Leo Explores Angel Investing

[Personal Blog] [Book Reviews]

April 9, 2013

Minimum Viable Everything

“The biggest source of waste in a startup is building something that nobody wants.” (Eric Ries)

Over the last few years, Eric Ries and other entrepreneurial thought leaders have popularized the idea of launching a minimum viable product (MVP). At its core, an MVP is a product with the smallest amount of features and polish that you can release while still making a few early customers happy.

For example, if you were building Instagram, your eventual goal might be an app that works on all of the major phone systems (Android, Apple iOS, Microsoft, BlackBerry, etc.), integrates with major sharing sites (Facebook, Twitter, Pinterest, Flickr, etc.), and offers dozens of cool filters. Your app is going to be awesome! It’s also going to require a lot of engineers and a lot of time — and what if it turns out you and your team are the only ones who care about applying filters to photos? You don’t want to waste time and money making something that nobody else is interested in, so you build an MVP: you create an iPhone app that offers one or two filters and lets you post your photos to Facebook. This is small step toward your long-term goal, but it lets you test the market and see if there are people who want what you’re making. Releasing an MVP to test the viability of an idea makes a lot of sense: you can try something out quickly, and if customers don’t care, you can shift your resources to a different idea. MVPs maximize your ability to learn in a short amount of time.

During my meetings with startup founders, I’ve noticed that while most of them believe in the usefulness of MVPs, many of them view the “minimum viable” concept as something that only applies to their initial product release. The truth is that the MVP approach can be applied to almost anything. There are plenty of business decisions where it’s tempting to go all-in, but where a small-scale test can prevent big headaches down the road. Here are some examples:

  • Finding a co-founder. You can start a company with someone you think would be a good partner, or you can test your relationship with a small project first so that you *know* whether the person would be a good co-founder.
  • Marketing. You can throw $5k/month at Google AdWords, or you can set small daily budgets for several ad networks to see which one works best. The latter approach will cost you a lot less and might show that AdWords is not effective for your purposes, or that there are better alternatives.
  • Hiring. You can hire someone full-time, or you can try them out on a short-term contracting project. If the person does well, then you can consider whether to make an offer.
  • Funding. You can raise as much money as possible, or you can raise only what you need. Taking less cash now can make it easier to raise more money later.
  • New features. You can go into hiding for 3 months as you spend 80-hour weeks implementing a new super-cool buzzword-compliant hyper-local gamified social network for your book review website, or you can spend a day adding Facebook integration to see if anyone actually comes to your site to make friends, or if people just want to check out book ratings and leave.

In fact, you can use the MVP approach in many non-work situations: you can buy a car based on its good reviews and a 3-minute test drive, or you can try to rent a similar model for a week and see if you still like it; you can sign-up for an 8-week salsa class, or go to Beginner Night at the local dance club; you can plan a 6-hour first date or start with a brief coffee meeting to see if you click; you can buy the 41-disc boxed set of House, or you can pay a few bucks to watch the first three episodes on Amazon to find out if medical shows appeal to you; you can invest 100% of your money in the stock market, or you can start with 5% and see if you can handle the ups and downs; and so on. When something requires a big commitment — whether that commitment is time, money, or another resource — it’s prudent to spend some effort to decide whether the commitment is warranted.

If you have a good story about using the “minimum viable” approach in work or in life, please add it to the comments! I’d love to hear about other people’s experiences.

March 27, 2013

Admission > Omission > Deception

Spoiler: this is an observation about life cloaked as an observation about startup pitches.

