Stretching the truth

23 June 2006

What do angel investors really look for in a start-up - and why won't they believe everything you tell them? Our second special report looks at factors that make or break deals

It's widely assumed among British beer lovers that doctors are primed to compensate for their over-optimistic view on life. If you're asked during a regular check-up how much alcohol you drink, the chances are your GP will double whatever figure you give. It's not necessarily that they assume you're lying - after all, it's your health they're examining - but more the belief that embarrassment and optimism tend to obscure the truth.

It's worth bearing this in mind when you're thinking of approaching an angel investor for funding. Experienced investors will listen to your development timetable and business projections and make two assumptions - first that it will take you longer to get there than you think, and second that your revenues will be lower than forecast.

This was a common theme emerging from investors at last month's First National Women's Angel Colloquium in San Francisco. Organised by the Women's Technology Cluster, the conference delved into the key issues facing investors as they attempt to pick winners from the huge number of business opportunities out there (see our first conference report, 'Risky Business') One of those issues was the whole process investors go through prior to handing over their cash.

To begin with, it's important to bear in mind that this isn't just about financial forecasts. A lot of entrepreneurs think of business plans in the context of spreadsheets, Profit & Loss accounts and cash flow forecasts, but that's not the first thing investors will be looking at. As Laura Roden, managing director of the Angels Forum, points out: 'One common myth is that you need a finance background [to be an angel investor] - it's just not true.' There are really only two important numbers for the investor, she says - what they can buy for, and what they can sell for.

What Roden is looking for is something beyond the 'Believe in Me' pitch - and preferably 'assets'. These won't be physical assets like machinery and equipment, but the intangibles that are critical to business success. She's particularly keen on seeing strong management already in place - in other words, she wants to be able to meet the CEO, not be told that the company's looking for one. Alternatively, there might be assets in marketing - has a prospect said they'll buy your product or service, and if so, can the angel speak to them? Assets might also take the form of intellectual property, patents, prototypes or beta products.

Once you've caught their eye, investors will want to hone in on some of the basics, according to Susan Preston, founder of angel investment group Seraph Capital Forum. Bear in mind that due diligence is time-consuming for everyone involved and can get expensive, so before they go into details investors will want to be sure there's a good chance they'll be able to come to a mutually acceptable deal with you. Some of the decisions they make will be outside your control - whether the deal meets their own investment criteria, for example, and whether they feel they can add value to the company. But there are also fundamental questions that centre on the founders themselves - Preston, for example, bluntly observes that she simply won't invest in a company where the entrepreneur is 'not coachable'.

Preston also warns entrepreneurs not to expect angels or venture capitalists to sign non-disclosure agreements (NDAs) early on. Yes, they accept that you've invested a huge amount of intellectual and physical capital in your product and you want to protect it - but they see too many deals to get into legal formalities straightaway. So the first presentation you give should focus on information that you're happy to have in the public domain: the time to get an NDA out is when you start giving sight of patents and reveal trade secrets.

If they progress further, Preston says investors will fundamentally be looking at five issues during the due diligence process *:

- Quality of management Entrepreneurs should have a proven track record, be passionate about the company, and good at leading a group and building a team. They should also be strong communicators: you should be able to tell your company story in 15 minutes with 10 slides

- The Market This will be an exhaustive study of macro factors such as size and barriers to entry, as well as company-specific issues like the revenue model and customer base

- The Method This includes key factors such as the business model, the value proposition and competitive differentiation

- The Money 'It takes three times as much money to get there as [entrepreneurs] say, and the revenues will be a third of what they say,' warns Preston. As well as looking at specifics like capital requirements and the exit strategy, she's also interested in some of the details of how the money's being spent. She doesn't, for example, want to see the entrepreneur taking a £100,000 salary

- The Numbers This is the point where entrepreneurs need to get out their spreadsheets and make sure that everything adds up, from revenue and cost projections to cash flow

Finally, speakers at the Colloquium raised one more issue that could jeopardise a deal and lies largely beyond entrepreneurs' control - what they feel about the other people who are putting in money. Pointing out that angels can be stuck with their fellow investors for years, several panellists argued that due diligence needs to extend beyond the company to cover everyone else who's digging into their pockets. How well aligned the investment team is will become particularly important if the company runs out of cash and needs a further injection. Mary Jo Potter of the Keiretsu Forum referred to a recent investment where one of the five original backers blocked the others from striking a new investment deal - so she recommends that angels ask other investors upfront if they're prepared to continue to invest beyond the initial phase. It's like a family, added one panellist - and everyone knows families go through ups and downs.

* g2i provides one-to-one sessions and group workshops that take start-ups through the investment process, explaining how investors will look at your business and the kinds of questions they'll ask. For more information, click here

By Keith Rodgers, Webster Buchanan Research