The first outside money an entrepreneur gets usually comes from friends and friends of friends. Why? Because they know the entrepreneur personally and they know where he lives. They are the father that buys a company a new computer system for video editing, the sister who gives a new developer enough to buy an IPAD, the long lost uncle who comes up with the first fifty thousand pounds for a new hair salon. These first investors are crazy enough to take a risk on a business with no assets, no income, no customers, and no provable business model. Properly put, your first “investments” should usually be called gifts.
After that first money in, your next request for money will probably go to an “angel investor”. They come in when your business needs a few hundred thousand pounds to a million pounds to grow. By the time you approach angels, you usually have something to show for yourself. Maybe it’s a patent. Maybe it’s a few customers. Maybe its a few extra dollars in income every month. Maybe you just have a great team and a great business plan. The important thing is that you can demonstrate you’re ready to launch what lots of people think will be a properly profitable business.
As you begin to approach angel investors, you need to know one thing about them. They are crazy. You need to know this so they don’t drive you crazy too.
Here’s a quick overview of just how and why most angel investors are insane.
- Angel investors are often entrepreneurs in their own right, and often they believe this gives them the expertise to run your business as well as they ran theirs. They are mostly right, but the devil in any business is in the details. Rules like “keep fixed costs down” are pretty universal. But the economics of the publishing industry are nothing like the economics of making aluminum cans. Angels understand this truth in the context of their own businesses, but not when it comes to discussing the merits of yours. This means they will often give you stupid advice based on complete ignorance and they’ll be cross when you don’t take it. Sometimes they’ll be right, and you should always hear them out, but don’t assume their advice has value just because they made money in some other business that’s nothing like yours.
- Angel Investors often invest in industries they are not intimately familiar with. Why? Because if they wanted to invest in the kind of business they know how to run, they already have that kind of business. Investing money in your business is part of their “diversification strategy”. If you are very lucky, your investor will know your industry, and will have a rolodex that can bring you customers as well as cash. If you meet that kind of investor, take their advice, and take their cash and connections as well. Give them a good return on investment so they’ll work with you again.
- Angel investors don’t believe in you either. If you’re so clever, why do you need their money to achieve your business objectives? How do they know things will work out as you’ve described? They don’t. They’re taking a risk on you. The majority of investment decisions they make are mistakes. This means if they invest in ten businesses, seven or eight will not generate a profit. That means you have to promise them a return that will pay for those mistakes. If you are offering them a 5% return on investment, they’ll laugh themselves sick. They usually want something closer to 30% compounded annually which is a bar very few businesses can hit.
- Angel investors almost always look for investments at the top of their range. Like most of us, when they go shopping they decide how much they can afford to spend and that is how much they spend. So if an investor has five million pounds to invest, and you only need one million pounds, he’s probably not going to be interested, even if you can almost guarantee a great return on investment in a credible way. Why? He’s looking for a “larger opportunity” even if it is not a better one. Always start investment conversations with Angels with a question about the size of their “usual” investment. Work as hard as you can to tell them that’s how much you want.
- Angel investors care more about the opinions of other investors than they do about the opinion of you, your experts or anything except your paying customers. Why? Because angels often invest in groups in order to reduce individual risk. So if they can’t get another investor to take part of their “action” with you, they feel like they are making an investment they’ll have to shoulder alone. That makes them nervous. Furthermore, they often owe one another favors. Two investors rarely have a very strong liking for exactly the same business, so one is always going along with the investment choice of another and they often take turns choosing opportunities. This means you can be hosed by coming along at the wrong time.
- Not all angel investors have money and they won’t tell you when they don’t. Why? If they are in any kind of a network, when they run out of money they need to get more investors to join in order to continue making investments. This is harder to do if people know they don’t have any cash to invest. So, this means Angels may make up reasons why they can’t or won’t invest in your business and if you take them to heart the bad information will harm you. If you can’t determine, for a fact, that an angel has money to invest in your business, you might do well to assume they don’t.
- The valuation of your business really doesn’t matter to Angel investors as much as the terms of the investment do. This is completely counter intuitive, but if you think for a moment, it makes sense. Whatever your business is currently worth, their investment, if successful, is going to make it worth more. The purpose of the investment is to increase the business’s income. Once the increased income arrives, investors want to know that income will be going to them or back into the business to scale it’s value. They care about those details because they care about your future income and your future value. Your present value is academic and uninteresting.
