Bad Behavior By Angel Groups -“Due Diligence”

Due diligence is supposed to help investors and the entrepreneurs, but many times it is a charade.

I am a member of several angel investor groups, and I am intimately familiar with many more. In general, angel investor groups can be a positive force for good: they teach entrepreneurs and angels how the investing system works, they put guardrails and guidelines in place, and they help get funding for entrepreneurs.

However, there is something more important: due diligence.

Due diligence is heralded as the most valuable aspect of angel groups, and the reason why you should pony up $1500 a year for membership, pay 2% management fee and give up 20% of your return.

Due diligence in an angel group is sold as bringing in all the resources of the group: the marketing expert, the financial expert, former executives in competing or complimentary businesses, and, on rare occasions, someone who knows about patent law.

The value of due diligence is that the group should be more comprehensive than an individual investor could be. Until it isn’t.

Thorough Due Diligence is the Most Loving Act.

In my view, due diligence should help the entrepreneur (and the investor) by uncovering areas that can be fixed and improved. And this is where an angel group adds immeasurable value.

For example, a startup company who might be less than proficient in marketing may be able to tap an angel group member with a marketing background. A former executive at a medical device company may be a great resource for an entrepreneur developing a product that would fit in the executive’s former company’s product line. An angel investor with technical expertise may be able to help with difficult design choices.

We uncover these deficiencies through due diligence, and an angel group can identify people who can help grow the startup.

Parsing Good vs Bad

Most new angel investors come from backgrounds of success. A canonical example is a retired (or nearly-retired) executive, business owner, doctor, or other professional who is intrigued by the startup ecosystem and wants to participate. They have deep experience in their successful career, but do not know how the “game is played” with startups.

For these angel investors, the startup ecosystem is full of weird and incomprehensible nonsense (e.g., convertible notes with drag along rights). It is hard for them to know what is good and what is bad. It takes experience to know where the land mines are buried, as well as how to know what might go wrong.

The angel group should have that experience, and it should be helping new angel investors identify red flags that would cause problems down the road. The best insights by experienced angel group leaders are always the war stories about problems that blew up a startup. This institutional knowledge is the angel group’s most valuable resource, and it helps protect the group’s members from investing in known problem companies.

What If We Find Something Bad?

I was considering joining yet another angel group, and as part of the onboarding process, I took the group’s class to become a member of their due diligence team.

During the class, I asked what should I do if I find a problem with the company, such as a huge problem that we should avoid the startup as radioactive.

The instructor said that I should NEVER SAY ANYTHING. He said that I should resign from the due diligence team and that “sends a signal.” The group would plow forward with due diligence, issue their report, and (presumably) invest in the company.

I was dumbfounded.

I asked “How could you say you run a ‘due diligence’ process?” The answer was that every angel investor signs a document saying that they do not rely on any recommendations from the angel group and that they make their own investment decisions. In other words, our diligence does not matter.

I did not join this angel group.

The Push To Invest vs Whats Best for the Angel Investors.

I often get a chance to opine on patents for a potential investment. On the eve of investing in a potential startup company, I get an email to evaluate a company’s patent from an angel group leader.

When I evaluated the patent, I am shocked to find evidence of criminal fraud by the entrepreneur, fraud against the USPTO, flagrant improper conduct by the patent attorney against USPTO rules, and countless other problems.

These problems were so severe that I am obligated to report the conduct to the USPTO Office of Enrollment and Discipline.

I immediately received a desperate phone call from one of the leaders of the angel group.

They were all set to invest in the company, and I was ruining their process. They were worried about how their own personal reputations if it came out that we uncovered some of the worst fraud against the USPTO that I have seen in 25+ years.

Think about that: they were worried about their reputations if the truth came out.

They were not concerned that their members would invest in a company with serious shortcomings and lose all their money. They were not concerned that other angel groups already invested in the company and were unaware of the problems. They were not concerned that the entrepreneur may or may not be aware of the issues.

They were concerned that they would look bad if they found a problem this late in the process.

I don’t understand this.

The biggest value that an angel group can have is to identify problems using their collective expertise and either (1) fix the problem or (2) avoid investing if the problem cannot be fixed. Here, the angel group wanted neither.

What I don’t understand is why an angel group leader would “protect their reputation” by hiding the truth.

I would think that this could be handled by quietly and discreetly alerting a board member about the issue so that they can investigate and take whatever action they think appropriate. For our angel group, we should discuss what we found so that the members see the value in our collective wisdom and get more comfortable raising questions and adding to the conversation.

We need not humiliate other investors, but we can help them understand the severity of the issues. Not only will this make them better angel investors, but it will help them guide entrepreneurs to avoid these problems in the future.

By sharing our findings in a discreet, thoughtful, and encouraging way, we would make the entire ecosystem function better.

But the angel group leaders were worried that making the ecosystem better would HARM their reputations.

The Shameful Scam of Angel Groups.

I always say “follow the money.”

I have tried out many angel groups, always looking for the leaders who had enough integrity to pass on investment after investment until we found a good one. At the end of the day, angel group leaders get paid for doing transactions, not on the outcome of the transactions.

They are not paid on whether the investment turns into a unicorn, but whether they can pitch a company at a dinner event and the group writes a check. If the group invests, the angel group leader’s “reputation” is good. If they do not invest, the angel group leader’s “reputation” is bad.

I have been pressured by angel group leaders to avoid asking hard questions and to just blindly invest. In fact, I have had angel group leaders yell during deep dive calls when the questions started uncovering issues that prevent further investment.

I am a Believer, but not a Follower.

I am still a believer in angel groups. I cannot give up my optimistic hope that there are leaders with integrity that really, truly want to make good investments. I believe that there might be good angel groups with the integrity to surface problems in a kind, loving way so that (1) the entrepreneur can learn and that (2) the angel groups can learn.

If there are angel group leaders with the integrity and determination to actually do thorough due diligence, please send them my way. I want to invest with you.