How do investors evaluate startup pitches?
by Oliver Jones (Angel Investor Network)
This post is adapted from an article by Oliver Jones in Angel Investment Network’s Learn centre. The original article advises angel investors on how to evaluate investment opportunities. This article is for the benefit of entrepreneurs.
An angel investor’s task is to predict the potential of a company based on early indications and very little else. There is no infallible process for doing this. This is the risk investors face; and the fear they must overcome to invest. Only then can they give themselves a shot at the returns available from a shrewd investment.
Your task as an entrepreneur seeking finance is to mitigate and alleviate that sense of fear and so lower each investor’s risk threshold. The two basic ways of doing this are:
1 – Demonstrate that the perceived risks are smaller or more easily overcome that they initially appear.
2 – Set out a credible vision for the success of the business such that the returns outweigh the risk.
This, you might argue, is easier said than done. And you’d be right.
In my experience, entrepreneurs who understand how investors assess deals, find it easiest to raise money. It’s part of the reason why people who’ve raised money before find it easier to do it again.
So this begs the question, how do investors evaluate startup deals?
As I touch on above, this is a hard thing to get right for investors – a company may tick all the boxes, but still fail down the line. But this is often a matter of luck and down to factors beyond the investors’ control.
In their evaluation steps, investors can take measures to ensure that the companies they do go into have the best chances of success.
So here’s a simple evaluation framework that we recommend to investors on Angel Investment Network. We base this on our own experience from 12 years’ hand-selecting startups for our brokerage division. Companies we’ve worked on include: SuperAwesome , SimbaSleep, Novastone, What3Words, Opun and Cornerstone .
A Simple Evaluation Framework:
We interviewed Jos Evans who has made a number of successful investments through us. Jos gave the following advice:
“Everything comes down to the quality of the founders. If the people are excellent they will succeed regardless of whether the initial business idea works. Meet as many people as possible and cross check your network for people who might know the founders of a company you are considering investing in.”
This is sound advice from someone who is making a career from angel investing.
It is the people behind a company led by the founders and validated by their advisory board that will optimise its chances of success. If the founders are relentlessly resourceful they will find the iteration that makes the company a winner.
In their due diligence, investors spend a long time researching the founders’ backgrounds. They also often try to spend time with them on the phone and, if possible, in person. The qualities that come across go a long way to giving investors confidence and lowering their risk threshold.
Similarly, the strength of the company’s advisory board can be a very strong index of potential:
1 – It reflects well on the founders if they have managed to persuade impressive people to back them.
2 – The fact that impressive advisers have backed the idea lends credibility and validation to it.
3 – The financial and social clout of high- profile board members means that the idea will struggle to fail. propelled on by a strong support network, companies tend to find a way.
Which is the more significant indicator of success – the team or the idea/market? This is an ongoing debate between investors.
Renowned US investor, Ron Conway, believes, like Jos, that the team are the foundation. The idea is liable to change, but the team’s motivation, talent and competence will remain to drive the project to success.
Other investors argue that great founders in a bad market are far less likely to succeed than bad founders in a great market.
But to polarise these two points of view misses the point a bit. Good founders will find good markets – otherwise they are not really good founders.
So, in your pitching docs you need to make sure you give clear details on the market opportunity. Are you pitching a scalable opportunity in a market of sufficient size and growth trajectory? And are you doing it at the right time?
Here is the advice we give to investors when they evaluate the market section of a pitch:
“…you want to research the market to ensure the opportunity is or will be as large as the founders claim. If your findings confirm theirs then you can feel comfortable that a) there is a significant market and b) the founders know what they’re on about!”
Remember, your pitch/business is as representative of you as you are of it. In trying to sell your pitch to investors you need to sell yourself and vice versa.
Investors want a startup investment to have as much real world proof of concept as possible.
What better way to give confidence? If you can exhibit positive feedback, high user retention, growing revenues, etc at an early stage, it proves the venture (as far as possible!).
