March 16th, 2009
Naval and I recently put together a talk for AngelConf, a conference for new angel investors. The conference was organized by Y Combinator and included a great group of notable angels like Ron Conway. According to the AngelConf website,
“Investing in startups seems mysterious and difficult. How much are you supposed to invest? What legal agreements do you need? Where do you find startups to invest in? How do you pick winners?”
People liked Naval’s presentation — Dave McClure called it an “awesome fucking talk“. So we thought you might like it too — it’s good advice for investors and entrepreneurs alike.
Paul Graham from Y Combinator wrote up his talk in a wonderful essay called How to Be an Angel Investor. So we’re calling our presentation “How to be an angel investor, Part 2”.
Slides: How to be an angel investor (pdf)
Here’s a transcript of the conversation. I’ve highlighted some of my favorite bits.
Nivi: Hi, this is Nivi from Venture Hacks.
Naval: And this is Naval from Venture Hacks.
Nivi: Naval recently gave a talk at Y Combinator’s AngelConf on how to be an angel investor and we thought we would record it — people liked the talk — and we thought we would record a slightly longer version and put it online.
Naval’s going to do most of the talking and I’m going to jump in with a question or a comment.
Naval: So, I’ve been in this business for a little while now, been involved with starting about seven companies, been an investor as an angel or a VC in well over 30 companies and been an advisor to over a dozen companies, and of course co-author Venture Hacks with Nivi.
After a while, you do enough of this and you start pattern matching — you notice a few things — and so I’ve put those together here and I’m using those to help out people who may want to get into the angel investment or even early stage venture business.
What do you need to be an Angel?
Naval: Basically, to be in the angel business you absolutely have to have three things — to be in the business and to do well. First of course, is access to capital: either you own or you manage to raise the funds or somebody just gives you money.
You need good dealflow and by good dealflow, I mean, proprietary or a high-quality dealflow that not everybody has seen or you have some unique ability to get in to. There has to be some reason why people will take your money instead of somebody else’s. Otherwise at the end of the day, you are commoditized and you get bid out of the game.
Finally, you need good judgment. Access to capital you either have or you don’t. If you don’t have it, then you probably shouldn’t be in the angel business, you’re just wasting people’s time. If you have good judgment, everybody thinks they have, and it takes about 10 years to figure that out so I can’t really help you there.
Naval: So, what I’m mostly going to focus on is dealflow, which is how do you find good dealflow, how do you process it efficiently, how do you get into good deals, how do you evaluate them? When it comes to dealflow, there are a lot of bad kinds of dealflow and there’s some good dealflow. Early on, you will be seeing very few deals and you’ll just be trying to get in the dealflow.
After you’ve made a few investments, you’ve got a few entrepreneurs who know what you’re doing, you have built a bit of a brand, you’ve connected to the other angels you will have too much dealflow, and you will quickly have the opposite problem. If you raise your hand and you say to the world, “I can write a check”, the world will beat a path to your door.
I’m going to help you with an odd problem, which is helping you filter the bad dealflow as well. So, you’re going to get a lot from your social friends, these are the people whose kid goes to school with your kid or someone you just hang out with.
Most of this dealflow, although you should be polite and you should see it, you’re going to have learn how to say no without taking a meeting, otherwise you’re going to find your time chewed up very quickly because these people are not in the business, they don’t have the same filters that you do, and they will pass along anything that looks like a company that’s raising money.
You, yourself, are going to be tempted to do the same thing and forward deals to other angels. Don’t ever forward a deal you wouldn’t do yourself.
Nivi: Or you’re not seriously considering.
Naval: Yes. It’s going to hurt your credibility, and it’s also going to also waste the entrepreneur’s time. The first thing any serious investor will ask you if you, yourself, are an investor and you forward a deal and say ‘”Are you investing?” You don’t want to hem and haw at that point.
You either want to say “Yes, I’m seriously considering it and I’m in the middle of my evaluation process” and you should mean it or you should actually be doing it. Those are kind of the only two legitimate answers.
If an entrepreneur asks you to forward a deal that you have passed on, your best approach is to politely explain to them that, it does not make sense for you to do so as it would send a very negative signal.
