On this episode of The Full Ratchet Nick covers part 4 of Best Practices for Angel Investing including:
Overview of Seed Investing- Developing an Angel Investor Strategy
- Identifying startups: Deal-flow
- Evaluation & Selection– The Team
- Evaluation & Selection– The Product & The Market
- The Deal
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Welcome back for our fourth segment in best practices, called: “How to Win”… Evaluating and choosing startups to invest in.
This topic is broken into four items. On this episode we will cover the high-level considerations when evaluating startups and also the first category of the three-prongs of evaluation, which is “The Team.” On the next episode we will be addressing the remaining two items in Evaluation, including The Product and The Market.
It’s a bit of a lengthier episode than normal as I will be covering two sets of ten best practices… but bear w/ me as the content on Evaluation, while involved, is maybe the most critical element. No matter what an investor does, if they choose startups poorly, nothing else matters.
The first, high-level category on evaluation, has ten items. They are:
Overview of Evaluation
- Jockeys, Horses & Racetracks
- Enthusiasm
- NDAs
- The Pitch
- Scale
- Schemes
- The Exit
- Contingencies
- Burn Rates
- Metrics
HIDE/SHOW Section 4a: Overview of Evaluation
- Jockeys, Horses & Racetracks: Often one will find that investors discuss startups in three broad categories: The Team, The Product/Technology and the Market. Each of these three broad categories has a range of components that merit analysis before an investment. Being mindful of the importance of these three branches and how well a startup is positioned for each is often the foundation for investment evaluation. As addressed previously, many early-stage investors prefer great founders over great ideas… jockeys over horses, so to speak. There is a thought that exceptional people will create and adapt the best ideas and find the big markets. Recall George Deeb’s comments from Episode five. He’d rather have an A+ team building a B idea than a B team building an A+ idea. David S. Rose has also written that the value of execution is 10x more important than the value of the idea. Naturally, having an A+ team in an A+ market working on an A+ idea is ideal, but these can be very rare. And when dealing with nascent markets and ideas that will change significantly during early-stages… sometimes the people are the most known entity of the three.
- Enthusiasm: Investors who have been doing this for a long time will all have a story about a startup that checked every box and passed every test, but they just couldn’t get excited about it. Some proceeded and some did not, but nearly all seem to have to same message: “You, as the investor, must be excited. If you are not enthusiastic and optimistic about the team and product, it will be a long, frustrating engagement.” We have already touched on how this is a long-term relationship, akin to a marriage. And the hard times and setbacks that will occur are rarely worth it in absence of this fundamental enthusiasm.
- NDA’S: The simple message… Don’t sign them. Venture Capitalists and experienced Angels will recommend to never sign an NDA. It exposes the investor far too much down the road. And startups that ask you to sign them have really not done their homework on fundraising and investor expectations.
- The Pitch: Business plans are not the preferred way to review startups… typically a 10 slide deck and a one sentence elevator pitch that articulates the problem and benefit is what’s necessary. In a later episode, we will discuss the components that should be present in every pitch deck. Until then, know that most angels do not waste their time reviewing business plans.
- Scale: If you are investing in venture via the traditional priced-round or convertible… startups must have an opportunity to scale fast and in a defensible way. Bill Payne advised us to refrain from investing in the standard, local, service business. These can be difficult to scale and defend. If you take an equity position it can be very difficult to both get the return you need and get your money out via an exit. And whether service or not, many startups can be quickly eliminated if their five-year pro-forma revenue does not reflect tremendous scale. Remember the goal is 10x or much higher return within five years. While forecasts are never accurate, startups must shoot for greatness to achieve it.
- Exit: Related to scale, all serious startups should have an awareness of potential exits. Will they be okay with a modest but positive exit that provides them the financial security to move on to something else? Is there a singular focus on this opportunity only, becoming a massive exit? As Gabriel Weinberg cautioned us in his lessons learned, a strategy of hitting singles and doubles is fine, if you can find a lot of them and have no reservations about committing the time, energy and capital for modest exits. But in his case, he has shifted his focus toward startups that have homerun potential with an out-sized potential exit. And remember, in this asset class, it is rare for an investor to get their money out, unless the startup has a strategic sale or IPO.
- Schemes: The other common trap includes scheme businesses. There are a number of startups that have gotten some traction with crafty businesses that trick customers into a purchase, yet provide no intrinsic value. While some of these can be very successful in the short-term, will they be sustainable? And even if they figure out a way to scale their scheme and have an exit… do you want your wins to include a scammy business that may make other uncomfortable? That may be okay for some, but it certainly doesn’t feel right to me.
- Contingencies: Have you asked the startup what they will do if this fails? Their answer can be critical. I have heard the following many times: “well I’ll probably launch a startup on this other problem over here or I’ll go to work for this other startup.” It doesn’t sound like full committment when failure is fully planned out. What feels much better is when the founder starts probing for the cause of failure (customer adoption, cash, quality, etc.) and then discusses contingencies for addressing those problems. To them, failure is not an option… if there is a problem that is threatening the life of their business, they will do whatever it takes to make sure it doesn’t sink the company. And speaking of contingencies, it’s a good habit to discuss what will be done if the cash outlook bcomes very grim. How will they adjust down their burn-rate? What costs will they cut. And as Bill Gurley has recently written about… when founders present items to be cut in a difficult cash situation, ask why they can not be cut now. Are they directly impacting customer growth or engagement? If not, maybe that modern, loft office in the entertainment district should move to the industrial district now, instead of when the cash runs out.
