What I've Learned in Angel Investing, March 2009

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Paul Graham of YCombinator ran a great afternoon conference called Angelconf where he brought together a great afternoon of Silicon Valley angels to talk about how to become an angel. He then wrote a great blog post about it. I managed to watch a lot of it, although I was in NYC at the time and it was tough to watch the whole afternoon.

I was also impressed with Naval Ravikant's segment, which is posted on VentureHacks. Reading Naval and Nivi's post sparked some thoughts about angel investing in my mind, so I thought I'd talk about what I've learned, and my views on angel investing. One thing you'll notice is that many of the things I consider important are what others think are important, but there are definitely differences too. So angel investing can have individual differences between angels.

The Problem With Angel Investing Is...

There is no one to teach you. No one to hold your hand. At least until Paul Graham ran his Angelconf. Yes there are many blog posts out there, but there is no really good guide that leads through the topics in an orderly and easily learn-able manner. You get a lot of information piecemeal and you can't always tell what it's relevant to, or whether it's relevant to whatever deal you're working on now.

I paid my lawyer 1.5 hours of time to have him walk me through, explain, and let me ask him questions about term sheets. Even that was not enough. The ins and outs and subtleties of investing I had to learn on my own, and only by doing 10+ deals in the last 2 years.

Should You Be an Angel?

First thing is you need cash - $250k is minimum, which would put $25k into 10 companies. This gives you good diversification, and you get some good learning which would otherwise be missed by investing more sparingly. Investing regularly also gives you good market information. I now have a good picture into valuations for companies with and without revenue, as a reference for whether or not a deal is good or too expensive.

You can start out lower than $250k, but generally it is rare that entrepreneurs will let you put less than $10K into a company. You usually must have some sort of alternative attraction, like being a prominent business individual.

Starting out with more is always fine....but....the starting amount needs to not be your life savings! You're likely to lose it all in angel investing! If it's not your life savings, then mentally you'll also be better prepared, since if you can lose it all it matters trivially to your life.

Also do not invest with people who are investing what you think is a significant part of their life savings. There is a high probability that they will not be happy to lose it all and could cause no end of trouble to the entrepreneur.

What's your risk profile? If you're conservative, you shouldn't be doing this. Angel investing can be akin to playing the lottery or going to Vegas. Really.

Expect the ratio of 9 failures to one success. Naval thinks it's much worse, like 1 out of 20 or even 30. So you have to go wide to minimize your loss potential.

So it's hard to make angel investing profitable if it's just a hobby, ie. investing in a startup every once in a while, like one a year or less. Probability is far against it.

Do you have something useful to offer to your companies? If not, then your money is just dumb money and it is less likely you'll get included in great deals. Entrepreneurs look for people to be involved that can help them.

Discipline

Stick to your operating philosophy. Don't waver. For example, I don't do notes and have not since, or only under very strict conditions.

Intuition

If something doesn't feel right, don't invest. You may have a funny feeling about the entrepreneurs, the business potential, the deal terms, or something else. Trust your instincts.

Picking Companies is Hard

I thought that with all my Internet experience at Yahoo!, I could pick great startups. Boy, was I wrong.

Don't delude yourself in thinking you can pick a great deal every time. There are so many factors that exist in generating success. You can find total idiots who have made it big, and totally smart people failing miserably. Market conditions could also affect success rates simply because capital is not available or the market is not ready for a product like yours. Just because you think this deal is a great idea doesn't mean it's going to actually be one.

Also be wary of laying your own way of getting to success onto the idea but the entrepreneur has not bought into that. Don't fall into the trap of thinking this is great idea because you personally think it should be executed in some way but the entrepreneur is attacking it in a slightly different way. If he has not bought into it, it won't be done your way; it'll be done his way. But also remember that if you think of a great way to execute, it is possible that you are the only one who can execute it that way, meaning you have the business contacts, the experience, the thought leadership etc. The entrepreneur may not.

So if you love the idea and space, but hate the execution plan and think you have a better one AND can't convince the entrepreneur that you have a better plan, I would walk away.

Dealflow

I am lucky to be able to filter my dealflow by referrals.

Try to be friendly and useful to more experienced angels and VCs out there. They'll direct some great dealflow your way because they know you'll help load the odds of success in their favor.

