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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Because traction is such a critical indicator of potential success, it is important to do diligence on the stated customer count and customer engagement and motivation.
examplePete once got excited about a company that claimed to have 85K customers. This was a consumer and small business product. After a few probing questions, it became clear that these “customers” were acquired when the company’s product was an add-on to a large ecosystem. These customers were on a free tier of the product, and the company determined that it could not monetize them, so it pivoted to a different value proposition. Entrepreneurs know how important customer traction is to investors, so the pressure to present numbers in a positive light can be extreme.
caution Early-stage companies may end up signing very unfavorable contracts to secure key deals or early customers that they need to move the business forward. If the company or its valuation is heavily dependent on a particular distribution contract or customer letter of intent (LOI), ask to see it.
B2B companies (or business-to-business companies) sell their product or service to other companies, not individual consumers. B2Bs sell things like an inventory tracking app to restaurants, or a loyalty system for retail stores. A subset of B2B is enterprise sales, where companies sell to larger organizations like Microsoft, Intel, HP, or Procter & Gamble. B2B companies will usually have a list of existing customers, a number of trialing or beta customers, and a pipeline of deals.
founder The hardest part of B2B startups is selling to businesses, especially enterprises. There was an old saying that “nobody gets fired for buying IBM”; meaning, go with a big name and reliable provider. A manager or executive takes a big risk when they buy a software system from a startup, since the company may not be around in a year, or could suffer operational problems when they try to scale, or fail to deliver software or training support. As a result, it is often the case that entrepreneurs’ first sales are to companies where they have a personal connection, such as a former employer. This is not a red flag. However, entrepreneurs need to be realistic about how they can expand their sales beyond their personal network.
exampleWhile Pete was performing due diligence on a startup that had created a software system for managing police staffing and the use of police department vehicles for events (such as football games), he asked the founder how he had gotten the first sales. The founder was a former police commander himself and used to manage this process on pieces of paper and chalk boards; so he had both great domain expertise and credibility with police departments. His first sale was to his former employer, the town’s police department, and his second sale was to the township next door, where he had a strong relationship with the head of the department. He had a few more sales in the state after that based on relationships and referrals. His challenge, he admitted, was finding sales people who would have credibility with police departments with whom he had no personal connection.
So, what’s the takeaway? The founder’s first sales were based on personal relationships, which is common. But if in his pitch he had said that the company had closed the first four sales within 30 days and had modeled accelerating sales rates in the first year, you now have reason to discount the next few months’ sales velocity. The entrepreneur is now having to sell outside of his personal network, so things will likely slow down until there is a good list of referenceable happy customers that the sales team can point to (ideally with case studies published on the company’s website.) Scrappy entrepreneurs very often tap their personal networks for early traction. Make sure you know where in the company’s story that ends and the sales to cold customers take over.
important There are many specialized markets in the B2B space, which is one reason that domain expertise is so important. Schools, governments, medical practitioners, and many other markets all have their own sales calendars and hurdles that entrepreneurs must navigate. Perhaps none is more daunting than enterprise sales, where the sales person has to navigate to find who in a large organization is the actual customer, who has purchasing authority, who has veto authority, and how the procurement department factors in.
The enterprise sales process can be very long and taxing. Because the sales process is long, and companies that sell to enterprises need to know how they are doing relative to sales expectations and cash forecasts, they track a sales pipeline, also called a sales funnel. The specific steps in that sales pipeline may vary by company, but it’s usually something like the following:
Leads. Leads are prospective customers that came to the company’s website and requested a demo.
Qualified leads. Prospects that someone has talked to in order to confirm that they have a budget, are looking to purchase a solution soon, and the contact has the authority to purchase.
Proposals or requests for proposals (RFPs). Some sales person has sent the prospect a proposal.
In-negotiation deals. There is active negotiation on a contract.
Trials or proofs of concept (POCs). This may be appropriate for some software products, but typically means that the product is being used on a test basis often for free within a prospective company.
Closed deals (or lost deals). Signed customer contracts, or definitive no’s from prospects.
founder An entrepreneur should be able to tell you about their sales pipeline, even if it is in the very early stages, and ideally their win/loss ratio. If they have a few sales, they should also be able to tell you about their annual contract value (ACV), that is, how much is the average customer paying per year for the product/service.
founder The entrepreneur’s financial model should reflect the length of time they need to close deals (three months? six months?) and the cost of sales people. Remember, those “in-network” sales we discussed in the example above will often reflect a shorter sales cycle than what the company will see as it tries to expand sales.
Ideally, you should speak to a handful of paying customers, if the company is far enough along to have any. If you spend a couple of hours talking to three or four customers you will be much more enlightened about the prospects of the company’s product, price point, and marketing. You may also learn who the key competitors really are in the eyes of customers. Ask them:
How did they hear about the company or product?
What are they using the product for?
What problem is it solving and how much is that worth to them?
What product were they using before, or what other solutions did they consider?
How do they like the product so far? Does it meet expectations?
How do they like working with the company? Is the company responsive, competent, et cetera?
Are they actually paying for the product?