Nivi: Yeah, and if you’re an entrepreneur in that situation, I would actually ask for some names of potential investors and tell the angel that just turned you down that you’re not going to use their name to reach out to these people, but you just want to get a list of names to find some other prospective angels to reach.
Naval: Yeah, that’s a very good point. A lot of angels know a lot of other angels, you get a list of names then you have to sift through your own resources and frankly, you browse through your LinkedIn and your Facebook networks. If you’ve been around in Silicon Valleyfor a little while, you can usually find someone who knows someone.
Finally, one issue that crops up a lot when people first get in to investing is, they think they’re going to add their value in some unique process-oriented way, and so they come up with non-standard models. One could be incubation; another one could be acting CEO or so on.
They kind of say, “OK, I’ll put in some money and then I’m going to be super-active, and I want this and that and I’m going to take more stock into that.” I would suggest not doing that. Certainly you can offer it to people you know well, and certainly people can ask you for additional help or these kinds of non-standard deals, but they have two problems.
One is if you end up taking too much equity early on. It makes the company difficult to fund by VCs down the line. Secondly, it will lead to an adverse selection case, where if you’re putting out your services as a rent-a-chairman or a rent-a-CEO, you’re going to see the companies that are so desperate raising financing where they won’t entertain that notion.
Most really great entrepreneurs, yes they could use some advice and they’ll listen to it, but they don’t need you to run their company for them. So be careful about that adverse selection trap and be prepared that with some of the very, very best companies, your only value-add is essentially will be your money plus a few connections and a little bit of advice here and there.
What’s good? Deals that come from other angels who are doing them are usually very good. You build these up by quid pro quo. If they send you deals, you send them deals back and vice versa.
Branding your advisory services is very good. So if you have particular domain expertise, you are the founder of a company that was successful in a certain space, then you should be able to brand yourself in such a way that you will see the companies in your space.
Another way to brand yourself would be through some kind of a horizontal play. If you’re a marketing genius for consumer web companies, then people may come to you for help on that.
Nivi: Yeah. So, here are a few examples of that. The way that Naval put it at AngelConf was Paul Buchheit is the Gmail guy; Naval, himself, is the Venture Hacks guy and he’s also an expert on viral marketing and Facebook, and Paul Graham is Paul Graham. Those are the kind of examples you want to try to follow.
Naval: So, let’s assume you’ve worked out this incredible dealflow pipeline and you’re getting a lot of companies that are coming to you. You want to get through them relatively efficiently. What you will find very quickly is that most business plans, executive summaries are a waste of time.
You can’t sign NDA’s, because doing so exposes you to far too much down the road. So what you really need is very high concept pitch where somebody explains to you, “we are this for that” like an analogy…
Nivi: Friendster for dogs.
Naval: Exactly. Dogster. Maybe a short 10 slide deck. If somebody comes to pitch you, don’t schedule hour-long meetings, you don’t need an hour to figure it out.
Usually within 20 minutes, is enough for the company to get their points across and you should not be pitching yourself at this point. First, you should just be listening; you can always pitch yourself a little bit later.
Nivi: I would say a high-concept pitch, like Friendster for dogs is great. One paragraph, or a couple paragraphs elevator pitch in email form is great, and if the company has it, a 10 slide deck. Of course, more important than any of that is a working demo or screen cast or mock-ups or some realized version of the product.
Naval: Generally, it’s a poor sign if a start-up comes to you, especially if they’re on the web, or consumer web, or iPhone, or one of these spaces where it’s pretty easy to hack something out and they haven’t put together a prototype or they haven’t, as Nivi would point out, made early and meaningful contact with the customer.
Nivi: Which can be done through things like surveys, as well, right? If its offline and it involves hardware or whatever, they could have gone out and talked to the customer via surveys or interviews, or they could have spent the last 10 years of their life working with that exact customer and know them inside out.
Evaluating Startups: Team
Naval: So, now when it comes to a valuable startup, you’ve got the short pitch, you’ve taken the half-hour meeting. There are times when you can eliminate the startup on the basis of team; this is not, obviously, fool-proof. Investing is not a science, it’s an art.
But here are some general rules of thumb I’ve developed over the years, which helped me, filter dealflow. One of those is that usually the optimal configuration for a company, in terms of the founder basis, two to three founders and three is the max.
