Happy 2021 Startup Founders, Geeks and Investors out there! I wanted to start this year with an article that will shed some light on what Startups and investors alike need to keep in mind when preparing for an angel investment round.
Let me start by introducing you to Neil: UK Angel investor and guest to a recent webinar we hosted at Silicon Roundabout.
Neil McInernrey has been an investor over the last 25 years. The former engineer and investment banker spent 20 of those years dealing in listed markets and the last 5 in private equity investments. Leveraging his experience and his private finance, Neil is now emerging as an active Angel investors in the Silicon Roundabout scene. And so, we asked him, through an interview with Sam Luckett, Co-Founder of Connectd, sponsor of the event: what do today’s UK angel investors look for when they evaluate startup investment opportunities?
Watch the complete video with Neil McInernery on the Silicon Roundabout YouTube Channel.
The Investment Process
Through years of evaluating pitches, Neil has made a few mistakes. By his own admission, he ended up investing in a venture or two that turned out to be less than stellar moves on his part. But the missteps and wrong turns helped him understand the process and formulate a flow that he has honed to a level of reliability.
Initially, Neil met people through word of mouth. He eventually joined an investor platform. This got him on email distribution lists, expanded his reach and got him into the flow of deal-making. He says there were so many startups, and one needs to be able to separate the wheat from the chaff. But at the beginning, his criteria were not high enough and he ended up making a few questionable investments. He was able to develop his process through a combination of platform resources and his privately built network.
When he first comes across an opportunity, he asks a few basic questions. What’s the sector? What’s the product?
This is the hook that determines whether he opens the deck or not.
If the venture appeals to him at this point (he says he is partial toward SaaS-type ventures), he digs deeper to find out what he really wants to know about the company.
Angel Investors Due Diligence
- Who is the “A-Team”? What have they done before? He evaluates the CVs, checks their expertise, and peruses each one’s track record. This gives him the confidence that the team or the founders running the company he plans to invest in are capable of executing.
- Concurrently, he also looks closely at the business concept. He looks out for at least a B+ idea, with above-average chance of success. The products and services must be able to scale and produce recurring revenues while not necessarily bringing the cost base up while they do so.
If things check out, he then discusses the opportunity with other people in his private network. He says it is invaluable to get into this with others ─ on a platform or in a private cohort ─ to bounce ideas around because assessing these factors often tends to be subjective.
If there are no serious concerns or objections, Neil express an interest, and schedules a call with the CEO or the founders. The initial call with the CEO should be able to unearth the following vital information.
- He looks for a tangible track record of financial savvy or demonstrable growth. The venture must show that it is past proof-of-concept and display historical figures and realistic projections. Neil is wary of a team with no financial record. He prefers to pay a slightly higher valuation for something with more financial substance behind it (such as a lead customer, contracts, sales, etc.) that provides some idea of the trajectory they are on.
- He wants to see a clear capital plan showing how the money invested is going to be spent and how internal returns are going to be made on the capital he intends to spend on.
- A sensible valuation. Astronomical valuations turn off angel investors.
If necessary, Neil follows up for more detail before coming to a point where he makes the decision to invest.
The Optimal Pitch Deck
Entrepreneurs naturally put in a lot of work on their pitch deck. They understand its importance in communicating the venture’s value and potential. But Neil reveals some surprising facts about optimising the pitch deck.
- Angel investors don’t have the patience to absorb a 50-page deck. It should be no more than 10 to 20 pages.
- The deck itself should show, within the 1st few pages:
- The problem to be solved and the proposed solution (the proposition)
- The team
- Historical financial information and the planned use of funds
- It should be able to communicate, in a couple of minutes, the very high-level schematic of what the investment is going to be.
- The 2nd part should contain more detail about the product and projections
- If more information is needed, founders can include an appendix with competitor analysis and some “tire-kicking” on the projections.
If angel investors can assimilate the important information in a couple of minutes, then they can determine whether or not they would like to take it further.
