How to angel invest, part 6: the market opportunity and due diligence
You’ll get more out of this series if you’ve read part 1 (high-level angel investing guidelines), part 2 (debt, equity, and key terms), part 3 (company stages), part 4 (deal flow), and part 5 (good founder qualities and red flags).
As an angel investor, your job is to pick the outlier companies. The outliers are all that matter. It’s worth stating again: most of your investments will fail. A handful will do alright, maybe selling for the amount they raised or a bit more. One or two will be absolutely massive, justifying everything you do. This is why you need to optimize for the outliers, picking companies that have the biggest potential (and usually the biggest risk). You want to back companies that are creating new industries from scratch, not fighting to gain a foothold in crowded spaces.
Guidelines on evaluating the market opportunity
- The company can reach a point where it’s generating hundreds of million in revenue within ~5 years.
- If a company is entering an existing market, that market is large and the company can reasonably capture enough of it to make a significant impact.
- The company is creating a new industry that didn’t exist before, and thus will be the first to define it.
- The market timing is right. If you’re too early, you could invest in a great idea that you know is going to happen in the future — say augmented reality contact lenses — but if there’s still many years of research and development needed before the product is ready and demand exists for it, it’ll be a miss. If you’re too late, the market will be saturated with competitors and a new entrant will not be able to make a dent.
- The company is in an industry that is about to experience highs in investment dollars raised and acquisition interest.
- The company is dislocating an existing market, pushing it out to irrelevance due to how revolutionary theirs is (e.g., what streaming music did to CDs).
- The solution that the company provides is essential, not just a nice-to-have. It’s a painkiller, not a vitamin.
- The product’s impact is far-reaching enough so that it couldn’t merely be a feature in a different product.
- Larger trends — economic, technological, political, regulatory, cultural — feel like they’re moving in line with the company.
- The company’s tech is differentiated, making it difficult for others to copy; the company may have IP protections like patents, although they are not essential.
- There are not significant go-to-market risks to overcome, including expensive hardware supply chain setup or FDA approval of medical devices; if there are, the company is uniquely skilled in overcoming these barriers.
- The company is scalable, meaning that it can multiply revenue with minimal incremental cost as it grows. Watch out for studio or high-touch service models that need more people to do their work. Software scales; people do not.
Frankly, the amount of diligence you’ll do on an angel-stage deal is low. Your read on the quality of the founders and the size of the market opportunity are the most important factors, and there’s not a lot that you can research to supplement what you’ll learn from meeting and questioning the founders.
Here is a simple diligence list that you can run through if you need some organization:
- Question the founders. This is where you should spend most of your time. Get to know them: their pasts, their work experience, what they’ve done well, and where they struggle. How have they dealt with adversity in the past? How do they work with others? What makes them tick? What keeps them up at night about this company?
- Use LinkedIn, AngelList, or another social network to find connections to the founders who weren’t on their references list and call them. They will divulge more than anyone on their provided reference list will.
- Ask the founders for any technical documentation on their product — whitepapers, patents, diagrams — and read through them. Ask questions about the parts you don’t understand.
- Do your own assessment of the addressable market. Don’t just trust the founders’ assertions about how big it can be.
- If an MVP (minimum viable product) exists, ask for a demo. It’s preferable if you can use it on your own, rather than the experience being driven by a founder.
- A list of all current employees, advisors, and investors with contact info so you can reach out to them.
- Identify and speak with experts in the company’s industry, focusing on what they think of the idea, how big the opportunity is, and any risks that you or the founders may not have foreseen.
- For highly technical products (if you aren’t technical yourself), ask a third-party expert to do an audit to confirm that the product does what it claims to do.
- If the company has an office, visit it and talk with the non-founder employees.