Due Diligence is often seen as not possible or relevant for an early-stage investment. Yet most business angels lose money on the majority of their investments

So, can due diligence help?

Many business angels comment that “they are taking a punt”, comforted that they are only risking a small proportion of their own capital, and encouraged by the tax credits they will receive, so do they have to do due diligence?

Equally, many business angels have also enjoyed significant success and trust their own gut feel as the barometer of an investment. Yet Nesta tells us (in their 2009 report on business angels) that “even a small amount of due diligence significantly reduces failure”.

Okay, it is true that Angel Investors are often investing money they can afford to lose – but will still experience any combination of anger, disappointment and remorse when that loss is incurred. Is that worth it? 

And there are plenty of examples of Angel Investors following their “gut feel” without exploring and rationalising the causes of these feelings – something that can be an illuminating process for both the angel and the potential investee business.

Whilst Angel Investment will always be a high risk activity, there are due diligence steps that can be taken to significantly increase the chances of success.

How to increase chance of success for early-stage investments

Due Diligence can (and should) be performed on an early-stage investment, focussing on the following areas:

1. The Market Opportunity:
   Market size, product position and pricing
   What is the value to the customer?

 

2. The Management Team:
   What are their competencies?
   What are their strengths?
   What are their personal expectations?
   Where are the gaps – and how easily can these be filled?

 

3. What is the structure for delivering the Business Plan?
   Are the best sales channels being used?
   What are the key risks in the supply chain?

 

4. What are the expectations of investors?
   How may value be realised for investors?

 

Working through these four questions provides structure, balance and focus to the investment process.

It also provides a much greater likelihood that the expectations of the Management Team and the investors are realistic – and aligned.  This means that the relationship between the investors and the executive team are much more likely to be friendly and to work in a cooperative and successful manner.

In my experience, the above process works best if it is seen as a collaborative, rather than confrontational, exercise.

So, bite the bullet, do the due diligence. you know it makes sense.

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Chilcomb helps investors and early-stage businesses through this due diligence process. Chilcomb’s Investor Checklist provides a robust structure to increase the chances of a successful investment.  To find out more, go to our website (www.chilcomb.com) or contact Matthew Dreaper.
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Many are successful, some very successful.

However, does that mean that they will always pick a good investment? No…

A shocking fact buried deep in the Nesta report about business angel investors (Siding with the angels, 2009) declared that the number of successful exits reduced when business angels became active investors.

Yes, that’s right, the conclusion is that angel investors and entrepreneurs do better when the business angels remain the investors who look after and care for their investment – as a non-exec director or with an observer role. They do less well when they become an executive with day to day responsibilities.

How can this be true?

Surely, you might think, a talented team with a talented Business Angel investor who is involved day to day, is more likely to succeed than a team in which the investor takes a back seat?

Indeed. It is possible of course, that the investments in which the Business Angel typically gets involved are weaker – and that is why he feels the need to jump in.

But, regardless, the business failure is largely due to the T-problem – that is the Team.

You see, it isn’t enough to have talented individuals (as anyone who witnesses England at the football World Cup will know), you must have a team that fits together.

And, the temptation of the Business Angel to ‘get involved’ in the team should be avoided. The statistics tell us that he would be better to find a better investment or send back the entrepreneurs to build a stronger team themselves.

So how do you assess the team?

Which begs the question, how do you build a better team? In fact, how do you assess the team you’ve already got to know whether or not it is a strong team?

This is a very tough question. If it was a matter of potential market share – we could look to a specialist who can assess market potential, or establish IP or Patent rights. If it were a matter of money, we would go to a corporate finance expert and ask their opinion. But team? Who do we ask and where do we go?

My gut feeling

Beyond a few ‘after the event’ actions – such as credit checks and references, most investors rely on their gut feeling. Beyond, ‘met the guy(s), like them’, what more do we do?

Well, over the years, very experienced and successful VCs have built up an instinct, a gut feeling.

However, if you are not a very experienced VC (perhaps just a business angel of a few years experience or a successful entrepreneur rather than a 30 year experienced expert in early stage business) then what do you do? Well, you could rely on other people’s experience, but apart from that?

That’s why the new Executive Team Tool (eTeamTool) offers an interesting and sensible alternative to guessing about the management team. (The eTeamTool has is a MediaModo LLP product, who also own www.iBusinessAngel.com).

This tool uses 6 attributes to test each executive team manager and then allows the user to plot each executives results on the same map to show overlap, duplication or the degree to which the team is complementary.

And, the interesting thing is that it doesn’t depend on the skills, but rather it assesses the key attributes that VCs look for. This means that your executive team shouldn’t be built based on skill bases – such as an IT person, a marketer or finance person. For early stage and fast growth companies, these skills can be bought in.

Instead, the composition of the team should ensure that all the key attributes are present – that is, an ability to focus and understand the core market plus the willingness to be open to ideas, advice and react to market behaviour. Lastly, the team needs to be led by someone with charisma and the ability to set a vision and persuade others to work to that vision – even though they might be be paid better by other companies.

