Bill Payne

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:

• How much time should be spent on due diligence
• Due diligence process
• Whether angels should speed up the due diligence process and why
• Whether angels and angel groups should hire due diligence service providers
• Payne’s due diligence red flags
• Whether intellectual property (IP) protection is important
• Due diligence on IP
• And more…

More About Bill Payne

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

Time Spent on Due Diligence

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.

Due Diligence Process

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.

Due Diligence Red Flags

VH: What are the top 5 to 10 red flags you look for during the due diligence process?

BP:

• Entrepreneur
• Team
• Size of opportunity
• Competitive landscape
• Amount of capital required
• Customer validated product/technology
• IP ownership (who owns the Intellectual Property)

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.

Image by: PhillipC

Talk with experienced angel investors, and you’ll realize that unless they have a trusted syndication partner across the border, proximity still matters.

True, tech advancement and the falling cost of communication might have enabled investors to invest farther from home, but the effect might not be as significant as we think.

After all, trust and face-to-face contacts are essential in angel investing.

Entrepreneurial angel Joshua Schachter, for example, doesn’t invest in companies that are out of his networks (Bay Area and New York). “I don’t like doing deals sight unseen,” Schachter avows.

Similarly, Canadian angel investor Boris Wertz, former COO of AbeBooks.com, which was sold to Amazon.com, told The Globe and Mail:

You need to be selective about it. Stick to an industry you really understand, and pick companies close to home – coaching over the phone is a tough one. You want to see them in person as often as possible.

In 2008, a team of academics from the University of Maryland drew a sample of 136 firms and examined proximity measures [PDF] based on the zip code of investors relative to the zip codes of the startups’ headquarters. They found that investors generally lived close to the companies they backed.

Sixty percent of angels lived within three hours of driving time from the firms in which they invested, and 18 percent were within the same zip code. The researchers also pointed out that pure angel-backed companies (i.e., those that haven’t raised money from venture capitalists) were most likely to be in the same zip code as the angels.

Yes, the sample size is small, but it does provide insights into investors’ preference in regards to proximity.

Why Angels Invest Close to Home

Angels invest for different reasons.

Some invest locally because they want to support local entrepreneurs as they’d been there themselves and want to “pay it forward” within their local community.

Others like Dharmesh Shah, an entrepreneurial angel and the founder of HubSpot, enjoys the welcoming advantages of helping out local entrepreneurs: “One of the side benefits of being an angel investor is that it builds credibility and good will within the local community,” Shan avouches.

For yet others, it’s due to the risky nature of angel investing. These investors invest close to home because it’s easier to monitor local investments and help resolve issues quickly at the first sign of trouble. They believe this helps improve company performance and reduce the risk of their investment.

Jamie Rhodes, chairman of Central Texas Angel Network (CTAN) in Austin, Texas, says: “We invest in Texas-based companies because investors like to drop in on their investments.”

Most investors don’t actually monitor their investment like a hawk or visit their portfolio companies every day, but the ability to do so without having to travel a long distance does offer them a sense of security.

Because they feel more secured, investors who invest close to home are more likely to “rely on trust in lieu of more formal control mechanisms,” according to Venture Capital: Investment Strategies, Structures, and Policies. Those who invest aboard tend to use more formal (and costly) control mechanisms to protect their investments.

Not to Say Angels Don’t Invest Abroad

Having said that, investors are willing to commute to find good deals. As mentioned in the beginning, experienced investors are more willing to invest aboard if they have a trusted syndication partner across the border.

They’re also more willing to back companies located in a distant area that they’re very familiar with or frequently travel to.

Even so, convenience still plays a big role.

As Forbes’ Maureen Farrell writes, “most angels and VC can only go so many places so often so proximity to investors or at least proximity to an easily traveled route helps.”

Don’t Do This Just Because It’s Close to Home

Of course, don’t invest in a company operating in an industry you’re unfamiliar with just because it’s close to home. Without knowledge of the industry, you can’t properly evaluate the real risks and potential of investing in that company. And you won’t be able to leverage your expertise if the company needs help.