Five is a very unstable configuration, eventually it will fall apart. You cannot have five cooks in the kitchen.
One is too difficult. The person gets too lonely and it gets too difficult to continue on, because they don’t have a thought partner. So two to three turns out to be ideal.
If you look at the very, very successful companies in the Valley, Apple had Steve Jobs and Steve Wozniak; Microsoft up in Seattle had Bill Gates and Paul Allen and later on Paul Allen dropped out, they had Steve Ballmer and of course, Google had Larry Page and Sergey Brin; even Oracle had Larry Ellison and quickly thereafter had Ray Lane.
So generally, you need teams of two founders at least. You want someone in the company who can build and someone who can sell and if there’s going to be an imbalance; it should, probably, be in favor of the builder.
Of course, it depends on the exact company, but you would rather be investing in a startup that has two builders and one salesperson, rather than have two sales people and one builder.
Generally, you want to say no to companies where the founders are all lawyers or all business guys and they don’t have the product development expertise to back them up or where they are outsourcing the product development completely.
Companies that outsource product development completely, generally have a hard time iterating and keeping up with the changes in the market and the competitors.
One learning that I’ve found the hard way is that is that, especially in consumer web deals, traction matters more than anything. It’s very hard to predict mass consumer behavior. It’s a very efficient market out there.
So, it’s good to find real customer adoption before you put too much money to work, whereas in enterprise deals, where you are selling to a small number of large customers, the team can make a meaningful difference.
Nivi: One thing on the topic of a guy that can sell; it doesn’t have to be your conception of a prototypical salesman or a car salesman or whatever. If you are in a one-on-one meeting with Bill Gates, even though he is a complete nerd, you would be extremely compelled by whatever he has to say to you.
So in that sense he is a salesman, right? A lot of nerds in their nerdiness can actually be extremely compelling in the proposition that they are trying to put in front of you.
Naval: Yes, by salesman, I don’t mean the bag-carrying enterprise sales quota matching guy. It’s exactly as Nivi said, people who are compelling and who can convince early customers to sign up, through whatever means possible. They can convince early employees to sign up when the company has very little cash. They can convince early investors to sign up.
In fact, usually if someone can sell you in an investment meeting really well, and you walk out dizzy, saying I don’t really get the product or this space, but this guy almost sold me. That’s a good sign.
Nivi: Yes, that in and of itself is an asset in terms of being able to sign on customers, employees, other investors, and so on.
Naval: One other thing to think about is when you are evaluating companies at an early stage, the appropriate title for the people in the company is usually founder, or engineer, or things of those sort.
If you see a company that’s very top-heavy, has its CEO, its CFO, VP of this, SVP of that, then it’s usually a bad sign. It means that the people involved are more interested in building up impressive titles for themselves or building a large organization than they are in having a successful product and a good financial outcome.
Nivi: Yes, we want builders.
Naval: In evaluating entrepreneurs, Warren Buffett often says that when he looks at the company he buys, and very often these are multi-billion dollar companies, he’s looking for intelligence, energy, and integrity. I find that the same criteria works extremely well in evaluating start-up founders also.
Intelligence for obvious reasons.
Energy because drive and passion are the number one predictor of an entrepreneur’s success, and it’s not actually intelligence in that case.
And integrity is paramount, because if you have someone with high intelligence and high energy, but they don’t have high integrity, you’ve basically got a hard-working crook. You don’t want to be associated with that. In fact, you prefer lazy, dumb crooks to hard-working smart crooks.
Nivi: Yes. They will have many opportunities to screw you, if they don’t have any integrity.
Evaluating Startups: Customers et al
Naval: So, intelligence and integrity I would not compromise on any of the three.
Similarly, we talked a little bit about teams. Let’s talk about the customers. As we talked about earlier, you don’t want to invest in companies that have made no contact with the customer yet whatsoever.
For an enterprise software company, it might be surveys; it might be a few big customers’ meetings references. For a web company, it usually means the product has been released or some facsimile of it has been released and tried out.
You definitely want to look at a lot of companies, before you make early investments. The usual failure mode for individual angel investors is that they invest too early and too quickly. Part of this is you don’t have a partner who can veto you.
