Invest angel investors in existing companies

The 7 most common mistakes made by angel investors

by Florian Huber, Angel Investor, Berlin

 

Most business angels lose money and many business angels do not provide startup founders with any real added value that goes beyond mere cash investments.

It is certain that every business angel with startup investments pursues different goals: Some see it as an (expensive) hobby that is simply fun, others want some of the success they had as entrepreneurs to pass on to the next Passing on the generation of founders. The third group sees startups as an exciting asset class and wants to earn money with it.

Startups are the asset class with the highest risk. It is not uncommon for a start-up to have to file for bankruptcy within a year of making an investment, which means that its own investment is completely lost. At the same time, startups are one of the few assets with an almost unlimited upside potential: who in 2009 only invested USD 10,000 in the American travel agencyabovehas invested, is now pleased with a fortune of USD 200 million!

Most business angels answer the “why” question for their job with a combination of the intention to pass knowledge and experience on to the next generation of business founders and the prospect of generating a positive return.

The following seven mistakes can be found in practice, especially among new angel investors.

Mistake 1: Investing in the "wrong" startups

 

That's how you win: by investing in the right startups. That is so much more important than anything else that I worry I'm misleading you by even talking about other things.

Paul Graham, founder of Y-Combinator and investor in Airbnb, Dropbox, Reddit

 

The biggest mistake in angel investing is choosing the "wrong" startups. You will only be successful as an angel by investing in the “right” startups.

All other parameters of a startup investment - such as the company valuation, the deal structure, the selection of co-investors and the BAFA Invest grant - can no longer compensate for the selection of the wrong startup in retrospect.

A startup with a below-average founding team and an unusable business model will not deliver a good exit or a good return at some point because as an angel you negotiated great deal terms with an expensive lawyer when you joined or because you have 20% of your investment with the BAFA - Grant is refunded.

Conversely, in the case of a “major” exit, it is practically irrelevant whether you paid an entry valuation that was one million too high ten years ago or whether you failed to optimize the structure of the liquidation preferences.

The crucial question now is, of course, how you can even recognize a “good” startup. How do you choose the right startup for your investment?

A basic rule from the VC area states: Every single startup must have the potential to earn back the investor's entire portfolio.

So if you invest EUR 50,000 each in ten startups (a total of EUR 500,000), you have to be convinced with each individual startup that there is at least a certain chance of increasing your stake of EUR 50,000 tenfold with this startup (10 X).

If you think this is unlikely because the founding team does not have the skills to build something big, the business model is not properly scalable or the market is simply too small, you should not invest.

Of course, even with this approach you will often be wrong and one or the other once promising start-up will “hit the wall”. As an investor it is of course always difficult to find the real onesWinnerto predict.

Conversely, over time and with a little experience, you develop a good sense of which business models are very likely Notfunction. Using this negative selection, you can usually very quickly reduce the number of startups that are closer to being selected for an investment.

A good guideline is that you are for aInvestment must have seen around 100 startups. Of these 100 you can usually sort out 80 very quickly and take a closer look at the remaining 20 (80-20 rule). Of these 20 there are then four remaining (again the 80-20 rule) in which one would like to invest.

With three of these four startups you will not reach an agreement with the founders about the deal terms, the founders will give preference to other investors; or maybe you just missed the closing of the round. Ultimately, there is only one left out of the original 100 “seen” startups aStartup investment left.

Only with discipline in the selection of startups is it possible to build up a high quality startup portfolio in the long term without making false compromises. 

Mistake 2: investing in too few startups

 

The second big mistake as a business angel is in too few Investing startups. Since the failure rate for early-stage investments is high, there is a risk that a small portfolio with only a few startups will not result in a single one Winnerand to get back less than the capital invested.

A basic rule of angel investing is: It is better to invest in more startups with smaller ticket sizes than in fewer startups with larger tickets.

An angel investor who traditionally invests in the pre-seed or seed phase should aim for a portfolio size of at least 15 to 20 startups. Only then is there a realistic chance, at least oneto have a real winner with a return of 10X to 30X on his capital investment. Only this one winner ensures that you generate a positive return overall (so-called power laws). If you did not have this winner in your portfolio, you would lose money or, at best, recover your stake.

In practice, one often encounters business angels who are frustrated and give up after four or five investments because “nothing really worked”. But with five investments, the chance of a winner is correspondingly low!

If, as a business angel, you tend to invest in somewhat later phases (Series A, B), the portfolio size can be reduced to ten to 15 startups.

Even within a startup portfolio, the distribution of success and failure can again be determined by the Pareto principle(80-20 rule) describe well: With a portfolio with 25 startups, only five startups (i.e. 20%) will do really well.

The other 20 (80%) will fall short of expectations (which of course does not mean that 20 is a total failure, only these startups never get beyond the "small business" phase). And of the five well-running startups, only one will be there (again the 80-20 rule!), Which will be a really big and successful company, maybe even one Unicorn, a company valued at over a billion dollars).

Mistake 3: Investing with the “wrong” co-investors

 

Another mistake is to invest with the “wrong” co-investors. You should not only be critical when choosing the founders, but also when choosing the other shareholders, as you will be connected with these people for a period of seven to ten years (sometimes even longer) and will go through ups and downs together .

A marriage can - with manageable effort - be dissolved by a unilateral declaration. With a partnership agreement, an early exit (before the exit) is very difficult and almost always depends on the consent of the other shareholders.

The following co-investors should be avoided:

  • Co-investors who have so far had little experience with startup investments: These block - often out of fear - important decisions and lead time-consuming discussions about uncritical detailed questions.
  • Co-investors without relevant industry experience and network: These do not provide the founders with any added value and often take up unnecessary time and attention from the founders.
  • Co-investors who do not have the opportunity to invest at least pro-rata in a subsequent round: These are no support for the founders in a subsequent round, often even bad signaling for potential new investors.

In practice, investing alongside experienced and well-known VCs has proven to be a successful strategy. VCs are often actively looking for business angels with specific industry experience and give them the opportunity - for example in the context of a Series A round - to invest with a smaller ticket.

Mistake 4: Investing with the wrong timing

 

When choosing the right startup (see Error 1), most investors pay particular attention to the scalability of the Business model, on the quality of the Teams, the novelty of the Productand the size of the Market. Another essential success factor is often overlooked, namely the right one timingfor the investment.

Most innovative business ideas have a window of time of a few years, within which one is not “too early” or “already too late” to build a leading company in this segment.

So it was certainly a good idea seven to ten years ago to invest in e-commerce startups in the fashion and furniture sector. In 2018, however, it will be difficult or even impossible to build something really “big” in this area. In contrast, a startup that offers special insurance for autonomous vehicles is more likely to be three to five years too early on the market.

It also doesn't hurt to keep an eye on current investment trends. Years ago it was e-commerce, social networks and SaaS concepts that were trendy, now the topics Digitel Health, Machine Learning, Blockchain and Mobility are in demand with investors. Only angel investors who have a good feeling for current trends can ensure that the startup will have enough interested parties to invest in a subsequent round in one to two years.

Mistake 5: Contracts without sufficient investor protection rights

 

As an investor, you should insist on corresponding investor protection rights in every participation agreement. Inexperienced angels sometimes do not know which regulations are customary in the market and therefore do not dare to actively demand these from the founders.

The following investor protection regulations are very relevant in practice and should therefore be found in every participation agreement (or the articles of association or management contracts):

  • Founder vesting:Conflicts within the founding team are relatively common and one of the founders often leaves the startup in a dispute. This co-founder is of course not allowed to simply "take" all the shares with him, but should only be allowed to keep his shares - which have been vested up to this point in time. Corresponding vesting clauses also usually differentiate between a good-leaver and a bad-leaver case.
  • Founder Salaries: There should also be an agreement in advance of the investment on the amount of the founder's salaries. No investor wants the majority of his investments to be “diverted” to the founder's private accounts within a few months through high salary and bonus payments.
  • Competition and secondary employment prohibition:As an investor, you want Stratup founders who focus exclusively on their activities as founders. A strict ban on competition and outside employment is therefore absolutely standard.
  • Liquidation preferences:This is about preferential revenue in the event of an exit. The principle is that the investors are always satisfied first (in the amount of their investment) from the pot of exit proceeds and only then the further proceeds (if any) are distributed among the shareholders on a pro rata basis. Liquidation preferences become particularly relevant if the exit proceeds are lower than the post-money valuation of the last financing round.
  • Information rights:A monthly, written reporting (by email) with the most important key figures should be a matter of course.

