August 24, 2011
Editor’s Note: This guest post is a three-part series on angel investing – Part I introduces angels and angel groups, Part II focuses on the due diligence process and the post-investment relationship, and Part III breaks down angel investing for entrepreneurs. The majority of content for these articles was gathered from a conference on angel investing hosted by Pipeline Fellowship, an organization that trains women to be angel investors and is committed to investing in women-led for-profit social ventures.
Part II: Due Diligence, Sealing the Deal and Post-Investment Relationship
The Need for Due Diligence
Angel investors need to vet the companies they want to invest in by going through a due diligence process. Due diligence can be boiled down to validating the plan, uncovering the missing pieces and defining the unknown to contain and define the risk of an investment. Having an inherent good feel for the entrepreneur and team, as well as the market, can definitely help with due diligence.
So why does due diligence need to be done? A Kauffman Foundation study on angel group returns showed that the returns for deals increased with the hours of due diligence invested. The mean time spent on due diligence was around 20 hours and the returns for deals with less than 20 hours of diligence was around 1.1X on average. Deals with more than 20 hours diligence had a 5.9X return and for more than 60 hours spent on diligence the return was strikingly higher – 7.1X. The process is heavily dependent on the type of deal (industry, stage and amount), potential and/or existing investors in the deal, and industry knowledge or expertise by the angel(s), along with their individual skills.
Due Diligence Process
Angel investors and groups may not have the same amount of time to allocate for due diligence as professional venture capital (VC) firms. This is where tiered due diligence is important – where you hit the high points of the deal before diving into extensive due diligence. This approach helps make the process more efficient and effective. First do an analysis of the market opportunity and then check if it fits with your investment thesis as an angel investor or angel group. Some questions to ask include:
- Does this meet your investment goals?
- Are there any conflicts – portfolio or personal?
- Can you add value? Where exactly can I add value to this company?
- Can you work with these people?
This helps a due diligence plan to find the details you must confirm, unknowable items and the risk of not knowing them, cost of confirming and the major risk factors and deal killers. Due diligence is also a progressive process. Key issues in the plan:
The process for due diligence is generally as follows:
- Business plan review
- Management presentation
- Site visit(s)
- Competitive analysis
- Financial analysis
- The Deal
The entrepreneurs’ credit score needs to be checked as part of the due diligence process to bring up any potential red flags. Impact investments need to be compared against mainstream products and services as a benchmark during the due diligence process.
Valuation of Early Stage Companies
The valuation depends on the company stage – seed or startup and on-going companies.
Some methods to value on-going companies are:
- Book value (liquidation)
- Transactional value
- Market value:
- Cash flows on a going forward basis to determine present value
- Looking at comparable companies to come up with a fair valuation, which is definitely both an art and a science
- Income value (discounted cash flow)
- Weighted average of methods
Always ratchet down the optimistic revenue projections by entrepreneurs and based the valuation on gross revenues not EBITDA. The supply of and demand for capital as evinced by market conditions also plays a role in the valuation of any company.
The valuation of a seed stage or startup company is completely based on the anticipation of growth. Some issues to factor in valuing these type of companies are:
- Typical investments
- What investments to avoid
- Ranges of fair valuations
- Factors impacting the valuation
- No specific formulas, as this is more of a black art and a conscientious process
- Estimating valuation using your best judgment
Also important to look at is how initial valuation drives future capital needs and valuations. This is more of an art than a science since it is hard to accurately predict the pricing of subsequent financings and value of ultimate exit valuation. A fair seed/startup valuation will be in the range of $1 million to $3 million.
The factors that would increase the valuation of companies in this stage and their impact are:
- Management team: 0 – 30 %
- Size of opportunity: 0 – 25 %
- Product or Service: 0 – 10 %
- Sales Channels: 0 – 10 %
- Stage of Business: 0 – 10 %
- Size of round: 0 – 5 %
- Need for more funding: 0 – 5 %
- Quality of plan: 0 – 5 %
These are some average impacts that can definitely change as you appraise a particular seed stage or startup opportunity.
Some expected rates of return:
Internal Rate of Return
5-Year Cash-on-Cash Return
60% + every year
25% every year
The Kauffman Foundation provides a great valuation worksheet that lists out a weighted ranking of all the factors impacting the valuation of pre-revenue startups that you can access here: Valuing Pre-Revenue Companies
Post Investment Relationship
Roughly, angels spend 100 hours doing the deal, and then around seven years engaged on a monthly and sometimes weekly basis with the company. Hence the post-investment relationship is almost as important as the structuring and closing the deal itself. Some key parts of this relationship include:
- Entrepreneur Engagement: Engagement specifics need to be discussed like who are the active angels? What roles will they have and for long? Will the roles be rotational?
- Board of Directors: The roles, mechanics and issues for the board need to be hashed out post-investment.
- Roles: Who will be representing the angels on the board – Directors or observer status? When will the angels exit the board and will there be rotating angel members? How many boards should angels serve on?
- Mechanics: The frequency of meetings, agenda setting and follow-up need to be discussed. When the company is a seed/startup company, monthly board meetings even if informal can be helpful. Setting a communication schedule will also help.
- Other Issues: Compensation for Directors is usually non-financial since investors don’t get options which are reserved for outside non-investors.
- Managing in Troubled Times: Angels should also step in to help as the company’s needs change and also prepare the founder/CEO for changing roles. Having conversations with the entrepreneurs on potential transitions before the investment is made is helpful.
- Follow-on Funding: Non-dilutive financing options should be explored in any investment that will probably need follow-on financing. When institutional investors like VCs come on board, the roles of angels need to be balanced with that of the VCs, especially on the board. Angels can help entrepreneurs pick the right angel investors in the case that another angel round is needed and also leverage their relationships with VCs for a larger institutional round.
- Exits: Discussion of exit options as part of the due diligence process will help to ensure that the entrepreneurs and investors are on the same page as far as the long term strategy of the company is concerned
Some great resources include:
- Angel Capital Education Foundation (sponsored by the Kauffman Foundation) has white papers on best practices in angel investing, common documents and other useful topics.
- For term sheet nuances, check out the term sheet blog series by Brad Feld and Jason Mendelson of Foundry Group
- Fred Wilson of Union Square Ventures has series of blog posts (MBA Mondays) on all financing options for startups/tech companies
- Term Sheets and Valuations is a great book by Alex Wilmerding that goes through the term sheet items one by one
What are other resources that you, the readers, have found useful?
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