The critical thing here, is to put skills to one side and ask yourself the question, can this team bring in what ever skills are (or may become) necessary to make the business a success?

Remember also, that the current hot product won’t always be. Instead, the business needs to develop a constant stream of invention and new product development. Can this team do it?

In otherwords, we are asking, does the executive team have the necessary leadership to see the business to profit and success?

This is the most important question for angel investors and entrepreneurs too. This is the big T or team problem that successful angel investors need to resolve for each and every investment.

Business angels usually don't have money to burn

You’re wealthy and you’re ready to invest large sums of money to make a decent return – so where do you invest your cash in 2010? Should you invest in a start-up business? Is angel investing right for you?

Property’s still looking a bit shaky, the stock market looks like it will continue to take a beating every time there’s a whiff of bad news coming from Europe or the US. Then there’s gold which until recent years has offered little to get excited about when it comes to a good return on investment.

So how about having a go at business angel investing?  Start-up businesses are apparently desperate for capital. Risk-averse banks are setting the bar too high on their lending criteria according to Vince Cable.

At this point I’ll stop…

A common misconception about business angels is that they are wealthy, the kind of wealthy that means they’ve got money to burn. They’re ready to invest large sums of cash in a promising idea, and if it doesn’t float, well it doesn’t matter nothing ventured, nothing gained. Perhaps TV shows like Dragons Den help create this image of the business angel, but in the real world it isn’t quite like that.

Business angels are unlikely to be sitting around surrounded by wads of cash whilst deciding whether or not to invest in a business. While it is important that you are prepared to invest a decent amount in a fledgling business this can be as little as £10,000, and, typically investments are often around the 25,000 mark. You really shouldn’t risk it if you cannot afford to take the very real risk that you might lose all of this money

So anyone can become an angel investor as long as they can afford to invest the sums mentioned above and take a hit if it doesn’t work out. But while anyone can become a business angel, angel investing is not for everyone.

The journey for a start-up business is far more volatile than a nice maturing property investment. It is true rewards can be much higher of course, and the journey exciting – assuming you back the right horse. But there is no guarantee and the odds will be stacked against making a return on your investment.

So as long as you have the stomach for failure, where even the most seasoned business angels can get it wrong sometimes, becoming a business angel may well be for you.

You can either go it alone or join a network. If you choose to go it alone, contacts in the business and experience in the type of the business you choose to invest in are invaluable. That way you will have a better grasp of the potential value and the amount of money it is sensible to invest. If your business knowledge is not up to scratch you could easily be misled by an excitable entrepreneur who believes that his or her idea is a sure bet that simply cannot fail.

The most successful business angels are the one’s prepared to be hands-on; Thomas Edison once said “Opportunity is missed by most people because it is dressed in overalls and looks like work”. So if you are prepared to get to work and help with your experience in the business you invest in then your investment is more likely to succeed.

Still fancy having a go?

Before you begin it is vital that you do your due-diligence. Start with obtaining legal advice to assess for assessing documentation and drawing up agreements. Get this wrong and things could get messy. If you are unsure, consider joining a network of business angels who can offer you some valuable advice before you begin as well as sharing any losses if a business fails to take off. But going it alone means you get to keep a greater share of the profit if the business is successful come exit time.

Remember keep in mind that as with any form of investment, it is important to be patient and wait for the right opportunity, it can take a long time to find an investment opportunity you are comfortable with. Be prepared to make a commitment of around three years by which time you can hopefully (there are no guarantees) exit with a nice profit.

Where Business Angels Fear to Tread?

Investors in early stage and start-up businesses are known as angel investors. The tag ‘angel’ coming from their tendency to operate in the margins where venture capitalists, banks and other backers choose not to go.

They also help plug a major funding gap to get such ventures off the ground and they happen to be the kind of investors who are prepared to take a risk, rely on their instincts and invest large sums without too many hard questions asked.

At least this is the accepted view.

But we may well be seeing a new breed of business angel emerge, one that takes a more conservative approach in these risk averse times.

Times, as Bob Dylan once sang, are a-changing as we see a trend emerging both in the UK and the US for a more cautious approach to investing in embryonic stage businesses. With many investors’ fingers burnt by the financial crisis it is hardly surprising that the appetite for risk remains limited – which in turn is making it increasingly harder for start-up businesses to attract funding.

According to the latest NESTA report on business angel activity in the UK, 83 per cent of angel investments were made with co-investors and a significant proportion (28 per cent) were made within just 50 kilometres of home. Working close to home and in the company of fellow investors shows that most business angels need security like anyone else and are careful where they put their money. The figures debunk any myths suggesting otherwise.

This is further borne out by statistics released in the US where an article this month in BusinessWeek suggests angel investors are getting pickier based on their analysis of data supplied by Angelsoft, an internet based company supplying online tools to angel investors.

The study looks at the share of companies seeking angel funds passing through each stage of the ‘deal funnel’ between 2007-2009. Not surprisingly, given the economic climate in the past two years, a glance at the chart reveals a dramatic decline in the number of businesses getting even as far as the screening process between 2007 and 2009. The statistics make worrying reading for anyone hoping for an easy ride when they approach potential investors for their start-up if the pattern is repeated her in the UK. .