- Almost all deals with angel investors fall through before completion. You’ll be happier negotiating with angels if you assume any given deal will fall through, but one sometime in the next five years, will work.
- Angels will almost never admit they aren’t going to invest in your enterprise. They will waste your time instead. Why? Because it’s barely possible you’re worth investing in. So, if you bring them a business and tell them you’re expecting a big contract next month, they’ll decide to wait to see if that comes through. If you tell them nothing new is on the horizon, they’ll say your business is stagnant. Delay always favors the angel investor, so they will seek to delay an investment decision as long as possible.
- Angels who don’t know each other will collude against you. Negotiation of terms for an angel investment start the second you meet. Remember that angel investors are not friends, they are not family, they are not mentors or bosses. They always have their own interests at heart. That means if you tell one investor that another is interested, they will call one another. If they decide to invest as a team it will be for less money at worse terms. Why? Because that best serves their economic interests. Never tell one investor the name of another investor or the terms being offered. You don’t owe them that and it weakens your position and reduces your value to them.
Having described all these common flaws, it is worth noting that Angel investors can and should be the best friend your business ever had.
The best Angels help the businesses they invest in immeasurably. They recognize good teams when they see them. They offer mentoring, advice, encouragement and occasionally a harsh word that keeps an entrepreneur focused, effective and motivated. Good angels are few and far between, but they are entirely worth looking for.
Every angel, like every entrepreneur, will have their own weaknesses, misconceptions and moments of irrationality, but like good entrepreneurs they will be able to surmount those on the way to building a strong business.
Andy Symonds
19 July 2010
10:32 am
Great article Doug.
I wouldn’t approach an Angel until I had spoken to all my family, friends and friends of friends as like you say surely the Angel thinks how come they can’t do this on their own?
The success rate of Angels you mention definitely makes me think you guys are a little insane – 10% – 20% of your investments are mistakes?! That seems like a lot of wasted time, money and energy from Gurus – do some of these come good in the end?
Nancy Fulton Mazur
20 July 2010
6:14 pm
Actually, the failure rate for angel investments is higher than 10%-20%. Its tough to build a startup . . .
Pingback: The insanity of Angel Investors « TheWaterRat
Neeta Patel
19 July 2010
10:54 am
Thank you for the tips Doug – very pertinent and useful. I’m in discussions with a number of angels/networks and do see some of the behaviours/positions you’ve mentioned in your blog. Very helpful to keep in mind…..
Ed French
20 July 2010
9:19 am
Good piece. Worth also mentioning that often business angels run a main business which is their primary asset and as such in that role the angel can often be motivated to be fairly conservative in order to preserve value. On the other hand, some angels will feel that the early-stage business in which only a small part of his or her wealth is invested is fair game to ‘experiment’ with more radical approaches to management, marketing or sales. When first described to me this was called the “train set effect” likening the small investment to something of a toy. Harsh perhaps, and far from universal, but a hazard none-the-less.
Justin Whitston
20 July 2010
2:53 pm
I have responded to this article at http://bit.ly/9WreYt. I agree with the bits about fee-earners but I can’t help but feel that this scares away potential start-ups, doesn’t differentiate between an angel network and investor and ultimately has a lot of flaws.
Feel free to respond,
Justin
Venturelab CEO
Nancy Fulton Mazur
20 July 2010
6:09 pm
Thanks for responding
Its nice to be part of a dialog . . .
I can’t speak for Doug, and I don’t know if he’ll have bandwidth to respond, but as a serial entrepreneur who has talked to angels and their networks, my experience is in line with what he describes. And the point of the article is to tell entrepreneurs not to be afraid.
Entrepreneurs put angels on a pedestal. They should not. MOST angels are entrepreneurs. They are the same guy who sits next to you at the coffee shop whinging when business is bad, or that you see hustling at conferences. They have the same flaws. When the good ones make good, and they do, they are inclined to invest in startups because they like doing that kind of “start small build big” business.
But their advice isn’t always appropriate to your business. They do not see your opportunity before you do or understand it better than you when you are pitching. They do tend to risk right up to their limit on projects, so entrepreneurs need to know that reducing risk and reducing investment may not help them in their search for capital. They do like to syndicate/share their investments because they like having multiple sources of capital to turn to in the future.
