How do I spot a good investment?

So now we come to the crux of the matter; the central question in comparison with which all other questions pale into insignificance. We have seen how you can increase your chances of finding high quality deal flow in the last section (II.1), but how do we properly evaluate the deals that you come across?

In some sense, this is the hardest thing to get right - a company may tick all the boxes, but still fail down the line. That’s just the nature of the game and the risk we all take to get in early at low valuations in the hope of huge returns. Your job as an angel investor is to predict the potential of a company based on only early indications and, necessarily, there is no infallible process for doing this – that’s the risk.

However, the actual evaluation process needn’t be so hard and you can easily learn to pick the companies with the best chance of success. As I mentioned in the previous section, the more deals you’ll look at the sooner you’ll develop your own ‘eye’ for evaluating deals.

But if you’re relatively new to this, it’s worth reading on. I’ll try to give you a simple framework that you can use as a sounding board for any deal.

A Simple Evaluation Framework:

Team

You may have already read the advice angel investor, Jos Evans, gave in an interview in section I.2 about picking the right startup. If you missed it, here it is again:

Q: Any advice for people thinking about getting into it [Angel Investing]?

A: Everything comes down to the quality of the founders. If the people are excellent they will succeed regardless of whether the initial business idea works. Meet as many people as possible and cross check your network for people who might know the founders of a company you are considering investing in.

Aside from ending with a preposition, this is extremely sound advice. 

It is the people behind a company led by the founders and validated by their advisory board that will optimise the chances of the company succeeding. If the founders are relentlessly resourceful they will find the iteration that makes the company a winner.

So, when you are looking into a company, spend a good deal of time researching the founders’ backgrounds and spending time with them on the phone and, if possible, in person. Their qualities should become apparent pretty quickly.

Similarly, the strength of the company’s advisory board can be a very strong indicator of potential for several reasons. For one, it reflects well on the quality of the founders if they have managed to persuade impressive people to back them. Secondly, the fact that these people have backed the idea suggests lends credibility and validation to it. Finally, the financial and networking clout of high-profile board members will hopefully mean that the idea will struggle to fail, propelled on by such a strong support network.

Market

There is an ongoing debate between investors over whether the people or the idea/market are more significant indices of future success. Renowned US investor, Ron Conway, believes, like Jos Evans, that the team are the foundation – the idea is liable to change, but the team’s motivation, talent and competence will remain to drive the project to success. Other investors argue that great founders in a bad market are far less likely to succeed than bad founders in a great market.

But to polarise these two points of view misses the point a bit. Good founders will find good markets – otherwise they are not really good founders.

So, in your evaluation you want to research the market to ensure the opportunity is or will be as large as the founders claim. If your findings confirm theirs then you can feel comfortable that a) there is a significant market and b) the founders know what they’re on about!

Traction

Progress or traction can be problematic for angel investors. Naturally, you want a business in which you’re interested to have as much real world proof of concept as possible. 

If you’re investing in an app, for example, you will be filled with confidence if, in its first 3 months of operating, it had 1 million downloads with 80% user retention. Obviously, this is strong evidence that the venture is destined for success. However, the more traction a company has and the more ‘proven’ it is, the higher the valuation is going to be and the smaller your potential return multiple will be. 

So your risk appears reduced but so have the chances for huge returns. In addition, venture capital funds tend to weigh in when the company has reached a certain level of traction – as an angel investor you really want to get in before the VC’s in order to get the lower valuations.

Idea

All of the above tie together to indicate whether the idea itself is valid. But there is no harm in listening to your initial gut feeling when you read about the idea. You will hardly need to be told this as it will be what comes naturally as you start evaluating. 

But the point is that you should not be afraid of trusting your initial instinct as it can be a sure indicator of whether the idea is a real solution to a real problem in real market. You may find in your subsequent research that their solution is rubbish or that the problem isn’t significant enough to make it a viable venture or both; but your initial instinct is always a good place to start.

Tip: if your instinct is not as finely tuned as you’d like it to be, use the Problem/Solution framework for a first assessment of the idea. Is there a real problem/gap in the market? Does the company solve this problem/fill this gap in the market well?

What do other investors say?

Just as I suggest using the advisory board as a metric of sorts for future success, other investors can be invaluable sources of insight. They may have spotted some key index of potential (success or failure) that you may have missed. 

You are also perfectly within your rights to ask the founder for an introduction to existing investors. And you should definitely show the deal to anyone in your network who has any expertise in the particular area both to see if they can offer any further insight and also because they may be willing to invest with you.

Many investors say it takes a lot of stress out of the experience if you can share it with someone – that’s why syndicates, both official ones and groups of like-minded friends, are so popular.

Summary

When picking a winner, there are a number of key indicators of potential that you should look to evaluate. This section has aimed to cover these key indicators as you make your initial assessment of an investment proposal.

The next section covers the detailed Due Diligence questions that you may need to ask as you aim to pin down whether the deal in question is worth your investment…