I have invested millions of dollars directly in over 100 startups over the last 25 years. Many more through Venture funds and other syndicates. I am often asked how I decide to write the check. Well here is my process which has produced a 3.5X return on capital (so far). This is my process for an investment of $50K or less. The process for larger checks is the same but requires a higher confidence score (>90%). This is basically an investment specific application of my Next Right Action decision framework which I use for all decisions.
If you like the approach, join my Syndicate and invest with me.
Minority investments are bets. Bets are by definition risking capital with incomplete information. You should bet when you have a high degree of confidence in a positive outcome (10x capital for an Angel investment) based on a sufficient amount of incomplete information you have at the time of the decision (bet). You should not bet if you don’t have the basic information to form a hypothesis with a high degree of confidence. You should not make any bet when you are not willing to loose 100% of your money (even a small chance of an existential threat is too much). You should bet when you have sufficient information to form a reasonable hypothesis with a high degree of confidence.
In many games, like poker, collecting the basic information can be very challenging. For the angel investor, the company should have all the basic information in a 20 minute pitch or call with the CEO. They may be bluffing, and you have to adjust your confidence level if you detect that.
The process takes less than an hour to collect all the information and make a decision. Remember my Next Right Action framework is Problem, Explore, Hypothesis, Action. For an investment the problem is “Should I write a check?” Explore is diligence, collecting the basic information. There are only two Hypothesis, invest (confidence > 80%) or not invest (confidence < 80%). And only one binary action. Invest or not invest.
So most of my time on an angel investment is spent in “Explore” to collect the basic information to produce the confidence interval which will drive the action decision. There are three steps.
- Read the pitch deck.
- Hear pitch from CEO (or read investment memo from the lead investor)
- Rank deal on 5 (weighted) key start-up risks. Write check if deal scores > 80% confidence of a 10x return.
The first two steps are self-evident and take 30-45 minutes. It is important to talk to the CEO or at least a lead investor you trust who knows the CEO well because 50% of the confidence interval is based on your trust and confidence in management’s truthfulness and ability to execute.
While you may hear many different approaches to investing from thematic, to momentum, to the shotgun, etc., I look at the 5 major categories of risk and score each based on my confidence (from 1-10) that the company is weak (1) or strong (10) in this area. Management is weighted 5x for 50% of the weight, terms are weighted 2X for 20% and the rest are equal-weighted for 10% each. Max score is 100. If funds are available, invest in companies with a score of 80 or more (>80% confidence). Pass on all rest.
5 Key Start Up Risks
Management: The start-up bet is first and foremost a bet on management. They run the company. Management’s ability to execute over time in a fast-changing environment is the single biggest predictor of success or failure.
I only invest in CEOs who have a resilience practice of some sort. Startups are a firehose of problems and opportunities. Management needs some “reset” practice that puts them into flow doing some non-work thing so that the subconscious can make sense of the work stuff. And your system 2 can get a break from work. Burning the brain on work 100% of the time is a well-worn path to burn out. I don’t want management to burn out. For me, meditation, mowing the yard, going for a walk with my kids, surfing, fixing the motorcycle, and riding the bike give me the reset. Most great leaders had some kind of resilience practice. For Seneca, it was writing philosophical letters to friends and family. For Epictetus, we can infer it was weight lifting. For Marcus Aurelius, it was hunting and possibly wrestling. For John Cage, it was mushroom hunting. For David Sedaris, it’s walking back roads and picking up trash. For Herbert Hoover, it was fishing. Reading, boxing, biking, surfing, swimming, puzzles, coding, journaling, golfing – whatever it is, management need something to take your mind off work. It is a critical skill.
Management of a startup is a “wear many hats” problem. You must LOVE the firehose and thrive on figuring shit out. I started my first company after a career as a programmer. I had never hired anyone, raised money, signed an office lease, created a sales and marketing organization, or basically any of the things that would take up 90% of my time as CEO. I wore all the hats and figured that shit out. I hired a very smart programmer with a PHD and put him on bug fixes. He complained about fixing other people’s code and just wanted to write his own. He was out of his comfort zone and didn’t want to even tilt his hat a little. Not the right mentality for a startup.
