In my previous post, I talked about how angel investors find and screen potential investments. In this post, I'm going to discuss what happens after the screening process is over.
Being Able to Invest in Great Companies
It might come to a surprise, but investors often have to convince companies to take their money. "How could this be?" you ask? It turns out that startups often polarize investors: either nobody wants to invest, or everybody does. The second case is interesting because companies that are universally appealing are offered much more capital than they want to take.
To make the discussion more concrete, let's assume there's a startup called Werner that has created a product that removes some of the uncertainties of online dating. This product, known as Heisenberg, will either tell you whether someone will be a good match for you or whether they're likely to be interested in you — though unfortunately the product is not sufficiently sophisticated to predict both things at once. Werner wants to raise $500k in exchange for 20% of the company. The startup has an awesome team of founders, a working product, and is already getting good traction from the press and great reviews from its early users. Unsurprisingly, angel investors are lining up to invest. In fact, various angels have offered a total of $1m, which is far more cash than Werner needs at this time. Here are some common ways of resolving this situation:
- The company sells more equity and takes more money. For example, Werner might take the $1m on the table in exchange for 40% of the company. This allows more investors to invest, but it's not ideal for the company and its founders because they are giving up equity that they do not need to give up. Shares of a company translate into more decision-making power now and more money later, and there's no sense in giving that up for cash investments that may not be necessary.
- The company sells less equity for the same price, or the same amount of equity for a higher price. For example, instead of asking for $500k for 20% of the company, Werner might change the terms to $750k for 20% of the company. Alternatively, it might offer the most desired investors 15% of the company for $500k, then let the second tier investors acquire the remaining 5% for $250k. This can create some resentment on the investor side. It's akin to going out to buy a Prius, deciding you want to pony up the $30k, then being told that the price just went up to $45k because the demand was higher than expected. The Prius might still be a good at the higher price, but the buyer will probably grumble and possibly walk away.
- The company selects which investors it wants to take money from. The best option is often for the company to pick the investors that offer it the most value. This works well for the company and works well for the "better" investors. It doesn't work as well for investors that don't have a lot of value to add, but alas that is how marketplaces work (the weaker participants either figure out how to get stronger or they get out of the market).
What does it mean that an investor can "offer the most value"? Here are some of the possibilities:
- The investor has a great image. For example, if you're working on a movie-related startup and you manage to get Steven Spielberg as an investor, that's huge! Even if Mr. Spielberg writes you a check and never talks to you, having his name associated with your company helps you get press, helps you raise further investments, gets your foot into more doors, and so on.
- The investor has a lot of domain expertise. For example, if you're building Facebook, getting help from people who built MySpace or Friendster could be very valuable.
- The investor has useful connections. These might be connections in the press, connections to bigger investors and venture capitalists (when you find yourself needing to raise more money), connections to companies (especially if your startup sells something to other companies instead of to individual consumers), connections to influential people in your domain, and so on.
- The investor was previously a great product manager, a finance whiz, an outstanding software engineer, etc. If product management or finance or software are a big part of your business plan, then getting expert advice in those areas — especially the ones you are weakest in — can be immensely helpful.
What Happens After the Investment?
Alright, you talked to a bunch of promising startups, narrowed down the long list to the few that you would like to invest in, and demonstrated to those startups that having you on their side would be a great asset. You've wired over a bunch of money, and then… and then what?
This phase of the investment cycle is actually very straightforward. At this point, the startup wants to succeed, and since you paid to own a small piece of the company, you really want them to succeed too. After all, if you own 3% of this $3m company, then wouldn't it be great if the company's value skyrocketed to $500m in a few years? Yes, yes it would. So what an investor should do at this stage is whatever they can do help the company succeed. This comes back to value-adds I just mentioned: you introduce the founders to useful connections, you give them advice on how to approach problems they face, you share your experiences with them so that they don't make mistakes, you ask them for progress reports every month or two to help them stay disciplined and on track, and you generally do whatever you can think of to do be helpful.
To give some concrete examples, I've been a software engineer for almost 10 years and some of the ways in which I've tried to help have been doing software design meetings, feature brainstorming, UI feedback, and algorithm design. I co-invest with several partners, and they bring their own strengths to the table. For example, one of my partners, Seth, has great connections among retailers and large brands, and that's huge for startups whose products cater to the retail space. Seth can often help those startups get some of their first customers and clients.
To summarize, what angel investors actually do is talk to tons of startup founders, decide which startups are the most promising, invest in those startups (which often requires competing with other investors), and then do whatever they can to help their investments grow and succeed.