Article adapted from Seraf: Portfolio Management for Early-Stage Investors
New angels, new entrepreneurs and people outside of the startup ecosystem may have a general sense of how early stage investments happen, but, if put on the spot and asked to describe the exact process, most would be hard-pressed to come up with much detail at all. Like cooking, changing a tire, playing a sport well, and so many other things in life, the angel process is simple in theory, but a bit more complicated in practice. The angel process is not rocket science, but there are a lot of steps, there is some complexity, and there can definitely be some science to doing some of the steps well.
Not every angel deal process is identical across different regions and types of angels, but they have many common elements. By understanding the elements, you can appreciate better the role angels play in helping startup companies get off the ground, and the many ways in which angels need to interact with their community, with companies and with each other to get their deals done.
Christopher has been leading deals for many years now, and through his long tenure on the board of the Angel Capital Association, he has seen and heard about angel processes from all over the US and beyond. He’s a great person to give us an overview of how these deals come together. Let’s get his perspective.
Christopher, let’s start with the basics. How do angels find companies needing financing?
Most angels start out having to work to build up access to interesting companies (i.e. deal flow.) It can take time to know where in their local ecosystem to look and time to build a reputation as an investor founders want to work with. But once an angel is more experienced and better known, or once they become part of an established group or fund, the companies tend to find them. Reputation and referrals tend to bring deals in. Important referral sources include:
- Entrepreneurs you have backed who recommend you to their peers,
- Investors looking for syndication partners or looking to help an interesting deal that is not a fit for them
- Other angels in your group, fund or network who are active in their community mentoring, advising, judging business plan competitions, teaching and speaking
- Professionals and service advisors such as lawyers and accountants.
Once they meet a company, how do they decide which ones to work with?
All angels go through some kind of screening process to separate the companies they do want to work with from the ones they don’t. Some solo angels may have firm criteria or a checklist they follow, but many will be relatively informal and follow their gut about which companies to follow up on. Angels in a group, network or fund will typically put the deal through some kind of scouting or screening process to check it to weigh:
- Fit with their investment focus areas
- Upside potential
- The absence of red flags or show-stoppers, and
- Relative attractiveness compared to other options vying for time, money and attention.
This process might be referred to as “scouting,” or “screening” or a “screening committee” or a “deal flow committee,” but regardless of what it is called, it serves as the first filter for separating the potential wheat from the chaff.
If they are an impact investor, do they evaluate companies any differently? Is their decision process different?
Overall, the process impact investors use is more similar than different, but it does have some distinctions. Impact investors are still concerned with the usual investor questions such as viability of the business, the quality of the team, the size of the opportunity, the urgency of the problem, the viability of the solution. This is because if the business fails, or fails to grow, it cannot have any positive impact at all, and the impact investors’ investment dollars could have been better applied elsewhere.
However, in addition to the normal business evaluation, impact investors are considering the motivation of the founders and their passion for the cause. They also look at the size and directness of the impact or societal benefit, how well the company’s mission aligns with the impact investors goals and values, whether there are any off-setting societal costs or negative impacts associated with the business, and how to think about measuring and monitoring the company’s impact relative to goals and objectives.
Once they have decided to work with a company, what happens next?
Unlike VC investing where a relatively small team controls the decision-making for a large pot of money, the angel decision-making is very distributed. In effect, a consensus needs to be built. To make any kind of decision, most angels need to spend time with a team to hear their story and interact with them live.
Experience teaches that the only way to do that kind of thing efficiently is to have the team “pitch” their opportunity to groups of investors. It might be an informal pitch in a coffee shop to a couple of solo investors, or it might be a more formal and organized pitch as part of a regular forum set aside for startup pitching. For example, most angel networks hold a monthly or quarterly meeting where promising startups efficiently pitch many angels at once, typically using a formal slide presentation on a screen. These pitches are typically followed by some Q&A. Pitches like this can be stressful for entrepreneurs and their teams because they are usually time-limited. It is difficult to be in front of a large audience, let alone deliver a complete yet compelling synopsis of a lot of detailed information. But they are time-efficient compared to the gallons of coffee an entrepreneur would have to drink for an equivalent number of 1:1 meetings. The best groups will add further efficiency by being decisive and transparent in their go/no-go decision, as well as generous with feedback and advice after the pitch.
If the pitch goes well, do they invest?
Some angels might invest after just a pitch, but most undertake at least a modicum, if not actually a significant amount, of due diligence review first. Although it takes different forms, the diligence process is really about asking questions and trying to verify the key assumptions and spot the easily avoidable mistakes. As it progresses, diligence may involve some modeling and scenario building. For solo angels diligence might consist of a couple more sit downs with the team and a bit of research or reference checking. For networked groups it might be a more formal team effort focused on digging into a longer checklist of issues and preparing a formal due diligence report which can be used by peers and syndication partners.
What happens after the diligence process?
Actually, the next step begins before the end of the diligence process. If the diligence is going well, the angel or angel group manager leading the deal will begin to talk to the entrepreneurs about prospective deal terms. (There also might be a sanity check before diligence even starts to make sure people are in the same ballpark.) It is at this point issues like deal structure, valuation and deal terms are discussed, with the goal being to negotiate a mutually acceptable set of terms and document them in a term sheet which can be shared with the diligence report when it is complete.