An investor’s first deep look into a startup often begins with a “pitch deck”. A pitch deck is a short PowerPoint deck that founders prepare to summarize their company, their product offering, their intended customer base, their financial projections, their current progress, and so on. Here’s a sample pitch deck:

Okay, so you’re reading the pitch deck, you skim past a slide, and then you hesitate. There’s an odd feeling in your gut and you’re not sure why, so you go back to the previous slide and read it again. And that’s when you find The Deception. The Deception can take on countless forms:

  • A startup focused on dieting exclaims that its revenues doubled last month. It doesn’t mention that last month was January, and that thanks to New Year’s resolutions, revenues always explode in January and then implode in February and March.
  • A social network claims that 80% of its users use the site everyday. What’s not me ntioned is that the site is only open to employees and their friends and families.
  • A company with a neat hardware product talks about their $5m annualized** revenue. What they neglected to add is that they ran a huge 24-hour promotion last week, had $15,000 in sales, and then extrapolated that outlier day’s revenues to an entire year.

The most obvious problem with these deceptions is that they are unethical. Even if you think you can get away with lying, you should consider that losing your integrity can be far more expensive than failing to get funding for your project.

Of course, some people care more about money than about ethics, but deception fails in that context, too. There are three things that can happen when you lie to potential investors:

  1. They figure out the ruse before deciding to invest. If this happens, they’re almost certainly not going to invest.
  2. They figure out the ruse after deciding to invest. If this happens, they’re going to be bitter, they’re not going to invest in anything you do in the future, and they’ll probably warn all of their other investor friends not to work with you.
  3. They don’t figure out the ruse. Congratulations, you’re safe! Consider, however, that if whatever you lied about wasn’t important enough to be noticed after the investment, then it probably wasn’t important enough to lie about. You risked your reputation for nothing.

I understand why it’s tempting want to exaggerate or even mislead: your venture is just starting up, you have a few glaring weaknesses along with all of your strengths, and you really need the money. Even though it’s a tempting path, don’t give in! There’s a ton of downside and very little upside. If you have a big weakness, it’s better to avoid talking about it rather than to lie about it. The best approach, however, is to be honest. If something is not going well at your startup, figure out what it is, brainstorm possible solutions, and tell people about your plan of attack. You’ll get feedback and advice, you’ll get respect for being open, and you’ll be setting a good example for your employees and the entrepreneur community.

I think the “admission > omission > deception” equation holds true outside of investing, too. It’s tempting to create a great image for yourself, even if that means an exaggeration here or an outright lie there. Regardless of what happens in the short run, however, dishonesty usually hurts in the long run. For example, it’s easy to fib on a resume. Maybe you can exaggerate your management role in that project you worked on in 2004. Or perhaps you can list your degree as computer science even though you actually majored in accounting. Who is going to check, right? This will work for a few months or a few years or a few decades, until someone decides to do a deeper background check. They’ll check LinkedIn, discover that one of their friends worked with you in 2004, and call that friend to ask about your management experience. “What management experience?” their friend will reply. Or they’ll call your alma mater and find out that the only time you got close to a computer was when you wanted to play Pacman. That’s when you fall from grace.

The moral of the story is: don’t lie . You might be able to get away with it, but you probably won’t. Lying is not worth the reputation risk, nor the anxiety about being discovered, nor the myriad of other potential consequences. Besides, succeeding with honesty and integrity is much more satisfying.

** ‘Annualized’ revenue means that you take revenues for some recent time period, and then assume they would hold steady for a full year. For example, if you sold $100 of homemade cookies last week, you could claim to have an annualized revenue of $5200/year.

March 22, 2013

What Do Angel Investors Actually Do? (Part 2)

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:

  1. 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.
  2. 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 deal at the higher price, but the buyer will probably grumble and possibly walk away.
  3. 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 friends, and they bring their own strengths to the table. For example, one of my friends is extremely well connected to other companies and large brands, and that’s huge for startups whose businesses require partnering with or selling to other companies. My friend 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 the do whatever they can to help their investments grow and succeed.

March 13, 2013

What Do Angel Investors Actually Do? (Part 1)

For a long time, I wondered what a day in the life of an angel investor looks like. How do investors and startups get introduced? What kind of information gets exchanged before and during meetings? How are decisions made? What happens after an investment? This post is an attempt to describe some of my recent experiences from the investor’s perspective. This is not meant to be authoritative or comprehensive, but instead to provide a good high-level overview for those who are interested in startup investing.