But if you must invest in a sector that’s new to you, either due to a strong urge or whatever reasons that captivate you, then check out “Angel Investing: Effective Ways to Invest in the Unknown” to learn how to go about it.

Image by: Ishmael Orendain

Thanks to the Bin 38 fiasco and the Valley’s hyperactive angel investing activities of late, industry participants were taken aback by the pessimistic findings in the angel market analysis report [PDF] for the first and second quarter of 2010, offered by the Center for Venture Research (CVR). Methinks it could be a “Chicken Little” threat that has more sound and fury than actual substance, though.

Shining Light on the Crystal Ball

There is plenty of data to support a bearish outlook. Total angel investments decreased more than 6% in the first quarter of 2010 compared to the same period last year, with deal size shrinking nearly 10%. Meanwhile the number of active investors and funded projects also diminished. More start-ups need extra help to survive the recession and credit is in shorter supply which makes their challenges even more acute.

But judging the future of the market based on a snapshot of 1 or 2 years – which happen to coincide with what may arguably be the worst global economic crisis and credit crunch in history – is premature.

Glass Half Full or Half Empty

The report pointed out, for example, that to realize sustainable growth we need a sustainable pool of active investors, but it also stated that the number of angel organizations and individuals is growing.

That includes lots of “latent angels” who are inactive while they search for better opportunities. The fact is that the majority of investors always sit on the sidelines during a recession. If the market is holding its own or only suffering minor declines now, then when all of that dormant money does decide to get back in the game there will be a great deal of activities in the making.

In other words, while some see this recent analysis as a glass half empty, others see it as a bullish indication that the glass may soon be overflowing.

One Analysis Does Not a Market Make

As Aristotle used to say, “One swallow does not a summer make.” There appears to be a harbinger of investment gloom in the angel market, no doubt, but the data is mixed when it comes to first-round investment from venture capitalists.

The Moneytree report, for example, shows that first-stage investments as a percentage of overall deals from venture capitalists have grown steadily since 2005 and will likely show continued growth in 2010, according to the Silicon Valley / San Jose Business Journal.

The bottom line is that it is just too soon to tell, and anyone who thinks they hear alarms sounding may be mistaking those for the sound of the starting bell that will usher in a new wave of progressive activity.

Image by Mykl Roventine

Got ambitions for risks and high-payoff investments? Allocate a portion of your investable capital to angel investing, a form of alternative investments that offer high risk, high return opportunities.

William S. Podd, executive director of Landmark Angels, suggests, “Angel investing, with its historical high risk/high reward strategy, can provide an opportunity for significant returns for high net worth investors as part of an asset allocation strategy.”

Amazon, Facebook, Google, Mint, PayPal, and Yahoo are just some of the high-profile companies that have made their angel investors very happy.

High Risks/High Returns

A study by Scott Shane, author of “Fool’s Gold?: The Truth Behind Angel Investing in America,” reveals that accredited angel investors see a negative return in 40% of their angel investments, and 7% of investments account for 75% of all returns.

Roughly speaking, out of every 10 angel investments, 3 or 4 will fail, 3 or 4 will be “walking dead” (survive but generate little or no return and not dead enough to be a write-off), and 2 or 3 will do okay (generate 2x to 5x return). It’s the 1 or 2 home runs that will make up for the losses and generate a handsome return to angel investors.

Brad Feld, managing director of Foundry Group, explains the concept of home runs:

Understand the difference between 0x and 100x: I’ve had two of my angel investments return over 100x each.

Since I had a strategy of investing the same amount in each company, all I needed was one 100x to allow me to have 99 companies completely flame out and return 0 and I’d still break even.

With two investments at over 100x, I now have a built in gain of significantly over 3x across all of my investments since I’m [sic] made about 75 of them and I’m now deliciously “playing with house money” on all of the rest.

