Due diligence best practices

Frank Peters did a great podcast years ago, Doin’ Due Diligence, which he kindly reposted, summing up best practices in due diligence and viewed by three angel investors with over 100 deals of experience between them. Highly recommended for those new to angel investing or seeking angel financing for the first time.

Frank Peters’ All About Angel Investing

I just shared this email with members of my angel group and I am hopeful it will be of benefit to some of my readers as well…

Dear members, TheFrankPetersShow, the top podcast on angel investing, kindly created a 4-part series on best practices in angel investing. It is an excellent overview with a relaxed, informal style. I thought some of you, especially our newer members, might find this enjoyable:

• Part 1: http://thefrankpetersshow.com/podcasts/mp3_files/FP354-Barach-Phillips.mp3
• Part 2: http://thefrankpetersshow.com/podcasts/mp3_files/FP356-Barach-Phillips.mp3
• Part 3: http://thefrankpetersshow.com/podcasts/mp3_files/FP357-Barach-Phillips.mp3
• Part 4: http://thefrankpetersshow.com/podcasts/mp3_files/FP358-Barach-Payne-Phillips.mp3

EI Concept Competition Video

This semester’s UMass Amherst Entrepreneurship Initiative’s Concept Competition was lively and, for the first time, recorded!

About the finalists:

• Samuel del Pilar of Sneakers for Success
• Brooke Renée of TheCoutureCook.com
• Melanie Black of Yoga With Mel
• Anthony Arena-DeRosa of Social-Lite
• Kevin Morde of Dragonfly Amplification

View video of the competition – pitches, audience Q&A, judge’s feedback, and more (kindly recorded by Hadrien Dykiel)!

Convertible notes: pros and cons

Yesterday I was speaking with an entrepreneur with an exciting company and terms structured as a convertible note. Convertible notes are non-starters for my angel group, as they are for many (though certainly not all) other groups. Why?

Convertible notes have numerous advantages, the biggest being lower legal expenses while dodging the emotionally and intellectually infuriating valuation fight for early-stage companies.

But it is the disadvantages that bother my angels. Some of the biggest being:

• If you look at the internal rate of return from the time of signing the note to when it converts, it is usually dramatically lower than the 60% equity investors are targeting – despite the fact that note investors are usually the ones taking the most risk.
• If the note signers help the company explode between now and the series A, they get the same benefit as if they did nothing to help grow the company. This can be mitigated somewhat by a cap… but only somewhat. In other words, the note does not align investor and entrepreneur interests .
• All old terms are always up for negotiation when new investors bring in new money. But de-facto, my (admittedly anecdotal) queries show that new investors have much more success negotiation down terms from notes than terms from prior equity rounds.

That’s my take.

Here are some others who also dislike convertible notes:

• Xconomy wrote up a detailed piece on reasons why entrepreneurs might want to avoid convertible notes here.
• Don Dodge, a respected member of the Northeast angel community had this to say.
• Basil Peters, a nationally recognized thought-leader in the angel community isn’t a fan either.

If folks know of some people who do like these notes, please let me know so I can fairly link to them. A quick search for me came up empty.

Pre-screening today (11/7)

I find that when entrepreneurs "see how the sausage is made" is helps them design their own documents and presentations to get through the gauntlet. Today I am pre-screening new deals coming into my angel group.

"[CompanyName] is a cloud-based video interviewing platform for employers and job candidates… The Company adds a filter into the hiring process between the resume review and the in-person interview and facilitates targeted, asynchronous (not-live), under-5-minute interviews that employers review at their convenience."

The text they used doesn’t stand out much for me (bad). They included a professionally produced video that is essentially a product demo, category evangelizing, and throws in some credibility by showing some reputable startup folks saying nice things (good). Affiliated with some high-credibility incubators/accelerators (good). There is more than enough credibility here for me to bounce it by a few of the people in my group. Time: 3 minutes. Decision: Bounce by specific people in the angel group.

"Centralized repository for healthcare providers to store, manage, update, comply, and share their licensing and credential documents online… We allow providers the capability to store all of their credentialing paperwork online, while we manage and update their information. Our automated notification system will notify providers of when they have obligations coming due and if their information is about to lapse. We also allow open communication and secure e-document transfer between the provider and their affiliated facility and staffing agency to minimize all party’s risk exposure."