At a high level, angel investors have handful of responsibilities:

  1. Find companies that look like good potential investments.
  2. Talk to said companies.
  3. Convince the more promising companies to take your money. (No, really.)
  4. Offer advice and introductions to existing investments.

I will cover the first two points in this post and last two points in the next post.

Looking for Prospective Investments

Okay, your business card says Angel Investor. Now what?

The first thing you need to do is to find companies to invest in. This is referred to as deal flow. If you don’t have any potential deals coming to you, then there’s nothing for you to do.

So how do you find potential investments? There are many viable approaches:

  • Your personal network. Sometimes an investor and a startup founder have a mutual friend who introduces them at the appropriate time.
  • Other angel investors. For the purposes of investment diversification, angels typically invest much less than companies are looking to raise. For example, a typical angel might seek to invest $50k in 20 different companies, but each of those companies will be looking for $400k or $800k or some other amount that much higher than $50k. You might expect angel investors to be competing with each other, but this is only the case for the hottest startups. Most of the time, because no single angel investor can provide a startup with all of the funds its looking for, investors will shares their deal flow with their investor friends.
  • Demo Days. These days, a large number of startups go through startup incubators and accelerators like YCombinator or 500 Startups. These incubators provide a little bit of funding and a lot of advice and connections to their startups in exchange for a small amount of equity. The incubators also host Demo Days 1-3x per year where startups have a chance to showcase their accomplishments to potential investors.
  • Sites like AngelList. AngelList is a directory of startups, entrepreneurs, and investors. The site frequently features startups that are looking to raise money, and it’s a great place to learn about what’s new in the startup world.
  • TechCrunch, etc. Sites like TechCrunch, Mashable, and VentureBeat can be good starting points for research. If you read an article about a product that you think is interesting, you can do a little research and if you’re still impressed, you can contact the company to see if they’re looking for funding.

Talking to Companies That Seem Promising

Great, it looks like you found a few companies that you’d like to talk to. What should you talk about? At a high level, the main goal of talking to a company is mutual understanding. The investor’s goals are to understand the startup’s mission, the problem that they’re trying to solve and how they plan to solve it, who the competitors are, and so on. The startup’s goal is to raise money (obviously), as well as to figure out if the investor is a good match: do they have the right connections? Are they a short-term investor or someone who’s in it for the long haul? Do they have any valuable-industry specific knowledge or experience? Investments ideally happen when there’s a good mutual fit between the investor and the startup.

Some specific things investors consider:

  • Understand the problem. What is the actual problem that the startup is trying to solve? Is the problem a huge pain or a minor nuisance? Does it affect most people, some people, or a small group of people? What do people currently do to solve this problem?
  • Understand the solution. How does the startup plan to solve the problem? Is their solution still just an idea, or do they have a prototype? If they have a prototype, have they gotten feedback on it and had a chance to improve it, or are they mostly guessing that it will address customers’ needs?
  • Understand the economics. How will the startup make money? How will they attract customers? Is there a cost to acquiring each customer? How much will the product cost to develop and how much will it be sold for? Can it be sold at different prices to different segments of the market? Does the founding team have a financial goal, like selling the company for 20 million dollars to the first person who’s interested, or do they hope to become a billion dollar company or die trying? What’s the startup’s current valuation* and what could its long term valuation potentially be?
  • Understand the competition. Who would the startup consider its competitors? If there are competitors, how does the startup plan to differentiate itself, is that differentiation strong enough? Does the startup have a strong competitive advantage that makes it hard for other competitors to catch up?
  • Understand the technical challenges. What are the biggest engineering challenges? Is the engineering team good enough to handle those challenges? How much of the product can be addressed with software and how much of it requires human input?
  • Understand the founders. What motivates them? Are they control freaks or are they looking for advice? Do they have a lot of experience in their startup’s area of focus? Do they have a well-rounded skill set or are they lacking in a major area like product management or engineering? Did you hit it off well enough to want to work with them on-and-off for the next few years?
  • Understand the fit between the investor and the startup. Do they have the same long term goals? Does the startup fit the investor’s thesis**? Does the investor have expertise or knowledge or connections that can help the startup?

