Reflections on angel due diligence

Reposted from the Seattle Angel Conference blog with permission from the author @joshmaher
As we approach deeper due diligence on the group of companies being considered for our 4th angel investment at the Seattle Angel Conference, I get to thinking about the hundreds of startups we’ve seen and reflect on the biggest challenges those startups have faced in the past. I also get to thinking about how those challenges could have been discovered earlier in the due diligence process.
There will always be challenges investing in early stage companies, some big and some small. The goal is to avoid the big ones as much as possible and understand how to mitigate the small ones. There are a lot of angel investing guides being published recently, as the historic JOBS Act general solicitation rules were put into effect on Sept. 23. I will reflect on the startups we’ve seen and the pitfalls we could have seen earlier. I won’t rehash all of those great posts (a short list of some good ones are below).
Past Seattle Angel Conference Investments
Thinking about past Seattle Angel Conference Investments, the challenges we’ve run into that have made a company “un-investable” for the seattle angel conference LLC members are quite varied. The variability is higher than most early stage funds as the people in the LLC making the investment decisions change for each investment round. This changing of the guard is a planned part of our approach to investing and training new investors. For example, one investment fund may have a medical professional, allowing us to better analyze startups in that space, while another investment fund may not have a medical professional, causing us to pass over some startups we don’t feel confident we can do adequate due diligence with our team.
Across the four rounds of investment so far, the shortcomings we see fall into the main categories that most early stage investors call out as the most important (read my series on the most important things for early stage investors for more insight here). There isn’t a specific order to the three main categories, but there is clearly a need for startups to focus emphasis placed on team, then product/market and finally the business model.
Absentee founders
We see a lot of very early stage companies and this means that many of the teams are being founded by people in the process of leaving their current job or are holding consulting roles to pay the bills. Sometimes that works well and the founders have moonlighting arrangements and solid plans to go full time on their startup at given milestones such as our investment. For others, there are no moonlighting arrangements or no solid plan to quit the day job and go full time. Founders MUST be COMMITTED and PRESENT. Finding a startup with a founder that has a minimal level engagement in their venture and the fund raising process like this is an issue we’ve seen a few times. We’ve never found a great startup that had an absentee founder on the team, yet as part of the training process for new investors we frequently entertain the idea of investing in a startup despite absentee founders making up a significant part of the team.
Other team issues we see:
  • Wrong people – we have seen a number of startups that simply have the wrong people on staff. That isn’t to say that every team must be 100% perfect, but having the wrong people on the team can be difficult if the team is not willing to change. It may be they need strong sales and have no person on the team who can make the first critical sales (see my post on Rudy Gadre’s view on founder charisma). Or it may be that they have founders taking equity or salaries and are providing no value to the business. Expect that we will be analyzing who should and shouldn’t be on the team early and have a frank conversation after a pitch or over coffee about what needs to happen to get the right team on board.
  • Wrong formation/agreements – It’s a rare start up that can get invested as an LLC, and if you don’t own the IP, you’re in a world of hurt.   Examples:– the team has formed their company as an LLC and need to take venture capital in the future to be successful, they need to be a C-corp. Check out Joe Wallin and Scott Usher’s post on incorporating an LLC.
Thinking about the product/market fit part of the equation we’ve seen a number of issues such as scaling issues, wrong people for the product, lack of competitive differentiation. The largest or at least most common issue in this area is definitely products that have no competitive differentiation.
Lack of competitive differentiation
Quite often we see businesses with a product that simply has no way to attract enough customers in a short enough period of time given the existing marketplace and existing competitors. Too often there are already many competitors in the space and the startup doesn’t  have anything incredibly unique that sets them apart. These may be great businesses and while their market is expanding they will certainly experience high growth. The difficulty comes in when the market stops expanding and they are faced with competitors who may be hungrier and better positioned than they are to expand market share.
The last issue we have seen come up with some regularity is related to the business model/economics of the business itself. This includes businesses that won’t make enough margin in relation to the other economics of their business, as well as businesses that simply aren’t raising or can’t raise enough money to move fast enough to succeed.  Companies raising the wrong amount of money because they don’t understand their cash needs is a frequent red flag or “disqualifier”.
Raising just enough money to fail
This problem plagues early stage growth companies all the time and it is fairly well documented by entrepreneurs and investors alike. Raising too little money to do anything meaningful to get to the next milestone. Raising too much money so the valuation is out of whack or the ability to raise the next round is hindered because the money was spent poorly. Raising money for the wrong reasons. Not focusing on customer acquisition in exchange for focusing only on raising money. The problem with identifying this type of problem early is that it can sometimes take really getting to know a business to be able to determine if they are raising the right amount of money and for the right reasons. Perhaps this is why the team and product/market fit come earlier in the analysis for most early stage investors. For the Seattle Angel Conference, I think most of these business model and fund raising issues will always be found in the final due diligence that we perform on the final six potential companies.
We need to get better at passing down the learning from one investor group to the next, but the complexity and uniqueness of each company makes it hard.  We as members of the LLC should spend more time studying other investors, and sharing best practices with each other, both before and during the SAC process.  Here are some great resources to use to increase your investor knowledge.  Please share whatever you find most useful with your fellow investors.
Locally, both Andy Sack and Chris Devore post insights on their investments regularly. There are a few other must reads such as Paul Graham, Brad Feld, Fred Wilson, Mark Suster, and Hunter Walk. In terms of following great early stage entrepreneurs we have some locally such as T.A. McCann, Dan Shapiro, and other great ones from around the country such as Sequoia Capital’s ‘grove’.

Regardless of whether you are a part of a Seattle Angel Conference investor fund or are doing your own early stage due diligence, identifying the pitfalls above earlier will be important for making smart decisions faster. As we continue to focus on educating new early stage investors, we will continue to look for ways to identify major pitfalls earlier in the process and leave the multitude of smaller pitfalls for later in the process.

Follow Josh on twitter @joshmaher

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