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Nelson Gray, experienced angel investor, catches the essence of the time-consuming, detail-oriented due diligence process in three simple questions: So what? Who cares? Why you? Be forthright because experienced investors have a sixth sense about matters, and when they find inconsistencies and loose ends, their radar goes off and tells them that you are not giving them the full story. No two angels will conduct exactly the same level or intensity of due diligence, so prepare for the most diligent angel investor. If you cannot adequately prepare for someone as important as an investor, what will you do with customers, suppliers, or strategic partners? So get your act together and present yourself as a capable, experienced, prepared entrepreneur. Be open about interactions between your angel investor and your employees. One deal killer for angels is a founder who feels able to do it all; no one is that talented nor has forty hours a day to handle every task necessary to grow a successful company. Many angels consider references one of the most important aspects of due diligence. Some angels will run a background check on you and your team, so dont be surprised if they ask for your drivers license number. Example: These are the main characteristics Mr. Collins will be looking for in your team: High-quality, experienced people covering key functional areas with complementary skills. A full-time commitment to the company either now or at the time of funding. Team compatibility and fit, often resulting from team members past experience in working together. Agreed-to and respected systems, controls, and reporting structure. A stake in the outcome through ownership. Interests aligned with those of investors to build a great company that is highly profitable with a strong potential exit strategy. Coachable, willing to listen and hear input, and then integrate that information into their work. Passion.
Mr. Collins will ask for references, possibly from a number of different sources including other investors, customers, suppliers, bankers, previous employers, and even competitors.
Financial Analysis
Investors want to see things like these: Financial projections that include a diversified customer base with multiple products off a broadplatform technology. Markets being entered in a thoughtful, calculated manner, with strong support for your choice of the first market. A well-mapped-out process for introduction of products. Enough flexibility in your numbers and your mind to adjust your projections should an unanticipated market show strong interest.
sources. However, having dozens of very small investors, particularly ones who are unsophisticated, spells a potential headache and distraction for the entrepreneur. One-trick ponies: If your company has only one product or a single-application technology, the available markets are very limited and the investor is essentially betting on acceptance in a single market. Claims of no competition: Every company has competition. Saying you have no competition will cause angels to run, not just walk away. Any portion of funds being used to cash out earlier investors or pay liabilities: Angels want every penny of their investment used to grow the company. Lack of participation by earlier investors (if relevant): If none of your prior investors step up to reinvest, it shows a possible lack of confidence in your company. Prior financings have greater protection and more favorable terms: The last gold rules. In other words, the most recent money in the door will expect the most favorable termsand will not enter without them. A history of failure by the management team: Though experience often comes in the form of a failure, investors are not interested in supporting someone who does not learn from past mistakes. Family business: Most angels refuse to invest in family businesses because nepotism and family drama can create unfavorable dynamics and cause the retention of marginal performers, which prevents real growth. Multiple licenses required for practicing technology: Licensing involves many different possible scenarios, from a concern that the field is already flooded to the chances of being sued for patent infringement, making the value of your technology or product questionable. It can also result in low realizable margins due to the license fees impact on the cost of goods. Heavy debt: If a young company is already carrying a disproportionate amount of debt, investors will interpret this as poor financial management skills, overspending, poor business judgment, or some other unfavorable sign about the companys worth. Hockey-stick growth projections: It is just not realistic to project a sudden, explosive rise in value. That kind of success would require every assumption to be 110 percent true, the market to react perfectly, no technical glitches to occur, and almost limitless funding to be at hand. You need exceptional proof for exceptional projections.
Key assumptions missing in financials: Not having considered many of the basics in developing financial documents can mean many thingsstarting with inexperience, poor business judgment, and a failure to retain skilled advisers. In general, incomplete financials will cause angels to seriously question your abilities and their interest in your company.
No board of advisers or board of directors, or only internal parties on either board: If you dont have boards with external participation, it suggests that you do not seek advice beyond your team, creating a question of your coach ability. Remember, external board members and advisers validate your ideas.
An entrepreneur who wants total control: In a start-up, the entrepreneur typically does everything from five-year strategy to answering customer support calls. One of the reasons for raising investment funds is to hire smart people to take over various responsibilities; people who have years of experience in their area of expertise. An entrepreneur who wants to be the ultimate Renaissance businessperson will ultimately fail to meet investors expectations, either keeping a small and interesting (but exit-proof) company or burning out and leaving the company and investors high and dry.
Unrealistic valuation: If you are asking for a $20 million valuation on a seed/start-up and your prospective angel is coming in thinking around $2 million, you are unlikely to have a meeting of the minds. No matter how much you love your idea, it is still only worth what the market will pay for it.
venture-capital-level funding, keep the terms relatively simple and straightforward with your early angel rounds. Sophisticated angels will understand your need for creating incentives rather than disincentives for follow-on funding. At the same time, you need to understand that angels are entitled to protect themselvesthey are taking a great risk on you. In negotiating the deal, understand each of your angel investors as an individual and let them get to know you, because angel investing is a personal decision. After all the negotiations, Make sure your lawyer is experienced in early-stage funding and able to guide you through the document creation process.
Deal Closing
After having gone through this entire process, one key lesson should be to plan ahead so you do not run out of money before investors are ready to invest.
SUMMARY THOUGHTS
If you have learned anything from all this discussion, it should at least include these maxims: Be prepared; stay two steps ahead of your prospective investors. Act professional; be professional. Recognize that investors enter due diligence with the thought of doing a deal and are looking for deal killers. Make sure you have a rough term sheet done before entering due diligence to avoid wasting your time and that of the investors. Discuss mutual expectations sooner rather than later. Dont think you can make an ill-fitted relationship work. Be open and honest at all times. Do not hide bad news; better you say something than the angel find out through other means. Angels dont expect a fully staffed company, but you should know what else you need to cover. Have the best advisory board you can assemble. Remember, angels put more stock in thirdparty opinions of your company than in your own self-praise. You are supposed to be
enthusiastic and totally committedthats passion, and essential, but it means angels will take what you say with a substantial grain of salt.