I am not an expert on this space, but their story about the problem and their solution sounds credible (good). Market seems large enough, even though it is only implied by the text (good). I don’t have many people with the right expertise (bad). Time: 30 seconds. Decision: Bounce by specific people in the angel group

"[CompanyName] is developing [chemical] a patented oral nonpsychotropic synthetic THC derivative for the treatment of life threatening scleroderma… [CompanyName] is leveraging $20M in prior investment in [chemical] and $400K in prior angel/founder financing to develop [chemical] for a scleroderma (SSc), a life threatening disease. As a result of expected fast track status for SSc and low fixed overhead costs, [CompanyName] believes it can complete a phase II POC trial in scleroderma for less than $1.75M and a pivotal phase II/III trial for less than $15M total. The company will seek exit opportunites at each milestone."

This is a pharma play – those TEND to be very capital intensive (very bad) and have long times to exit (bad). This company claims they are different. I have almost zero pharma experience in my group (bad). This deal is affiliated with another angel group that has more domain experience. Time: 30 seconds. Decision: If another angel group invests and wants to syndicate, reconsider. Until then decline.

US bill tries to legalize crowdfunding

Today I learned of a house bill aiming to legalize crowdfunding for for-profits. 80 years ago there were frauds walking around convincing people to invest in their bogus ideas. A lot of decent people lost a lot of money. To try and stop this, the US government passed laws meant to protect unsophisticated investors from these folks. In theory this sounds great. The problem is… how do you define "unsophisticated?"

I will grossly over-generalize here: the US government decided to essentially define it as "not rich." So, anyone who has a lot of money is assumed to know what they are doing and can invest in startups with few restrictions. Folks who aren’t rich face more restrictions. And so the not-rich are protected from loosing their money… sadly they also lose the opportunity to MAKE money. And we loose the benefit of the wisdom of that crowd!

The power of the internet is now allowing crowdfunding – lots and lots of small checks from lots and lots of people adding up to a big pile – but our legal code essentially forbids crowdfunding of for-profits. What if we could unleash that potential? There are obvious benefits (and risks). In general, I’m in favor. What about you?

Hat tip to Jason Calacanis.

Pre-screening today (10/31)

I find that when entrepreneurs "see how the sausage is made" is helps them design their own documents and presentations to get through the gauntlet. Today I am pre-screening new deals coming into my angel group.

"[CompanyName] the only ultraviolet military camouflage. The perfect UV signature for the warfighter in any terrain, any season… We develop patented UV camouflage based upon thin-film filtering and nanoparticles. Applied in-the-field or as part of the printing process, [product] on a uniform, tent, or camouflage net defeats detection by UV sensors without altering the underlying visible or near-IR camouflage. Whether the threat is air-borne UV sensors, or inexpensive hand-held units, UVRC manages the UV signature of any military asset, in any terrain."

We have some defense people in our group AND a defense co in our portfolio (good). We have some high-tech textiles people in our group (good). Reading further documentation it is not clear if this is a concept or a real venture (bad). NO CONTACT INFORMATION IN APPLICATION’s FRONT PAGE (stupid). Time: 1 minute. Decision: Schedule 20-minute chat with CEO to learn more. Complain about lack of contact info on call

"Revenue leader in new reusable space systems with a value proposition measured in orders of magnitude by commercial clients & governments… [CompanyName] is the leader in new reusable rocket propulsion systems & vehicles. We are successful "wet leasing" the [Product], a suborbital space plane, to sovereign nations & new "spaceline" operators. [Product] is capable of flying to space 4 times/day, 6 days/week. Further, the core propulsion technology enabling this incredible feat is of keen interest to major aerospace system providers and the US Government. We also successfully sell to this customer base.

I’m a geek. This stuff is major cool to me. Some of my people will love just to check it out. But this is WAY outside our area of expertise, the region we invest in, the raise amount we feel comfortable with… Time: 1 minute. Decision: Decline, but forward on to some members who will enjoy checking it out.

Pre-screening today (10/27)

I find that when entrepreneurs "see how the sausage is made" is helps them design their own documents and presentations to get through the gauntlet. Today I am pre-screening new deals coming into my angel group.

Some samples from today’s pre-screening (anonymized):

"We offer services for create or grow own small businesses. We estimate our potential market 1.2 billion people… We are creating a website based on “Time Bank” idea and scientific study “The Denationalization of Money”. The relevance and practicality is obvious to a generation brought up on social media. We aim to provide a 21st century business solution."

Based outside of US (very bad, I have no investors with experience in this country). Summary is confusing/unclear (bad). Looks like spam. Time Spent: 15 seconds. Decison: Decline.

