How angels evaluate their opportunities
This article is meant to help angel investors (“angels”) build a framework to evaluate startups.
We know investment decisions are personal and logic (‘gut feeling’ about a deal and founder) does not always apply. We do recommend however to build an evaluation framework and stick to it, simply because investing is a constant learning process and you want to construct a portfolio of companies and look back in a few years to evaluate your framework and sharpen your decision-making process.
Our method
By using the 4-layered structure below one should be able to touch all essential aspects while evaluating a deal:
- Pre-qualification phase
- Interview phase
- Research & Review phase
- Due Diligence phase
With HH Investments VC we have refined this framework over the years and it’s proven to be successful.
Our ratio of investments is typically 1 out of 100 companies that we evaluate.
Exceptions to the rules
It is important to realise that the answers to the questions below do not make the investment decisions for you. We have to accept that no company nor founder is perfect and it’s fine to make exceptions to your decision framework, just make sure you have the logical reasoning to do so.
You wouldn’t be the first angel that makes the difference for a startup that wasn’t perfect when the investment was made:
“Atari: founded in 1971. Had initial success with arcade video game ‘Pong’. Wanted to launch a home video game console in 1975 but was struggling to get it sold and raise funds. Sequoia funded Atari, but more important, they brought them their first customer to enter the (rapidly growing) consumer market for home video games.”
Time
We have broken down the approach in multiple layers in order to introduce the ‘time’ factor. Investors might fall in love with a startup or a founder immediately after the first interactions.
It is important however to take a step back and see if the founder is persistent and pursues the investment opportunity or if we simply feel a deal is not ready for our investment yet but it might in be in several months from now, we want to spectate.
Or perhaps we want to see if the founder can find other investors to join as you don’t want to be the only one?
How about the ‘fear-of-missing-out’ (FOMO)?
The really (rare) ‘amazing’ deals and founders typically don’t allow you to spectate and you simply have to make fast decisions as the funding round will likely fill rapidly and you should be grateful that you are allowed to have a place on the cap table. Worse; you might not even see these type of deals as they are typically concluded in small circles of investors.
However, the majority of the deals are not immediately ‘amazing’, they are ‘potentially good’ (diamonds in the rough) (even though a lot of founders attempt to create FOMO, it’s probably better to wait, 9 out of 10 times these founders are still trying to raise money in 2 months from now), you need to have patience and take a proper deep dive before making a decision.
Pre-qualification phase (1 week — 6 months)
During this stage we typically haven’t spoken much to the founders yet. We let them fill out a form or we simply extract information from the investment deck that we ask them to share with us.
Note: I try to refrain from using classifications such as pre-seed, seed and pre-series A in this article as they can be confusing and are not helpful metrics for evaluation. It’s fine to put a stage label on a company, but let’s do it AFTER the evaluation.
Holding incorporated where?
Our focus is Southeast Asia and we like Singapore to be the country where the HQ (legal and tax safe-haven) is established. Your preference can be different but you want to look at the legal aspects and whether you feel comfortable to invest in the relevant country or not.
What is the industry focus?
Stick with what you understand. As an angel investor you need to be able to envision growth in this industry, so you’ll need to understand it. Also, you want to add as much value to the company as you can (the founders will need it). Sure, you can venture in to new industries but be prepared to put in the extra work.
Raising money for how many months?
We want companies to raise money for growth and not for survival. So we like to see at least 18–20 months of runway after the round has been closed.
Is there a minimum viable product with at least 6 months of data?
If you like to invest ‘very’ early stage with smaller tickets you’ll find companies that are still in the idea stage and I personally think you’ll be taking an unnecessary risk of the company not even being able to launch a product or service. Instead there’s sufficient good companies with traction out there (coming out of accelerators, venture builders or started by second time founders) with at least 6 months of data that we should focus on.
Is there a business- and financial plan?
We want founders that have thought things through even though a lot of it might still be guesswork.
Is it clear from the deck what problem the company is solving and how they are solving it?
We like to see a clear problem statement and a deck built around it. This shows that the founder and the company have focus. Even though the problem might be very complicated, a great founder is able to break it down in understandable chunks of information.
Raising how much?
