Boulder Startup Week Kicks Off With Look at Angel Investing Pitfalls

5/13/14Follow @MichaelXBD

Angel investing isn’t for the faint of heart. Doing it right takes patience, acceptance of risk, and the knack for spotting entrepreneurs who can work together as a team.

Those were the major themes at a panel discussion Monday that was part of the first day of Boulder Startup Week. The panel, titled “Trouble in Paradise: Lessons from Angel Investment and Capital Raising Failures,” featured Foundry Group managing director Seth Levine; VictorOps co-founder and CEO Todd Vernon; Impact Angel Group managing director Elizabeth Kraus; and Victors & Spoils co-founder Claudia Batten.

The panelists provided some dos and don’ts for people interested in angel investing, as well as tips for entrepreneurs. Here are some lessons taken from their talk:

For investors:

—Know the risks and manage them

Angel investing is risky business. Most startups that get angel capital fail without ever returning a cent to their investors. If potential investors can’t cope with that knowledge and still write sizeable checks, or lack the financial wherewithal to sustain large losses, they shouldn’t be making angel investments, Vernon said.

Vernon said he’s made about 10 angel investments and had one or two successes. His track record in founding companies is much better: he co-founded Raindance Communications, Lijit (now sovrn Holdings), and VictorOps.

For those willing to take the plunge, Levine, who said he’s made about 30 personal angel investments, offered a few pieces of advice. One is to take a portfolio approach with at least 10 or so investments. That increases the odds of a success or two, but it doesn’t guarantee it, which leads to his second point.

“You need to be ready, willing, and able to lose 100 percent of your money,” Levine said.

He also recommended not seeking to follow on in subsequent rounds, and he emphasized the need to be “super passionate about the team, the idea, or both.”

—Don’t obsess over due diligence; focus on the team instead

Investing the time on extensive due diligence might seem prudent when you’re putting up $25,000 or so in a company, but Levine said it’s actually counterproductive and bogs down a startup. The founders’ time would be better spent refining their product and courting customers than dealing with umpteen requests for information from potential investors.

Batten was even more blunt about over-involved investors creating headaches.

“Angels waste a lot of entrepreneurs’ time with question after question about stuff that is irrelevant,” Batten said. That’s especially true because the company is almost certain to change course dramatically after an investment has been made, making the answers an entrepreneur gave at the time irrelevant.

“All of the companies I’ve been involved with started in one place and pivoted significantly to someplace else,” she said.

Focusing on the qualifications of the founders and their interpersonal dynamics is a better clue as to whether a startup could succeed, Levine said.

“The right thing to do is find really passionate people that you are very passionate about that are doing something in a market you think is at least interesting,” Levine said.

Most startups that fail at the angel level do so because of problems with the founders, he said. Deciding which teams will be winners requires a judgment call, he said.

“A lot of angel investing really is trusting your gut, trusting your instincts. It doesn’t mean you won’t be wrong, but if you have a portfolio of investments, you only need to be right once or twice.

—Look at a lot of deals

Of course, not all guts are created equal. Kraus pointed out that Levine has seen hundreds if not thousands of potential deals as an angel investor and venture capitalist, but that for beginners, there’s a steep learning curve.

“I’ve only been doing this for about three-and-a-half years. Three-and-a-half years ago, I couldn’t have gone with my gut,” she said.

Kraus said she thinks it takes looking at 200 or so deals before someone really develops a sense of what deals might work.

—Ask smart questions

Badgering entrepreneurs isn’t the same as asking good questions that could reveal valuable information about team dynamics and their commitment, Batten said. She believes the focus should be on the strength and quality of the team.

Levine said he likes to ask entrepreneurs how they came up with their idea and their startup’s origin story.

“I want to understand the path they took to come up with the idea they’re passionate about,” he said.

Vernon takes a different tack. He likes to ask entrepreneurs pitching him why no one else has built a successful company around their idea.

For entrepreneurs:

—Avoid “smart rich guy” syndrome

Entrepreneurs desperate for capital could be excused for thinking a huge check from a single investor might be much better than raising money one $25,000 check at a time.

But it’s not, Vernon said, especially when it comes from someone who’s not used to angel investing, doesn’t know the industry the startup is in, and demands too much control.

“What happens is, an entrepreneur becomes very invested in the business they want to start, they get very excited about it, they look for money, they do all the classic things, and they end up finding a smart rich guy who doesn’t know anything about the business,” Vernon said. “This can be a successful contractor who builds houses, or a successful restaurant owner that just has a lot of free income and fancies himself an investor.”

The investor is willing to put up a lot of money—maybe even all the founders need in their angel round—and they take it. Then the trouble starts, Vernon said. The investor has too much control, his or her interests might not be aligned with the entrepreneurs, and he or she could refuse to allow them to raise more money and diminish the investor’s stake in the company.

“It’s the perfect example of getting mixed up in a total shit show because you can’t go get new money because he won’t allow it and he’s the number one shareholder, and he’d actually ride it to zero before he’ll let you go get another investor,” Vernon said.

It seems hard to believe an investor would be so short-sighted, but Vernon has seen it multiple times.

“I’ve seen it happen three times with three different people. That is a recipe for disaster,” he said.

Vernon wasn’t alone, as Levine said he has had experience with similar problem investors.

—Don’t try to hide the risks

When making a pitch, it might be tempting for an entrepreneur to try to minimize the risks his or her company faces. That’s a bad idea, according to the panelists.

First, savvy angel investors know the odds, so trying to hide them doesn’t make sense.

“The most probable outcome is we’ll fail. Statistically, that’s the truth,” Vernon said.

Plus, being upfront about risks and challenges tells a prospective investor something valuable about an entrepreneur.

“I always own the risks,” Batten said. “As an entrepreneur I’m flat out about it. I’m showing I know what’s coming, [and that] I know how to manage it.”

Finally, keep in mind good angels are more focused on the upside.

“I don’t think your job is to frame the risks,” Levine said of entrepreneurs. “Your job is to frame the opportunity and/or yourself in a way that’s compelling. The risk is the risk.”

Michael Davidson is the editor of Xconomy Boulder/Denver. He covers startups, venture capital, clean tech, energy, aerospace, telecoms, and whatever else happens above 5,280 feet. Contact him at mdavidson@xconomy.com. Follow @MichaelXBD

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