Companies may resist giving you actual customers to call as they may worry that it will make their customers nervous. Keep in mind that all startups are trying to punch above their weight, meaning they want to appear to their customers in many cases as mature businesses that are not in need of money.
This can be a valid concern, but there is usually a way to work through this. For example, you could let the entrepreneur know that you’ll position the financing round as “expansion capital,” and will follow a script like this when you talk to customers:
“We love the team and the product. It seems to solve some real problems and have some real advantages. We are interested in investing in the company, and part of our investment process is to talk to a few customers.”
That sort of a script should ease most of the concerns of an entrepreneur.
danger If a company refuses to let you talk to customers or drags their feet in giving you contact information, that could be a red flag. It may be that the entrepreneurs have claimed that a company is a “customer” when they are in fact just evaluating the product and have not committed to purchasing it or even trialing it.
Early-stage companies may not have paying customers or even trialing customers or beta customers. In that case they are very early in the traction stage and likely much more risky. If they are following best startup practices, they have done a lot of potential-customer interviews and demos of a minimum viable product to gain confidence that they are working on a product that customers will buy. Ask to talk to some of the potential customers they interviewed.
For very early-stage investments, it is all the more important to work your own network and angel group to find people who are familiar with the company’s product category so that you can validate the customer pain point, and the fit of the product as a solution. Ask them what they think of the product, the value proposition, and the solutions that already exist in the market. Is the startup really solving an urgent pain point? Is there really a gap in the solutions available?
If a company is not selling to large enterprises but is selling to small or medium-sized businesses, then many of the B2C metrics below should also be examined. Finally, make sure that the revenue generated from a customer aligns with the marketing and sales effort to acquire that customer. For example, if the product is going to generate less than $1K per year in revenue, it should likely not be sold via a sales team; it should be largely self-serve for the customer, with little support required. If a product sale requires the customer’s CTO or CEO approval and it involves a six-month sales cycle, it needs to generate thousands or tens of thousands of dollars a month in revenue from that sale to justify the costs of sales people, contract negotiations, and any on-boarding and support costs.
B2C companies (or business-to-consumer companies) are offering a product or service to the general public.
B2C companies at the early stages will typically not provide a list of customers to talk to (imagine downloading a yoga app and then getting a call from an angel investor 😬) but if the company has an app or product in the marketplace you can hear the voice of the customer by reading customer reviews (see Usability). Beyond that, there is still work you can do to better understand the company’s relationship with any customers it may have.
Many companies are building products that will be profitable only if customers use them over a period of time and come back fairly frequently. This includes gaming companies, online services businesses like on-demand food delivery, online marketplaces, fitness apps, and so on. In this case, digging into what Dave McClure brilliantly popularized as the “pirate metrics” (AARRR!) is really important:
Acquisition. How many new customers is the company acquiring and at what cost?
Activation. Are those new customers engaging in the product? Having customers downloading an app and then never using it will not result in a profitable business.
Retention. How engaged are those users? Learn what percent are coming back daily, weekly, monthly, never.
Referral. Do the customers refer other customers? This is often key to scaling profitably.
Revenue. What percentage of customers are generating revenue, often in the form of upgrading from a free product to a paid version? What percentage of customers are delivering more margin than it costs to acquire them?
The entrepreneur should be able to show you charts with actual numbers pulled from a database of how many customers are signing up per week or month, the number of daily or monthly active users, and the level of attrition (leaving, quitting, cancelling).
If the company’s revenue model is purely transactional, like selling widgets, then many of the same metrics apply, with the exception of activation. The retention metric is about repeat purchases, which is often critical to profitability.
Customer acquisition cost (CAC) is a critical metric of the B2C startup. The company should be able to tell you about their most effective marketing channels, and what it costs on average to acquire a customer.
Customer lifetime value (or CLTV or CLV) is another critical metric. Entrepreneurs should understand (or at least have a model with assumptions around) the customer lifetime value and how long it takes for them to recover the cost of acquisition. For the company to be profitable, their CLTV has to dramatically exceed their customer acquisition cost (CAC). That may not be the case initially while they are experimenting and tuning their marketing mix and retention and pricing strategies—but they should have a hypothesis of how they are going to get there.
dangerIf a company cannot provide the data discussed in this section, that might be a red flag. If some of the numbers don’t look good, that is not a deal killer as long as they are tracking the right KPIs (key performance indicators) and working and testing diligently to improve the ones that are not working.
In every pitch deck there should be a slide about competition.
danger If a company says there is no competition it may be a red flag that they don’t understand their customers or their market. If you were the inventor of the first car, for example, you might have been tempted to say that there was no competition; but in fact the competition was horses and carriages and trolleys and trains and bicycles and human feet.
founder Most entrepreneurs know that they have to be better than the competition or at least differentiated to get funded, but their products are early and as a result are often lacking in features. This creates a temptation for founders to be dismissive of certain competitors or to leave them out of the competitive slide in their pitch altogether. They shouldn’t—again, these are key indicators of how well a founder understands her market, customers, and product. Evaluating competition is very company-specific, but the following are some general guidelines for angels to follow when doing diligence on competition: