How Angels Evaluate Entrepreneurial Investment

This post is the second of seven posts about angel investment in entrepreneurial ventures.

Early stage investing is a time-consuming process for an angel investor. Because of the hands-on involvement required at this state of entrepreneurial investment, each investor develops his or her unique criteria for weeding through business plans and proposals to identify an opportunity that is the best match for their interests, background, skills, and abilities. Nonetheless, there are a few foundational basics many investors use to evaluate an opportunity. Here are five things an angel investor is likely to consider when first looking at an investment opportunity:

1. Source of the opportunity

Angel investors trust their network and will often use it as the first step of their evaluation of any potential investment (Amis & Stevenson, 2001). Sourcing opportunities through a network typically provide the investor higher quality opportunities which often reduces the time spent in the early stages of deal evaluation (Amis & Stevenson). This is not to say the investor does not conduct his or her due diligence on the opportunity. A network-sourced opportunity can facilitate a faster evaluation process because the trust in the network can serve as the first stage of screening.

Keep in mind most angel investors are looking for a competent entrepreneur as much if not more than a home-run investment. Those opportunities sourced from a trusted network are likely to involve an entrepreneur with whom someone from the network has a personal experience. This first-hand experience with the entrepreneur carries a lot of weight for the Angel (Amis & Stevenson, 2001). Should an angel choose to invest in a venture, he or she is likely to spend a lot of time with the entrepreneur and most will want to know if the individual is worth the time and energy before any further review of the opportunity.

Entrepreneurs should not discount other sources of revenue, such as crowdfunding, to get a project off the ground. However, an experienced investor is invaluable in taking a venture to the next level. For entrepreneurs and investors alike, personal relationships and an engaged network make all the difference in setting the foundation for success.

2. Viability of the business model

Once the opportunity has passed the first step in the evaluation, an investor will look more closely at the business model and the overall opportunity. The entrepreneur’s business plan is often less relevant than the business model (i.e., purpose, processes, how it creates customer value, how it is monetized, etc.) (Amis & Stevenson, 2001). The business plan typically focuses more on the execution of the model, whereas the business model provides a more strategic foundation for the firm’s operations. An angel with experience with the business type or in the industry sector may see the viability of the opportunity based on the business model alone, without regard to the proposed execution.

Entrepreneurs should take care to develop a business model where the narrative (i.e., how the business is better than its competition) and the company financials make strong business sense (Magretta, 2002). In this stage of evaluation, a viable business model should peak an investor’s interest enough to consider what experience, insights, skills, and abilities he or she might bring to help the business grow should an investment occur.

3. Value add in involvement

With the viability of the business model confirmed, an investor will next consider what value he or she might add to the venture. In addition to a financial investment, the investor will evaluate how his or her personal experience, knowledge, and networks might enhance the business opportunity. An angel investor typically takes a hands-on approach to investments and will ultimately serve as a mentor for the selected entrepreneur (Amis & Stevenson, 2001). As such, many angels considers how the time he or she spends with the entrepreneurs contributes not only to the venture’s success but also provide personal growth opportunities for the entrepreneur as well.

Entrepreneurs should also evaluate angel investors on the broader value they might bring to the venture. Financial resources are important, but so is experience, knowledge, and networks. An angel investor who is willing to invest time to help you think and grow as an entrepreneur in addition to financial resources is worth far more than an investor who contributes only money.

4. Strength of the Entrepreneur

Considering that an angel investor will invest time as well as money in a new venture, he or she will want to make sure both are well spent. Therefore, when an entrepreneur is invited to pitch an investor, the investor is looking at more than the business; he or she is looking at the personality and behavior of the entrepreneur (Harvard Business Journal Staff, 2017). By the time of the pitch the investor has already assessed the business opportunity and determined whether he or she is interested. What the investor asses in the pitch are whether the entrepreneur is highly prepared, coachable, trustworthy and perceived by the investor to have good character (Argerich, Hormiga, & Valls-Pasola, 2013).  These last factors in the evaluation of the pitch, sometimes considered to be soft factors, can make the difference in whether the investor passes on the opportunity or chooses to proceed to the next stage of the assessment.

When making a pitch, entrepreneurs should be extraordinarily prepared to discuss all aspects of the business opportunity in detail. Savvy investors will probe for those details to determine your knowledge and understanding of the opportunity being presented. Be confident, but not argumentative, in responses to questions. Listen, and respond thoughtfully. Everyone has something to learn, and the investor will want to make sure that you, the entrepreneur, are open to coaching.

5. Exit opportunity

Finally, angel investors will want to know the exit plan for the venture. More specifically, investors will want to know how they will extract profit from their investments of time and money. Since IPOs, particularly in technology firms, have declined investors significantly will know what other exit options (e.g., acquisition or selling the investment on a secondary market) might exist (Hairston, 2013). Research suggests the average angel investor sees roughly a 27% Internal Rate of Return (IRR) or a return of 2.6 times their initial investment (median: $75,000) within about three-and-a-half years (Bell, 2014). Certainly, this seems like a good return for the investor, but considering the possibility of a higher time involvement to achieve that performance, it may not be as good as it may appear.

Entrepreneurs should have a well-devised exit strategy as part of their overall business plan and model. Investors informed in advance of an actionable plan for achieving an exit are more likely to commit to an investment in a new venture (Amis & Stevenson, 2001). Entrepreneurs should also incorporate the risks and realistic probability of failure as part of their exit strategy. The possible downside must always accompany the possible upside when framing potential exit opportunities.

This list of steps in the evaluation of early-stage investing is certainly not exhaustive. Still, it does provide you with some insights as to how an angel investor might begin to evaluate your entrepreneurial investment opportunity.

References

Amis, D., & Stevenson, H. (2001). Winning Angels: The Seven Fundamentals of Early-Stage Investing. London: Pearson Education Limited.

Argerich, J., Hormiga, E., & Valls-Pasola, J. (2013). Financial services support for entrepreneurial projects: key issues in the business angels investment decision process. The Services Industries Journal, 33(9-10), 806-819. Retrieved from http://dx.doi.org/10.1080/02642069.2013.719891

Bell, J. (2014). Angle Investor Sophistication: Increasing Application of Pre-Revenue Venture Valuations Methodologies. The Journal of Private Equity, 59-64.

Hairston, T. (2013). Changing the Game of Venture Capital: Expert Insights. The Journal of Private Equity, 57-68.

Harvard Business Journal Staff. (2017, May – June). How Venture Capitalists Really Assess a Pitch. Harvard Business Journal, 26-28.

Magretta, J. (2002, May). Why Business Models Matter. Retrieved May 28, 2017, from hbr.org: https://hbr.org/2002/05/why-business-models-matter

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