Wealth Systems: Direct Investing, Part III
Making money is hard.
Keeping it is arguably more difficult.
Most people can’t help themselves, they increase their surface area as soon as they get money.
First they buy all the nice things they wanted.
Soon some well-meaning friend or perhaps a financial manager convinces them to “slow their spending, start to invest”.
That’s when their wealth really starts to degrade.
Investing into things comes with friction. Closing fees, commissions, bid-ask spreads, load fees and other costs related making an investment.
Then there’s insurance premiums, management fees, custodial fees, taxes of 57 varieties and so much more.
You see simply owning assets costs money.
Time to sell those assets you just paid to acquire and maintain?
You guessed it - more expenses.
Direct Investment
Doing a direct deal comes with tons of expenses too - money spent sourcing deals, conducting due diligence, monitoring your holdings, etc..
You can’t escape fees and financial friction, but you can work your strategy to mitigate them.
For example, if you have a strong personal network that contains other private investors you can externalize sourcing costs. For the price of a coffee and enjoying a great conversation with a friend you can learn about the latest private placements on Wall St.
You should evaluate ways to externalize as many of your operating costs as possible.
Due diligence is a prime example where you can externalize partially — you can’t invest in something without doing your own analysis. That doesn’t mean you need to execute all the supply chain analyses and market breakdowns by yourself. There is an endless supply of research material, due diligence portals and other resources published freely on the internet.
Fold these resources into your different investment motions — scanning opportunities, evaluating them, timing market entrances, etc…
Let’s zoom out and look at the Direct Investment process as a step-by-step process.
The Direct Investing Process
Step One: Preparation and Strategy
Define your investment thesis:
What industries or sectors interest you?
What stage of companies are you targeting (seed, early-stage, etc.)?
What is your risk tolerance?
What are your expected returns?
How much capital are you willing to allocate to angel investing?
Build your network:
Connect with other angel investors, venture capitalists, entrepreneurs, and industry experts.
Attend industry events, conferences, and pitch competitions.
Step Two: Deal Sourcing
Leverage your network:
Let your contacts know you're actively looking to invest.
Ask for referrals and introductions to promising startups.
Utilize online platforms:
Explore angel investment platforms and crowdfunding sites.
Attend pitch events and demo days:
Get exposure to a variety of startups and their pitches.
Step Three: Initial Screening
Review pitch decks and executive summaries:
Evaluate the business idea, market opportunity, team, and financials.
Identify any red flags or concerns.
Conduct preliminary interviews:
Talk to the founders to assess their vision, passion, and expertise.
Step Four: Due Diligence
In-depth market research:
Analyze the market size, growth potential, and competitive landscape.
Identify key trends and potential disruptors.
Financial analysis:
Review financial statements, projections, and key performance indicators.
Assess the company's burn rate, runway, and capital needs.
Customer and product validation:
Talk to customers to understand their needs and pain points.
Evaluate the product or service and its value proposition.
Team assessment:
Evaluate the founders' experience, skills, and track record.
Assess the team's dynamics and ability to execute.
Legal and regulatory review:
Review any contracts, agreements, and intellectual property.
Ensure the company is compliant with relevant regulations.
Reference checks:
Talk to former employees, advisors, and investors to get insights on the team and company.
Step Five: Valuation and Negotiation
Assess the company's valuation:
Use comparable company analysis and other valuation methods.
Negotiate the terms of the investment:
Determine the equity stake, investor rights, and board representation.
Step Six: Investment and Post-Investment Management
Complete the investment:
Execute the legal documents and transfer funds.
Provide ongoing support and mentorship:
Offer guidance and advice to the founders.
Help the company with strategic planning and business development.
Leverage your network to connect the company with potential customers, partners, and investors.
Monitor the company's progress:
Attend board meetings and review regular updates.
Stay informed about the company's performance and challenges.
Step Seven: Exit Strategy
Have a clear exit strategy in mind:
Potential exits include acquisitions, IPOs, or secondary sales.
Be prepared for a long-term investment horizon:
Angel investments typically take several years to realize returns.
“Begin with the end in mind” is excellent advice for investors and founders alike.
Angel investing is easy to get into, and difficult to get out of — another piece of advice to keep in mind. Understand these deals have a long tail. They take a long time to reach liquidity of any sort, good or bad.
We’ll exit with some quick-hit tips to improve your process each step of the way.
1. Preparation and Strategy
Niche Down: Don't try to be everything to everyone. Focus on industries where you have experience or genuine interest. Your passion and expertise will shine through.
Set Realistic Expectations: Angel investing is high-risk. Most startups fail. Aim for a portfolio approach, expecting some losses but hoping for a few big wins.