Financial Returns: Angel Investments vs. Other Asset Classes

Few years ago, the Ewing Marion Kauffman Foundation and the Angel Capital Education Foundation conducted the largest study on the financial returns of angel investors in North America and released a report in 2007, showing that angel investors participating in organized angel groups achieved an average 27% internal rate of return (IRR) on their angel investments.

Overall, this set of angel investors affiliated with angel groups experienced exits that generated 2.6 times their invested capital in 3.5 years from investment to exit. This return compares favorably to that of other private equity investments, including those of early-stage venture capital. Seven percent of exits generated returns above 10 times their initial investment.

New Series: Asset Allocation Strategies for Angel Investors

You see, angel investing is a high-risk, high-payoff activity. To help investors tap into the potential lucrative returns without risking more than what they can stomach, we’ve prepared a new series on asset allocation strategies, which studies what veteran angel investors recommend in respect to personal asset allocation and effective portfolio building.

Next, Easiest Way to Determine How Much to Allocate to Angel Investing.

Quick Notes

• Venture capital investing is up 41% in the 1st quarter this year vs. a year ago
• Number of startup acquisitions is at an all time high
• Quantity and quality of acquisitions are good
• 14 to 15 IPOs in 1st quarter, compared to 18 IPOs in the last 2 years
• Quality of IPOs – some good; some aren’t
• Briefly discussed corporate VCs

William R. Kerr

Startup businesses need more than just cash in their kitty to achieve success and business longevity, according to a Harvard Business School paper into entrepreneurial funding.

While it is important that seed businesses receive the necessary funding to get their operations up and running, sometimes the psychological support they receive is just as important as the financial leg up.

Only an archangel can make this happen!

Angels vs. VCs and Friends & Family

Where a venture capitalist may swill some cash around in their managed fund and occasionally flick some in the general direction of promising startups, angel investors give new businesses their proverbial set of wings – give yourselves a pat on your cherubic backs for that one!

Angels are oftentimes seen to provide the same type of support that friends and family might.

But just like the merciless honesty we expect to receive from friends and family, angel investors don’t back a venture they don’t believe in – and this point of distinction appears to make all of the difference.

Angel-Backed Companies Less Likely to Kick the Bucket

The Harvard report penned by William R. Kerr, Josh Lerner, and Antoinette Schoar tables evidence that angel-funded firms are less likely to kick the bucket than firms that rely on other forms of initial financing.

This is good news for you angels out there who have invested your hard-earned cash in a venture and look forward to continued pay days!

While venture capitalists might be intent to keep flogging the dead horse that still promises to win a race, angel investors are proven to seek out companies that are committed to the growth of more than just their bank accounts.

According to Kerr, Lerner and Schoar, the improvements that can be seen within businesses funded by sophisticated angel investors can be logged at between 30% and 50% – more than the improvements noted in businesses using other types of initial financing.

Kerr, Lerner and Schoar go on to say that these statistics can be attributed to:

• the use of networking that is initiated by most angel investors;
• the dedicated due diligence they put into researching each new venture before signing on the dotted line;
• the personal assessment undertaken to weigh up the chances of recovering their outgoings; and
• the way that angel firms survive and thrive by upping the ante on diversifying their portfolio and maintaining a personalised approach to their business backing.

It is okay to initiate a “Give me an A, N, G, E, L” cheer here punters!

More Than Money

The concept comes back to the nature vs. nurture school of thought.

Josh Lerner

Does a new baby require only milk to satisfy her growth and development needs?

Unlikely.

Just like an infant, startup businesses are usually seeking added value from an angel financier.

Adding value means helping out and being there when the
company needs you (e.g. providing helpful advice and critical connections), not stepping on the founder’s toes when your help isn’t needed.

The overall vibe of the Kerr, Lerner and Schoar report is that angel investors should embrace the fact that they are expected to give more to their investments than just the funds.

Take Away

You’re all acutely aware of the fact that the success of your investments is balanced greatly on the success of those you invest in, so take away some key points of thought from the Kerr, Lerner and Schoar paper.

