups right to do what they’d like here, but by the numbers know that charging entrepreneurs effectively cuts deal-flow in half. Clearly, these groups also close fewer rounds… a little more than half of those that don’t charge. I think it goes without saying that seed investing is not an activity that most get into to nickel and dime or scratch out a small living. It’s an industry where one looks for homeruns. There may be other factors that influence the decision to charge entrepreneurs… I can’t pretend to know them all but I’m not sure how they outweigh the importance of halving your deal-flow. And I’m also a believer that the exceptional teams that one invests in do not need the investors, via a fee, to compel them to put together a strong pitch. If there’s no bozo filter and the startup submits a low-effort application or deck… maybe that tells you something.
- Upfront Info: The vast majority of Angel Groups use Gust to manage deal-flow and process. And 95% of those groups use the entrepreneur application feature. This requires the startup founders to fill in a form with Key items that are required when one reviews a company. This includes:
- The financial forecast
- Monthly Burn Rate
- Previous capital raised
- Pre-money valuation
- Target current capital raise
- A Business Summary
- An elevator pitch
- Profile of the founders
- The problem being solved
- The Target Market
- The Sales/Marketing/Channel Strategy
- The Business Model
- Competitive Advantage
- and a few other details…
- This list is not all that is needed to make an investment decision… but answers to these items are absolutely required just to decide if you should spend your time with a deep screen. While they all should be covered in a pitch deck, some are often missed and pitch decks are really just a presentation tool. One still needs a dashboard of key decision criteria. The answers to this set of questions on a one-two pager saves me a great deal of time b/c I don’t have to ask each individually. I get the form and typically in 5 minutes or less I can decide to pass or continue an evaluation with stage two of my screening process. If a startup is not ready to answer these questions they, honestly, are really not ready to raise capital.
- Access: One of the “epiphanies” I had regarding deal-flow was the realization that many well-connected investors will invest some capital in a venture funds and/or accelerators. And this actually provides them first access to deals of their choice. For example if you invest in Charlie O’Donnell’s fund, he has mentioned that he gives all his LPs the ability to make additional side-car investments in any portfolio company. While $10 or $20k may not be enough to get into these deals, when it’s bolted on to the main investment and doesn’t occupy an extra line on the cap table, it works. And it’s a similar case with accelerators. Invest in an accelerator’s fund and you’ll likely get the first opportunity to invest in the accelerator companies of your choice when they graduate.
That wraps up our eighth and final item for today.
When thinking about deal-flow, remember that, even moreso than money, time is the most valuable asset. The better prepared an investor is upfront, the more time they’ll save filtering and triaging deal-flow. Some startups will criticize angel groups for taking far too long to make a decision on an investment. While initially, I thought this was the case b/c meetings are infrequent and the members are not full-time startup investors, I’ve learned that many angel groups run in a professional and efficient manner, providing a decision in the same amount of time as a VC firm. It is those groups that lack alignment on process and gating criteria that drag their feet on investment decisions and leave startups in limbo. Whether one’s an angel group leader, an angel group member or an independent startup investor… it’s always a good idea to spec out the process, set a target timeframe for each step and measure both time and % of startups that proceed through the funnel.
As mentioned, we will be covering part 4, evaluation and picking startups to invest in on our next installment of best practices. Shoot me an e-mail if you have any questions, comments or are looking for input on your process. My email is simple, it’s firstname.lastname@example.org.
And jump on the website to download, save or print out the best practice items. I’d imagine you may be driving, exercising or doing other activities while listening that are not very conducive to taking notes… so I will have all the items on the site at fullratchet.net.
Until next time… remember to overprepare, choose carefully and invest confidently. Thanks for tuning in.