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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
At a minimum, you should get a thorough demo of the company’s product (if it has one). If it is a product that you can use yourself, then use it as much as you can even if you are not the target customer. Is it elegant and effective or confusing and buggy?
It is not uncommon for an entrepreneur to show a very polished demo of their product using a very specific scenario, and it may turn out that the product only works elegantly under quite specific constraints.
exampleLet’s say the startup you’re considering has an app that finds adventure activities for travelers, and the demo shows someone going to Belize looking for a scuba diving trip. The demo shows five options with pricing information, and everything else you’d need to know. Great. Now you should try the app yourself and search for glacier walks in Iceland, rock climbing in Patagonia, whatever you can think of. Are the results just as good?
If the product is live in the marketplace, look for reviews. The Apple app store has reviews, as does the Android Play store. There are review sites for enterprise software as well, though it often takes longer for a startup’s product to show up in those listings. When in doubt, just Google for reviews and often sites you have never heard of will have written about the app or service in question. Reading reviews is a great way to get a sense of whether actual users are happy with the product, where it falls short of expectations, and whether there are real limitations to how well it works.
Hopefully you or someone on your diligence team has the skills to do some technical due diligence. Understand what technology choices they have made and why. How will they scale? If it is a hardware or manufacturing company you are considering investing in, then take a look at their manufacturing and/or prototyping facilities. Venture capitalists often hire technical experts to do thorough technical diligence and talk in depth to the company’s engineering leader(s). If you do not have the requisite technical knowledge on your diligence team, consider asking a friend or colleague with the skills to help you.
It is beyond the scope of this book to do a deep dive on technology due diligence. It is common that the initial implementation of a product is a little rough around the edges because startup teams are trying to build a lot of functionality quickly. That said, in the case of a company with a software product there should be the capability, or at least a clear plan, for user scalability, meaning the ability to support 10X or 100X more users. There is nothing more heartbreaking than seeing a huge surge in demand for the company’s product only to have the application or service collapse under the load. Even if you are not technical you can ask questions like “What will it take to support 10X your current user base?” The wonderful advantage the current startups have over those of years ago is that with modern web services like AWS, the answer in a properly architected system is often just more money.
Depending on the company’s product, there may be many regulatory requirements it needs to meet. That can vary from UL underwriting to HIPAA compliance. If you are staying within a domain you know well, you will likely know the regulatory compliance issues and can gauge the management team based on their approach to them. If you are not familiar with the regulatory compliance issues, make sure someone on your diligence team or perhaps your lawyer can help you.
There are some new compliance issues that have been introduced over the last few years around consumer privacy and the obligations they place on any companies that store consumer data. These include the EU’s General Data Protection Regulation and the California Consumer Privacy Act.
Every pitch deck has a financial projections slide showing that in 3–5 years the company will have millions or tens of millions of dollars in revenue and be profitable. Those projections come from a financial model built on a set of assumptions about growth rates, customer transaction size, customer acquisition costs, attrition rates, and others more specific to the type of business.*
The model and the assumptions will be very specific to the type of business. Especially in B2C businesses, the profitability will be very sensitive to some of those assumptions. Any of the pirate metrics mentioned above will likely have big impacts on profitability. The entrepreneur should be able to defend any critical assumptions in the model by pointing to comparable businesses. For B2B businesses, some of the critical assumptions will be conversion rates in the sales pipeline we mentioned above, attrition rates (how many customers don’t renew their contracts), length of the sales cycle (impacts growth rate and cost of customer acquisition), contract size, and how much revenue a single salesperson can generate.