• Due diligence, due diligence, due diligence – Look beyond the business plan and executive summary. Intensively evaluate every member on the startup team. Listen carefully as they present their ideas to you. Do they believe in themselves as much as they expect you to?
• Document, document, document – The Kerr, Lerner and Schoar report details information about how much effort Tech Coast Angels put into maintaining their database of companies not funded by them, but should be! Food for thought…
• Score it – Take a ballot on a new venture detailing your interest level in a pitch delivered by a startup, your overall confidence in the facts and figures that back them up, and your belief in their commitment to drop their egos and put in the hard yards to make success happen.

The Center for Venture Research at UNH has released a report [PDF] on the angel investor market in 2009. The report indicates that angels haven’t significantly decreased investment activity. But they’re committing fewer dollars due to lower valuations and a cautious approach to investing.

The report also highlights the significant changes in the critical seed and startup stage investment landscape.

• Total investments in 2009 were US$17.6 billion, a decrease of 8.3% over 2008.
• A total of 57,225 entrepreneurial ventures received angel funding in 2009, a reserved 3.1% increase from 2008.
• The number of active investors in 2009 was 259,480 individuals, virtually unchanged from 2008.
• A decline in deal size of 11.1% from 2008 (as a result of the small decline in total dollars and the increase in number of investments).
• Mergers and acquisitions represented 54% of the angel exits.
• Bankruptcies accounted for 40% of the exits in 2009.
• 250,000 new jobs created due to angel investments, or 4.4 jobs per angel investment. This represents approximately 5% of new jobs in the US in 2009.

Stage

• Seed and startup investments accounted for 35% of 2009 angel investments, a decrease of 10% from 2008.
• Post-seed/startup investing represented 62% of investments, an increase from 2008, indicating angels’ increased interests in the early and expansion stage.
• New, first sequence, investments represented 47% of 2009 angel activity, a significant decline from the last 2 years.

Sectors

As a percentage of total investments in 2009.

• Software (19%)
• Healthcare Services/Medical Devices and Equipment (17%)
• Industrial/Energy (17% — significant increase from 2008, reflecting a growing appetite for green technologies)
• Retail (9%)
• Biotech (8%)

Women

• Women angels represented 11.3% of the angel market.
• Women-owned ventures accounted for 21% of the entrepreneurs that are seeking angel capital.
• 9.4% of these women entrepreneurs received angel investment in 2009.
• Both the number of women seeking angel capital and the percentage that receives angel investments are low compared to the overall market.
• These data indicate that when women do seek angel capital they lag behind the market yield rate by 5%.

Why are some investors more successful than others? What makes them different from the average ones?

Successful investors understand risks and they use risks to their advantage. For this reason, we started a 2-part series on risks, and on improving the odds of turning someone else’s ideas into profits.

The 4 primary types of risks are:

• Financial
• Market
• People / Execution
• Product / Technology / Technical

We’ve looked at Financial and Market risks in Part 1. Here, we’ll look at People and Product.

People / Execution Risk

Time and time again investors all around the world place significant weight on the founding team. You’d want to have the right talents. You’d want to know that the team has what it takes to execute their oh-so-brilliant plan. You’d want to bet on the jockey not on the horse.

According to Harvard Business School’s working paper, “Performance Persistence in Entrepreneurship”:

All else equal, a venture-capital-backed entrepreneur who starts a company that goes public has a 30 percent chance of succeeding in his or her next venture. First-time entrepreneurs, on the other hand, have only an 18 percent chance of succeeding, and entrepreneurs who previously failed have a 20 percent chance of succeeding.

Bet on an A-team. In an A-team, at least one of the founding members has a history of success. Head over to Startup Team That Adds the Steam and Doing Due Diligence on Startup Team to find out what an A-team looks like.

Note, though, we’re not suggesting you should automatically reject inexperienced entrepreneurs. After all, angels are more likely than VCs to back first-time entrepreneurs. Ultimately, you need to ask yourself whether you believe in the team or their products.

