Insights and Opinions

Screening for Success

There must be a better way. I've been an angel investor for more than 10 years now; clobbered by the Internet Bubble and now this. If I claimed I'd lost 40% of my net worth no one would be surprised, I'd be in good company. To heck with giving back and doing the right thing! If I'm such a smart guy why can't I make any money at angel investing? I suspect there are fundamental problems with the way I've been going about it. Pain to this degree is motivating; I'm ready to rethink my approach. Sacred cows are too expensive; I'm taking a fresh look at the successes and failures in my early stage portfolio.

Ian Sobieski of the Band of Angels says that M&A buyouts of angel-backed companies only gets us to a breakeven point; big gains only happen with IPOs. Fools Gold author Scott Shane suggests that if angels want more IPO exits then they should invest in the kinds of companies that typically go public. What kind of companies are these? Although we haven't seen many lately, it's easy to describe what they're not. Palomar Ventures' Randy Lunn says that successful investing is all about finding the companies that can scale. The way I put it, we want companies that can achieve rapid adoption in very large markets. Let me suggest some that might be better suited to an IPO and those that aren't.

Research VP John Taylor at the National Venture Capital Association says IPOs are often companies that are easy to explain and simple in their approach, product or technology. We've all heard plenty of complex and esoteric pitches, let's avoid these.

I fondly remember Luis Villalobos' quip after one presentation last year, calling it ‘rust bucket' technology. Although screening these odd balls adds to a stimulating meeting, these rust buckets aren't likely leveraging the internet and cannot achieve rapid adoption.

Speaking of leveraging the internet, is there a better way to describe the potential for rapid adoption? Software, saas and e-tailing all offer scale possibilities.

“Consumer products scare me,” says Tech Coast Angel Frank Singer. Let's take him at his word and save ourselves some money. They're too expensive to market. I recommend we avoid things where everyone is a potential customer; we'll go broke trying to pitch to such big markets.

Avoid the Education, Law Enforcement and other quasi-governmental markets. These all have long sales cycles; even if they love your product it's going in next year's budget. These are the epitome of what rapid adoption isn't. Likewise, isn't it time you tallied up all those deals that promised riches due to regulatory edicts that would compel people to stand in line to buy their product? On my scorecard these Sarbanes Oxley and Food Safety regulations seldom create commercial winners. Cyber-Rain comes to mind here.

Have you noticed? Many deals come to us with a promising technology and a few customers, now they need money for ‘business development'. Success shouldn't be so hard. What's the likelihood that this techy CEO will know how to hire and manage an effective sales manager? Let's look for companies where we know the dogs are already eating the dog food.

What's left? Software, saas, and anything that can be sold over the web without a direct sales force. Netbooks look poised to deliver ubiquitous computing. What opportunities await? Which companies can make money while they sleep?

David Verrill, founder of the Hub Angels says he's working a new angle. If he and his group can't fund 18 months worth of burn rate then he's not going to do the deal. Let's take a page from his book and be extra alert; are we adequately funding these latest startups? It's trendy to do small deals right now, but are we setting ourselves up for more poor results? Beware out of balance “Needed vs. Got” funding ratios.

While we're throwing the baby out with the bath water let's watch out for knee-jerk reactions. I've heard so much talk about a new style of angel investing, one that doesn't presuppose a venture capital follow-on round. Instead we'll focus on deals angels can fund with just one or two small rounds then exit at $40-50Million. Sounds sensible since none of us know when VCs will be back, but let's think this through. At TCA we have a portfolio of over 150 startups funded over the last 11 years; how many of these already fit this new strategy and still aren't exiting. Many more than a few, I'd wager. Montgomery & Company's Kevin Covert says angels don't see more exits because too many of the companies we fund don't grow to the size where an acquirer would think that buying them would ‘move the needle'. So let's take our time and not jump on this new strategy too quickly.

Watch out for the ‘retail models'. We often hear these schemes described as geographic rollouts, “first we'll target LA then Orange County, then San Diego and eventually, with another round of funding, we'll expand to Las Vegas”. Besides Vegas being busted, this strategy works great for Craigslist, but most of these retail business models run out of gas.

We should create new term sheets and let's not waste any time. Angels need more control over their investments and entrepreneurs need better incentives to cash us out. Let's reinvent our screening process and filter out the least likely. In Los Angeles we're drinking from a fire hose when it comes to funding applicant business plans. Let's give some thought to the pay-to-play deals our existing portfolio companies will require this year and estimate our budget for new deals. It's gonna be a lean year, so let's apply the best filters and fine tune our funnel. What deals do we want our members to evaluate? So we don't waste their time and frustrate the entrepreneur. Let's start screening for success.

We're angels; we don't have a big fund behind us. We've got to be smart investors. Educate yourself; read Taleb's Black Swan and Shane's Fools Gold and listen to the leading angels and VCs that appear on my show. Lately I've had a big interest in healthcare and eldercare. We Baby Boomers are going to enjoy long life spans and we'll need lots of money to live comfortably. Few of us have pensions to fall back on, so all this time we're devoting to angel investing had better pay off. We're gonna need it.

>Frank Peters is Chairman Emeritus of Tech Coast Angels, a large angel group in Southern California. He's host of the Frank Peters Show, a podcast dedicated to angel investing and venture capital. Tune in to Frank's new show, After the Cottage, which focuses on the healthcare needs of seniors.