Angel investors are often the first group to invest in a startup. Here is a checklist of things you should look at closely before you decide to make an offer.

Review Your Own Situation

Review your personal financial situation carefully. If the company fails and you lose your entire investment, will you have enough liquid assets to cover your future expenses? If not, put your money somewhere else. But even if you have plenty of money now, will you be able to sleep at night once you invest? Will your spouse? If you stay up late at night worrying about your mutual fund portfolio, you should probably avoid startups altogether. If your financial situation is good and you are a sound sleeper, go ahead and consider investing in a startup, but limit your exposure to a small percent of your net worth.

Business Model

Startups are notoriously hard to evaluate. Even the savviest investors make serious mistakes. If you are thinking of investing in a startup, at an absolute minimum make sure you understand EVERYTHING about the company’s business model. I have seen private placements where the business model was shrouded in so much secrecy (“proprietary technology”, “proprietary processes”, etc.) that it was almost impossible to tell what the business really did. Ask questions. If anything looks odd, then ask more questions. If the answers don’t make sense, walk away --- quickly.

Market Size and Trends

Entrepreneurs usually overestimate the market for their products or services. Be sure you do some independent research to get several estimates of the market size. Contact one or two industry experts to see what they think. Often there are at least three or four ways to estimate market size. If the smallest number isn’t at least 5 or 10 times bigger than the company’s projected revenue in Year 5, you might want to pass on this opportunity. Another consideration is market trends. Is the market growing, shrinking, or static? If the trend signals are mixed, do the positive factors outweigh the negative ones? Venture capitalists usually invest in businesses where the market is growing rapidly due to outside influences (population is getting older, etc.). This way, even if their portfolio companies do not become market leaders, at least they aren’t swimming against the tide.

Competition

Many entrepreneurs say they have no competition. They think this means they are ahead of the curve. Most investors think otherwise. I have spoken to nearly a thousand entrepreneurs in the past 5 years. More than half told me they had no competition. I cannot think of a single case where that was actually true. If there is truly no competition, you need to find out why. Is this company really so far ahead of its time that no one has thought of it before? Or is this something others have looked at and decided there is no competition because there is no demand? Another possibility is that the company is ahead of its time, and demand will grow rapidly, but the timing is still not right. In this case you have to examine the tradeoffs in being “first to market” with being “too early to market”.

Who are the top competitors? List them (if just a few) or categorize them (if there are many). If there isn’t much competition now, try to imagine what the landscape will look like in a few years. Competitors can come from almost anywhere. Remember Sears and Home Depot? Schwinn and Cannondale? Microsoft and Google?

Also, remember that competition doesn’t always look like competition. There is a story about a company that invented a pen for astronauts. It worked in a zero-gravity environment. It seemed like a great idea until investors discovered that the Russians had solved the problem by using a pencil. Sometimes a “great” idea loses out because a simple, inexpensive alternative already exists.

Look for “800 pound gorillas” (market leaders with strong brands and large amounts of cash). If any of these become competitors, how will the company compete against them? If you do not get a convincing answer to this question, run, don’t walk, away. Startups need some sort of edge, beyond economies of scale, to succeed. The edge can be almost anything --- better quality, lower cost suppliers; specialized, proprietary technology; more efficient operations; etc. But there has to be some sort of edge.

Finally, realize that the existence of competition is usually a good thing. Competition means there is a market for the company’s products or services. It also means market information is available so the company can learn from competitors’ mistakes.

Management

Conventional wisdom says the management team is everything. While there is some truth in this, the fact is many entrepreneurs make louzy managers at mature companies, but they are incredibly effective in the early stages. On the other hand, many seasoned managers are ineffective at the startup stage and great once things have matured. In a startup there will probably be a transition at some point – in a few years the entrepreneur will hand over the reins and a seasoned manager will take over. Interview the entrepreneur to determine if he or she is really a startup manager, or a stable company manager. True entrepreneurs thrive in fast-paced, challenging environment. Stable managers prefer order.

I have seen cases where a startup management team seemed to have everything going for it: wisdom, experience, a history of working together, great social and leadership skills, etc. However, when I investigated further, it became clear that they all had very different visions of the company. Look for signs of bitterness, in-fighting, grudges, etc. If you see potential problems, dig a little deeper. If you don’t see any sensible solutions, walk away.

Financials

If this is truly a startup, it is either pre-revenue, or revenues are negligible. There really is no history to evaluate. In this case, you still need to look at the company’s pro-forma financials. Of course, most startup companies have the same revenue graph – the fabled hockey stick. It starts out slow and then takes off like a rocket.

Pay close attention to the income statement and the cash flow statement. Make sure you have monthly projections for all major revenue streams and expenses during the first 2 years. Review the revenues carefully. Does the hockey stick turn up faster than a speeding bullet? Make sure the timing at the turning point is realistic. For instance, if the projections assume sales will begin in 3 months and grow rapidly, but you know the industry sales cycle tends to average 9 months, then you have found a problem.

Look at the monthly cash flow statement for the first two years. Is there enough cash to keep the company solvent through this period if revenues follow the projections? Note that the annual cash flow statement is not detailed enough since it is quite possible for the company to have cash in months 1 and 12, but run out of cash in month 9. The annual cashflow statement will not show this, but the monthly statement will.

Ask about contingencies and scenario analyses. What happens if revenues are off by 20% during the first two years? Will the company have enough money to get through this? How will they change their plans if revenues grow slower than expected?