Prior success in similar stage startups is a plus. Success at a big company and the first time in a start-up is a minus. Look for obvious holes in management. Technical founder when it will be a sales-driven company? Given that every management team will need to grow, how ready is access to top talent? Is the stage and company attractive to top talent? What is the culture like? Will the CEO share responsibility, or is it a follow the leader culture? Who are the “fundable” management team members? the more fundable team members, the higher my confidence in management.
Examples that Increase Confidence in Management:
- Prior startup success through superior execution
- Resilience practice
- Meritocracy culture driven by KPIs and dates
- Multiple “fundable” management team members
- Management with proven track record of attracting A team members
- Management is thoughtful, accountable, and trustworthy
- Management can explain prior failures and what they learned
Examples that Decrease Confidence in Management:
- First time CEO out of large company as mid level decision maker
- Strategic positions missing (CTO in tech driven company)
- Follow the leader culture.
- “B” players in key roles
- Lacking recruiting network
- Management relies on market projections and external indicators for goals and drive
- Management has not displayed growth from prior failures
1: First time CEO from Big company, used to be a CFO. Weak technical co founder, no marketing team, consumer sales channel.
5: Second time CEO (prior success) with new team in a market tangential to what they worked in before with tier 2 investors backing them.
10: Third time CEO with two successful exits working with a complete management team that she has worked with before and known for more than 10 years in a market they have competed in before and been backed by tier 1 Venture capitalists prior.
Product. What stage is the product in? Can it be built? Is version 1 the right set of features? Are they building the product they are passionate about. I recently heard a pitch from a company who had a clear vision of a transformational product. But it was too hard to build so they wanted to start with a different product to”make money now” and build their vision later. Pass. Build your dream product. Build it in logical stages sure, but don’t do the easy thing. Tesla wanted to build electric cars for everyone but the market wasn’t ready. So they build electric cars for rich people and started building the supply chain and innovations to drive toward a car for everyone. It was a logical path to the promised land.
Single product companies also tend to loose to platform companies over time. If your product fills a small niche in an ecosystem, and customers start to want it, eventually others with deeper customer ties in the ecosystem will copy your product and replace (or buy) you. Facebook is a platform not a product. Slack which started as a product has become a platform and is now much harder to dislodge despite others in the ecosystem copying the features (microsoft, facebook, etc.) Products that have network effects are superior to products without network effects. Products that require other users to be useful, that reward connecting new customers, etc. are superior to products sold to individuals one at a time.
If the product is creating a blue ocean, expanding a market instead of competing for one, my confidence goes up. What was the market for ride hailing services before Uber? The product created the market. The product/company that creates a new product category ends up with a far greater share than the followers. Invest in product category creators, not competitors in crowded markets.
Every product must fundamentally remove some friction in the market. The core invention should depend on technology which is innovated in the company. Amazon used technology to fundamentally reduce friction in retail. It took traditional retail with their physical locations as their primary assets a long time to adapt, and most did/could not follow because their core assets were not based in technology.
The 10x rule applies. A new product must be 10x better to get people to change. Back in the early days of search I used AltaVista and Yahoo. When Google launched, I tried it and the results were 10x better. I switched and never looked back. What will be 10X better than Google? Hard to imagine, especially since Google understands the 10x rule and keeps going.
Examples that Increase confidence in Product:
- Clear MVP with short term product roadmap that fits in the funding window.
- Customer demand, especially wait list, for MVP
- Measurable metrics on friction reduction from product.
- Network affects apply – product is a platform
- Product creates a blue ocean (its own market)
- Category creator
- Clear product milestones, questions within the funding window
- Efficient customer feedback loop to development
- Very short, limited scope development sprints
- Product is in the power position in the value chain.
Examples that Decrease confidence in Product:
- Scale of MVP too large and complex.
- Building an “easy” product for short term $$, not transformational product
- Product has only a few feature differences from competitors
- Product innovation not key to competitive advantage (sales channel is, or marketing, etc.)
- Category follower
- “fishing expedition” product development
- Long, complex development and release process
- Product not designed for customers to leave it easily
- Product is an add-on or incremental product to others in the value chain
1: Complex product vision with long development cycle going against established competitors with limited innovation (10-20% better) and easy to copy innovation.
5: 2-4x better specialist product in emerging market with some traction, little opportunity for protection or branding or network effects, enterprise sale.