"[CompanyName]: first ever titanium fishing equip. co. w/ advantages of a proprietary method of [alloy] production, 10+ pats. pndg. & free media… [CompanyName] mfrs and sells the highest quality [Alloy] fishing rods, rod components, reels & hardware at equivalent prices to industry aluminum & steel products due to its cost reducing proprietary method of titanium production. Fortitude has extensive free media exposure from the founder’s TV show, film, book deal & magazines. And, numerous patents pending, including a revolutionary universal modular design which creates an accesory & upgrade mkt"

Lightly referred by another angel group (so-so). Based in MA (good, close). Consumer products play (very bad, my group has little experience). Lots of abbreviations makes the app look unprofessional (bad). Founders have their own TV show, sounds like some credibility (good). Time: 15 seconds. Decision: decline.

Pre-screening today (10/26)

I find that when entrepreneurs "see how the sausage is made" is helps them design their own documents and presentations to get through the gauntlet. Today I am pre-screening new deals coming into my angel group.

Some samples from today’s pre-screening (anonymized):

"[CompanyName] replaces local newspaper advertisement, coupon circulars and other traditional options with effective online brand advertising delivered to [CompanyName] rich demographic of local organizations and their members… [CompanyName] is a unique on-demand Cloud service for local volunteer organizations (youth sports teams, churches, civic associations, etc.) and the families that they serve powered by a local advertising business model. [CompanyName] provides organizations, families and their communities functionality not previously available, integrated with an empowering and unique fundraising component. [CompanyName] provides local businesses a level of effective advertising previously not available through traditional options or online"

This is undifferentiated. We’ve seen lots of plays roughly like this. Nothing they frontloaded screams credibility – is there a killer team? Great initial clients? Generating revenue (good!). Based in the Midwest (outside our range criteria = bad). Referred by another angel group we swap dealflow with (good!). Given my group’s lack of expertise in these kinds of plays, the distance, and the company’s undifferentiated application text, this is unattractive. Time spent: 1 minute. Decision: decline.

"[CompanyName]‘s LED Lighting System saves you money and has more features than the competition… [CompanyName] is focused on commercializing its LED lighting intellectual property to the worldwide lighting market. [CompanyName] LED System saves the consumer cost, has better light, a longer lifetime, and is more efficent. [CompanyName]‘s unique I.P. allows for advanced features such user adjustable lamp color and the use wireless control from any internet connected device. [CompanyName] is an early stage company founded in 2010 by consumer electronic executives"

Spelling error in summary (bad). Good indication of problem & solution & benefits (good). Implication team has domain expertise (so-so, would have been better if they showed an accomplishment). They’ve been around for about a year and remembered to tell us (so-so). Implied they have IP (so-so, just about everyone claims they have good IP). Lightly referred to us by an angel group we like (good). Based on the west coast (bad, too far). Included a video, but sadly it was a product demo instead of an investor pitch demo (so-so). Pre-money is $2/5 million even though they are pre-revenue (bad). Time: 1 minute. Decison: decline.

"[CompanyName] provides a proven rating system to identify athletic ability and potential for students, coaches and the sports industry… [CompanyName] is a platform for identifying and promoting the athletic abilities of the 7 million high school student-athletes at the base of the U.S. intercollegiate athletics market where 75,000 students participate in NCAA sports in more than 1,000 U.S. colleges. We use a proven talent identification system that provides intelligence and critical decision-making data to bring unique advantages to athletes, colleges and the sports industry"

From this text I have only a vague idea of what it is they do (bad). Lots of data points hinting there is a real market (so-so, everyone makes claims, but at least they are quantifying it!). Lightly referred by an angel group we like (good). Located within two-hours of us (so-so). Included a video full of testimonials from happy customers (good) and a SVP from a Sport Equipment brand so big even I know about it (GREAT!). This is a case where even thought the text of the application is pretty poor, the traction implied from the video makes me want to proceed. Time spent: 5 minutes. Decision: Include in packet to bounce by all members of my angel group.

Classic entrepreneur weaknesses

It is popular to point out the many faults of investors. And we have plenty worthy of pointing out . However, there are some common problems entrepreneurs bring to the table that kill deals just as effectively. Mark Girolimetti wrote up a nice article on SpinSucks that does a nice job of listing some of these common problems.

Here are the highlights: Six Reasons Entrepreneurs Suck

1. Entrepreneurs think they have the most beautiful baby on the block.
2. Entrepreneurs are terrible communicators.
3. Entrepreneurs are liars.
4. Entrepreneurs take things too personally and can’t handle negativity.
5. Entrepreneurs are impatient.
6. Entrepreneurs fear success.

Get the full story here. Hat tip to Dan Lieberman!