It’s like you’re in an episode of Silicon Valley. Here you are in a glass-paned conference room across from the hip CEO in Birkenstocks and an MIT sweatshirt. The pens all bear the company logo, and the mock ups of the new landing page jump out at you in shades of burnt orange and cornflower blue. Even the coffee is being served by an intern who’s probably worked at six different startups before this one. Everything about this place screams “breakthrough,” “innovation,” and “give me all your money.” And you’re thinking you hit a home run your first time up to bat.
The fact is, in the angel investing world, new investors are akin to a kid in a candy store. Everywhere you look there’s a flashy new startup that is sure to yield maximum returns. And in a world where every advancement is potentially game-changing, it’s easy to succumb to temptation and pull the trigger too fast.
But there are things you have to watch out for before you get your feet wet. Things like: What are the terms of this deal? and What is the timeline to exit? and Should I really trust the management team when they promise to make me a billionaire overnight? Yeah, those little details.
So, here are the five biggest mistakes beginning angels make, along with how to fix them.
Mistake 1: Not Asking Enough Questions
So your colleague in the cubicle across from you swears that this new technology is going to change the way people think about styling their hair, and you’re thinking: “I can roll with this. My colleague wouldn’t let me down. They’re always the life of the company holiday party.” You meet with management team, and everyone is charismatic and welcoming. The pitch deck was eye-catching and dissolved perfectly from one slide to the next. What more could you need to know? Plenty.
At the end of the day, angel investing is a risky business. And not the Tom Cruise sliding down a hallway in socks and an oversized button-down kind of risky. Risky-risky. Like “I am placing my money in the hands of an as-of-yet unproven business venture” risky.
We get it. You love your friends, and you trust them. And you should if you’re asking for advice about whether or not you should respond to the text your ex sent you about meeting up for coffee. But when it comes to angel investing, a friend’s assurances do not a successful deal make. A recent survey showed that most investors don’t follow what other angels are doing.
The Fix: Do Your Own Due Diligence
Asking questions is the first step in getting a thorough evaluation of the company. And it’s important to get feedback from as many sources as possible. Even an internal evaluation done by the startup may not reveal everything there is to know. In any formalized due diligence process, outside experts will weigh in and vet the technology being developed. And any reputable startup should welcome the chance to have their company analyzed through a critical lens. That said, though, it is up to you to insist on these results, and you’ll get there by posing questions.
Some questions to start off with include:
- How pressing is your need for this solution? What are your other alternatives? Why is this alternative better?
- What are the alternatives that currently exist to solve the problem? What are their shortcomings? Which companies offer these alternatives?
- What protections does the company have for its technology (patents, trade secrets, brand, existing relationships etc.)?
- How far along is the technology development: Is there a lab prototype? Customer-ready prototype? Manufacturing-ready model?
- Is this area regulated and, if so, by whom?
- Do you have patents? Has a Freedom to Operate (FTO) search been conducted?
- What is the expected exit value? How is this exit value determined?
Even when you’re just starting out, it’s important to establish yourself as an independent investor. Not only does this signal to a startup that you mean business, it helps you develop your personal and business goals (more on this later.)
Mistake 2: Not Reviewing Enough Deals
We’re all familiar with the simile of a kid in a candy store. And to adults, a promising investment opportunity is like the sweetest pastry in the shop. But biting in too quickly is likely to land you with a toothache and seriously sour wallet.
The Fix: Don’t Get Ahead of Yourself
Seasoned angels know better than to jump at the first shiny opportunity that comes their way. Instead, they’ll review multiple companies before making an ultimate decision. The Center for Venture Research at University of New Hampshire suggests that 15% of startups that look for funding actually get funded. Extrapolating from this, angels should evaluate at least 7 deals before investing in one.
Mistake 3: Putting All Your Eggs in One Basket
Do you have $50-70 k burning a hole in your pocket? If not, we sympathize. If you do, you’re probably ready to spend some of it. But beware investing too much in any one deal. Beginning angels are often tempted to write a huge check for their first investment. However, the most important thing you can do as a fledgling angel is to build a diversified portfolio.
The Fix: Seek Variety–It’s the Spice of Life
The key to building a diversified investment portfolio is starting small. Investors should set aside a certain sum of money and invest across 10-12 different startups right off the bat. Unless you have the opportunity to spread your investment over several startups, don’t start investing. Lack of diversification is the surest way to lose money.
Luckily, in the internet age, diversification is easier than ever. Online investment platforms–like Propel(x)–give you access to the same opportunities as the Silicon Valley, no matter where you live. Many platforms also enable diversification by means of investing through a syndicate. With a minimum investment requirement of only $3,000, you can easily spread your capital over many different companies. You can learn more about diversification and investing through a syndicate in Part 5 of our Angel Investing Guide.
Mistake 4: Not Understanding the Terms of the Deal
We’ll state the obvious here: every deal is going to have certain investor terms, and it’s your job to figure out what they mean. Not having a full understanding of what the deal terms are is like showing up to class without having done the required reading. You might be able to muddle your way through based on what other people tell you, but you’re probably not going to get the grade you want. The fact is, if you don’t understand what the deal terms mean, you’re going to be disappointed.
The Fix: Do Your Homework
Immerse yourself in deal terms 101. Some of the most common types of funding are through convertible notes (which we cover in greater depth here) and equity funding (where the company sells shares of stock–common or preferred.) It’s also helpful to brush up on your deal terms vocabulary. Make sure you understand terms like pay-to-play, anti-dilution protection, drag-along, and voting rights. If you haven’t already read this, I highly recommend the book Term Sheets and Valuations by Alex Wilmerding. In the end, no matter the terms, it is always good to do your own research before investing so that you know what you’re getting into before you sign on the dotted line.
Mistake 5: Not Identifying Personal and Business Goals
So you’ve found a startup with fascinating, breakthrough technology. You’re sure this is going to change the industry and impact millions of lives. But what is the benefit for you? What do you hope to gain by investing in this company? Often times, beginning angels get caught up in the initial draw of a company without making sure that it aligns with their ultimate goals.
The Fix: Set a Goal and Stick to It
You can do all the research in the world on due diligence and deal terms, but the only person who can decide your ultimate investing goal is you. You need to ask yourself: what do I want to get out of this investment? Are you investing for personal reasons like building a better future by mitigating climate change? Or for economic reasons like getting a 30% IRR? Determine what you want to gain from your investments, and align those ideals with the companies you invest in. At the end of the day, angel investing should be a rewarding pursuit, and chasing your goals will help get you there.
What do you think are the biggest mistakes beginning angel investors make? Continue the discussion in the comments below!