"For Angels Only...When to say No...”

As always, these are general rules, and any good entrepreneur will tell you that every opportunity is unique. At the same time, in the last 3.5 years we’ve received about 1,500 applications for financing, performed about 750 basic reviews and about 100 detailed reviews, and participated in or facilitated more than a dozen investments (and a couple misfires). So here are seven rules on avoiding mistakes, and a final reminder of why we’re doing this in the first place.

Rule # 1: When in doubt, don’t.

While I’ve probably just horrified most of the entrepreneurs seeking financing, this is a simple reality. It’s easy to write the check—but very hard to get it back. Keep in mind that these are likely to be 5-10 year investments, and a lot of things can go wrong. There will be other opportunities, and the red flag you’ve spotted might only be the first.

Rule #2: Under-funding a company is worse than not funding it at all.

Again, the entrepreneurs won’t be happy with this, but an angel who participates in under-funding a company has signed away her rights to extraordinary returns. An under-funded company is likely to complete most, but not all of the work necessary to hit that next crucial milestone, and that means the next time they need money they will be desperate. I guarantee you that in the next round of financing the current investors will get hit the hardest. As an angel, you should determine the minimum investment you want the company to receive. If you won’t be providing that amount, insist on escrowing your money until the minimum is met. Requesting an anti-dilution clause is great, but if the next round financier wants to negate that clause as a condition of the investment, you may be out of luck. Anti-dilution works for VCs with veto/filibuster power, but not for minority-ownership angels.

Rule #3: Guilty until proven innocent.

Statistics suggest that at least 60% of all high-tech startups will fail. At the same time, 100% of entrepreneurs will assure you that their company is in the other 40%. Not all drivers can be above average, and not all start-ups will succeed. It’s crucial, therefore, to require the entrepreneur to demonstrate how the company will succeed, not just in the short term, but also in the long run. I constantly remind angels that creating a “long-term sustainable competitive advantage” is simply not easy. Ask questions, and then ask more questions. Strong management teams know that the questions are coming, and they have the answers worked out, or they get them quickly and cogently.

Rule #4: Hang together, don’t hang separately

Angels are sometimes (perhaps unfairly) compared to lemmings. The derogatory aspect of this is the bandwagon effect, where individuals invest (or don’t invest) simply because everyone else does. The more benevolent interpretation is that a group of angels can bring more experience, expertise, and analysis to the table. Certainly, there are “lone” angels with the knowledge and skills to make sizable investments with confidence. Our experience, however, is that half a dozen angels working together learn faster and process opportunities with more wisdom than solo players.

Yes, it’s easier for a group to find a flaw, but that’s pretty much the point.

Rule #5: Make rules and stick to them

One of the hardest trials for an angel is turning down a “sure deal” simply because it doesn’t match the characteristics she set out initially. Entrepreneurs are often fantastic pitchmen, and I’ve seen angels who’ve sworn themselves out of the investment game hop right back in because they fear kicking themselves later.

Smart angel investors know how much they can invest each year, which industry sectors they want to focus on, what kind of returns they hope to get, and what criteria for investment they want to see. They may have a “reserve” for that one opportunity that’s just too good to be true, but it really should be a “reserve,” because we all know the truth about deals that are too good to be true.

Rule #6: Nothing shines like experience

The best indicator of potential success to angels is prior success. The reason is simple: managers who’ve started, run, and sold a company have been there, done that, made the mistakes, survived them, and proved their willingness and ability to cash out. Of course, somebody has to take chances on unproven management, but that should be left to the most seasoned angels with the deepest resources. That’s not to say that angels shouldn’t take a careful look at managers and teams that have tried and failed. After all, they’ve been there and done that, but perhaps a market change or minor mistake or even just bad luck held them back. These situations can be very hard to evaluate—I’d suggest that your best source of information will be the investors from their previous venture.

Do most people wish they had invested in an untested, untried Bill Gates after he dropped out of college? Yes. But a portfolio angel investor has to do a certain amount of odds-playing. You can’t know everything about a company or its future. If the returns were the same, would you bet on the long- shot or the front-runner?


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Adam J. Bock is the research manager for Early Stage Research, an angel network, and a regular contributor to the Wisconsin Technology Network. Please submit your questions and opinions to adam@wistechnology.com.