Part IV of a Continuing Series on How to Select an Angel Group

Several months before Jason Calcanis’ crusade (or jihad—depending on your political affiliation) against for-profit angel groups, I wrote a post about evaluating angel groups and the criteria to use when seeking investment. For those that didn’t see the earlier post, the list included:

1.    Do they charge fees
2.    Do they actually have capital and a track record of investing their own personal funds
3.    How transparent is their organization and investment process
4.    How do they say ‘no’
5.    Honesty and integrity
6.    Rolodex and connections
7.    Advice
8.    Are they respectful of entrepreneurs
9.    Do they help entrepreneurs, regardless of whether or not they invest
10.    Do they support the local entrepreneurial community

Although pitching fees—or pay to play—is a good litmus test for weeding out disreputable angel groups, you’ll also find that for-profit angel groups typically have a poor track record with these other criteria.

Most angel groups have money, and one group’s money isn’t any greener than another’s. Beyond cash, the other ways an angel group adds value to a startup is through great advice and personal connections.

One of the easiest ways to assess an angel investor’s ability to provide advice and connections is to read their bios on their website. High-caliber Angels with a lot of experience at both large and small companies, tend to have strong Rolodexes and skills that can be applied to helping portfolio companies. When reviewing their experience, consider both their work history and the companies they’ve backed as investors.

You can also judge the caliber of the group through your initial experiences, as many Angels provide worthwhile advice and introductions to their networks in the early stages and prior to investing. If you’re further along with an angel group, consider doing more diligence on the group and its members by contacting CEOs of their portfolio companies.

When it comes to connections, one of the most important when evaluating an angel group are links to VCs. Although many of our portfolio companies have told us the Angel round is the last tranche of money they’ll need (and they even say it with a straight face), most startups will invariably require follow-on funds.

A couple of years ago, William Quigley of Clearstone Venture Partners wrote an appropriate blog post, Value of Certain Angel Investors:

As a VC, I divide angel investors into two buckets.  The first group includes angel investors who know the space they are investing in. Perhaps they previously started a company in the same industry or were part of a successful company targeting the same market.  As it happens, angel investors in this category usually know the VCs who invest in their space and can be a great help in introducing a start up to smart venture capital investors. Better still, these angels typically know the going terms for a start up in their market. Accordingly, they can help the entrepreneur get the best deal warranted given the progress of the business.

The second bucket of angel investors are those who have some spare cash to invest but don’t have any familiarity with the target market. These investors are generally not known by VCs active in the specific market the start up is pursuing. In most cases, they can’t help with follow on fund raising. Because they don’t know what the going VC terms are, they often set terms for their investment that make it harder to raise money in the next round.

VCs can’t know everything about an industry. So how do they get comfortable with a new business? They rely on smart people who are accomplished and well connected in that industry. If someone of that caliber happens to already be an angel in your business, raising venture capital just got a lot easier.

Given that Clearstone has invested in one of our portfolio companies—LeisureLink—that’s managed by two of our members, it’s a pretty good bet that the Pasadena Angels fall into the first bucket.

In the current environment, CEOs and entrepreneurs don’t always have a choice when it comes to selecting their investors. However, when you do, it’s important to pick an angel group that can deliver the intangibles, such as advice and network, along with the cash.

Far too many of my angel colleagues are fixated on patents as the source of sustainable competitive advantage. While these are often the source of competitive barriers they are by no means the only effective method for generating high growth. In fact, there are many situations where the patent itself provides little growth momentum.

We need to see a potential investment in a business in more holistic terms and especially we need to focus on the way in which the business interacts in the marketplace with its customers and competitors. If you want to drive high growth then you first need a combination of a well defined large niche market, a robust channel to market and a product or service which satisfies a compelling need. The next critical component is to have something which give you a strong competitive advantage. It is this combination which drives high growth. A patent alone, which provides some level of competitive advantage is somewhat meaningless without the other attributes.

Competitive advantage is anything that gives you an advantage against others attempting to satisfy the same need. But there are many points along the supply chain where you can gain such an advantage. You can control the point of purchase by ensuring yours is the only product offered. You might have an exclusive right to a geographical region for the only product which satisfies the need. If there is a unique component, ingredient or area of knowledge required to produce the solution, you might own or control the supply. Your objective is to own the customer solution and there are many ways in which that can be achieved of which patents are only one of many possibilities.

There are of course a number of more obvious barriers to entry including brands, copyright, licenses and patents. But being able to take advantage of significant economies of scale or learning curve effects might give you a cost advantage.

Patents are useful because they are an obvious source of competitive protection, but in themselves really don’t drive growth potential. If we focus too much on the patent element, we are in danger of missing the real growth drivers which are resident in the problem being solved and access to willing and easily addressable customers.

Given that most of the Angel exits are via a trade sale, our focus on competitive advantage and growth potential should be from the viewpoint of the buyer not the venture itself. It is the ability of the buyer to take advantage of the competitive advantage position which results in the higher exit values. This is especially relevant where the venture itself is not able to fully exploit the advantage. For example, a weak open market competitive position may change dramatically for an acquirer which can position the acquired product alongside a strong complementary product or inside a product portfolio. Similarly, a product which can be sold directly into an existing customer base may be very attractive to an acquirer even if it not the best stand alone product in the market.

In evaluating a venture, especially for a strategic value exit, we need to take a broad view of competitive advantage and look at the revenue possibilities of the acquisition from the buyer’s perspective given the buyer’s ability to exploit the underlying potential. In this regard, the ability of the buyer to rapidly deploy and scale the acquired asset or capability is of much more importance than the strength of any underlying patents.