The size of the amount by itself doesn’t say much, but it does show how realistic the team is when you look at it in combination with the problem statement and the goals of the company. Typical angel rounds are between USD$100.000–USD$500.000.
Did the founders run a startup before?
Working with founders that have ‘done it before’ whether successfully or not can save a lot of learning costs.
Interview phase (2–3 hours)
Once a company passes the pre-qualification phase we speak to them personally and take a deep dive. A lot of the questions below are meant to establish how the founders react to potential challenges and help us to try and understand their personalities better. A lot of times there’s no right or wrong answer and we simply want to see the right mentality.
I call this the ‘immigrant mentality’ and wrote about it before:
“.. the mindset of these founders can be defined as ‘getting out of the comfort zone’, there’s simply no plan B, but only plan A.”
“I’m not claiming that all founders should be immigrants. As long as there is a healthy level of ‘out-of-comfort’ in their lives and they see a real problem they would like to solve with passion, they’ll likely be more creative and run harder than somebody who wants to start a company because their friends did and they try to launch a copy-cat because they lack the inspiration for real innovation.”
How did the founders find us?
We like to be introduced through our trusted connections. Or we want to hear why a founder wants to work with us. We have to be mindful when working with founders that are shopping for any money they can find.
What is the background of the founders?
Why did they start this venture? Was it a personal problem they were facing and how passionate are they about this idea? Do they have the relevant expertise? Building a successful company can take up to 10 years, so we want to founders to be resilient.
Did the founders run a startup before?
We already looked at this question before during the pre-qualification. But if they did built a startup before, we want to understand more. What happened? Did they exit? What did they learn from any success of failures? Why did they start a new venture?
What is the company trying to achieve?
We want founders to lay out a clear goal to us. They can be aiming for the stars which is fine as long as there is a realistic plan for execution. The bigger the goal the more detailed the founders should understand the execution plans.
What is the market size?
Marketing sizing is important, even though it might be a process that is completed with a lot of assumptions, it shows that founders understand the potential value that the company is trying to (and realistically can) extract from the market.
We don’t just want to see that the total market of ‘product X’ is worth $X billion. We want to always see:
- Total Addressable Market
- Service Available Market
- Serviceable Obtainable Market
Why is now a good time?
Timing is critical when launching a new startup. We want the founders to be able to explain why right now is not too early or too late.
The competition
We want to understand who the direct- and indirect competitors are. It is critical that founders deeply understand the landscape and who else is trying to get a piece of the pie. Saying ‘there is no competition’ means that the founder doesn’t understand the landscape well enough. There is always competition.
We also want to see a competitive advantage that can be validated with the limited data that the company already has.
What is the unfair advantage?
We want to see a logical explanation why this team is better than other companies that are trying to get in to the same industry. Effectively this can be things like; contacts, unique knowledge etc.
The unfair advantage typically relates to the team and less to the product or service that the company is selling.
How much revenue does the company have?
For B2B companies we want to see some revenue in the range of $USD5–10k per month. For B2C or C2C companies we can typically look at user growth alone if there’s no revenue.
How large is the team?
One of the skills of a founder that we are a looking for is the ability to attract a talented team around him. By the time we invest, we want to see the essential skills already hired or a very clear hiring plan in place.
How do you make money?
We want to understand the business model and the logic behind it.
How much do you charge your customers?
We want to see a competitive price point that can provide healthy (top line) margins. Also, the best solutions out there have some form of pricing power or might get it down the road.
How much does the average customer spend?
With this data we can start to predict the potential life-time value of a customer. At the same time it shows us how ‘sticky’ the product / service is if there are recurring customers.
How much money have you raised in this round?
We like to see founders that are able to secure (soft- or hard commitments) funds from other investors besides ourselves or get existing investors to reinvest.
What are the top 3 reasons the business might fail?
We always end the interview with this question. We are looking for founders that are realistic and understand the risks of doing business.
Did the founder follow-up after the interview?
Finding investors means ‘selling’ for the founders. Investors don’t close directly during or after the first meeting.
Do the founders follow-up with more information? Do they follow-up again after 2 weeks if they haven’t heard from us?
Are they keen to share with us what they have achieved and keep us updated on the progress of the company while we were doing our research or if we have indicated that now might not be right time to invest but we like to stay updated?