Naval Ravikant of VentureHacks once said, “The team matters more in enterprise deals, traction matters more in consumer deals.” So, a consumer Internet startup that has traction run by an inexperienced team might be just as good.

Some evaluation questions include:

• Can the team execute?
• Does the team have a track record of success?
• Do they have business acumen?
• Do they have the domain expertise?
• Do they have operational experience to make it a success?

Product / Technology / Technical Risk

The product or technology is the central basis of a startup’s value proposition. No product, no business. A mighty cool product without applications is still mighty useless. You can be looking at a solar-powered torch so sleekly designed that it’ll put Apple to shame. But if the torch only works when the sun is out, shining brightly in the sky, then the torch hardly solves anything. Who needs a torch when you can see clearly under the sun?

If you think the technology is cool but not quite sure about its application, consult with independent experts who get the technology. Ask them to validate and assess the risks before making any investment decision.

If you’re looking at a unique product / technology that actually solves problems, conduct searches on patent applications and make sure the product hasn’t infringed existing patents on the market.

If there’s possibility of infringement but you’re convinced of the technology’s potential, talk with an experienced lawyer to see if there are any workarounds. Otherwise, you may want to simply pass on the opportunity and save yourself some sleepless nights.

Some evaluation questions include:

• Does the product solve a real problem?
• Is the product unique?
• Is it patented or protected by IP?
• If not, does it have first-mover advantage?
• Can the product operate freely on the market?

Final Thoughts

Higher risks yield higher returns. Understand the risks involved and weight them against potential rewards. Learn to adore risks and use risks to your advantage.

For Jason Cohen, an angel investor and the founder of Smart Bear Software, he wants the entrepreneur to list the known risks so he can evaluate them. He wants to see that she’s honest, that she has both eyes open. And he wants to know how she’s addressing and reducing risks.

If the entrepreneur claims that risks are minimal because she’s “in control” or “in the know,” it’s likely that she isn’t even aware of the risks. Cohen doesn’t invest in such entrepreneurs.

Keep these in mind when you’re evaluating a potential investment.

And think ahead. Take calculated risks. That’s how you can improve the odds of profiting from promising startups.

Times have changed.

Now, not only are women running businesses, they are starting them. And they aren’t sticking with cosmetics or flowers or anything else traditionally “female.”

Ning was co-founded by a woman. So was Flickr, which was bought by Yahoo in 2005 for US$30 million.

Research Findings

Research from venture capital firm Illuminate Ventures presents a compelling case for funding female entrepreneurs. Some of the notable findings are:

• Efficiency, efficiency, efficiency:  The high-tech companies women build are more capital-efficient than the norm. The average venture-backed company run by a woman had achieved comparable early-year revenues, using an average of one-third less committed capital.
• Fewer Failures: Despite often being capital-constrained, women-owned businesses are more likely to survive the transition from raw start-up to established company than the average.
• Growing Influence in Tech:  Women-owned or led firms are the fastest growing sector of new venture creation in the U.S., growing at five times the rate of all new firms between 1997 and 2006 – now representing nearly 50% of all privately held businesses.
• Diversity Improves Performance: Organizations that are the most inclusive of women in top management achieve 35% higher ROE and 34% better total return to shareholders versus their peers – and research shows gender diversity to be particularly valuable where innovation is key.

Looks like, giving women a shot isn’t that bad of an idea. In fact, far from it. It can bring about social progress. And it can restart our economy in the process. Sounds like, it’s worth a bet.

Yet, the Center for Venture Research has found that, in the first half of 2009, 22% of businesses looking for angel investors were owned by women. But only 6% of them were able to establish a relationship with an angel investor.

What’s Missing

Thanks to Facebook, Twitter, and a bounty of blogs, wikis, and everything else that comes with Web 2.0, people are organizing and connecting in ways unknown 5 years ago. Women in the technology sector are on the forefront of these advances.

Women in Technology International (WITI) is a trade association that connects and supports female technology professionals. WITI’s membership numbers 140,000, half of whom either own or hold an executive role in a technology company, according to the association’s 2010 demographics.