Optimising Founder-Investor Relations
For Neil, transparency is the key to a harmonious union between founders and investors. He understands that the A-Team is probably working 24/7 on the business. So, in order to disrupt that focus as minimally as possible, yet keep the investors informed and “feeling loved,” he recommends the following communication.
- Monthly updates on key metrics are reasonable to ask for and shouldn’t take too long to put together.
- Ad hoc communications in case some problems or issues arise.
- Some salient information for the shareholder representative on the board so that the investors can feel that they are up to date with info on developments.
- A more substantive quarterly report.
Neil recognises that Covid-19 has digitised the due diligence process. And while online video communication can’t really replace the value of face-to-face dialogues, he thinks that it is an adequate substitute. He points out several advantages. You can get more people to join a call because the technology minimises travel time and preparations.
For entrepreneurs, Zoom calls help to maximise time for raising capital. Using third-party fundraising support platforms can also help to standardise and pool together all the legal and information bits. Neil believes that digitising and “platformising” the act of due diligence and transparency is the way forward for founders wanting to be efficient.
The Importance and Limits of Financial Planning
Neil tends to be skeptical about a startup’s comprehensive financial plan.
He explains that every financial plan he has seen has never been met. Besides, he believes that it’s impossible to forecast the performance of high-growth, high-opportunity startups. However, he says that startups do need a financial projection and a capital plan. Investors are keen to find out where will the startup intends to use the money invested and what it aims to get back from it.
The plan needs to make clear that the startup is past proof-of-concept and that they have a lead customer. It should show who the next customers will be, what’s the projected market share, what the venture can take, why their product is better and consolidate all of these into a min-max assumption. For Neil, the plan should show projections for the next 18 months, not the next 6 years. It should have a credible min-max for level of sales and costs over the next 18 months. He recommends that the plan over-raise capital and bank more on the min instead of the max.
The initial investment should result in some growth, or the development of intellectual property, or the moving the product nearer to a launch if it’s pre-revenue, getting more customers and generating a monthly recurring revenue (MRR). The founders need to be transparent with their investors so as not to surprise them with a sudden request for more money.
How it should work is that the company should make good use of the capital it has been given.
Profit is not necessarily something that it should shoot for at this growing phase of the venture.
If the company can develop its IP and grow sales, then this drives up the valuation. Most shareholders, Neil believes, will be happy to see progress and therefore top up their holdings. If a business goes quiet then later requests for more money, this deprecates its chances to raise money. The benefits of being transparent works both ways.
To Be or Not to Be Profitable
When scaling a business, immediate profitability may be nice, but what the investor really wants to see in a new venture is the internal rate of return (IRR) potential by the time an exit comes, the growth of the top line, and the development of the IP.
The potential of the business needs to be enhanced by investing that money and what matters is the explosive value-growth of the business.
If the team have successfully made the necessary investments but need to come to the table to ask for more cash, it is not normally a problem to put up a high valuation to reflect what’s been done and raise more money.
The most important thing is the demonstrable progress of the business ─its sales, its customers, and its IP.
Early-stage businesses are investing in their future, and so they will probably be losing on a cash flow basis, to start with. Otherwise, the venture may not be growing.
Neil compares this situation with high dividend stocks on the listed markets. These are high in valuation because they have nothing better to do with their cash, not because they are growing. So, driving for profit this early is not necessarily the most important thing for a startup.
A Final Word on Valuation
Valuation is very subjective. Neil says it begins by asking:
where can the startup get the investment?
The approach in US startup ecosystems is to first establish interest and then set the price. In the UK, companies often set the valuation first, then offer to prospective investors. But determining valuation is a case-to-case basis for the investor.
Again, Neil refers to the listed market for comparison. The listed markets offer several metrics that can help an investor determine the value of the investment. These metrics do not apply to private equity. In this way, listed markets are more transparent. The venture capital market offers much more upside. But it is also much more likely for investors to make a lot more mistakes.
A successful serial entrepreneur with nothing more than a new business plan can secure a high valuation solely based on reputation. But an unknown founder that can generate early traction by customer acquisition and cash flow might also obtain good valuation.
If you’d like to watch Neil’s interview in full, here is the link to the complete video.