Qualifying Angel Investors

Angel investors – those who invest their own money in startups – are often an essential capital source in the earliest stages. Good angels are wise, insightful, and patient partners for early-stage founding teams. Qualifying them well is essential to setting your startup up for success.

Over the course of three startups, I have raised about $20M in angel capital in 10 or so rounds, ranging in size from $750K to $2.5M per round.  I have raised from about 100 angel investors and spoken to hundreds more. Needless to say, I have a whole spectrum of experiences to draw from, so I thought it might be helpful to other startup fundraisers out there to share a few war stories and tips that I have distilled along the way.

Remember my basic definition of an angel investor: these are wealthy people (defined as Accredited Investors by the SEC) who choose to invest their own capital in other people’s startups. 

The best angels are smart, knowledgeable investors who understand that startups are risky with the potential for outsize rewards. They know how to support an entrepreneurial team and play well with other investors. They can make the earliest stages of a startup journey possible and help bring later investors into the mix.

However, just because someone labels themselves as an angel investor does not automatically mean they are a good fit for your startup.  Qualifying potential angel investors is as important as successfully recruiting them. Important things to look for in a potential angel investor:

• Does this angel understand the risks of angel investing?  When meeting an angel investor for the first time, my most important qualifier is, does this individual have any experience with angel investing? Do they understand the risks involved? Most importantly, do they know that there is a significant probability that they will lose all of the money they invest – and are they in a financial position to accept such a loss?  This is tricky because you cannot ask these questions directly without seeming rude, especially when you are also seeking to entice them to become interested in your startup.  However, it is essential to be listening for tell-tale signs that an investor should not be an angel investor – and to gracefully decline to take their investment if you discern that they are not ready for this high-stakes game. That said, I will accept a first-time investor who has done the work of learning the space and is open about where they are in that process.
  
  Let me share an example of a potential angel investor that I declined. This individual was so excited about what we were doing. He was easily persuaded, did not ask hard questions, and expressed enthusiasm about participating in the open round.  After slogging for months raising, the notion that an “easy” one might just have appeared crept into my consciousness along with that bit of spidey sense uncertainty. That sense bloomed into a big red flag when the potential angel asked, “So can I sell my income property to fund my investment?” Whoa! No sir. You absolutely may not. An income property has an entirely different risk profile from a startup. An income property produces income, consistently. You are unlikely to lose your entire investment in a piece of real estate as they can almost always be sold for something. A technology-based startup investment is an entirely different beast.  I gently thanked him for his interest and support and encouraged him to not invest his income property capital in startups.  We had a good talk and I spent time doing some investor 101 education about the risks of startups. The lesson learned is that when you discover that a potential investor has not yet learned enough about this asset class, you do not want to have them in your investor group when the going gets rough (and it always does at some time). Make sure that your potential investor understands the risk as well as the potential reward.

• Does this angel have an excellent reputation with other investors? Angel reputations and relationships matter.  Be sure to ask around about the angels who are potentially interested in investing. Some of my worst early fundraising mistakes were accepting investment from certain investors I would later learn had unfortunate reputations or did not work well with other investors. I learned this the hard way when later potential investors found out who was already in my investor group and told me plainly that, while they were excited about my startup, they would not invest alongside certain investors. Once those “certain investors” were in, they caused an anchor in my fundraising for several future rounds, making the process far harder than it might otherwise have been. After I learned that lesson, I started making discrete inquiries when investors began getting serious about diligence to make sure I was not creating headaches for myself later. I also learned to do some online due diligence of my own and occasionally discovered major issues (SEC indictments for fraud, other criminal activity in areas that would have created reputational problems for the startup, etc.) and opted to terminate further discussions.
  
  
• Does this angel understand that investing in a company typically involves follow-on investments?  New angels sometimes think that investing in a single round is the expectation. While it is certainly possible to invest in only one round, early-stage angel investors should be prepared to follow-up and invest in future rounds as a rule. Assuming the startup is making good progress, for the investor, it is important to invest in future rounds to protect their position and provide needed capital to the startup as it grows to improve its chances of success.  For the startup, in addition to supporting future capital raises, the optics of investors not participating in future rounds leads to awkward questions from new investors about why your current investors are not participating.  While some drop-off can be explained, too much is an indicator that “something is wrong” with the startup. This is where it can be essential to make sure that investors hold back for future rounds. If an investor tells me they will only invest $100K per company, I may suggest that they invest one-third to one-half of their total in the current round and reserve the rest for future rounds.  While that makes my immediate task of raising the current round incrementally harder, it starts the trust relationship with the investor off in a good place and helps address future funding needs.
  
  
• Does this angel have the investment sophistication to understand this investment and this startup?  This is my caution flag on friends and family investors who are most interested in helping you because of their relationship with you, not because of what your startup is doing or because they have decided to deploy some of their precious capital in a risky asset class. Personally, I value my relationships with friends and family above the transient nature of a startup, so I am very cautious about approaching them for investments. Losing your parents’ money can put a real strain on your relationship. Is it worth the risk to the relationship? While I would certainly like my friends and family to benefit from the success of a startup I am building, unless they are active investors in this asset class, I usually steer clear. I can always give them a gift if everything turns out great!  And, if it doesn’t, then I haven’t damaged the relationships with people who will stick with me during a hard time. To be clear, I have taken investment from a few friends along the way, but only if they approached me, were otherwise angel investors, and usually had some particular expertise in the startup’s business that made it a good fit for them to assess its prospects for success. Even then, I am careful to let them lean in, to have a frank heart-to-heart about the importance of their relationship to me, and that I want to be sure we are not risking that. If we can openly talk about the risks, and we can both gain the confidence that we want to have a business relationship as well as a family/friendship relationship. In that case, I may be willing to take the risk of letting them invest.

I have had fantastic angel investors who have been so supportive and have invested across multiple companies with me. I treasure those angels and am always looking for others who are a good fit.  However, I am equally disciplined and cautious about steering clear of would-be angels who are not yet ready to ride the rollercoaster with me. It is not easy to turn away an interested investor, however, every investor will be with you for a long haul, and experiencing the pain of a problem investor or two makes one more careful the next time around!