Inside the Venture Capital (or How Angels work)

 

This time we want to acquaint you with the awesome article by Charles Wiles about Angel investments. He made this text like notes for young Angel investors: what to see in startups, what's the key factors, general dos and don'ts. So, the best thing to understand your competitor — think like a competitor. That's why we're highly recommend this text for startups who are looking for investments and in search of their Angel. Here you will know what are the most important things you need to know about your business and top 6 questions that let you find your angel. So, here we go.
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The tech startup economy is booming in London and great startups are popping up all over the place. From FinTech to EdTech, from PropTech to the IOT, in every vertical you’ll find passionate founders pitching their business as the next big thing. In my last article, I explained how it’s now easier than ever for you to make angel investments and share in the success of the next Google, Facebook or Snapchat. But for every company that wins big, there are perhaps a hundred that fail. So how do you make sure you pick the winners and not the losers?

Here are three strategies to help you succeed...

 

Strategy 1: Team, Team, Team

I was at an event recently where Chris Chrysanthou, a leading VC at Notion Capital, was asked what he looks for in a great investment. His answer was that they look for five things and the first three were all “team”.  As a Product Manager at Google one of my tasks was to look for acquisitions. The three criteria were the three “T’s” of team, technology and traction, but by far the biggest emphasis was on team.  When my own company Zzish was accepted on the Techstars program they told us that they didn’t really care about our business idea. That’s not to say that they didn’t think we had a great business idea, but the reason they had picked us out of a thousand companies which had applied was because they thought we were an outstanding team.

So why all the focus on team? Surely the biggest emphasis should be on the idea and business opportunity?  

Well, the reality is twofold. Firstly, most ideas “have their time” and while your founder may tell you, and honestly believe, that they are the only player in town, the reality is that there are probably half a dozen similar companies starting up at the same time, each competing for the same prize. A key factor in deciding the winner is the quality of the team. The quality of the team impacts both how well they execute and also, rather unfairly, their ability to access finance and move faster. When many people are competing with the same prize, execution is everything and the company that can raise the most money and grow faster has a big advantage.

Secondly, most business opportunities, no matter how “obvious” it is that they should work, do not work out as planned. Most founders have a great idea in principle, but often the product is not fulfilling an important enough need that customers are willing to pay for it.  It lacks the dreaded “product/market fit”. Alternatively, sometimes the product is too early for the market. Sometimes market forces change and a business can’t get the planned traction.  One way to mitigate against these forces is to invest in a great team with the capability to “pivot” and build a different, but related, business when the first one does not succeed as planned. Great teams can do this, poor teams disintegrate and give up. At Techstars they positively encourage teams to test their ideas quickly and pivot if necessary.

What makes a great team? Well, as a sage man (or woman) once said, there is no “I” in “team” and great teams usually have two or three great individuals. One popular model is that all great teams have the Hipster, Hacker and Hustler (the designer, the techie and the salesperson). Sometimes a founder can capably play two of these roles (Jobs was both Hipster and Hustler), but for a startup to be successful you need these three core skills.  If one is missing then there’s a key hire to be made! In my experience it’s often the hustler who is missing.

In terms of the soft skills, perhaps “resilience” is the one outstanding characteristic of founders of successful startups. Indeed, the difference between those who fail and those who succeed is that those who succeed don’t give up when they fail. “Experience” is another valuable asset, particularly experience in the market which the startup is tackling.  Product/market fit is much easier to identify when you know the market inside out already.

 

Strategy 2: The holistic approach

Team is arguably the most important factor and can compensate for a host of other factors, but there are a number of other key factors for a company to succeed and to get a good return on your investment. These should all be covered in a good pitch deck:

  1. Product and market fit
  2. Market size
  3. Customers
  4. Traction
  5. Competition
  6. Exit strategy

Product and market fit:  The best way to prove product and market fit is for the company to already have several paying customers, but usually by the time this part is proven a company has moved past the point of taking angel investment and is onto raising a Series A from mainstream funds. So this is often a point of risk for angel investors. Ideally startups have done their “customer discovery” phase and have strong evidence to support that customers will pay. Indeed, CB insights carried out a study of more than one hundred failed tech-related startups and found that by far the biggest reason for failure, accounting for 42% of all failures, was a lack of market need (note the third one was “Not the Right Team”). However, note that many of the most successful companies on the planet would not have got off the ground if they had been required to have proof that customers would be willing to pay before raising funding.  Google, Facebook and YouTube are all good examples. It might be obvious now that they can generate strong revenue from advertising, but it certainly wasn’t obvious at the time Google started. Moreover, if you had surveyed 1,000 people back in January 2004, the month before Facebook was launched, and asked them whether they had a need to share every last detail of their life online with their friends, you would have got a big fat zero.

Market size:  A company may have a killer product, but if there are only a handful of customers, they aren’t going to make much money and you won’t get a great return.  Ideally a company is playing in a big market.  A key factor here is understanding what the true “addressable market size” is, in other words, the total market revenue for the company and its direct competitors. An advertising technology company that says their market is the $600b global advertising industry, or even the slightly smaller $200b digital advertising industry, hasn’t really done their homework. One challenge here is that, again, the most exciting companies with the biggest upside may actually be creating an entirely new market that is initially very small.  Indeed, Peter Thiel, one of the world’s legendary entrepreneurs and investors has a very practical view on this, start with a really small market and become a monopoly. Check out his lecture on “Competition is for Losers” from Stanford’s excellent ”How to start a start up” course.  My own company Zzish is a play along these lines, we’re creating a software platform for developers of education applications. We’re creating a brand new market, but one that we expect to be worth many billions in years to come.

