You just read another story on how quickly certain angels invest and you’re secretly admiring their ability to make decisions on the spot. Now you’re thinking: Due diligence is SO yesterday – screw it and close more deals already!
Do what you want; you’re investing your own money, not ours. But first, check out our interview with Bill Payne, Angel of the Year in 2009. You might want to rethink your “strategy.”
What you’ll learn:
Payne co-founded Solid State Dielectrics, a capacitor dielectric materials company, in 1971 and sold it to DuPont in 1982. Having made his first angel investment in 1980, he went on to become one of the most prominent angel investors in the U.S.
Payne’s received the Hans Severiens Award (the highest honor in angel investing in the U.S.) in 2009, and a similar designation as the Arch Angel of New Zealand in 2010.
As an angel educator, Payne was appointed Entrepreneur-in-Residence to the Kauffman Foundation and he’s served on the founding committee of the Angel Capital Association. To date, he’s taught over 80 workshops and seminars on angel investing in five countries.
At the time of writing, Payne’s invested in over 50 startup ventures.
* Edited interview
VH: As you’ve already pointed out, in a 2007 study, “Returns for Angels in Groups,” angels who did less than 20 hours of due diligence per deal received portfolio returns of 1.1x, as compared with the 7.1x return received by those who spent more than 40 hours on due diligence. So, it does appear that there’s a positive correlation between portfolio returns and the time spent on due diligence.
However, we often hear that good angels make decisions quickly. Some super angels even go as far as to using an “index fund” approach to angel investing. They make a bunch of bets across a wide range of startups, hoping that a few would turn into Facebook or Groupon. Some did, and went on become some of the hottest companies of our time. Their portfolio is diversified, no doubt, but these super angels appear to spend significantly less time on due diligence.
Based on your experience, how much time should average angels spend on due diligence?
BP: 100 hours sounds about right.
Super angels spend significantly less time on everything. Remember, angels invest time and money in portfolio companies. How much time per company can super angels invest when they have 100 companies in their portfolios?
Super angels aren’t typical angels, who invest with their own money. Super angels are just prolific seed-stage investors, most of whom invest from a fund that consist not just their own money.
VH: Some inexperienced angels believe that if super angels are using the “index fund” approach then it must be a good strategy. They might model super angels at a much smaller scale, making small bets on a bunch of startups without doing much due diligence. What warnings or advice would you give to average angels who attempt the “index fund” approach?
BP: Average angels won’t try it because they know better.
New and naïve angels may, but frankly they won’t have enough money to make 100 investments at US $25,000 a pop.
If the wealthy want to invest in 100 untested and unstudied companies, what can I do? They could spend their money on a 10-year cruise around the world!
VH: Yuri Milner and SV Angel recently announced that they’ll invest in every single Y Combinator startup, some 40 startups in total. They’re investing in these startups sight unseen and basically outsourcing due diligence to Y Combinator. How do you feel about that?
BP: Well, how will Y Combinator handle the next 10 people who want to do that? It’s a one-time thing that physically can’t be repeated.
REMEMBER: Super angels are a Silicon Valley phenomenon. There are angel groups and entrepreneurs all over the country. Why focus so much time and effort on Silicon Valley? Let’s talk about trends outside Silicon Valley…in the real world.
VH: You made half of your 50+ investments before joining your first angel group. What was your due diligence process like before joining a group?
BP: Solo angels don’t have the time or sufficient knowledge to do adequate due diligence on all deals, so they do deals less frequently or they do less due diligence. Now I only invest through angel groups.
VH: Can you briefly explain the due diligence process? For example, what does validating the business plan mean? What are involved? How long does it take?
BP: Due diligence is a process for comparing reality with a target company’s business plan.
Groups usually assign due diligence to a team of five or so. Some focus on background checks on the team and the entrepreneur, others validate the technology, size of the opportunity, financials, competitive landscape, and the “must-have” nature of the product.
By talking to customers, we determine if the product is something those potential buyers need or must-have.
All this takes about 100 hours of our collective time.
VH: Some criticize angel groups for turning into micro VC firms because of the relatively long due diligence process. How can angels speed up and streamline the process without skipping necessary steps?
BP: Frankly, angels in groups don’t care what others think about our doing it. Due diligence is clearly important. The 2007 studied you mentioned in the beginning clearly shows the value.
It’ll take a couple of months to validate any business plan. There’s no need to speed up the process. We’re part-time investors. Get over it!
And, we’re not VCs – we do our own due diligence. Are we really being criticized for doing more preparation before investing? Is this really a justifiable position for anyone to take?
The bottom line: We’re part-time investors. Due diligence is going to take a while. Be patient.
VH: Should solo angels and angel groups outsource due diligence to due diligence service providers?
BP: Let’s see…I’m personally investing US $25,000. How much can I afford to outsource? Clearly none of it!
It also can’t be justified for angel groups, who make an average investment of about US $300,000.
VH: What are the top 5 to 10 red flags you look for during the due diligence process?
VH: Some investors believe IP protection is important while others believe otherwise. Which school of thought is correct? What does due diligence on IP involve?
BP: Angel-funded companies never have enough money to defend infringement. This is why the importance of intellectual property is questioned.
Nonetheless, investors seek a competitive advantage. We use our networks to attempt to ascertain the exclusivity and freedom to operate.
Where I find IP valuable is at exit.
* Special thanks to exit strategist Basil Peters for recommending Bill.
* For series, references are published in the last installment of the series.