- Burn-Rate / Burn-Down: We can’t have a strong message on costs without discussing Burn rate. Every startup should closely track cash-flows and understand their monthly “burn” (ie. Spend). It is pretty straightforward to calculate how much runway this fundraise will provide, in months. A common, yet surprising oversight from startups is when they will burn through the cash from the current raise within months of a planned subsequent raise. Fundraising can take a lot longer than planned, so either they need accounting help or are hoping for a miracle.
- Metrics: Every startup should be able to articulate to investors the key KPIs used to manage the business. It is usually recommended that the founder & CEO has 3-5 metrics that are critical to success and reaching the next milestone. As an investor, assess whether the KPIs are appropriate. And ask how often are they reviewed. Startup or not, one can’t manage what they don’t measure. And well-structured metrics that are reviewed on a regular cycle will provide focus on the key goals, allow issues to be addressed and countermeasured quickly and gives an investor a much better indication of whether the startup is winning or losing. Realistically, timelines and goals change. When a startup pivots… growth goals, burn rates and key milestones may be missed. Those that adapt, are honest and learn from the missteps are much better positioned for success.
Now that we have addressed the high-level evaluation items, we will move on to the three major sub-components, starting with the “Team” ie. The Founders. This sub-section also includes 10 items:
The Team / The Founders – “The Jockey”
- Relationship
- “The Sell”
- Composition
- Outliers
- Emotional IQ
- Profile
- Salary
- Pivots
- Past Behavior
- Product-Founder Fit
HIDE/SHOW Section 4a: Evaluating The Team / The Founders
- Relationship: You must like the founder… this is a long-term relationship and you must trust and like the people in portfolio companies. As Jeff Carter mentioned, whether it be startups or investors, scum-bags are scum-bags and he doesn’t work with them.
- “The Sell”: It’s very critical that the founders can sell you on the product or potential. They may not be a sales person, but they should be able to articulate it in a way that gets you excited. Throughout a startup’s lifecycle, they will have to sell themselves and the business to customers, employees, and investors. We all know the feeling of walking in skeptical to walking out inspired. Technical or not, some have and some don’t.
- Composition: Optimal configuration is 2-3 founders. 5 is too many. 1 is to little. The reality is that founders can get lonely and even depressed. Not have a partner to share the pressure and bounce ideas off of is a huge challenge. Naval Ravikant recommends to look for founder composition of builder & and a seller. Two marketing founders only or two technologists only present a lot of challenges. Outsourcing product development completely makes it hard to iterate, adapt, fix and update as necessary. Teams consisting of an exceptional engineer or technologist and an exceptional marketer/commercial person have strong composition.
- Outliers: When Rob Go was a guest, he talked about how this is an outliers business and he looks for not great people, but exceptional people… not just the top 10% or top 20%. When they conduct diligence and make calls for references, their portfolio company founders are not described as really good, they are considered the best.
- Emotional IQ: When it comes to assessing people, one must have their Emotional IQ radar up. With so many investors advocating to bet on the jockey early-on, one should get a sense for founder’s personality while you are evaluating. This could be the single most critical component to picking. The subtleties of interaction can significantly help when assessing integrity, work-ethic and resourcefulness. Subtle tactics like timing email responsiveness and asking about relationships previous investors can provide great insight into committment and integrity.
- Profile: Founders that easily get discouraged or overwhelmed will likely give up. As mentioned, if you can understand and empathize well with founders, your odds of picking great ones will go up. A list of the most often-cited charcteristics of great founders includes: resourceful, intelligent, energetic, obsessive, flexible, resilient, honest, driven and determined. The best founders will find a way and people with a profile of these characteristics are obsessed with finding a way.
- Salary: Salaries should be low, equity upside should be high (standard salary range is anywhere from $40k-90k). Paul Graham has stated that if he could only ask one question of a startup, it would be: “how much salary is the founder taking?” There is a surprisingly strong, indirect correlation between salary level and success. The higher the salary, the less likely to succeed.
- Pivots: The vast majority of startups will have to pivot their strategy, product, channel, messaging, monetization, target market, etc. This should be the expectation at the seed stage, not a surprise. Are the founders willing to pivot for success, or are they obstinate and unyielding in their assumptions?
- Past Behavior: It is very likely that a startup team will treat you much like they’ve treated previous investors. I have had more than three cases now, where I was very close to making an investment, when the cap table discussion comes up. And in each instance the founders sort of gave a chuckle and a smirk while saying that the previous investors don’t have any dilution protection so we’ll just go ahead and dilute them out. The real thing that insenced me here is that these are early, friends and family investors… and these founders had so little integrity that they enjoy the prospect of screwing these people. While I understand that close attention to terms allows me to include the necessary protections, if founders are treating previous investors poorly, guess who’s next… and the so-called “marriage” of angel investing is not at all interesting… with people like these.
- Product-Founder Fit: You often hear angels talk of product-market fit and proof-of-concept. Maybe even more important that those is “product-founder” fit. Simply, this asks the question “is the founder the best person to be leading the growth and development of this particular product?” Does their background, experience and interests lead them uniquely to address this problem & solution? An investor should never have to keep a founder motivated to work on their business. Is the founder totally familiar with the target market? Do they have a track-record relevant to Venture? Whether they have direct experience in the industry vertical or they are applying horizontal expertise to a new vertical, founders should have strong knowledge of the industry dynamics and customers. While Jerry Neumann talked about how he was a top 10 sector expert in adtech, he still had the expectation that he would be learning from his startup founders. While his strategic role may be that of teacher, his sector role is that of student.