This spring, Women Who Tech will hold its Third Annual Telesummit for Women in Technology. These virtual symposiums broadcast panel discussions via podcasts, which makes them free resources that are available on demand.

Earlier in February, Women 2.0 held its 2-day “Will it Launch?” workshop in San Francisco to help women polish their startup ideas.

Apparently, the business resources are in place. What’s missing is your investment to transform business plans into businesses.

BUT, barriers to entry is low and there are heaps of other issues to consider. With all ‘em challenges and all ‘em developers itching to try their luck, how do you identify startups that have good potential?

Let’s take a look at the kind of startups VCs are backing and the things they said about the space. This will at least give you some clues as to what criteria should be met, which could save you some time in the screening process should you decide to back an iPhone startup.

I. Target

The key is to look for iPhone startups whose goal is to build scalable businesses, not individual developers who are just hoping to hit the jackpot.

II. Exit

Investors typically make money upon exits (e.g. M&A, IPO). They expect the startups to have an exit within 10 years.

For KPCB, it invests in companies that have the potential to become standalone, public companies. Successful investors aim big and look for homeruns.

III. Focus

KPCB has its hearts for location based services, social networking, mCommerce (including advertising and payments), communication, and entertainment.

For aggregate data, ChubbyBrain offered a breakdown of companies per industry that have received angel and VC funding. Industries that appear relatively hot within the iPhone ecosystem include: social network, gaming & entertainment, diversified application development, information provider, and monitoring & security.

IV. Multi-Platform

iFund manager Matt Murphy told mocoNews that they’re not betting solely on the iPhone platform. “Over time, most companies [in the fund] will eventually diversify to other platforms.” This is important as portfolio companies can leverage the popularity of other platforms like Android.

Case in point: Most recently iFund-backed GOGII has released its textPlus app for Android.

V. Business model

How do the companies make money? “Majority of apps right now are moving towards, or are pursuing a free ad-subsidized model, or a model using virtual goods with some apps being a paid download or monthly recurring charge,” said Murphy. “90 percent will be monetized by advertising, virtual goods, or some form of affiliate fees or commerce.”

A word about micro-payments: With the golden price point being US$0.99, your investee will need to sell a whole lot to ensure you get the great ROI. Is the market for the app there and is it big enough?

And take note of the freemium model. Mobile knowledge portal MSearchGroove (MSG) cited studies from Pinch Media which showed that iPhone app usage drops significantly after 90 days as novelty wears off. The iPhone startups you’re evaluating must be quick and meticulous in releasing apps. Fredrick and Rainey note that a clear and compelling upgrade path is a must.

While [the freemium model] works in some sectors, overall, the gap between free and paying customers is widening. This is happening because buyers can be very fickle. As their attention spans shorten, their brand loyalty diminishes as well.

In the mobile space, for instance, a game or app that’s hot today can easily be forgotten tomorrow. Users have little or no incentive to upgrade, so they just move on to the next trendy, free offering. Providers must innovate at an incredibly rapid pace in order to keep pace with market demand. But they can’t be careless – offerings must be thoroughly tested before they go public, since most people won’t give something a second chance if they’re unhappy the first time. And these providers must have a clear and compelling upgrade path to entice a larger percentage of paying customers.

Of course, you’d want to do your due diligence and look at other factors like the startup team, the company’s competitive edge, piracy concerns and go-to-market issues before opening the checkbook. But now that you’ve gained a clearer picture of what a fundable iPhone startup looks like, it’ll help you filter out a good chunk that obviously don’t fit the bill and give you an easier time to find that special company that hasn’t reached the VC stage. You might come across it in 3 to 5 days or 3 to 5 months, or you might never find one that steals your heart.

Just to give it some context, iPhone startups received between US$15,000 and US$15.5 million from VCs and angels as of June 2009, according to ChubbyBrain’s aggregate statistics. For the initiated, there’s plenty of room for individual angels and angel groups to play.