Due diligence for angel investors.
90% of angels don't do this right.
As angel investor, it’s a lot about managing excitement. In a first step, we assess the deck and if we catch fire, we continue to have a first call with the founders. From our experience, this is where the process starts to deviate quite a lot between angel investors and VCs. While angels mostly have a less structured process due to time or resource constraints, VCs only start to get going at this moment, kicking off their investment process and due diligence (DD).
However, we realized that having an investment process and DD is also extremely helpful for angels. In the end, it’s all about improving decision-making in an environment of high uncertainty.
This is why we created our own short and efficient DD process for angels.
Step 1: Writing an Investment Memo
We started to do basic Due Diligence along our Investment Memo. This helps us to structure our thoughts and challenge our conviction. At this point, we are excited to join the startup’s mission. So we try to find if there are any hidden facts that we did not see right away after “falling in love”.
After or during the first personal meeting, we start to assemble our investment memo and collect all necessary information from the founders. In addition, we like to work together with the founders on this process. Here we also assess soft factors like response times and the way they provide the documents to establish a better feeling for the case.
The structure of the Investment Memo reflects our thoughts on:
The Company
Team
Product
USP
Business model
Go-To-Market
Porters Five Forces
The Fundraising
Financials
Fundraising Roadmap
Cap table
The Investment Profile
Hypotheses
Return Profile
The Deal
Characteristics
Strength/Weaknesses
Terms
Risks
Here we normally need additional input from the founders, so we start to ask for documents that are normally not supplied right away.
Are you interested in our Investment Memo Template?
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Data Room or No Data Room?
We almost never deep dive into provided data rooms, even if they are provided in an accessible form on Notion, for example. Instead, we discuss the case internally and raise questions. To answer these questions, we look for answers, ideally by diving into the respective documents. Not having a data room is also very common for early-stage startups from our perspective. Nevertheless, we would advise all founders to prepare all documents for a potential due diligence before the fundraising.
From a founder’s perspective, this is actually also a chance to use a killer ability during their fundraising: Engagement with investors. Instead of shooting over all kind of documents that are actually not requested yet, they should ask what documents would help them to build conviction or what they need to answer open questions. This enables a deeper conversation from both sides.
In fact, data rooms have also a significant potential to bring interesting conversations to an end. Mark Suster wrote an interesting article, why data rooms should be abandoned for early-stage startups. He argues that startups should always trade data for engagement and try to make it as personal as possible.
Step 2: Fill In The Gaps - What Documents We Look At
We don’t want much, just the absolute essentials. But we also often see that a lot of angels are actually not looking into these documents. So we advise every angel to do some basic DD. Here is what we are normally looking at:
Business case or financial model to test hypotheses
Look into the mechanics, not the absolute numbers. We always try to understand what drives the key assumptions of the business - especially, how the marketing funnel works, what drives revenue, and what the cost breakdown looks like over a 3-5 year time window.
Here, we also try to challenge the founders and discuss changes in hypothesis (e.g. what happens if the marketing budget is doubled?).
If we look into absolute numbers, we basically do a reality check to see if their assumptions are running in a realistic direction. If founders overexaggerate (e.g. €100M ARR after 5 years), we would potentially see this a yellow flag. Especially, if other business assumptions are also built upon this.
In addition, we need to understand their future capital requirements and their planned runway (e.g. bank balance development over time). This helps to get a better feeling for the following fundraising round, which normally is extremely important for us, as we build some part of our strategy on VC follow-on rounds.
Interestingly, we also take a closer look at the planned payroll structure and what the salaries of the founders will look like. High salaries early on are always a yellow, maybe even red flag for us.
If you are looking for a template, how a good business case should be built for a SaaS startup, look into the best-practice template of Christoph Janz.
Balanced cap table
Here we look into the history of what happened before. How are the shares distributed among the founders? How much dilution did they incur in their former rounds. If there was a prior fundraising round, we would regard a dilution of 10-20% as acceptable from our perspective.
For us, it’s very interesting to understand how much money went into the company already and who invested what amounts. Especially, also the share classes are interesting to dive into and see their right structure (e.g. liquidation preferences). In general, we look for a balanced cap table among both the founders and the investors. For example, if 1 of 3 founders is holding 80% of the founding shares would potentially raise some additional questions. The same holds true for the investors, if there is a specific angel or strategic investor already has the majority among the investor shares.
Also, the fully diluted cap table including VSOP and other options is important to see. Of course, we distinguish between option pool and assigned options, to get the full picture.
Simple legal structure
We try to keep it short on the legal side, but of course we need to check the SHA, if existing already or if in draft mode. What’s most interesting here is what happened in prior fundraising rounds. Especially, this means any terms with regard to valuation, total investment amount, share rights, etc.
💪 A complete deep dive into our view on SHA would go beyond the scope of this article, so feel free to subscribe to receive updates on our upcoming legal series at startup investments.
Next to the SHA, we skim other legal documents that are helping to understand yellow flags. For example, if one founder is incentivized only by VSOP, we would take a deeper look into the options plan.
As a soft factor, we also look into the level of legal experience of the founders. At early-stage startups we like to see plain vanilla legal settings. If founders pile up legal complications, it’s normally an indicator that they are influenced by some lawyers and don’t bring a lot of legal expertise to the table.
Complementary team
If possible, we try to meet all founders, but not necessarily request this. Often we see it as a sign of inexperience, if the whole team is present in initial investor calls (instead of the CEO/responsible founder only).
If we meet the founder (virtually), we try to get a feeling for the chemistry within the team. How do they share talking time? Do they interrupt each other? Are they complementary in their skill set?
Even if we don’t meet them, we still try to understand the founder’s background and their potential motivation to founding in general and building the startup at hand.
Teams that are too large and solo founders and not a red flag, but need additional explanations and other aspects covering for them.
Relevant deep dives
In addition, of course, we look into other forms of deep dives, if applicable. We would advise founders to prepare documents for every applicable category to quickly share the requested documents (or stack up a data room).
Especially, we want to see:
Cohort analysis
Product (e.g. roadmap)
Competitors review
Marketing funnel analysis (CAC)
As we look for anything to support or challenge our conviction, there is no benchmarking while looking into these documents, but rather building a comprehensive picture of the company.
Step 3: (Our Secret Weapon) Building a Risk/Return Profile
Last but not least, we try to understand the potential development of risk and return. Here we apply one of our secret sauces: Our Risk/Return Calculator. This helps us to create or challenge some of our core assumptions:
Risk factors (risk of total failure)
Potential exit value
Number of fundraising rounds and dilution to get to exit
Time to get to exit
In the end, we get a more compelling image about Expected Returns (adjusted for risk), true Multiples (including future dilution), and IRR (to account for time-value of money).
If you want our Investment Memo Template or our Risk/Return Calculator, feel free to join our closed AngelCrew Community. It’s not just about tools, tips and opinions, but we also share our deal flow there!