More worrying still, just 2.8% of businesses made it as far as the due diligence stage, a fall of more than 50% on 2007/08 figures. This would indicate that angel investors in the US have become, as the article suggests, more ‘picky’.

But is it simply a case of angel investors becoming more picky? The figures reveal that just under half of businesses make it through screening to the due diligence phase, which is a pattern that has been broadly repeated since 2007.

However even though there were around 50% less businesses making it through the deal funnel, when we reach the end of the funnel and to what those business are striving to achieve i.e. investment, the proportion of those businesses making it through the final stages, is shown to be higher in 2009 than in 2007 or 2008, with 2.8% making it to due diligence and 2.1% securing investment.

Herein lies the good news for those businesses who sought funding. The proportion of businesses receiving funding in 2009 compared to 2008 suggests that if a business made it to the due diligence stage, there was a significantly better chance of securing investment.

The small percentage of businesses that made it through screening and the presentation phase also stood a greater chance of making it to the end of the deal funnel. This may suggest that angel investors are indeed becoming more choosy, but it could well be more a case of less money in the angel investor’s pot making it tougher to get past this initial screening process.

We know that more than half of investments fail; therefore it doesn’t take a great leap of the imagination to conclude that angel investors are willing to take fewer risks than they once were. This will be bad news for many start-ups and there will be many innovative businesses that fail to get a vital injection of capital. The number of businesses that have slipped through the net since 2007 is anyone’s guess.

It isn’t all bad news, according to the figures in the US business angels are choosing to invest in a greater proportion of those businesses that make it through screening. But we may be seeing that even business angels have their limits.

Business angels often find it easier to work in teams.

We have already established that angel investing is a risky business but one with potentially high rewards. So is it better to go it alone? Or seek the company of others?

It is more often the case these days that angel investing is best pursued as a  team activity. While they still exist, the lone business angel poring over opportunities to ride to the rescue of the startup seeking that vital injection of start-up capital is becoming an endangered species, more an exception than the rule, but why is this so? Why do business angels increasingly work as part of a team?

While the high risk nature of angel investing is one significant factor there are also others to consider. It is true that angel investing is not an entirely altruistic activity (despite what many angel investors might tell you). While it may be satisfying to help nurture a fledgling business to growth and profitabilty, the main aim is to make money and lots of it when it comes to exit time.

With the odds stacked against a successful outcome, by working with other investors you can spread the risk and avoid sinking your hard earned cash into one single business which may, as statistics often show, fail and leave you with a loss.

But there are always those who prefer to go it alone and try their luck, after all if you believe the business you invest in has every chance of success and it’s in an area you’re familiar with, then why not?  You are able to help shape the direction of the business and for those with an entrepreneurial background this can be a way to re-live the excitement of starting up and hopefully watching a business grow thanks to your experienced input and investment.

Going it alone as a business angel means more direct involvement and greater access to the business you invest in. Working with a team of investors or a network often means a portfolio approach where a number of businesses and investors will be working together but in a less hands-on way. Therefore, on the one hand you are able to spread risk as part of a network, but the downside is you will also be sharing any profits and spending less time on individual businesses.

The main advantage of not having a business angel network in the middle is that you won’t need to pay the usual 5% of the sum invested as a fee and granting options to the network which would eat into any future success. Networks also have the incentive to increase the sum raised – so that they earn a larger percentage.

But despite the attractions of going it alone which also includes not having to work with other investors or share profits if the business is successful, weighing the pros and cons between being part of a team and going it alone,  it becomes easy to see why the chances of successful outcomes are greater when working alongside other business angels as a member of a group or network.

And there are plenty of business angel groups out there in the UK. For the less experienced business angels, these can be excellent starting points where experience and knowledge can be shared. There are a number of established angel networks in the UK, often regional, which meet regularly to discuss strategy and share experience and they can also provide opportunities to network with other investors with varying levels of experience.

You will often hear that the great advantage of being part of a business angel network is the chance to tap into deal flows. However, you can still find them, depending on the size and effectiveness of your network or you can even gain access through online business networking sites like Linkedin, but the effort of due diligence and supporting the business is high – especially if you are alone,  therefore, although you may find the deal, it is still better to get a team involved.

Networks can provide a ready supply of angel investment opportunities numbering in the hundreds or even thousands. The process is organised and unsuitable businesses are filtered out at an early stage with the help of video presentations, saving the time and effort usually required to find the best deals out there.

The responsibility for due diligence still lies with the investors themselves but this is one area worth spending a lot of time on. You also benefit from the variety of expertise and experience offered by your fellow investors. Due diligence can be complicated, so by dividing work among its members a network can offer a more complete understanding of a business when knowledge can be pooled.

Being part of a network can only lead to better investment decisions overall and those businesses seeking investment can also benefit from having access to broader knowledge. Angel investing is not for the faint hearted but there is relative safety in numbers!