Network Strategically: Don't just collect business cards. Build relationships with people who can introduce you to quality deals and offer valuable advice.
"Invest in Lines, Not Dots": One investment rarely makes a difference. Invest consistently over time to build a diversified portfolio and increase your chances of success.
Consider Syndicates: Joining forces with other angels can pool resources, share due diligence, and provide collective wisdom.
2. Deal Sourcing
Be Proactive: Don't wait for deals to come to you. Attend events, reach out to founders, and let people know you're actively investing.
Filter Ruthlessly: You'll see far more bad deals than good ones. Develop a quick "no" trigger to avoid wasting time on obvious misfits.
"Warm" Intros are Gold: Referrals from trusted sources carry more weight than cold calls. Cultivate relationships with people who have a good track record.
Go Beyond the Hype: Hot trends come and go. Focus on the underlying problem the startup is solving and whether there's a sustainable business model.
Trust Your Gut: If something feels off about the team or the opportunity, walk away. Intuition matters, especially in early-stage investing.
3. Initial Screening
Read Between the Lines: Pitch decks are sales tools. Look for clarity, substance, and evidence of traction, not just flashy slides.
"The Team, the Team, the Team": Early-stage success hinges on the founders. Evaluate their experience, passion, resilience, and coachability.
Market Matters: A great team with a mediocre product in a shrinking market is a recipe for disaster. Assess market potential and competitive dynamics.
Ask Tough Questions: Don't be afraid to challenge assumptions and probe for weaknesses. The founders' responses will reveal a lot.
"No" is the Default: Most deals won't make it past this stage. Be decisive and move on quickly if you're not convinced.
4. Due Diligence
Dig Deep: This is where you separate serious investors from tourists. Verify claims, talk to customers, and leave no stone unturned.
Financial Forensics: Don't just take projections at face value. Understand the key drivers of the business and stress-test assumptions.
"Reference Check Everyone": Talk to former employees, customers who churned, and anyone else who can provide an unbiased perspective.
Legal & IP Review: Don't skimp on this. Make sure the company's intellectual property is protected and there are no hidden liabilities.
Red Flags: Pay attention to inconsistencies, evasiveness, and a lack of transparency. Trust your instincts if something doesn't add up.
5. Valuation and Negotiation
Understand the Dynamics: Early-stage valuations are more art than science. There's room for negotiation, but don't lowball or overpay.
"Fair" is Subjective: What's fair to the founders might not be fair to you. Find a balance that aligns incentives and allows for future growth.
Terms Matter: Equity stake is just one piece of the puzzle. Negotiate board seats, protective provisions, and other investor rights.
Don't Get Greedy: A smaller piece of a bigger pie is often better than a larger piece of a stagnant one. Focus on long-term value creation.
Walk Away if Necessary: If you can't reach a mutually agreeable deal, don't force it. There will be other opportunities.
6. Investment and Post-Investment Management
Be a Value-Add Investor: Offer your expertise, connections, and support, but don't micromanage. Founders need autonomy and energy to succeed.
"Mentorship, Not Management": Guide and advise, but let the founders make the final decisions. They're the ones in the trenches.
Regular Communication: Stay informed about the company's progress, challenges, and needs. Be available when they need you.
Celebrate Wins, Acknowledge Losses: Startups are a rollercoaster. Be there to cheer them on and offer support during tough times.
"Exit is Inevitable": Have a plan for how you'll eventually realize your investment. But don't rush the process or push for a premature exit.
7. Exit Strategy
Align with Founders: Discuss exit expectations early on. Make sure you're on the same page about timelines and potential outcomes.
Be Patient: Angel investments typically take 5-7 years (or longer) to mature. Don't expect a quick flip.
"Liquidity Events are Rare": IPOs are the exception, not the rule. Acquisitions and secondary sales are more common exit paths.
Think Beyond the Money: A successful exit is about more than just financial returns. It's about helping build a lasting company and making a positive impact.
Celebrate Success, Learn from Failures: Every exit, good or bad, is an opportunity to reflect and improve your investment approach.
Remember, direct investing is a journey, not a destination.
You are adding energy to ideas and people at key times in their life cycle… it is an exciting and sometimes too exciting career.
It takes time, dedication, and a willingness to learn and adapt. By following these practical tips and staying true to your investment thesis, you can increase your chances of success and make a meaningful contribution to the startup ecosystem.
The Road Ahead
In Part IV we will transition from diligence to dealmaking aka negotiating terms and structuring the deal.
Part V we will discuss the often missed post-investment period. Not just monitoring (but absolutely monitoring) but enabling / accelerating. Getting the team resources they need, access to clients and prospects, and so much more.
We will conclude with a collection of best practices I’ve collected to make you a more effective investor and entrepreneur.
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