10: Leading platform company with huge viral component, virtuous cycle already going and proven, creating market demand for new product category, clearly reducing market friction by an order of magnitude or more, clear customer pull for product, proprietary, protectable technology key to innovation.
Market. How big is the market for the product? Does the existence of the product expand the market (see Uber)? Does the market have a clear leader? Do customers show a willingness to buy innovation? Why now? What is the mega trend that the existing competitors are missing that the company sees that they can capitalize on now. The fact that a market is growing at double digits a year is not a reason to be in it. Why does this market need YOUR product NOW? Is there a clear path to $$? Does the company have an active pipeline? Is there a thin edge of the wedge to get into the market? How do you get to market? Direct to consumer? Enterprise? use a Chanel? influencers? Is there a Blue or Red (competitive) ocean market? What mega trends that you see in the market are you betting on? Are these trends long term or short term? Betting on market rebound from COVID is short term. Betting on Moores law is long term. The expansion of work from home is long term. Telemedicine is long term. Selling to hospitals is short term.
There also has to be a product/market fit. The right product at the right stage of the market. A very innovative product in a market which doesn’t buy innovation will languish. Determine the switching costs in the market. Is it easy for customers to switch? or Hard? How much of the product/market fit has been proven by the company to date? How long will this take? The product/market fit should also be exploiting a long term dislocation or trend also. I remember talking to lots of start ups who wanted to do banking for the emerging cannabis market using existing banking infrastructure and taking the new market risk for higher fees. Banking is an incredibly efficient business and traditional banks were prohibited by regulations to be in it. But those regulations could change quickly and the arbitrage would disappear quickly. Since the start ups did not bringing innovation to the market, simply taking risk, their market would evaporate quickly. I passed.
Examples that Increase confidence in Market:
- Blue Ocean, product innovation creates new market space
- Efficient, cost effective channels to customers.
- Many diverse market segments (industries, customer sizes, etc.)
- Positive CAC:LTV which can scale
- Way customers like to buy matches way customer sells
- Customer revenue goes up with product purchase.
- Customers proven desire to embrace change, new products
- Consumers can pull product into Enterprise (apple)
- Proven product/market fit
Examples that Decrease confidence in Market:
- Customer concentration (small number of customers control most of market)
- Many look alike customers
- Customers change adverse
- Enterprise market for SMB focused startup and vice versa
- Few or expensive clear leveraged channels to customers
- Too large geographic market for startup (world wide for small company)
- Enterprise only sale.
- Way company wants to sell is mismatched with how customers want to buy
- Customer revenue not affected by product.
- Risk adverse customers
- Unproven product/market fit
1: Small market not growing (<$1B) with customers averse to change. Like selling software to municipalities or healthcare.
5: Growing market (> 10%/year) with clear leader (s) taking 70%+ share and a few concentrated customers. A few possible new segments but all very small, company has early traction in some of these early markets and customers.
10: Product creates its own market demand. Many market segments, company innovation expands market to 10x or more new customers. Customers show proven desire for new product or service, can switch quickly. Can prove positive CAC:LTV very easily. Clear leveraged channels to reach customers.
Regulatory. Many investors never consider the potential regulatory hurdles facing startups. Uber faced serious ones. So do everyone in Healthcare (the FDA). Facebook and Microsoft did not until they got huge. While some investors see regulatory hurdles as a positive (healthcare) because they are expensive to get over and may come with market exclusivity and ability to print money for some time (drug discovery), i see regulatory hurdles as generally negative for the investment decision. You can have the most innovative product in an amazing market and the regulators can tell you you cant sell it, or could stop you from selling it (see Uber in California recently or AirBNB). A complex regulatory environment or unclear regulatory framework lowers my confidence that the company can clear the regulatory hurdle. How many biotech companies have consumed $100M investor dollars and failed to get approval for their drugs? Most. Take the recent interest in psychedelics. Lots of investor and consumer interests. Very murky regulatory framework, in fact criminal penalties for getting it wrong. Until the framework or mega trend toward clear regulations are in place, I am unlikely to invest directly in products. In unclear regulatory markets like psychedelics, it is often better to invest in the early media properties, or unregulated parts of the market very early (I have one of those).
Examples that Increase confidence in Regulatory:
- No clear regulatory body
- Clear lack of regulation of similar products
- Many similar products in market without regulation.