Venture funds are deliberately organized, in such a way that there are a lot of experienced people saying no to the new guy’s urge to go invest in the first hot thing he finds.
In angel fund, I would suggest that you be disciplined either by numbers, so say to yourself, I’m not going to make an investment until I see at least twenty companies. One hundred might not be a bad number. In a busy year, I’ll easily see four, five, six hundred companies.
An even better approach might be to find some experienced angels that you team up with and give them an effective veto. No matter how much you like the deal, if you can’t talk them into it, don’t do it.
Nivi: Yes, and along those lines, you could just say, I’m not going to invest in any deals that these five notable angels are not also investing in for my first couple of companies.
Naval: So, saying no is something that you are going to be doing far more often than saying yes. So, let’s get that out of the way. You have to learn how to say no, you have to learn how to turn down people.
It’s uncomfortable, but usually people appreciate a quick and up-front and reasoned no, with some good advice and hopefully a little bit of help attached to it, than they do a dragged out long process where at the end then you hem and haw and have to say no.
So, the best time to say no is before you take a meeting. If some of these deals fail your filters, or if you just can’t see yourself getting excited about the company or the business, say no over email before you meet.
If you hear the pitch, and it is not compelling, take five minutes out after the pitch, talk about it, think about it, and then say no to the entrepreneur before they even leave.
Since angel deals tend to be pretty small, you are investing tens or hundreds of thousands of dollars, you don’t want to drag it out over months. You don’t want to take weeks of the entrepreneur’s time. You don’t want to cause them to generate additional documents or write code just for you.
So try and be efficient about it. Don’t spend more than a couple of hours of their time, or if you had to noodle on it yourself for more than a few weeks, then it probably isn’t right for you.
Warren Buffett makes two really good points. Actually, Ron Conway lists one of them at the angel conference, which was don’t invest in people that you really aren’t excited about working with, because at the end of the day, the business model will change. The details will change. The company’s progress will change.
The only constant will be the person you invested in. If you don’t like to take their phone calls, if you don’t like to sit down there and talk to them all the time, then eventually you are going to see the deal as a burden.
You will eventually run out of time. So, it’s very important that you only pick the people that you want to work with. I just can’t emphasize that enough. It sounds like an easy thing to say, and hard to follow, but in reality, you will find that it will make all the difference in the long term.
The other thing that Buffett points out is that this is a game where the swings that you don’t make are not counted against you. You just have to find a few hits, and if you let a lot of hits go by while you are waiting for the perfect pitch, that’s absolutely fine. So, when in doubt, just say no.
Since the angel community is very small, the entrepreneur community is very small, your reputation is everything. So, it’s very important that you try and add value to every company whether you invest in them or not.
If they took the time to present to you, and they paid you that honor, then you should take the time to maybe make an introduction or two for them, or give them some useful, honest advice. Generally, it’s not a good idea to try and withhold your capability to help them too much, just because you did not make an investment.
Navi: Yes, and that is where you area of expertise, whether it is raising money or marketing or Facebook or whatever, can really shine right at the end of a meeting.
Saying Yes: Terms
Naval: So, let’s talk about the terms for a moment. So, let’s say you’ve processed a huge amount of deals, you’ve found a company that you want. You’ve said no to the ones that you don’t want. You want to make an investment. Some things to keep in mind is that one of the biggest risks of angel investing is the downstream financing risk.
You may look at a company and say, I could see this being a small but highly likely exit. That’s not initially a great company for you to invest in. The danger there is that a lot of companies use up cash very quickly, they run out of cash. You don’t want to put money after your own investments, because you are obviously now a biased investor.
And VCs always evaluate things in terms of their huge market potential, as VCs have very large funds. It ends up being a little bit of what the economists call the Keynesian beauty contest, which is you pick a winner based on who you think the judges are going to pick to win in the next round.
So, you are not initially picking the most beautiful start-up, you are picking the start-up the judges are most likely to pick. So, it is a dead-end trap to finance too many companies that don’t have the possibility of turning into something huge somewhere down the line.
One way to mitigate that is to co-invest with other venture capitalists. This is where you’re an angel, you’re putting a small amount of money and the VCs are putting in most of the money.