Look carefully at expenses. Most entrepreneurs vastly underestimate typical expenses such as administration, sales commissions, marketing costs, taxes and legal fees. Also, don’t just look at expenses in Year 1. Look at how they scale with revenue, number of employees, number of offices, etc. Often the pro-formas have the initial expense levels right, but they don’t scale properly, leading to inflated profit projections in later years.

Does the company have any outstanding short- or long-term debt? Find out when these debts were incurred, for what purpose, and what the terms are. Does the company have enough cash, liquid assets, and positive cash-flow to pay off the short term debts? Will future cash-flow be sufficient to pay off the long term debt?

Internal Processes

In a startup situation there is often very little in the way of “operations”. But once the company gets going (when the hockey stick turns up), operations will be a crucial factor in the company’s success or failure. Ask detailed questions about operations. Look at all the different functions of the company and ask how they will get done, and who will do them. Thoughtful answers are a good sign. Vague, incomplete, or just plain silly answers are a sign of trouble.

Customer Satisfaction

Since this is a startup, there probably aren’t any customers, so customer satisfaction isn’t an issue right now. But once the company takes off, customer satisfaction will jump to the top of the priority list. What measures will the company put in place to retain existing customers? How do these measures compare with what competitors are doing? If the company is not meeting or beating competitors’ standards, how will they stay in business over the long haul?

Sales and Marketing

How much does the company plan to spend on sales and marketing? Divide this by the number of customers gained during the year to obtain an average customer acquisition cost (CAC). Calculate the ratio of marketing plus sales costs divided by total revenue. Compare these numbers to others in the industry to see if they are high or low. If they are high, you need to find out why. Remember that startups generally have higher CACs than established companies, so a high CAC is not necessarily a bad sign. But you still need to ask questions to see if this has really been thought through carefully or if they are just making up numbers.

Also look at the marketing plan. (Is there a marketing plan?) What channels are involved? Do these make sense? For instance, suppose the company plans a major Internet push. What are the components? Are they relying exclusively on pay-per-click advertising, or are they also considering search engine optimization, affiliate marketing, and opt-in email campaigns? How does this company’s marketing strategy compare with competitors?

Pricing

How does the company plan to position itself in the marketplace? Are they a “low cost provider”, a “premium provider”, or somewhere in between? Is pricing consistent with the brand, or is there a mismatch? For example a premium product brand can be destroyed by careless discounting. If Coach bags were available on the Internet for $20 a bag, Coach would undercut its entire brand and its distribution network. “Small” mistakes like this can be fatal.

Technology

Technology can be a huge differentiator between market leaders and losers. Leaders use technology to grow the business in ways their competitors never imagined. Losers spend too much --- usually on ill-conceived internal projects that ultimately fail, or too little --- resulting in slow or inefficient execution. Compare the company’s projected technology spending per person and per dollar of revenue with others in the industry. If they are very different from the norm, then ask why.

Intellectual Property Protection

Does the company have any patents, trademarks, or other intellectual property (IP) protection? If not, why not? If they do have patents or other safeguards, are they current, and are they in the right countries? Although U.S. patents carry a lot of weight in many areas of the world, sometimes an international patent is also needed. International patents tend to be extremely expensive. Are these costs included in the financial projections?

Exit Strategy

At some point, you will want to get your original investment back, plus hopefully a significant positive return. How and when will this happen? Be sure you have at least one viable potential exit strategy before you make an investment. Note that you cannot simply rely on your attorney for this --- the exit strategy has to have a basis in reality, not just be a clause in a contract. If your exit strategy is an IPO, but the company only has a small chance of going public (because of market conditions, the company’s business model, or …), then this is not a realistic exit strategy. Consider other alternatives such as a sale, a merger, or simply distributions over time. Finally, make sure your exit strategy is consistent with the company’s business plan.

Valuation

Consider hiring an expert to value the company. Be forewarned that a professional valuation ranges from a low of $5,000 to a high of $100,000. Also realize that valuation is as much an art as a science, and this is particularly true in the case of a startup. The company could have no customers, no products, no revenues, no assets, and no historical financials. Nevertheless, a valuation expert can do some net present value calculations and examine industry comparables. If the resulting valuation is much lower than the “pre-money” value of the company, you should reconsider your investment.

Personality and Style

It is quite possible that you will find a startup that meets all of your criteria --- great business model, superb management team, perfect timing, strong competitive edge, etc. The only problem is that you and the entrepreneur do not see eye to eye on a few “minor” issues. For instance, you want an active role in the company, but the entrepreneur wants a passive investor. Or, you want the entrepreneur to relocate headquarters to within 50 miles of your home, and he wants to stay exactly where he is. These “minor” problems often become much bigger problems soon after the ink has dried on your agreement. Take a good look at potential personality or style conflicts before you sign a deal. It is probably better to take a pass on a questionable personality match than risk months of bitterness and acrimony.

Conclusion

Although many people have made fortunes by investing in startups, there are significant risks. Most entrepreneurs are honest, but a small percentage will intentionally hide problems from business buyers or investors. More often, entrepreneurs are simply blind to potential problems because they are so focused on building their business as quickly as possible. Smart investors protect themselves by asking good questions and looking “behind the curtain”. The issues listed here barely scratch the surface, but they are a start. If you are considering investing in a startup, be sure you do your homework before you sign a deal. Your wallet will thank you for it.

Andrew Clarke is the CEO of Ground Floor Partners, a business consulting firm that helps early-stage, small and middle-market businesses grow through design and execution of sound business strategies. This article appeared in The Angel Journal in Oct/Nov 2007.

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