Is the term sheet the last step?
No, you still have to find the money to fill the round. So while you are finishing diligence and talking about term sheet issues, you are also trying to get a sense of how much investor interest is currently engaged, and how much additional money needs to be found. This is the beginning of the process typically referred to as deal syndication. The goal of the entrepreneur and the lead investor is to bring desirable investors in as quickly as possible. Naturally there is some tension between fast and desirable, because you cannot hold up your closing forever waiting for preferred investors when there is money being offered by perfectly acceptable investors. By preferred and acceptable, I am talking about more than just reputation and whether they are nice people. The key issues are alignment amongst investors and alignment between investors and the management team, and value-add in terms of expertise and connections. It is obviously also necessary to find investors who will accept the terms as negotiated; if every investor wanted to renegotiate the terms of the deal, chaos would ensue and the deal would never get done.
Once the term sheet and diligence is done, and some syndication discussions are happening, surely now the checks actually get written?
You would think, but… you’d be wrong.
Before any checks can be written, the definitive legal documents need to be written up, and a closing needs to be prepared. Term sheets typically contain a clause specifying whether company counsel or investor counsel will take the pen on the first drafts. Regardless of who is in the lead, someone has to do it, and they use the term sheet as the instructions for how to draw up the documents.
In theory this means the process is simple and straightforward since all the big issues are already decided and memorialized in the term sheet, but in practice this stage is actually a field of sticky wickets. A term sheet is a 3-5 page document formatted with big margins. The definitive legal documents in a priced equity round are reams of pages of paper. There are many concepts in a term sheet that are open to interpretation or require additional detail to be supplied as part of the document implementation.
As a result, there are plenty of opportunities for the non-drafting party to disagree with, and want to make changes to, the first draft of the documents. Usually counsel experienced with these kinds of deals are involved and since they are familiar with market norms and standards, the first draft is not too far off the mark. But even if it is, the fees of both sets of lawyers are typically capped in these early stage deals, so they don’t have a big incentive to fight just for the sake of fighting. So deal documents can usually be pulled together fairly quickly. Typical might be a week to draft, a week to negotiate and a week to finalize. A fast process might be half that time.
OK, so the legal documents are done. What happens next?
A closing date and process is outlined, and the definitive documents are sent to all the investors who have soft-circled (committed money to the deal by indicating they intend to invest). The documents are accompanied by instructions for returning signatures, mailing checks or wiring funds. Creating a good closing package is somewhat of an art – done well it can be orderly and efficient; done poorly it can lead to frustrations, mistakes, and delays. But from the investor’s perspective on the receiving end, it is tedious desk work, and definitely not the most fun part of angel investing. When you have a lot of companies in your portfolio, there is a lot of this kind of desk work, and productivity and organizational hacks are essential.
So the closing is the last step?
Yes and no. It is definitely the end of this financing round (phew), but not close to the end of the work you need to do on this company. Once you are an investor, you have every incentive to help in any way you can with board advice, mentoring, introductions, and possibly board service. If you are invested in blue chip stocks, you probably couldn’t help your companies much even if you were allowed. But with thinly capitalized and thinly staffed start-ups, many times run by young first time entrepreneurs, there are tons of ways you can help, and the collective help of the angels can have a huge positive effect on outcomes.
So aside from giving advice and making intros, does the angel just sit back and wait for their money to be returned?
If only it were so easy. Not long after you go through this process with a company, they are going to need to raise another round of funding. This will be the case whether they are successful or not. Growth does not produce cash, it consumes cash. So not that many months after you write your first check it is lather, rinse, repeat. You are going to need to do the analysis to figure out whether this is one of the investments which merits follow-on money from you. Unfortunately, it is more work – essentially the same steps outlined above, but from the diligence stage forward. Fortunately, it may be a great opportunity to double down on one of your winners with some smart money and significantly boost your overall returns.
Do impact investors do anything different during this period?
The activities of impact investors during the post-investment period are going to be fairly similar to traditional angels, but the tracking process is more involved and the follow-on financing decisions are a bit more complicated. In addition to tracking business performance, impact investors need to track the company’s progress against the various metrics or KPIs they have identified as indicators of the impact the company is having. It is not enough for the company to merely stay alive or grow, for an impact investor the company also needs to provide the anticipated social good.
The follow-on investment decision similarly brings an added layer of complexity for impact investors. They need to assess the company financially to ensure that it is viable and growing as a business and meriting follow on investment. This evaluation might require a more patient perspective, given the non-financial freight the company is trying to carry.
They also need to consider two additional angles. First is a reevaluation of the opportunity cost of putting follow on investment into the company as compared to another company which might be producing greater societal good per dollar invested. This company might need their dollars, but another company might be in a better position to leverage those dollars for maximum impact. That has to be weighed if the investor is going to maximize their impact. Second, the impact investor needs to think especially hard about the negative impacts of withholding their financial support. No investor likes to withhold their financial support, but ordinary investors recognize that good money after bad is just a waste. Impact investors need to consider how the community of stakeholders will be affected if the company cannot grow or, worse, fails, due to their lack of support. Will employees lose their jobs? Will impacted community members reliant on the company’s support be unduly harmed? This makes it a much more nuanced and complex decision.
So there you have it. A step by step unpacking of all the details embedded in the seemingly simple concept of a startup raising a little money from a few investors.