Due Diligence

How Do Angels Deal with High Risk Investing?

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Angel investors make decisions to invest under conditions of extreme uncertainty. Angel investors face cases in which uncertainty is so extreme that it qualifies as unknowable: they decide on investments in ideas for markets that often do not yet exist, and they propose new products and services without knowing whether they will work. For experienced Angel investors rather than being undesirable, unknowable risks are deliberately sought, on the basis that it is by investing in companies with unknowable risks that they can find the most attractive, most profitable investments.

Experienced Angels do not seek to maximize each decision but instead seek potentially extraordinarily profitable opportunities and accept a high failure rate. They rely on building a large portfolio to spread risk and accept that the overall failure rate, by number of investments, may be as high as 70%, even in the most developed capital markets[1], with 85% of all returns coming from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

A key role for “training” therefore needs to be providing nascent Angels with an understanding of the characteristics of the Angel market, tactics to deal with the high risk, and thus confidence to join with others in making their first investments.

Experienced Angel educators suggest that individuals new to Angel investing tend to seek out training on subjects such as valuation, looking for the “correct” valuation method or formula, reflecting a desire to reduce uncertainty (and perceived risk). In practical terms valuation training will likely highlight that there is no “right” answer, instead presenting a number of different methodologies, and suggesting that several should be used in each case and the results compared, but that local comparatives are likely to be the most significant influencer. Many of those new to investment struggle with this lack of a definitive answer but gain confidence when they see that all Angels face the same issues.

[1] 2016 Angel Returns Study, Angel Resource Institute, 2016.

Angel Decision Making – How do they get to Yes?

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Reading the available  academic research and discussions with experienced Angel investors suggest that “technical” subjects (valuation, financial modelling, technical due diligence) play a relatively limited role in the overall decision-making process, significantly due to the lack of “hard facts” in so many aspects of an Angel type investment. It is not a formalistic driven process. There is no proven formula for success, and no hard data to put into a formula should one exist.

Rather, decision making is based on a mix of technical analysis and intuitive assessment (what Angels frequently refer to as their “gut feeling”), with recent research suggesting that intuitive assessment is favoured over technical analysis[1].

The typical Angel decision making process begins with a subjective assessment as to whether the investment is likely to ‘fit’ with their personal investment criteria rather than a technical analysis. This may include location, amount sought, knowledge of and interest in the sector, and their own ability to add value.

Experienced investors rely heavily on their prior experience and previous investments to inform their present decision making and typically prioritize their intuitions about the entrepreneur over process and “hard fact” (e.g. business viability data).  Finance, in terms of the financial structure of and projections for the venture, is the most important criterion for both nascent and novice Angels but ranks only fourth for experienced investors[2].

The Learning Process

Investors who may now be classified as experienced consistently said that initially investing with other, and then more experienced, Angels had been their most valuable source of learning.  A number added that they had learnt more from failed investments than successful ones!

This suggests that the most effective way to improve the skills of new Angels is through engaging with experienced Angels in actual real investments. How do they get that engagement? Join an existing, active local Angel group, attend their meetings, help with the due diligence and join in a few syndicated deals.

 

[1] Managing the Unknowable: The Effectiveness of Early- stage Investor Gut Feel in Entrepreneurial Investment Decisions, Laura Huang and Jone L. Pearce, Johnson Cornell University, 2017.

[2] Heuristics, learning and the business Angel investment  decision-making process, Richard T. Harrison, Colin Mason & Donald Smith, 2015.

“First Mover” is not a Strategic Advantage.

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Far too many times I see company barely past the idea stage claim “First Mover Advantage” as a justification (or at least a major one) for their proposed pre investment valuation.

More likely, this should go on the other side of the evaluation equation – it’s a disadvantage.

  • “Google? Not the first search engine.
  • Facebook? Not the first social network.
  • Groupon? Not the first deal site.
  • Even in the mists of software industry time: MS-DOS – not the first operating system.

It’s not about having the idea first – it’s about having the best execution of the idea. Who can quickly and effectively engage with a profit paying customer base. It all comes back to the effectiveness and skill of the management team. So when doing due diligence look for real evidence that this management team have the experience, and skills and focus needed to rapidly engage with a critical mass of paying customers.