Customers:  Tightly related to market fit, a promising startup should have clear customers that they have already engaged with and tested the proposition. According to the “Four steps to the epiphany” (one of the bible’s of modern tech startups), the goal here is not to be able to demonstrate that every potential customer in the market wants your product.  Indeed if you are doing something innovative you are likely to be ahead of the curve and many customers won’t yet realise the need. Instead, you are looking for a small number of earlyvangelists who are committed and want the product even if it isn’t built yet.

Traction:  Traction (a growing customer base) almost always comes with product market fit unless the cost of acquisition for customers is exceptionally high. As such by the time a company has strong traction it is usually past the angel funding stage (indeed strong traction and revenue are usually the final two pieces a startup needs to prove before they can raise VC funding). What you are ideally looking for at the angel stage is not strong traction and revenue, but proof of drivers and, ideally, better than linear early month-on-month growth that provides strong evidence to support rapid growth and strong traction down the line. Two of the most important drivers are the cost of acquisition and the lifetime value of customers. If a company has proved that the latter is higher than the former, it’s a great time to invest.  Doug Scott focuses on finding companies that have impressive early traction and you can participate in these investments by joining his angel syndicate.

Competition:  Be wary of any startup that says it has no competition, as there is always competition of some form. For Zzish the main competition is developers wanting to build all their technology in-house themselves.  Fundamentally, the “competition” is all the other companies who are trying to fulfil the same needs of your customers and/or competing for your customer’s limited funds. Having competition is actually a good thing, as it shows there is a market and that customers have the propensity to spend. What you are really most interested in is what the startup’s “unfair advantage” is, what will allow them to beat the competition or at least carve out a profitable niche in the market.

Exit strategy:  This is often overlooked by new angels, but you won’t make any money unless the company you invest in “exits”, either by being bought by another company or by floating on a stock market. What is the planned time frame? Who are the likely buyers?  What is your company’s likely valuation? What is the exit multiple?  Sales to traditional established companies in a sector are not likely to deliver a high multiple as these companies often look at contribution to the bottom line when valuing acquisitions. The highest multiples are obtained when a company exits to a tech giant such as Google, Facebook, Apple or Microsoft, particularly when these giants enter into a bidding war to obtain the company for strategic purposes.  Perhaps, critically, steer well clear of founders who are creating “lifestyle businesses”, businesses where the founders have no real desire to grow big and their main goal is to create a business that supports a good salary and comfortable lifestyle. These businesses may never exit.

 

Strategy 3: Thematic investing

Some of the bigger VCs focus on a handful of key themes at any one time. Ten years ago, investing in Social Networks and Mobile Advertising companies were key areas of focus.  Today Artificial Intelligence and the Internet of Things are popular. The theory here is that these areas are where the next big “unicorns” are going to inevitably emerge and that the big tech giants will be proactive acquirers of many companies in the space.   Google, for example, has already made big, high multiple acquisitions in both these two spaces (AI and IoT) with their acquisitions of DeepMind and Nest. Virtual Reality is another key area of opportunity with Facebook acquiring Oculus Rift not too long ago.

One thing to bear in mind here is an empirical rule that I recall from the Technology Entrepreneurship course that I studied on my MBA at London Business School. The rule is that it takes 30 years from when a new technology is first demonstrated in the research labs until companies exploiting that technology start that are commercially successful. Moreover, halfway through that period, after 15 years, there is always a first wave of companies that launch and subsequently fail.  When I finished my research fellowship in Japan in 1996, I was due to start work back in England at a spin out from the leading VR company of the day, W Industries, founded by Jonathan Waldern. His PhD from 1985-1990 was groundbreaking and my first experience of VR in the London Trocadero back in 1994 was with one of his machines. Sadly, the day before I was due to fly back from Tokyo, W Industries went bankrupt. It’s taken nearly 20 years for VR to return to the mainstream and 1985-2015 is spot on on the 30-year rule.  So be careful not to get caught-up in the exuberance of the first wave!

Paul Werbos published his seminal thesis on neural networks in 1974, so arguably AI is behind the norm and coming up to 40 years now! However, Horizons Ventures, who have been a pioneer in thematic investing, has had a focus on AI for many years already. They invested in and exited Siri, now part of everyone’s favourite mobile phone. AI is indeed a hot space and tech accelerator Entrepreneurs First is focusing this year on taking fresh AI PhD grads and matching them with more experienced commercial founders to launch new ventures.  So perhaps that’s a good place to start looking for investments if you go down the route of thematic investing.

 

Summary

Picking the winners is not easy and even the experts get it wrong half the time. So the key here is to build a portfolio of investments and to expect half to fail. The good news is that if you invest smartly, then for every ten startups in which you make an angel investment, one should make it big and the return more than make up for those that fail.
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This is the article made by Charles Wiles in his LinkedIn Blog. We provide this article for informational purposes only. All rights reserved by the author: Charles Wiles. You can find the original text here.