Beware of (some) Angel Group’s Due Diligence

Not all “due diligence” is created equal.

There are hundreds of angel groups all across the country, and each one has a different flavor. Some are occasional “dinner clubs” fashioned after Shark Tank, where a couple startups pitch and investors might make an investment on the spot. Others are extraordinarily sophisticated in their screening, mentoring, education, and management of investments.

Each angel group is a different experiment on how to create, run, and manage a group of angel investors. Each group tries different ways to address different needs, and each group goes through different stages of a lifecycle.

One of the common themes amongst angel groups is due diligence.

Angel groups *can* be very effective at due diligence

Angel groups are populated by angel investors. Angel investors are typically more experienced people who have had success in business. They have deep knowledge and experience in their field, and, when put to use, their insights can be extraordinary. Here is a list of the Members of the Angel Capital Association, for example.

I am a member of Frontier Angels in Montana. At one of our recent meetings, a company was pitching a obscure medical device. After the pitch, there was a discussion in the room about the pitch. It turned out that two people in the room had deep, deep experience in the exact technology and a rich history of other startups in the space. As an individual investor, I would never had their perspective and experience. But in an angel group, I take advantage of that expertise.

What do I want from due diligence?

Personally, I prefer to hear the opinions from other angel investors who have deep industry knowledge. I want their opinions. I want to know the good – but more importantly – I want to know the bad. (Here’s my guide to due diligence for IP and patents. You might also be interested in this webinar on startup due diligence.)

I want the expert CPA to dig through the financials. I do not have that expertise, but I want to know what they think about it. Is the company well run? Do they have enough capital to get to the next milestone?

I want the manufacturing and supply chain expert to look at the company’s supply process. I want the marketing expert to evaluate their marketing and advertising processes and budget. I want the securities lawyer to go through the corporate structure and agreements and render an opinion.

I want to know where the strengths lie, but also the weakness. Why do I want to know the weaknesses?

Weaknesses can be addressed.

We can find an expert in marketing to offer a better strategy. We can find a person who knows about design for manufacturing. We can provide sound guidance from ex-CEOs who have managed multiple companies.

Having weaknesses does not mean failure, it just means the next things that need to be addressed. The point is to make the company better, not to humiliate the founder.

Characteristics of good due diligence.

Our angel group does due diligence for internal consumption only. Our due diligence is never shared with the entrepreneur. This is because our due diligence reports contain both the good and the bad.

Our group may have legal liability if we broadcast bad news about a startup in writing. An entrepreneur can sue us if our due diligence is factually incorrect and we have (perceived) negative opinions about the entrepreneur’s prospects.

Consequently, any angel group that allows their due diligence to be public – or even gives a copy to the entrepreneur – walks into a liability minefield.

Some groups, like ours, keep the due diligence reports confidential.

Others, give the entrepreneur a copy and allow them to share it publicly. This changes the dynamics of what goes into the due diligence report.

“Happy” due diligence reports are evil.

Some angel groups write very “happy” due diligence reports. I call these “happy” due diligence reports because they refuse to say anything bad. There is no critical thinking, no expert analysis of the risks, and never – ever – say anything bad.

I was in a due diligence class for an unnamed angel group and I asked: “What do I do if I uncover something really bad? Do I point this out so my fellow angels so that they won’t invest?”

The answer was: “You never say a thing.”

The only appropriate action, at least from the due diligence instructor, was to resign from the due diligence team. I was not allowed to say why I resigned, either.

In other words, every due diligence report needed to be “happy” in every aspect. There could be no critical analysis.

Happy due diligence reports cover up the bad – and many do so intentionally. Why?

Why do angel groups write “happy” due diligence reports?

Follow the money.

It takes a lot of effort to run an angel group.

It takes a lot of effort and money to run an angel group. There are costs for renting a room, providing food and drinks, and putting on the “show” of a meeting. There are staff who plan the meetings, send out invites, register attendees, and so on, which is a lot of work.

Behind the scenes, there are staff who find the startup companies to present, then wrangle the cats to show up at the meeting. This involves weeding through countless pitches from budding startup CEOs, finding the ones that meet the angel group’s criteria, and then getting investors to take time out of their lives to show up at the meetings.