I would caution you on investing in companies in industries you know nothing about.

I personally don't like to have an inbox full of proposals from strangers. I can't tell what is good and what is not. So build referral networks if you can.

Don't Be a Flake

Say you're going to do a deal or not. Don't be waffling in the middle. Nobody wants to invest with a flake who can't decide or is really just unwilling to part with his money but can't say so.

Branding Yourself

I started David Shen Ventures, LLC and it has become a slowly growing brand. People know me for being useful and many entrepreneurs appreciate, and can attest to, my usefulness.

People do think I'm bigger than I really am though. It's the risk of sticking the word "Ventures" on the end of your name. I'm just one guy, with an advising and investing operation and that's it.

Don't Refer Anything That You Would Not Invest in Yourself

This is brand building, which is to refer only great deals that you're personally going to invest in. No better validation can be given than if you vote with your own money. Don't get known for passing only junk that nobody else wants.

On the other hand, if for some reason you do want to help, be clear that you're not investing but think it's interesting. But don't do this often. Investors' inboxes are clogged enough with random deals that are coming from everywhere. Don't clog investors' inboxes further. So I would not do this very often at all.

Be Wary of How Many Deals You Can Handle at One Time

I went out very fast. It was fun, I learned a lot, but I also quickly throttled the process because advising too many companies at once was getting tough and I didn't want to short change anyone. I also started running short of available capital so be careful of putting too much money out there all at once.

In addition, I would be very disciplined in deploying the same amount of capital every time. Don't get caught up with the excitement of deals in the beginning and put more money in than what you planned. You'll run out of money faster, and also I guarantee that the probability of finding your google isn't any higher in the beginning than it is later on.

Pitches

I can't sign NDAs unless I get involved. I see too many pitches across many different internet industries and my business can't survive if I limit that.

The quality of referred pitches is much higher than randomly appearing pitches.

Be wary of being dazzled during a pitch, but be impressed at people who can be so dazzling. Always come back to earth after the meeting and take an objective look at the pitch when you're out of the mindcontrol ray that some great pitch people can point at you.

Let your intuition be your first guide, and then verify the rest: integrity/intelligence/energy of entrepreneurs, market idea, etc. If something feels wrong, don't invest.

Investing in More than One Company in Similar Business Areas

I generally try not to do this. I don't want to accidentally say something that one company is doing to another possible competitor. I also don't want to be accused of conflict of interest if I'm introducing one company to another for business development or M&A.

There are those who are willing to do this but I don't think it's a good idea for me.

Learning to Say No and Walk Away

You need to go into angel investing by having the courage and discipline to just get up and walk away. Every pitch will sound like a game changing next google opportunity for you. That's their job, to sell you the idea and get you to invest. Do not get mesmerized by that. Be objective in your decision and not emotional, and just say no. Don't be a flake and waver on telling someone yes or no.

By the way, it's easy to stress AFTER you say no. You feel regret that maybe you walked away from a great deal. In my experience, this is natural especially after a great attractive, sales pitch. Who can walk away from a hot woman who walks up to you, puts their hand on your rear end, and wants you to come home with her? Let me tell you; I have never regretted walking away from a deal. Remember your intuition - if it says no, it's saying so for a reason. Better to live to fight (invest) another day, then to get into a deal that may make you miserable later. Also, the probability of any early stage deal being successful is extremely low no matter how sexy the pitch is.

The Best Way to Say Yes

Don't just say yes. There are many first time entrepreneurs out there who think that when you say yes at the first meeting, they mean they have you. But that is not really true. It's only the first yes in a string of yes-es, which follow due diligence, checking references, checking the idea independently, or any other decision process items you may have. So make sure first time entrepreneurs understand that.

Do Not Skip Due Diligence

I ask my investments to give me a whole list of due diligence items. It's a good discipline to have and gives you a deep dive into the company. Luckily, early stage companies don't have much to dive into, but you can still see problems, like weird debt, or bad corporate structure. You may not want to invest if the entrepreneur is unwilling to clean problems internally.

Also be wary if the entrepreneur is unwilling to give this info to you freely and openly. This only sets the stage for how the relationship will be later on for other things.

I have walked away from deals in failing the due diligence process.