These questions are often answered over the course of several phone calls or meetings. Like an interview process, which might start with an HR phone screen and end with several hours of in-person grilling, each meeting is progressively more technical and intense, finally culminating in a decision of whether to go forward with the investment.

Next week, I’ll discuss how and why investors sometimes have to convince startups to take their money, and what happens after an investment is made.

* A startup’s valuation is what it claims to be worth. For example, if a startup is raising $1m at a valuation of $10m, then that means they’re claiming to be worth $10m and are selling approximately 10% of the company for $1m. The valuation is typically determined through some combination of the strength of the founders, the current state of the product (idea vs. prototype vs. in production), current revenues (if any) and costs, projected revenues and costs, the size of the target market, optimism, and moxie. (Valuations are either reported as pre-money or post-money valuations. I don’t want to get into the technical details, but if you want to understand the difference between the two, the Wikipedia article is quite good.)
** An investor’s thesis is their investing philosophy. This might be something generic: “I invest in companies which have great founders with proven track records.” It could also be very specific: “I believe the future of medical devices is the use of QR barcodes and RFID tags, and I invest in startups that use those two technologies creatively.”

February 28, 2013

Welcome!

About This Blog

I’m a software engineer who has recently transitioned into angel investing. I’m currently the technical partner of a yet-to-be-named seed fund, and my day-to-day work involves meeting and talking with startup founders, asking technical and non-technical questions to decide if specific startups are a good match for the seed fund, and offering technical advice to companies that the fund has already invested in. It’s an awesome job that allows me to meet with a lot of smart, passionate entrepreneurs.

I’ve been a student of angel investing and tech startups for a number of years and this blog will be my attempt to write down some of my observations about how the angel investing world works: what makes startup pitches more or less effective, what founders should consider about when doing fundraising, which questions are effective (or ineffective) when doing technical due diligence, and so on. One of my ambitions is to do my own startup in the next few years, and sitting on the investor’s side of the table often gives me a chance to learn from the mistakes and successes of others. My hope is that this blog gives other current and future angel investors an opportunity to learn from my successes and failures.

About The Author

My career has been filled with good fortune, and I’ve managed to worked at some great companies since graduating from college. A brief summary of my work experience:

  • Microsoft (2003) – Microsoft was a nice company but I got assigned to a soul-sucking project, so I left after four months.
  • LinkedIn (2003-2005) – I somehow managed to become the 2nd non-founding engineer at LinkedIn (overall employee #14 or #15). I didn’t really know what I was doing when I joined LinkedIn — I just wanted to get the hell out of Microsoft — but needless to say my job change worked out well in the grand scheme of things. I spent two years at LinkedIn working on most of the core features that the company is currently known for: LinkedIn Groups, LinkedIn Jobs, etc. The full story of how I ended up at the company is amusing, and I might write about it as soon as I’m out of meaty blog post ideas.
  • Google (2005-2009) – I applied to Google on a whim after most of my LinkedIn colleagues had moved there. After accepting the job offer, I spent three years working on automated fraud detection and a few months working on Google Docs before deciding that I would rather be employed at a much smaller company.
  • Factual (2009-2012) – I joined Factual’s engineering team when the company had about 15 people and learned a lot about software engineering while writing search engines and leveraging lots of machines to clean up and process large, messy datasets.

Since the end of 2012, I’ve been spending most of my time working with the seed fund and thinking about what I’d like to work on for my own startup.

My personal interests include international travel, scuba diving, rock climbing, reading, writing, photography, and good food. I’m also an avid CrossFitter. I started doing CrossFit back in 2006 when there were only a few dozen affiliated gyms in the country, and I became a certified CrossFit instructor in 2012.