The Back of the Napkin

6 minutes, 5 links


Updated August 29, 2023
Angel Investing

You’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.

As an angel investor, you will see some really early companies and have a chance to be the first money in. But there is a huge range in the how far along these companies will be as they raise their first outside investment so before we talk about the angel’s investment process, it is worth a brief discussion about what expectations you should have.

Years ago, when it was expensive to build websites and set up servers in data centers to host a website and license layers of software, founders who didn’t have deep pockets themselves (or rich uncles) had to raise money on little more than an idea and a business plan. If you were creating a physical product, you needed significant cash for molds and prototyping. That was then.

The environment has improved dramatically in this regard. Startups don’t have to buy servers and rack space in data centers now, they rent servers by the hour from Amazon Web Services or Microsoft’s Azure. There are many existing software services that can be leveraged to create a software prototype, including drag-and-drop website builders and mobile app prototypers. There are dozens if not hundreds of low-cost offshore app development companies that can build version-1 products. In the physical product space, one can buy desktop laser cutters and 3D printers. There are simple computers like Arduino and Raspberry Pi that are designed to be embedded in hardware as controllers. It’s a golden age for innovation!*

All that said, how far an entrepreneurial team can get before needing to raise money depends on what they are doing. The more fundamental a company’s innovation is, the more money it may take to get to a working prototype or functional product. Artificial intelligence is a hot investment area, for example, but it can take a lot of processing power to develop and test and train new algorithms. The last AI startup that Pete worked at was spending sometimes over $100K a month on cloud processing costs to support its customers and development! Quantum computing is another example of an extremely expensive industry. Rivian, the electric vehicle startup that built a completely new and innovative electric vehicle platform, raised $1.3B without a product to take to market.

founderHowever far along a company’s product is, the team should be following Lean Startup principles. Lean Startup had its origins in Steve Blank and Bob Dorf’s book, The Startup Owner’s Manual, and was then popularized in Eric Ries’ The Lean Startup. (Here is a quick primer.) The basic idea is that startups are a series of experiments and need to be managed very differently than more mature businesses; and most importantly, that before you build anything, you should be validating every iteration of the idea with potential customers—even if it is drawing on the back of a napkin. This process is called customer discovery or customer development. So at a minimum, even if the entrepreneurial team has not written a line of code or printed their first plastic widget, they should have done dozens, ideally hundreds, of potential customer interviews. (There is even a book called Lean Customer Development you can check out.)

So in short, given the time, entrepreneurs should be able to make quite a bit of progress in terms of understanding and gathering data around whether customers really want this product or service, and building a prototype or MVP before they need to raise money. Again, exclusions apply, but this context will be helpful if you run into one of those exclusions.

Not all startups you meet will be at this MVP stage. Entrepreneurs who are just getting started on their idea may approach you for advice on when they should start raising money. Wise entrepreneurs may start meeting casually with angels long before they need to raise money in order to build those relationships for when the time comes. Investing in very early-stage companies (that have no paying customers) is a bit like speed dating. You are betting on the entrepreneur him or herself almost exclusively, with very little else to go on. You have to be passionate about the idea, ideally know a lot about the industry, and really click with the entrepreneur.

At the other end of the spectrum, you may be approached by companies that have been around for years, are on their third or fourth generation product, have dozens or hundreds of customers or hundreds of thousands of consumer users. You will see companies raising their first external round who have self-funded for years because the founders had prior exits or other resources that allowed them to pursue their idea. You will also see entrepreneurs who need the validation and external money to be able to quit their day jobs and engage full-time in their startups.

Finally, as an angel investor, you will see deals where the company has a sizable team and has raised several rounds of investment prior to pitching to you. These opportunities often have higher pre-money valuations and can require more due diligence, but they can be great investments too if they have executed on the prior money and decreased a lot of the risks.

As an investor, you will find your comfort zone, whether that is getting in very early when there are the biggest risks and biggest rewards, or waiting until there is more evidence of potential success.

The Investment Process Flow

Below, we will walk through what an idealized process looks like when an angel group is investing in a preferred stock funding round. (We discuss the types of financings and the relevant terms in Part III, but you don’t need to know all those details now.)

A preferred stock round is usually closed in one or more coordinated “closings” when, after months of pitching, due diligence, and negotiation, the formal documents for all investors are signed and the funds delivered to the company at the same time. At that point the entrepreneur and team pop a bottle of champagne and collapse in exhaustion.

In contrast, convertible note rounds are often much simpler than priced rounds, and the process is typically much faster. The time between first meeting with an angel and the writing of the check can be as little as a couple of weeks (or even less). If the company is raising a large round through convertible notes, say $500K, and is pitching to angel groups, then the process will look much more like the process outlined here:

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