Trust

There has to be a large amount of trust no matter what all the business docs say. You have to see integrity in your entrepreneur and be able to trust that this person won't screw you later on, because business contracts still can't protect you 100%. Fundamentally, you need to trust the entrepreneur and he has to be trustworthy.

Be Wary of Business Guys With No Technical Partners

It's not that I don't think business only teams can make it big, it's just that in this day and age it's more expensive to run an internet business as just a business guy with an outsourced team, which results in increased burn and increased need of capital. And you have to ask why this person can't court another technical founder to help - is there something wrong here that you're missing?

Be Wary of Entrepreneurs Who are Building for Businesses They Have No Experience In

Most of the time the idea is great. But then I ask if they have any real world experience in the area they are building in and that's where I get them most of the time. I don't like it when people are theorizing about how a certain market is or isn't. They will most likely find problems that they have no experience tackling. It's better to find a company who has a veteran of the industry they are tackling so that they have at least have some first hand knowledge of what goes on in that industry.

I know that many would argue that entrepreneurs often need to adapt and dance back and forth a bit before they find their sweet spot. My only issue with this is that learning takes time and they may not have enough time to learn before their money runs out. This is especially relevant at the early stage where we angels often play.

Reputation is Everything

Totally agree here. Build your brand by being a good angel, useful and helpful to the entrepreneurs.

Learn the Terms, and Don't Just Trust the Entrepreneur to Treat You Right

I spent a lot of time and money, and doing a lot of deals before I could get a broader understanding of all the terms and legal speak of term sheets. It's tough to keep track of all that. It's also tough to understand the effects of all the terms in each situation. Experience helps you learn, and, unfortunately, making mistakes.

As I mentioned before, I asked my lawyer to help me understand the terms. But also get a good lawyer to review every term sheet for you and point out what is good and bad and explain why. I have found many angels to barely seem to care about the terms at all. They just "trust" the entrepreneur. I think this is bad. I think you should not fall into this kind of behavior and get a good lawyer to work with you on your angel investing.

If you can affect the terms to your favor, I would advise you to try no matter who is leading. I have also even been able to affect the terms AFTER the financing was over, so it never hurts to ask if you are the last one into a deal and you find something not to your liking.

Selecting a Good Lawyer

It's unfortunate but I have not met many lawyers who are experienced in the early stage. There are many who have done larger financings at later stages but not many who have done a lot at early stage. I can tell you definitely that there are differences. For example, there are terms that are just not appropriate at early stage but fine for later stage. You don't want to burden at seed financing negotiating over these kinds of terms, or waste money doing so.

Interview your lawyer for their experience in early stage financings. Get referrals from other angels.

Board Seats

In the companies I've observed, I think that taking a board seat should only be done if the person taking it can add value beyond that of just watching over the investors' money. I've seen some pretty ineffective board members and I've seen some that were amazing. The amazing part comes in when the company needs to be sold or needs business deals or needs additional funding. Board members with lots of industry experience and connections can make or break whether a company is going to die today or live on.

If you're just there to watch over the money, then i've heard horror stories of board members whose only mission was to protect the investors and not care what happens to the company.

How Much of the Company Should I Get After an Angel Investment?

Assuming you're not doing a note, I originally set my goal for getting about 1% of a company with a $50K investment. Before the current economic climate, I was seeing deals raising about $1MM on a $4MM pre-money valuation. This seemed like a reasonable benchmark at the time. But now times have changed a lot. The valuations have dropped quite a bit and now you can get more of the company for the same $50K. Still, I see many startups trying to raise money at pre-2008 valuations and I just pass on them because I know there are better deals around the corner. This where having a good finger on the pulse of seed financing can help greatly.

I Don't Do Notes

Sorry all, too many misadventures with notes, even those with caps. Read about my misadventures here. It's too risky and troublesome for me.

Assume You Lost the Money As Soon As You Invest It

Definitely you'll sleep better if you think this way. If you can't let go of your money, angel investing is truly not for you.

Matchmaking and Connections

Your job after you invest should be to go out and meet people who can help your startup. You should keep a rolodex of these connections and cultivate them, because you never know when any of your startups might need their help.

Don't be a passive investor and not help. You want to increase the odds of your startups' success, and not be dumb money.