In short, I think the article is removing angels from a position of authority and turning them into the collaborators they should be in a business.
And this really is me speaking here. When I watch the Dragons Den and similar shows I’m struck by the fact that people stutter and become awkward when they address the folks that might give them money.
If . . .
Your business model is solid.
You can find customers or potential customers willing to give you purchase orders or letters of intent.
You have a good team.
Then dealing with angels is much easier because you KNOW you have a solid business.
I’m not sure that you should chat up investors until you have that stuff. Pitching is so much easier when you know exactly what you want to do and why and you’re just looking for someone who shares your vision . . . I think without that stuff you should be scared because you might actually get an angel on board that wants to do something entirely different, and from a business standpoint you and your business are married to him.
Nick White
21 July 2010
3:22 pm
Both Doug and Justin have valid points drawn from real world experience.
The Business Angel community is a broad church. They invest alone or hunt in packs and that’s significant in the context of this debate. When they syndicate those companies looking for money at that level should not be too concerned about the motivations and personalities of those in the syndicate as all you really need is their money keeping them at relative arms length form the business. Tick the boxes get the money. A bit like an early stage VC. Then you have the lone angel (a dying breed?).
In addition to Doug’s list there is another trait (sorry a another sweeping generalisation) that entrepreneurs are only too aware of or should be aware of. The investment community is, in the main, arrogant and this is especially prevalent in the angel sector.
A reasonable number of angels ONLY have money to offer. That is the major issue for an entrepreneur. Some have not even obtained their wealth through business, some will be a one trick pony and here is the rub. Given the opportunity again they would not be able to pull off the same trick.
Yet despite these deficiencies you would think they walk on water because they have the £50K you need even though they are unable to add any real value to the business that you have devised and created. As Doug points out they can actually harm your business.
So avoid investors who over emphasise “skin” in the business or 100% of your wealth on the line when they are only investing 1% of theirs. Put them under the spot light. What can they bring to the business? If they look incredulous at the question and point to their cheque book show them the door. As Ed points out there are a lot of “Hornby” enthusiasts around.
What is appealing about Venturelab and School for Start Ups is that it is not all about the money. It’s about creating and nurturing new businesses through their early stages. There is precious little of that form of investment; that’s the insanity.
Nancy Fulton Mazur
21 July 2010
9:15 pm
Wow . . . That was a cool post. Thanks Nick.
Lloyd Pennington
26 July 2010
3:14 pm
As a product designer I am often involved in the production of intellectual Property (IP). What I find surprising is that investors get very hung up on protecting IP with a patent. With so little that is truly ‘novel and inventive and not otherwise known to ones skilled in the art’, most innovations cannot be successfully patented and yet add significant value and competitive edge to the IP owners business.
Given the very high cost of acquiring and maintaining a patent and the probable sky high cost of defending infringements, I find it ‘insane’ that so many investors don’t actually take stock of the risk-to-reward of a patent and it’s robustness to attack.
I have seen at first hand a client who was a PLC company run by one of the UK’s most notable chairman loose so much of its share value that it went into liquidation despite winning its case against the inventor of its IP who himself went bankrupt with debts in excess of £34M.
I think what is required is a considerable re-design of the IP protection system, but failing that, investors and businesses need to look carefully at the business case for the whole business including the investment in IP protection.
Not having IP protection doesn’t not always mean a business will fail, even if the risks are somewhat greater
Nick White
26 July 2010
4:02 pm
You raise some very interesting points LLoyd that resonate with my experience. I’m a patent attorney and investor.
What I have determined over many years is that investors are largely ignorant of IP in general and patents in particular. You see many varied approaches and reactions from investors. See last week’s Dragons Den to see the contrast between Duncan Bannatyne and Peter Jones. I would hazard a guess that neither had a clue about the relevance or value of the patent in question to their investment decision. Investors will invest on the mere fact that a patent application is in process and that is all the due diligence they do!
Investors should be able to determine the risk/reward but are generally ill equipped to undertake this assessment either through lack of ability or more probably lack of relevant information. However, equally problematic is that companies seeking investment often do not understand this either and are unable to give would be investors a clear understanding or rationale of their IP position and the relevance of the IP to their business and the investment. It’s the blind leading the blind.