The issue there is that VCs are ownership sensitive. They want to own a lot of the company, but they tend not to be as price sensitive as angels because they have lot of money to throw around. So, one way to mitigate that is to give the VC some different rights that you don’t care about, such as the ability to invest more money the next round, and in exchange keep the valuation lower for you as the angel of this round.
Another opportunity for some superstar angels, or if you are taking a very active role in the company, is you might be able to get a little additional advisory stock, relative to the amount you invested.
Nivi: Just to be clear on Naval’s concern, his concern is that the seed round — that VCs get involved — ends up being for a lot of cash coming in at the high valuation. That makes it economically uninteresting for you as an angel investor, because you will end up owning a very small slice of the company because the valuation will be high.
So his suggestion, if I understand it right, is you basically give the investors — you do the round at a low valuation, you have a reasonable amount of cash coming in, the VCs co-invest, and what you give them is basically an option to invest in the next round. Is that right?
Naval: That’s correct. And in fact, another point of the economics is a lot of first-time angels, especially when investing their own money, tend to invest in what are called “uncapped debt.” So they’re put in a convertible note at a 20% discount to whatever the next round is going to be.
That’s an extremely uneconomic proposition. The odds of a startup going out of business are far greater than 20%, or the 16% that would be required to cover your investment. In fact, there are corporate bonds trading in the public markets today that are yielding 15-16%. So they are far more liquid with companies that are far better capitalized.
Generally, you’re looking for a 3X, 4X, 5X increase in valuation between rounds, which means you are price sensitive. So it’s OK to do a convertible note because that’s often simpler for everybody involved, from a legal perspective. But you generally want to establish a conversion price cap, which pays you back for the risk that you’re taking at this stage.
Nivi: One thing, just going back to the VC thing, from the perspective of an entrepreneur, if I have VCs investing in the seed round, the issue that it creates for me is that if those VCs don’t want to invest in the series A, it makes it very difficult to do the series A, because the inside investors who knows the company best are basically saying the company is not a venture investment.
Naval: One other point about investing with groups. A good reason to invest with other angels, no matter how much you like the company, is that stuff always goes wrong with a startup. And when stuff goes wrong, very often the entrepreneur can make the choice to walk away, especially if the company has a very small amount of money invested.
Or the entrepreneur can choose to do something that would be adverse to you, because you’re a minority shareholder without a lot of the protections that VCs often have. If you’re in a group of angels, you are much more likely to have a good outcome in that situation.
An entrepreneur is much less likely to walk away, if there are five good angels as investors than if there’s only one. An entrepreneur is less likely to change the terms that are adverse to you, if you’re with four other angel investors rather than if you’re alone.
One way in which, if you’re an angel investor, you can squander a lot of time is if you’re board seats. Essentially if you’re taking board seats, you’re going to be limiting yourself to only being able to handle five, six, seven investments, which may not be enough for you to achieve the portfolio affect that you need for the economics to work.
If 1-out-of-20 to 1-out-of-30 angel investments work, and you can only make five because you’ve taken board seats and your time is full, then your economic model is in trouble, and you would have to augment it by sprinkling around a lot of companies where you almost spend no time with them.
Board seats are really only worthwhile taking if you’re getting paid for it, if you have some unique and proprietary insight to the company and it’s market — maybe you started a company in a similar space that did really well — or in that unique case where the company is just someone who is very, very close to you.
Otherwise, realize that boards spend a lot of time on corporate governance issues, which often isn’t the best use of your time.
Nivi: Yeah, I mean, you can simply advise the company. You don’t have to be on the board to advise the company. The other downside is if you’re not willing to leave the board whenever the company asks you to, you can screw up their series A investment, because VCs don’t want to come into a company, which has a random guy who was one of the angels on the board of directors.
Naval: Yeah. It depends on who the angel is, of course.
Nivi: It depends, yeah.
In terms of how much of the company you want to buy, you’re not going to end up with 40% or 50% of the company after an angel or seed round.
You should be thinking more in terms of 5%, 10%, 20%. Capital that is coming into the company is $25K, $50K, $100K, up to $250K, the valuations that you’re looking at are going to be in the $0.5 million to $2 million dollar post-money valuations.