Invest with Other Helpful Folks

When you have a group of well connected, motivated individuals you increase the chance that a company will succeed, as the other investors will apply their connections and expertise to the startup.

Never Invest By Yourself

Again, you can increase the odds of your startup's success by having a pool of helpful investors. If you invest by yourself, you only have yourself to help and the startup may need more than you can give. Incent others by including them in the deal. Forcing the entrepreneur to find other investors can also lend some more validation to the business idea.

Don't Invest in People You Don't Want to Hang Out With

Like Naval says, why would you want to give money to people you don't like or don't care about? Once you invest, you'll be involved for a long time. Remember that. You can't just walk away from an angel investment. There is no cash out and washing of your hands of a deal afterwards.

Make Sure the Company Raises Enough Money Before Sending Your Money In

I'm guilty of doing this for sure. You need to make sure a company can get enough money to survive before you put your money in. You don't want to just extend out when a startup will die by giving them a little extra money. You want to give them enough money to survive to a good place. So commit, but make sure the entrepreneur has other money committed and coming in before you give your money in.

Don't get entranced by the excitement of the business idea and want to see it started NOW, so you put your money in now thinking that it's going to be all right. It may not be all right. You may have just wasted your money on letting the company run a little longer and then it dies.

Angel Investing Return is Not About the Money

My return is not all economic. I find it extremely satisfying to work with young, smart entrepreneurs and sharing with them my experiences at Yahoo, and helping them with their businesses and products.

This also helps me to consider invested money as "already spent" and not stress about whether that money is coming back or not.

I also consider it a challenge to see if what I think will work for a company really works. Thus, I apply my expertise and advice to my companies and am gratified when they do work (and bummed, and learn a lot when they don't).

This is partly why I started advising when I invest. I get part of my return from working with the entrepreneurs. But I also want to make sure they really want my help and are not just telling me, then get my money, and don't bother to talk to me. By executing an advisor agreement, this really creates the commitment from the company that they do want my help and want to engage me in that way. I've also walked away from deals because they did not want my help like that. It's OK; remember...discipline to stick to your plan!

It's an Individual Thing

In listening to Angelconf, you'll find that most angels are consistent with many operating strategies. But then you'll see some who'll say one thing and another say something completely different on the same topic. A lot of that goes to what experiences they've had in the past, whether they were VCs before, or got burned on something in the past.

The important thing is that you need to figure out how you want to work and then stick with it (unless shown that you should change of course). Don't go and tell someone else that they should do something your way. Their way may work perfectly well with them and it can be dangerous to adopt a new way of operating if you're not able or ready to make it work that way.

How do I compare to other angels out there? Or to your own operations if you're an angel?

10 Comments

This is a GREAT read. The best investors I've worked with match the sentiment of your guidance here, almost identically.

Likewise, I think every entrepreneur should use your list to determine who they want as Angels. It reads like a cheat sheet to finding smart money that will benefit you much more than just financially over the long term.

If you ever want to get lunch, I bet we'd have a lot to talk about.

Hi Ted

Are you sure you meant 1% for $50K? While that's not outrageous, it doesn't seem to fit with your comment on $1M to $4M valuations before the recent downturn.

Thanks for the article!

Terry

Oops.... my hi Ted, was unthinkingly addressed to the last commenter, not to you David :-)

What a great article, every potential angel investor should read this.

So where can I apply =)

Grey text on white = too hard to read article this long.

Hi Dave, please make the text larger and darker on your blog.

Yours respectfully,
Mark

re: terry jones

Before the downturn, I set my goal to get about 1% of an early stage startup with $50K. A lot of early stage startups were raising $1MM on a pre-money valuation of $4MM. This results in a $5MM post-money valuation, of which my $50K bought 1% of the company. Unless my math is wrong of course - but that's what I was referring to.

re: darker text

Thanks for the feedback - the MT template is a bit hard to navigate but I'll do what I can.

Hi Dave--
Nice article. You might want to take a look at the Angel Capital Association. Lot of great info on angel investing:

http://www.angelcapitalassociation.org/

Also, annual Summit coming up in Atlanta April 15-17. Hundreds of angel investors from across the country will be there.

http://www.angelcapitalassociation.org/dir_events/event_detail.aspx?id=121

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This page contains a single entry by DShen published on March 22, 2009 4:25 PM.

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