- Clear, inexpensive mature regulatory framework
Examples that Reduce confidence in Regulatory:
- Regulatory “grey area”
- Company success depends on regulators “looking the other way”
- Growing trend toward regulation driven by existing bad actors
- Existing, clear regulatory body
- Many level of possible regulation (city, county, state, federal, etc.)
- Immature regulatory framework subject to sudden shifts.
- Politicians attention in market likely to cause knee-jerk regulation during black swan event.
1: Product clearly requires complicated, expensive regulatory approval. Like an FDA approved drug.
5: Regulatory framework unclear, but others are selling into the market, regulation may come but it has not yet and profits could be made before regulation comes. Like early stem cell therapy, Hemp products, supplements. No clear regulatory body yet.
10: No obvious regulatory hurdles on the horizon. Facebook and Microsoft early. Many companies selling unregulated products into markets, or completely new product in new market.
Terms. What are the terms of the deal. This includes price, pro rata rights, share class, co-investors, is the deal “hot”, and more. I recently found a company with an 8 management team, a 10 product, 10 market and 8 regulatory but the terms were 2. The company was based in Canada (where Americans have problems owning shares), they were selling common shares without any pro rata rights, no top tier investors (all retail) and was over priced relative to traction and comps. If the terms had been 8 or above I would have likely invested $500K. With crappy terms, I invested $50K.
At every point in the life cycle of a company investors should expect higher returns for higher risk and this should be reflected in the terms. In poker this is called “pot odds”. What is the expected return for the capital I am putting in versus the odds of that return? If I have a 20% chance of winning and I am getting more than 5:1 on my money (basically the return odds outweigh the win odds) I should make the bet even with low odds of winning because the implied return will be worth it. In the very early stages, pre-seed, seed, you should have a very high confidence of a 10x or better return. At $100M valuation, with a-lot of risk washed out of the business, you should expect a 2-3x return. The terms should reflect the risk/reward gamble you are taking.
I put co-investors into the terms section. If they have already committed to the terms of the round. If I am following other smart investors who have approved the terms, it increases my confidence that the terms are fair and appropriate. I also check the “smart” investors check size against their bank roll. A common tactic of unscrupulous companies is to name drop smart investors with “undisclosed” investment sizes. Active investors may write small checks just for laughs and may hot have really engaged in diligence or verifying the terms. I looked at a deal once that was touting Peter Thiel as an investor (he put in $250K). The size was so small relative to Thiel’s bankroll that it didn’t improve my confidence in the deal that much (but I am sure other investors were swayed).
Positive investor terms include low valuation versus comparable stage companies, low valuation versus mature companies, pro rata rights, preferred shares, capped notes, interest on notes, redemption rights, voting rights, top tier, smart co-investors and a trusted partner doing diligence.
Negative investor terms include common shares, high valuation relative to comps, a “hot” deal where you are pressured to decide quickly, uncapped notes, and lackluster co-investors.
Examples that Increase confidence in Terms:
- Terms approved by credible co-investors who performed significant diligence.
- Preferred shares
- Pro Rata rights
- Valuation at a discount to comparable stage companies recently
- Limited investment allocation due to oversubscription of Terms
- Pari Pasu preferences (for early investors)
- Redemption rights
- Minority blocking rights
- Weighted anti dilution
- Revenue traction implying low multiple vs public comps
Examples that Decrease confidence in Terms:
- Lack of Tier 1 co-investors
- Premium valuation to comparable stage companies
- Common shares
- lack of pro rata rights
- Stacked preferences (last money in, first money out)
- No minority voting rights
- Ratchet on later rounds without weighted anti dilution
- Revenue traction implies high multiple vs public comps.
1: Small investment into a late stage company trading at a premium to public comps. I actually saw one of those on Angel list from a top syndicate.
5: Reasonable valuation relative to stage and traction, without pro rata rights and few followable co-investors.
10: Sub $10M valuation, preferred shares, pro rata rights for company with >$1M revenue growing > 100% a year, profitable with amazing co-investors. I have actually done a handful of these terms.
So there it is, my high level framework for making Angel Investments. This is by no means exhaustive, but it is directional. The key is to quickly assess the 5 risk areas and determine a confidence level that the investment can deliver a 10X return within 5 years. If > 40 (80%), I write the check.
If you like the approach, join my Syndicate and invest with me.