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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.
Of all the opportunities you’re likely to come across, how do you narrow your list down to the companies you’re willing to spend the time and effort of due diligence on? There is an ongoing debate among venture capitalists and angel investors about what is most important in determining the likelihood of a startup’s success: a strong team, a big market, or a compelling idea? They are all important, so we will cover how to evaluate all three below.
Ideas are everywhere, and there are very few unique ones. There is a long road between the idea and an actual compelling product, and longer still to a revenue-generating business (and longer still to profits!). It is the team that is going to build the business out of the idea, so you should be as confident as possible that the people pitching to you are going to be able to execute. Many believe that one of the best predictors of success is an entrepreneur who has built and exited one or more successful companies. Absent that scenario, below are some key things to consider after hearing the pitch. (We’ll address team issues in more detail in Business Due Diligence for Angel Investments.)
Your goal here is to figure out whether the team is particularly well-suited to tackle the problem that they have set out to solve because of their skills, background, and experience.
A good team generally has domain expertise in the industry that they are now planning to disrupt, and ideally in the functions that are core to succeeding with that disruption.
Domain expertise (or domain knowledge) means a thorough understanding of a particular field of study. In the context of angel investing, a deep knowledge of a particular industry’s inner workings, including the ecosystem, market, competitors, and customers. Domain expertise can also refer to functional domain expertise, such as a deep understanding of social media marketing or iOS app development.
exampleIf a company is bringing an internet of things (IoT) solution to the managing of railroad cars, it’s important that someone on the team has a thorough understanding of IoT technical architectures (has built IoT systems before) and someone has spent time working in the railroad industry or has specific insight into that industry.
In addition to domain knowledge, is there enough functional domain expterise—practical experience—among the team to tackle the problem they’ve chosen? You might ask it this way: How functionally complete is the team? Is it two engineers with no experience in marketing, sales, or operations? Ideally, each key area of functional expertise required for success is represented by someone on the team. Often, each member of a small startup team is wearing many hats, and so they need to convince you that they can execute those roles or be clear that they will use the money they are raising to hire to fill the gaps. It can be challenging for a very early-stage company to hire a great marketing person, or a great engineering leader, so if a key function is lacking, it creates extra risk for the company.
The other aspect of an investment opportunity that can sway an investor is the sheer size of the market opportunity presented. Angels and venture capital investors frequently focus on the size of the market for the company’s product to evaluate the potential return on investment.
important It is important that the company can convince you that they can be a $100M-revenue company while owning only a small fraction of their target market. That suggests that the company needs to be targeting a $1B market or larger. Angel investors typically do not want to invest in a lifestyle business* that tops out at less than $10M in revenue, because there are fewer exit possibilities, and it is hard to achieve the levels of returns that VCs and angels seek if the company is going after a small market.
A typical scenario for a startup is that they are targeting a large market, but are starting with a very focused market entry strategy. This is a smart approach: create a beachhead and initial traction with a very focused product in a very specific market and then expand to the broader market as their resources for engineering and sales grow. So while the initial market may be small, the total addressable market (TAM) in which they believe their product, service, or approach will be superior, should be large.
Angel investors will often categorize an idea as a painkiller or a vitamin. A vitamin is something that makes the customer’s life a little easier or a little better, whereas a painkiller is something that solves a real pain point for the customer. The assumption is that if you are addressing an actual problem a customer has, they will have a greater urgency to purchase your product or service and will more readily take on the risk of buying and using a product or service from a startup.
B2B startups have a particular challenge in that they are asking their customers to take a chance on the product and the company. If a customer buys a startup’s product, invests in setting it up and training their employees on it, and then the company disappears in a year because they ran out of money or pivoted, then the customer is up a creek, and that purchasing manager has some explaining to do to his or her boss. The product has to be really compelling for the buyer to take that chance. It is often not enough that it has better features than existing products or that it saves the customer 10%-20% on their costs.
Even for B2C companies, it can be challenging to get consumers to change their behavior. The product has to be significantly better than the alternatives to get consumers to switch and stick around.
Sales to paying customers is the greatest validation of an idea, and the product that delivers on the idea. Traction is a term that most often refers to a startup’s progress in getting customers.
A company’s traction with customers indicates that there is actually demand for the product or service. This is sometimes referred to as (or as an important part of) product/market fit,* meaning that there is a validated market for the product at the stated price. Traction also shows that the company has actually built a working version of their product, and that they can sell it to businesses or generate consumer demand, for B2B or B2C offerings respectively.
In many cases you, the angel investor, will not be the intended customer for the startup’s product, and without interviewing lots of potential customers it can be challenging to assess the appeal of the product. Traction tells you unequivocally whether the intended customer is willing to use and pay for the product. You do not need to be an expert in the domain or up to date on the competition, because the customers are making rational decisions with all that information.
caution Keep in mind that traction with a free product is not necessarily indicative of customers’ willingness to pay.
important As we have said elsewhere in this book, the stages companies are at when seeking angel investment vary radically, and every angel has a different level of comfort around risk. Some companies you might choose to invest in won’t have reached product/market fit, but can demonstrate how they plan to get there. As you proceed on your angel investing journey, you’ll have a better sense of what are deal-breakers for your investment, and what you’re willing to forego.
A little bit of competition—especially from other early-stage companies—is a good thing: competition validates that a market exists. Hopefully, the company in question has some well-articulated advantage over the competition. Crowded markets are more challenging for investors and companies because it is harder to define a clearly superior product or differentiated value proposition when there are lots of products in the mix. Even if it is a clearly better widget, it is hard for new entrants to rise above the noise and gain significant mindshare.
In addition to looking for a first-to-market advantage, investors often look at whether the company can build barriers to competition. If the idea proves great and the company begins to get traction, they will also gain the attention of potential competitors who could move to address the same market:
Can the company lock up key customers, distributors, or vendor relationships?
Do they have intellectual property that will act as barriers to competition?
What hard problems has this company solved that will be hard for competitors to duplicate?
We’ll talk more about competition in Business Due Diligence for Angel Investments.
We mentioned intellectual property as a barrier to competition above. Intellectual property may include traditional forms such as patents or trademarks or even a particularly effective domain name. Often an early-stage company will only have filed provisional patents, but this can be an indicator that there is some real innovation in the company’s technology or approach. While an early-stage company would likely not have the resources to defend their patents, a strong patent portfolio might make them an attractive acquisition target for a company that could leverage and defend those patents.
Business due diligence is where things start to get a bit more serious. You’ve evaluated opportunities and chosen a handful of companies that might merit an investment. Due diligence digs deeper and sometimes wider to validate whether the story told by the entrepreneur stands up under scrutiny.
Due diligence (or business due diligence) refers to the process by which investors investigate a company and its market before deciding whether to invest. Due diligence typically happens after an investor hears the pitch and before investment terms are discussed in any detail.
important Due diligence is arguably the most important part of the angel investing process. The amount of due diligence that is done on a company is the factor most correlated with investor return; the more due diligence you do, the more likely you are going to invest in companies that make you money. Rob Wiltbank looked at the amount of due diligence completed by angel investors, and found that the number of hours of due diligence performed on a company was one of the key success factors in angel investing outcomes.* In fact, investors got a 2X better return on an investment when they did more than 20 hours of due diligence versus when they did less than 20 hours. We cannot overstress the importance of due diligence.