I don’t agree with your assessment about what can or cannot be patented. If you have a new (novel) technical feature and that gives you a “competitive edge” it’s highly likely that something may be protectable almost by definition. The problem is that many companies patent things that do not have a “competitive edge”’ what’s the point of that!! A lot of wasted money and effort here with not enough emphasis on the business case or cost/benefit . I completely agree that securing IP protection is not always a pre-requisite for success in business as you can obtain competitive advantage in many other ways. However, in some circumstances the protection of IP is essential for commercial success and investment.
The anecdote you provide is not unusual in scenario (the numbers are highly unusual!). Disputes about IP ownership between investors, companies and/or directors /inventors are more common than many realise. I came across an angel investor who wasted EURO 1 million after a fight with an IP owner related to the business incurring EURO 300K of legal costs. This could have been avoided at a cost of £200! The sad thing is that a lot of this type of problem arises through ignorance rather than malice on the part of any of the parties.
You flag the costs around IP. That is a very important issue. Many start-ups have extremely lean budgets and cannot afford to handle their IP in a robust way. Equally Angel investors looking to invest say £50 to £100K do not want to spend up to £10-15K on due diligence, legals and IP assessments.
Lloyd Pennington
26 July 2010
5:52 pm
Nick.
Thank you for your reply. It’s always good for me to learn from IP professionals such as yourself about the often very subtle nuances’ that people like me, even though we generate and deal with IP on a daily basis, we are still very much less than expert on the matter. I always try to encourage clients to seek advice from a reputable patent attorney. Alas as you say many start ups and even larger clients seem reluctant to invest in this area. Most of my clients when questioned I find have done little or no study of even prior art and are often unaware that they may be infringing some other party’s IP.
I have to say; perhaps I have been misleading regarding the sums involved in the aforementioned case. I must confess that the amount of debt incurred may not be entirely due to legal costs; however I do know the battle was long, complex and quite bitter and the PLC involved surely did suffer as a direct result of the fall in shareholder confidence as the case dragged on.
Your disagreement with me regarding patentable novel features really only goes to underline I think that in almost every case where some form of innovation is introduced into a new product design, the IP owner should seek the advice of a patent attorney. Your comment certainly rings true as I have often been surprised at some of the innovations that have been successfully patented by the skilful writing of an abstract and claims. I would further add hopefully to the benefit of readers that a reputable patent attorney can help make life difficult for industrial designers like myself, overcome a patent by finding technical solutions to circumnavigate the problem. Patent attorneys I find as both valuable colleagues and worthy adversaries all wrapped up into one.
Nick White
29 July 2010
6:17 pm
Lloyd,
Thank you for your observations. A further insanity! You highlight the more important IP issue of freedom to operate (FTO). I’m not surprised that most of your clients have not given this attention before securing their own IP or looking to spend money and effort on other things. Mostly companies (and investors) are ignorant of this issue and it is expensive to address. I don’t think I have ever heard a Dragon on DD ask about FTO.
I’m a patent attorney but my mantra is “The last thing you should do is file for a patent”! To be frank a lot of what is patented is worthless from a commercial point of view. It is a problem sometimes with investors. I do an assessment and have to impart the bad news to all that the IP is of little value. The real pity (insanity) is that if the right assessments had been undertaken earlier a much better IP outcome could have been achieved. I see this scenario time and time again. It’s a bit depressing. The problem is that investors and entrepreneurs do not fully understand what can be achieved if IP is handled and assessed in a commercial way as opposed to a purely legal framework. Also it is expensive to do well.
Getting back to Doug’s theme perhaps Angels are bonkers or enjoy living dangerously. They put money into early stage opportunities at a level of investment that simply cannot justify the expense of doing the early stage assessments to de-risk. Perhaps that’s one of the reasons their returns are so poor on average and a lot of investments bomb. It’s akin to picking your racing bets with a pin as opposed to studying the form books.
How do we address this insanity? By the way this form of insanity is surprisingly prevalent at the VC level when the size of the investment does justify the expense!
Gordon Brown
2 February 2011
11:42 am
I have alway had in the back of my mind wether and angle invester would be a good direction to go. You obiously need to be very careful, but once your out of options and it comes down to close the business or look for investment you need to ask your question. why can’t you make the business work, is it a none starter, wrong time and if you get investment, is it going to make any difference.