In addition, there are other investor protection rights such as guarantees, protection against dilution, transfer of industrial property rights, regulations on voting majorities and transactions requiring approval, as well as pre-acquisition and co-sale rights.

Error 6: Do not reserve any capital for follow-on investments

 

Experience shows that startups usually need more money than originally planned, which means that the founders will soon have to look for more capital again after a successful financing round. At first you will probably always approach the existing investors and ask them for further capital. After the funding round is before the funding round.

The new investors in the next round (often VCs and other institutional investors) usually see it as a strong, positive signal when the old investors also go along with their own money in a new round. As a rule, existing investors have much better insights than any new investor - even after extensive due diligence. If nobody from the existing group of investors also invests in the next round, this is one for many investors Red flag.

As a business angel, you should therefore always reserve sufficient capital for possible follow-on investments.

In very few cases, Angels have “unlimited” capital, so no one expects that the previous Angels will manage the majority of a Series A single-handedly. However, the expectation is usually such that the previous investors in a new round at least pro-ratago with them (i.e. invest at least enough new capital to compensate for the dilution of their stake).

But: As with other asset classes, the following principle applies to startups: Throw bad money, not good money. This means that if the development of the startup falls completely below expectations and there is no longer any trust in the founding team to turn things around, you as an investor have to have the courage to "pull the plug" and no longer have any more money available put. Especially not out of “pity” or a misunderstood “do-gooder”.

Conversely, in a startup that is doing very well, you should always aim for a subsequent round more than just the pro-rata shareto invest. This is the only way to achieve the desired effect within your portfolio of allocating the majority of your investment budget to the good startups (winners) over the years and not distributing it according to the watering can principle.

Only with this follow-on strategy will you be able to generate a return of 3X to 4X (based on the capital employed) for your portfolio over the course of seven to ten years - appropriate to the risk class.

Mistake 7: Not delivering any real added value for the startup

 

In addition to money, a business angel should always bring industry experience, know-how and network contacts with them in order to be able to actively support the startup founders in the difficult initial and development phase of the company.

Good startups with strong founding teams usually have few problems getting capital and are therefore in the comfortable position of being able to choose their investors. Those who want to invest in the "best" startups can usually only do so if they have built up a good reputation as a business angel over the years and are recommended by successful founders.

Two types of business angels in particular are of little help to the startup:

  • Angels who do nothing: These are business angels who more or less disappear after the notary appointment and the transfer of the money and - for whatever reasons - are no longer particularly interested in the startup. In most cases, these are also the angels, who are not prepared to invest pro-rata in a subsequent round even with a very well-running startup and thus cause poor signaling for possible follow-up investors. If active support for the founders is not possible due to time constraints, this should also be communicated in advance of the investment so as not to create false expectations.
  • Even more harmful than angels who "do nothing" can be angels,who do too much: These are angels who interfere too much in the operative business and thereby more or less prevent the founders from doing their work. Most of these Angels were or are successful entrepreneurs themselves and now see their “calling” in telling the young founders exactly how the business is to be run, since that is how you have always done it yourself. This micro-management means that conflicts in the group of shareholders are inevitable.

 

As a business angel (and a former entrepreneur) you have to learn that you are not at the wheel of the car yourself, but only in the passenger seat.And when VCs or other institutional investors get on board later on, you don't even sit there, you quickly find yourself in the back seat or even in the boot of the startup car.

 

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Aug 15, 2018 by Florian Huber