The Essential Guide to Angel Investor Due Diligence

April 19, 2020 bookshelf-1082309

The level of due diligence conducted by angel investors on the startups they’re considering varies wildly. Some “cowboy” angel investors confidently jump into investments after a single meeting. At the other end of the spectrum, there are prudent angel investors who pour over details for months. While both strategies can be successful, trigger-happy angel investors are bound to eventually get burned by their lack of due diligence, and overcautious angel investors will inevitably miss great opportunities. As with almost anything in life, moderation is the key. What, then, are the most critical due diligence factors angel investors consider?

Team

For most angel investors, the management team is the most important factor when deciding whether to invest. As the adage goes, “an A team with a B plan will always outperform a B team with an A plan.” So, what are angel investors looking for when it comes to a winning team?

To start, the founding team should have at least two people. If a founder can’t convince at least one person to join his cause, that’s a red flag for angel investors. That being said, more than four founders can also be a concern due to the potential for diverging visions.

Perhaps surprisingly, founders’ technical skills and experience are often less important to angel investors. The role of founders is to guide the ship from the helm, not repair broken pipes in the engine room. Successful founders, therefore, tend to have leadership qualities like integrity and tenacity. It’s essential that every team member who is eventually onboarded respects and trusts the founders. Further, founders need the tenacity to overcome the rough waters their startup will inevitably encounter. This means making tough choices like the decision to pivot early on when, for example, market forces are aligning against the startup.

Opportunity

Many angel investors assess the opportunity for investing in a startup by consider (1) potential, (2) probability, and (3) period.

Potential – this is the expected payout. Where does this startup fit on the scale between billion-dollar IPO and early-buyout exit at a modest valuation? Probability – this is an examination of the risks (see next section). Is it reasonable for the founders to overcome the risks, or is there a low chance of success?

Period – this is the time needed to gain liquidity on the investment. Will the startup get bought out in a few years, or will the angel investor have to wait 10 years for an IPO?

Risks

The best angel investors consider a wide array risks when assessing startups. However, they also know that putting too much weight on the potential risks will paralyze them, preventing them from making any investments at all. While technical risks, financing risks, regulatory risks, and intellectual-property related risks all factor into most angel investors due diligence, it’s market risk and competitive risk that typically weigh heaviest.

Market size, product fit, and scalability

The best angel investors take time to investigate the size of market for the product proposed by the startup. Specifically, they are looking for:

How many people the product solves a top pain point for, and
How many people would consider the product a top buying priority.

Detailed market research is particularly important for the second point because, especially if the product doesn’t represent a huge improvement over the status quo, there’s a serious danger that too many people will consider it as “nice to have” rather than “need to have.”

Another important factor to consider here is the cost of customer acquisition. If it costs more to reach new customers than the life-time value of those customers, the company will never scale.

Competitive Risk

Smart angel investors don’t see competition as inherently bad. In fact, healthy competition is a clear validation of the need for the product. Not only that, getting bought out by a big competitor is also a potential exit strategy. The challenge, then, is to determine whether the startup can grow fast enough to gain a strategic foothold. In that regard, the important risks here relate to the following:

Is there a deep-pocketed giant who is willing to operate at a loss until the startup has bled out?
How easy would it be for a competitor to spin up a rival product once they see the market has been validated by this startup’s efforts?

A final note

While too much due diligence can be counter-productive, some level of due diligence is critical for angel investor success. The important thing is to have a clearly defined due diligence process. Taking the time to map out a framework, and stick to it, will help with appropriately comparing one investment opportunity from the next.

After due diligence, what's next?