The way you justify the company’s valuation isn’t on the basis that the company is actually worth that much money, in the sense that somebody would buy the company for that price today. The way you justify it and the way entrepreneurs justify it, is through dilution.
You need to leave enough of the company in the hands of the entrepreneurs who are the guys who are creating value for you and for themselves alike, to be incented to create value for the two of you.
If after the first round they own less than half the company, and there are three more rounds of financing coming along over the next five years, they’re not incented to create value for you or for themselves.
So that’s where you end up with the angels or the seed investors owning somewhere between 5% and up to 20% of the company after a seed round.
The other way entrepreneurs justify the valuation is just through a market clearing price. Things are worth what people pay for them, and as long as someone is willing to pay $2 million post money for a company, you have to pay the same price, either if you want to invest alongside them or you want to outbid them.
Naval: So let’s talk about the economics a little bit. Think of yourself as a patron of the arts. If you were in 16th or 17th century Italy, you would be investing in paintings and sculptures. You’re doing the same sort of thing now. You’re not really in this so much to make money, as you are to help the next batch of entrepreneurs get to where you got to.
It’s unlikely that most of us as entrepreneurs would have been successful and gone up in value, without angels as investors, and now you’re giving that opportunity to the next young batch. And I say that because it’s very difficult to make money in this business.
The hit rate is extremely low; the economics are tough because on the really interesting companies it gets bid up by the venture capitalists.
And very often even if you find a hit company and you manage to get a piece of it early on by making and investment, very often you can get wiped out if there’s a bump in the road down the line and you don’t have the capital to pony up.
So think of yourself as a patron of innovation. You’ll sleep a lot better at night, if you assume your investments are lost on the day that you make them. And I’m not the only one to say that. At AngelConf, I think most of the professional angels, including the ones who had been in it for a long time like Ron Conway, made that point.
And your personal portfolio, outside of your angel investments, should be balanced with ultra-safe investments. Nassim Taleb, the author of “Fooled by Randomness” and “The Black Swan,” advocates having a 10% ultra-risky portfolio, in other words, looking for a positive “black swan.” And the other 90% being in T-bills and cash and equivalent safe investments.
But it’s an extremely rewarding business in the sense that you get to work with very, very bright people who are young, full of energy and fire. They show up and they tell you everything they’ve learned about a topic, that they’re deeply passionate about, in a short period of time. So the learning curve is high.
It’s extremely fun, but if you’re not careful you can lose a lot of money and annoy people.
Nivi: I don’t think that I’ve been involved in a company that somewhere along the way was not catalyzed by an angel investor or a seed stage investor. I don’t know if that’s the case for Naval or not.
Naval: I have, but usually the ones that had good angel investors worked out much better. In the angel case, as an entrepreneur, you can get the advice and help and connections that you look for out of a VC but you can get it with much less dilution and much less capital and, most importantly, much less control over your company.
If you’re really looking for good advisors, it’s usually a much better idea to go and get a couple of angels than it is to raise a big VC round. If you need a lot of capital, because you have something that you’ve figured out is working and you want to scale it, that’s when venture investment makes sense.
Nivi: Yeah. One way to think of yourself as an angel is, as basically an advisor that pays for the privilege of advising a company, and in the process gets a little chip in the business, in the case that the company happens to be a Google or a sub-Google like exit, Skype, MySpace or whatever.
Naval: And to echo a point that Paul Graham made a long time ago, the best, highest quality people that you want involved in your startup are usually already pretty successful. You’re not going to be able to recruit them as employees, you probably won’t even be able to bring them on as advisors for small amounts of equity.
The only way that those people will participate in your businesses is, if they have a meaningful stake.
And you don’t want to give huge stakes to a person just for a few words here or there where you don’t know what the value will be down the line, no matter how famous or how successful they are. So the way the market clears is they get to invest in your company.
Naval: If you have any questions about this or if you would like to talk more about it, feel free to contact us at firstname.lastname@example.org. We’d also like to know if you’re an angel investor who’s available to invest capital and what your profile is.
So feel free to email us with that and we will try to show you interesting companies. What we would ask is that you tell us how much capital you have to invest, how much you’re looking to put to work, and what your particular areas of expertise are.