How Angels Evaluate Entrepreneurial Investment

May 29, 2017 ENT640 - Entrepreneurial Feasibility Analysis, Entrepreneurship, M.E. Program Coursework Comments (13) 353

ENT640 - WEEK 3

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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Featured Image Source: Getty Images, Hero Images

 

 

David Harkins is a serial entrepreneur, which is a more professional way of saying he is still trying to figure out what he wants to be when he grows up.
When not working for himself, he has had a fulfilling career in marketing, advising both large and small companies including several in the Fortune 500 and many of America’s largest nonprofit organizations. In his spare time, he consults, speaks, writes, hikes, explores, and creates art. Although, not necessarily in that order. Connect with him on social media below:

13 Responses to :
How Angels Evaluate Entrepreneurial Investment

  1. tcomer1 says:

    David,
    This was a very and helpful post. After reading this post and considering what I have read in the book, devising an exit strategy is now high on the priorities list. Before reading the text I had not considered how important an exit strategy could be for an investor. Early stage can be quite risky and a good investor should know when to tip their hat and leave. It also important for the entrepreneur and investor to plan ahead in case the business relationship goes south or the business model changes and the investor does not agree.

    1. Hi Toshia,

      I think devising a primary and alternative exit strategies at the beginning is definitely the way to go. It helps the angel know that you are focused on facilitating a positive exit for his or her investment and likely makes the business more attractive for investment.

  2. John says:

    David,

    I think you made a great point for entrepreneurs to not only focus on the business plan but the business model as well. As you said, it is what peaks the investors interest to consider the business as a whole. I like how you mentioned that entrepreneurs need to make sure the investors are a good fit the company as well. Often times, entrepreneurs are so concerned with simply raising capital that they do not take into account the other value, or lack of value, the investor brings.
    John

    1. Hi John,

      In my opinion, the business model is critical. So is a good relationship with an investor who understands that business model. I agree that many entrepreneurs are only concerned with the money needed to get to the next step. It would be good for them, as you point out, to think about the other value an investor might bring.

  3. David,

    This is a great post! Well written and easy to follow! You had some great advice for entrepreneurs! I especially liked the portion on pitching to angel investors. This is a huge deal and you should be well prepared, because like you mentioned they are not only looking at the business but YOU!! How you act, how you speak, how you interact, etc. I would have to practice many many times with a variety of audiences, to perfect the pitch before I go “live” with an investor.

    Thanks for the great post!

    Christina

    1. Thank you! I think practice is important. When I speak or pitch something, I practice quite a bit. But, mostly I concentrate on style and delivery. I try to be well versed in what I’m talking about and that takes a lot of the pressure off. If you know your business and the opportunity, practicing will only improve your opportunity to deliver with clarity.

  4. David,
    Your business model description is excellent. I used it to tailor my post as well as my preparation for a pitch I’m going to do. Thank you for your help (without you knowing). The one thing I hadn’t considered is an exit strategy. I truly enjoy the startup I’m creating. However, I see realistically I need to create this as it’s a core component and necessary. Thank you again.
    Nicole

    1. Thanks, Nicole. I’m happy to hear I was of some help with your work. Determining a realistic exit option may well help get investors interested.

  5. I like your description of the business model – and the emphasis on the model. I think the use of narrative is also helpful. Clearly this is a more personal type of investment and the value obtained is beyond cash (to both sides). I think your comment about the return not necessarily being that high is also right on. The Angel’s time has value too. And a low return will lead them question if all that effort was really worth it in the end.

    — Brad http://blog.medstudentlearning.com/2017/05/angels-evaluating-your-life-science.html

    1. Thanks, Brad. I’m a strong believer in the narrative. Everything grows from the story and setting the tone of the business. An angel’s time does indeed have value. My experience is they do want a solid return, but they also want to know that they’re making a difference and, in some small way, paying forward their success by passing on their knowledge.

  6. Another excellent post on the evaluation an angel may do. I am curious with all your experience with start ups, do most of them have an exit plan? I know it shows commitment to the investor. Is the whole idea to get in and get out for an investor and the entrepreneur? As you mentioned, IPOs are on the decline and I wonder if entrepreneurs want to hold onto their companies longer and diversity their products and services. Amazon comes to mind.

    1. Hi CeCe,

      I think it depends on the goal. If large and now public companies like Amazon have had the benefit of an IPO. The market defines the value of the stock, so any early investor may hold his or her stock and cash out at any time to reap the rewards of early investment. That’s one exit strategy.

      Conversely, the number of startups that go public these days is pretty low. So, an IPO is probably a less likely exit option. Investors, particularly Angel Investors, are probably going to want to know the exit strategy at the time of investment. This lets them know you’re thinking about their return from day one. It does not necessarily mean that you have to exit in that way. You may, for example, decide on diversification of products and the angel may go along thereby changing original exit strategy. It’s hard to say. Still, I think that for most of us seeking early stage investment, having a logical plan to get out might improve our chances of getting our business off the ground.

      By the way, Amazon is an interesting animal. I read an article last week in the Wall Street Journal on the value of stock splits and how few public companies are taking this option to allow for investment by a larger number of people (Here’s the non-walled off version: http://www.newsmax.com/Finance/StreetTalk/Amazon-Stock-Splits-Share/2017/05/26/id/792654/). And Barron’s offered this opinion on Amazon’s real value yesterday: http://www.barrons.com/articles/amazons-grand-stock-price-means-less-than-you-think-1496172889

      Thanks for asking such a great question. 🙂

      1. David,
        Thanks for the articles and the explanations. Good reads. They both seem to agree that the stock price is not a big deal. It sure keeps anyone but the very wealthy from trying to own a share at those prices. At least Apple is more attainable for some. It does remind me of the saying what goes up must come down.
        Cece

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How Angels Evaluate Entrepreneurial Investment

by David Harkins time to read: 5 min
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