Review & Research Phase (1–4 weeks)
During the Review & Research we go in depth and look at every aspect of the business. This is the phase where we typically involve other investors with relevant knowledge.
What has been the monthly revenue growth for the past 6 months (B2B)?
We like to see companies in the early stages grow revenue by at least 10–20% on a monthly basis.
What has been the daily active user growth for the past 6 months on a weekly basis (B2C or C2C)?
We like to see companies in the early stages grow their user base by at least 10–20% on a weekly basis.
Customer Acquisition Cost (CAC) to Lifetime value (LTV) ratio
When evaluating the financials we like to see a healthy CAC to LTV ratio of at least 1:3 within the next 2 -3 years. More information can be found here.
Burn multiple
Capital efficiency is an important metric when looking at the financials of a company. As an angel we want to understand how much money the company is burning or expects to burn (on a monthly, quarterly or yearly basis) to generate new revenue. We typically calculate the multiple as follows:
- Efficiency Score = Net New ARR / Net Burn
Any score below 2 is considered efficient (and could be unrealistic). Anything above 2 is cause for investors to take a closer look at the financials. The score can be higher in early stages as the company is burning money to gain traction. However, the company should never use raised capital inefficiently and scores above 3 are unacceptable.
Is it realistic that the company can reach her goals with the funding raised?
This is where our industry knowledge & entrepreneurial experience kicks in. Imagine yourself at the helm of the company. How would you do it? Are the goals realistic? Should they raise more funds?
They will likely run out of money in the next 15–20 months, but would the team by then have created sufficient traction to raise follow-on funding from a venture capitalist or is there a big risk that they will require more angel money?
Valuation
Pricing the company in the early stages is challenging since there’s little revenue and data available. Many companies offer a convertible note to investors and basically postpone the valuation discussion until the next funding round closes.
In case founders or investors would like to price the round there’s a few methods they could try to use:
- (net Monthly Recurring Revenue * 12) * 5–10x (multiplier to be negotiated)
- Discounted Cashflow
- Trying to predict what a future VC might want to pay for the business in the next 24 months. An investor can then decide whether this is a worthy multiple on the ‘current’ valuation.
- Look at the valuation of similar deals in the same industry and region
From experience we know that the value of a company in the stages that we look at is typically between $USD1–3.5 million pre-money.
We will discuss valuations a bit more in a future article as there’s a lot to say about it.
Cash flow positive
At what point in time will the company be cash flow positive? Every business will need to generate cash at some point in time (aside from the fact that more investments might be needed to grow).
Try out the product or service
We typically sign up for the product/ service that the company is offering to try it out and put ourselves in the shoes of the customer.
External investors
We usually bring in other investors to share ideas and opinions. This is a critical part of the process and helps us to defy biases.
Market / competition research
It is important that we do our own market and competition research. This will give us a deeper understanding of the challenges and possibilities in the market.
At the same time it helps us to compare other companies that are trying to solve the same problem to the company that we are evaluating.
What is our exit strategy?
Maybe one of the most important topics. We need to decide how long we want to stay in the company. Will we be trying to sell our shares in secondary transactions or do we wait until a company might be acquired (IPOs are unlikely in Southeast Asia)?
If I’m going to be invested for 5 years I want to try and see if I can predict what (I hope) the company could be worth at that time?
Due diligence (1 week)
The due diligence is the tail that starts after we have evaluated the company. At this point in time we likely already have made a decision for ourselves that we like the company.
Due diligence is performed for two reasons:
- We want to make sure what we heard from the founders so far during our discussions matches with the reality
- We want to make sure there’s no irregularities
The due diligence can be executed using a standardised checklist. Examples can be found here (keep in mind that most companies raising capital from angels might not have a whole lot of data and documents yet):
Conclusion
Evaluating companies is hard work. As mentioned; for each investment we typically look at 100 companies. There are good companies out there but one has to be willing to put in the effort to find and evaluate them.
This article is part of a series on angel investing
We discussed earlier:
- What should you consider before becoming an angel investor?
- What does the portfolio of a successful angel investor look like?
- What can we learn from successful venture capitalists?
- Why founders & venture capitalists in the Asia Pacific and Europe should start thinking globally
- Why Southeast Asia is great for your angel investments
- How do angel investors source opportunities?