The more traction a company has, the more ‘proven’ it appears and thus the less likely it seems that it will fail. When we remember that persuading investors is about lowering their risk threshold, it’s clear how important traction points are. Traction points instil confidence in the vision and its execution.
They are as close to evidence as an early-stage startup is likely to get.
An obvious concern for early-stage companies is that they feel they may lack traction. They are especially likely to feel this way if they are not generating revenue.
So what constitutes traction?
Traction is anything that validates your business. This will depend on the business: sometimes it will be revenue; sometimes it will be downloads or subscribers; sometimes it will be page views or awards.
In their efforts to provide traction points for their startup, entrepreneurs often make the mistake of relying on ‘vanity metrics’. For instance, an app may have had 100,000 downloads in its first month. But if 97% of those users never use the app again, the initial metric flatters to deceive. Most investors will work this out very quickly.
So the traction points you choose must actually prove the value of your business or they will undermine your pitch.
The best way to think about this, I have found, is to work out what your North Star Metric is. North Star Metric is a term coined by Growth Hackers to describe the one authentic value which shows that the business is doing what it set out to do.
The points above help qualify the idea itself as valid. But we should not underestimate the effect of gut feeling when it comes to an investor’s initial assessment of an idea.
The timeless human fondness for the ego means that an initial gut feeling can have a powerful effect on the ultimate evaluation of the investor.
If an investor feels that an idea is good, they want to be proved right.
So when an investor first reads about an idea, if they think it is a real solution to a real problem in a real market, they are likely to pursue the opportunity. They want to vindicate their instinct.
This is a classic example of cognitive bias. This is the term used in psychology to describe when it is hard to undo your initial judgment because your brain will keep finding evidence to support that judgement.
It’s why the hotel industry focuses so hard on the initial impression it creates in the lobby. If the atmosphere and décor feel high-end and luxurious and you are handed a complimentary glass of champagne, your whole stay will be filtered through the lens of this initial assessment. If the lobby is grubby, your bias will lean in the opposite direction.
This can be capitalised on by entrepreneurs. When you set out what your business actually does, do so in such a way that plays up to this bias. Make a clear and powerful first impression.
The visual impression of the design of your pitch deck is very important. But so is the clear articulation of your value proposition.
We tell investors to assess whether the business is offering a real solution to a real problem. So, entrepreneurs should set out their idea using this ‘Problem/Solution framework’.
Here’s a quick example of what I could write for Angel Investment Network:
Problem: The startup industry is huge, but access to finance and investors remains difficult for entrepreneurs…
Solution: Angel Investment Network’s platform connects entrepreneurs with 130,000+ angel investors from around the world so that they can realise their potential and grow a lucrative and successful company….
The principal value of the service comes across clearly and concisely.
5. What do other investors say?
We have seen how the advisory board can be considered a metric of sorts for future success. It follows from this that other investors can be invaluable sources of insight.
Many investors say it takes away a lot of the stress if you can share the experience. That’s why syndicates, both official ones and groups of like-minded friends, are so popular. Others may have spotted some key index of potential (success or failure) that one investor on their own may have missed.
If you already have investors on board, it is, therefore, a good idea to ask them if you can share their contact details with prospective investors.
This transparency is likely to give investors confidence in you. And allow them to allay any fears they may have by talking to people who have already invested. One caveat to this is that a prospective investor may point out a flaw that the existing investor may have overlooked!
There are many factors that any individual investor may take into account when they evaluate an opportunity. This article has aimed to cover the most general and universally useful for entrepreneurs.
But you should expect each new conversation to be different. Every prospective investor wants to see whether you are a good fit for their personal investment agenda.
On that note, it is worth saying that you should never take it personally when someone decides not to invest. It is a) a huge waste of emotional energy and b) pointless. There are so many reasons why someone may choose not to invest. One of our entrepreneurs once became despondent because a good investor had withdrawn. Little did they know it was because of a divorce!
Rejection is also a good opportunity to get candid and constructive feedback from people with real expertise – sometimes what hurts the most is the most useful in the long run.