Once a deal is pitched, someone needs to get the commitments from the investors, organize a due diligence team, and circulate paperwork for everyone to sign. They also create a special purpose LLC corporation, handle the yearly tax paperwork, and sometimes take a board seat on the portfolio company.

This is no small task. And someone needs to pay for it.

Follow the money.

Each angel group works on a different type of financial model. Most angel groups take a percentage of the ‘carry’ if and when an investment returns money. This model means that the angel group gets funding when their investments perform well, which is great. However, most angel investments may take 5, 10, or even 15 years before they return any money at all.

This means an angel group needs to cover their immediate expenses long before they see any ‘pop’ from a great exit.

Most angel groups charge some kind of membership fee. Some charge per meeting, which might cover the dinner and drinks. Typically, angel groups charge an annual fee. For many groups, the annual fee might be a few hundred dollars to a few thousand dollars.

Charging startup companies money to pitch to investors makes the startup the angel group’s ‘customer.’

Some angel groups charge startup companies to pitch to investors. This kind of fee can help ‘weed out’ startups who are not serious. But it can have a very negative effect.

One of the problems with charging startups, especially if the charges are very high, is that the startups become the customer, not the angel investors.

When the startups are the “customers” of an angel group, due diligence seems to suffer.

If a startup is paying a lot of money to pitch to the group, they expect a good return on their investment. What startup will pay tens of thousands of dollars if they do not get funded?

Consequently, the due diligence for these types of angel groups tend to be overly optimistic “happy” reports that never criticize the startup.

When the investors are the “customer” of the angel group, there is much less motivation to promote the company with unrealistic due diligence reports.

Assets under management versus return on investment.

Many angel groups have “side car funds” or other investment vehicles. These are fantastic ways for angel investors to put in a bit of money, maybe $25,000, and have it invested across many startups.

It is a well-worn mantra that you need to invest in 10 or 20 startup companies to have a reasonable return over time. To invest $10,000 in 20 different startups means a $2M total outlay, but by participating in a fund, you can get the same exposure with a much smaller investment.

The classic venture capital fund has a 2% annual management fee and a 20% success fee. This means that 2% of the fund pays the salaries and costs of the managers, and the managers also get 20% of the back-end profit of the fund.

The funds for many angel groups are relatively small, maybe $2-5M. However, there are some angel groups with much larger funds in the range of $20M or even $50M. A 2% management fee on a $50M fund is $1M/year. This size fund can provide a huge revenue stream for an angel group.

In fact, once this level of fund size is reached, the focus changes from return on investment to assets under management.

The smaller funds live or die by their returns. If the fund does well, the managers get paid. But for larger funds, the annual 2% management fee is so big that the managers do very well – even if the fund does poorly.

I have seen several angel groups where their assets under management have begun to get very large, and this changes the dynamic of the group.

When the primary focus is making good investments, the group is scrappy and intensely focused on finding good companies.

When the primary focus is on assets under management, the angel group seems to lose its way from my viewpoint. These angel groups have the flexibility to pander to special interests, indulge in strange investments, and promote various political or ideological causes that have nothing to do with identifying and investing in companies who will be successful.

Every angel group goes through growth phases.

An angel group typically starts out with a few investors who look at deals and make their own investments. If the group can stay together long enough for one or two of those investments to pay off.

With one or two successes, other investors “see the light” in angel investing, and the group has a growth spurt.

With more investors, the group can provide more funds to startups, meaning they attract better startups. It is a virtuous circle.

At this growth phase, the angel groups start formalizing their due diligence processes, get better at creating and managing their special purpose investment vehicles, provide better oversight and management of the startups, and overall become more “professional.”

This is where angel groups sometimes can rapidly accelerate – or they can lose their focus.

Professional, full time managers can have an enormous impact on an angel group. They can set up educational content, add programming for new angels as well as entrepreneurs, and build the group through outreach into the investor community as well as the startup community.

At the same time, the larger the organization, the easier it is to lose their way.

Angel groups can lose focus on making good investments when their time, energy, and money gets spent on other causes. Yes, it is important to become a meaningful, helpful part of a local or national startup ecosystem. But that can take away from the core purpose of finding and funding good startups.

There are many very well organized and sophisticated angel groups across the country. Each has its own quirks, but all of them are experimenting with what works for them and what does not.

Thankfully, most of them are trying different strategies and pushing the boundaries in their own way.